A View from the Trenches, January 12th, 2010: "On the volatility of fixed exchange rates"
Please, click here to read this article in pdf format: january-13-2009
As we woke up early on Tuesday, we learned that the People’s Bank of China had raised its auction rate on 1-yr bill by 8bps, or 100% higher than the expected 4bps. Together with lower than expected earnings coming from Alcoa, this set the stage for the profit taking that took place yesterday. Does it make any sense to raise rates for China? I think the answer is negative and because this may likely be the beginning of a tightening cycle, we now have to expect more volatility, which is EXACTLY as I anticipated in previous letters. On December 11th, a month ago, I wrote:
“…Next year will give us an environment with a US Treasury issuing more debt (and with longer average duration), with a still unsolved demand for Agency debt (once the Fed stops its bid in Apr/10), with the Euro zone falling into pieces, and with creditor countries in Asia exacerbating the USD peg. This is barely a picture of muted volatility and higher valuations…I am confident we will see effective policy action on all of these fronts. But, muted volatility? I don’t think so…” (www.sibileau.com/martin/2009/12/11 “Thinking about 2010”)
Briefly, with a bird’s eye view of the current situation, during last year in the debtor countries, we witnessed a transfer of risk (and losses) from the private sector to the public sector, and the public sector took the losses with leverage. Now, the public sector has to cover those losses. The leverage, partly came from monetization of public debt and from straightforward debt issuance. Let’s call creditor countries those whose governments and/or central banks are net buyers of such issuance. One of these creditor countries is of course China. As everyone knows, China has a fixed exchange rate regime. Under this system, with the trade surpluses they have, the USD accumulation forces the People’s Bank to issue Yuans, to maintain the exchange rate, which currently stands at 6.82+ Yuans/USD. It is difficult to sterilize the effect (i.e. the monetary expansion) of this accumulation process, because it requires to change the composition of the asset side of the balance sheet, and this side gets increasingly crowded with USDs.
The other simultaneous problem arising from this situation is that the continuous expansion of the local currency (in China’s case the Yuan) increases asset prices. Unlike a central bank with flexible exchange rate regime, if the People’s Bank of China wants to keep the currency peg, it cannot be a lender of last resort, if the asset bubbles caused by the monetary expansion go bust. Therefore, the path of least resistance is to directly intervene the credit (not monetary) expansion process, by raising policy rates. However, when rates (i.e. prices) are distorted, liquidity must adjust. But the demand for liquidity has a tangible counterparty in the real economy. If the People’s Bank surprises the market, it surprises the real economy as well, generating volatility.
I know that most of you understand this process very well. I bring it up however to point out two issues that I think are underestimated: a) the underlying source of volatility that this unstable situation represents for the whole world, and b) the shock that a delayed correction will bring either through a financial crisis in China or an appreciation of the Yuan (USD devaluation). As I mentioned above, the public sector in the developed (and also not so developed) world took the pain in 2009, but at some point, everybody needs to pay its dues.
Martin Sibileau
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