Dueling Central Banks, Devaluing Together

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On December 13, 1990, the Federal Reserve Board amended Regulation D to change the reserve requirement on all "nontransaction liabilities" at FR2900 weekly reporters from 3% to 1.5%. That was the first step in three that removed all reserve requirements for these types of accounts at all styles of regulated banks, as by January 17, 1991, even FR2900 quarterly reporters were allowed into the ruling. Collectively, spelled out under authority of the Federal Reserve Act, as amended by the Monetary Control Act of 1980, nontransaction accounts were afforded the same level of exemption as federal funds.

The federal funds marketplace had grown in size and scope under this regulatory favor to become more than just an adjustment in daily bank liabilities. Owing to financialization and modernization of banks after the Monetary Control Act, the proportion of bank liabilities raised from non-deposit sources greatly expanded. In relative comparison, deposits were an expensive liability and thus banks seeking greater capital efficiency became more interested in non-traditional banking methods.

This regulatory scheme thus favored the growing element of shadow banking and non-depository credit production. The 1990 reserve requirement changes were thus only belated recognitions to what banks were already pursuing. However, there was distinction that did not seem to be very well appreciated at the time. Eurodollar liabilities, or what the Federal Reserve calls Eurocurrency, were finally given full regulatory blessing. That meant eurodollar markets were equivalent to federal funds in terms of capital efficiency.

Almost immediately, eurodollar balances spiked above federal funds liability balances as banks noted the shift with their own favor. From 1990 until the middle of 1992, gross federal funds balances fell from about $300 billion to a little more than $200 billion. Over the same period, gross balances due to foreign related offices (eurodollars) increased from $200 billion to $300 billion. By 2003, eurodollar balances were double that of federal funds balances.

Despite the dramatic change in the relative importance of each wholesale market, Federal Reserve monetary policy was still only conducted in the federal funds market. That had never been a problem until 2007, owing to the close connection between New York and London - any potential policy shift creating a rift between federal funds and eurodollars was closed very quickly by banks seeking such arbitrage and transferring ledger dollars between New York and London.

The change in relative condition of both wholesale markets also began to reflect a change in the ultimate disposition of all those "dollars." Ostensibly, these foreign markets for the world's reserve currency are believed to be driven by trade concerns. In the early days of the eurodollar market, that was true.

With the US dollar as a reserve currency under the Bretton Woods gold exchange standard, the US was "obliged" to run a current account deficit in order to supply dollars to the global trade markets. That led inevitably to tensions with ultimate dollar holders since they rightly saw the mismatch as a potential inability of the US to convert dollars to gold at the official price. The result was numerous runs on US gold holdings as early as the 1950's, with a serious near-crisis leading to the creation of the London Gold Pool in 1960.

This monetary tension was called Triffin's Paradox because the monetarist system's creators were unwilling to force balanced trade either onto the US or foreign debtors, as a true gold standard would. The growth of the eurodollar market provided just the answer to Triffin's Paradox since it allowed trade in dollars to advance without any reference to the US current account. The US need not supply dollars into the international system because global banks operating in London and the Caribbean would do it for them.

In fact, most eurodollar trade in the earlier years (prior to the Monetary Control Act of 1980) was truly foreign. As the petrodollar system, as it has been called, became operational through eurodollar conduits, the origination and destination of trade rarely reached US shores. Middle Eastern oil producers could supply oil to importing nations, moving dollars in deposit accounts at these London banks, without ever having to directly access US dollars domestically.

As Milton Friedman helpfully illustrated in an essay from October 1969, eurodollars of this kind are not really dollars in either the classical sense or the more modern sense. Banks are the engines of dollar creation, using deposit accounts and lending to expand the "money supply", but typically all tying back to multiple claims on "reserves." In the traditional banking sense, reserves were US dollar currency, i.e., Federal Reserve Notes. As ledger money has overtaken cash, this distinction has been reduced, but it largely survives as the basis.

In eurodollars, that fractional system is taken to another level. There are still US dollar claims on US dollars, but it is now largely derivative and dependent on that accounting link between London and New York (or New York and Caribbean affiliates). What eurodollar holders are ultimately claiming is not reserves of US currency stored in vaults in London, but line items on US bank balance sheets. They are fractions of fractions.

That was rarely a problem in the international trade period, as faith in eurodollars as dollars was never seriously tested - even during or after the Latin Debt Crisis of the late 1970's and early 1980's. Again, oil export nations were perfectly happy to accept US dollar-denominated deposit accounts drawn on London subsidiaries of US banks (or of foreign bank branches with New York subsidiaries). The arbitrage opportunity of interest rates kept the accounting of "dollars" flowing back and forth enough for the system to fully function as it evolved.

Between 1990 and 2007, the eurodollar market grew to immense size and proportion. By 2007, eurodollar claims were almost a third the size of the total US dollar market. That growth in proportion could never have been driven exclusively by trade, instead it was increasingly devoted to financial arbitrage of various types. In 1984, the proportion of eurodollar markets applied to lending back to the US was negligible, less than 5%. By 1990, that share grew to over 20%; by the time of the housing bubble it was almost half. In other words, the eurodollar market was increasingly used as a source of dollars not for global trade but for lending and asset creation, and the lion's share of that growth happened after the 1990 reserve change. The occurrence of asset bubbles inside the US at the same time is not just correlation.

On the liability side, by 1980 US claims on eurodollar banks were about 45%, having risen throughout the 1970's as interest rate differentials and bank regulations favored eurodollars. After 1980, banks operating in eurodollars increasingly moved away from US-based funding sources. By 1995, eurodollar markets were 80% sourced by foreign "dollars." That changed again in the late 1990's as US sources moved back into that market, providing almost a third of the funding throughout the 2000's.

The net effect of these changing proportions was to transform dollars created for global trade into dollars created for the purposes of expanding financialization. Owing to regulatory divergences that remained after 1990, particularly the drastic differences between depository banks and investment banks, including European banks that were regulated far more like the latter, sourcing eurodollars for financial purposes was the logical course.

What was particularly odd was the European bank experience. These banks held numerous regulatory advantages over their American counterparts (which led these American banks to whine to Congress in the 1990's about how they could not compete, and thus to lobby for changes that would allow American banks to be more like their European counterparts in their own dollar markets or risk being overrun by the Europeans; leading ultimately to Gramm-Leach-Bliley) but rarely expressed that domestically inside the US. Instead, the eurodollar system evolved in the 1990's to where these European banks borrowed "dollars", largely sourced from money market funds, through their eurodollar subsidiaries transferring those dollars back to foreign offices.

On the other side, US banks were doing the opposite. They were increasingly sourcing "dollars" via eurodollar subsidiaries and then transferring them back to the US to fund their domestic operations. So where the European banks were enticing domestic dollars outside to be lent into eurodollar markets themselves, US banks were trying to source outside dollars to lend back in. Perhaps that is the nature of competition amongst markets, but more than likely it was regulatory concerns that drove both trends.

The focus of all of these "dollars" was "low risk", highly-rated debt securities that could readily be used as repo collateral - mortgage bonds and other structured debt products (including the initiation of synthetics). That meant a supply of loans and credit had to be developed for both systems simultaneously. Foreign banks would lend those dollars back into the US, just as US banks would lend those foreign "dollars" in US credit markets. Eventually they would run out of obligors, creating new classes of borrowers and credit products (subprime, Alt-A, NINJA) with the ready acceptance of political influence.

That was a direct reason for the growth of eurodollars in importance beyond internal dollar markets, and it was mostly unaccounted during the buildup. It does not show up in the current account balance because of that two-way trade - they net out. Further, it was a huge blindspot for both the banking system and the Federal Reserve as the potential for fragmentation was all but ignored. The system was regarded as seamless and, for all intents and purposes, unified. And it remained largely hidden to even the FOMC, as evidenced by the expression of surprise at the size of European conduits at the September 2007 FOMC meeting.

That meant nobody in position of monetary authority had any idea about the size of dollar markets, the depth of dollar expansion or the potential for drastic problem due to increasing fragmentation. Even when the FOMC voted in favor of implementing dollar swaps at the December 2007 meeting, it was still more of a token gesture to reassure markets than a concrete solution to the foreign dollar problem. In other words, it was a lack of appreciation of the fact that dollar creation and flow was far more complex than anticipated. Policy had never kept up with actual systemic conditions.

In the wake of all the changes that the dollar panic in 2008 caused, including the fragmentation between New York and London, the dollar system is again evolving. There are numerous trends conspiring here, not the least of which is the retreat of European banks from the borrow domestic dollars/lend eurodollars system. At the same time, due to uncertainty in eurodollar markets, as well as regulatory changes such as Dodd-Frank and FDIC assessments, US banks have drawn back on the idea of using "foreign dollars" as a funding source for domestic operations. The eurodollar system is devolving.

What we don't know yet is how that retreat might affect global trade financing, though we got some pretty strong indications as this summer's taper-driven fireworks suggested. The dramatic slides in emerging market currencies were not local affairs, they were directly related to dollar conditions in eurodollar markets. How much of those drastic devaluations were related to this devolution is not clear, but it would be unwise to ignore the potential relation.

Just as the FOMC was surprised by how large the foreign dollar market had become, it is highly likely, in my opinion, that they might be equally surprised by how much it has shrank in the years hence. While the BIS and other sources track what they can, the truth is that nobody has any real idea about these dollar markets, their size or reach, or how far they might be retreating. Again, the emerging market crisis of this summer (that may already be renewed) hints at further stresses than are readily apparent.

Much of these complex interactions will be beyond any capacity to predict. On top of that, we have dueling central banks appealing to monetary debasements at the same time, driving even more uncertainty into a system undergoing a tremendous phase shift. Right now, most of the inferred dissatisfaction with US dollar policy has been focused on that debasement, but that was before the summer's realizations. While we may never know just how much global trade concerns influenced the FOMC decision in September, and you know that emerging market officials were delivering to Washington their observations, it may well be out of the hands of policymakers.

After all, the growth of eurodollars was mostly driven in the dark, unseen by authorities except the occasional notice of "bubbles", but no causality was ever assigned or even contemplated. The removal of dollar growth in the same arena may well be solely reliant on banks, including those European and foreign banks that were nearly destroyed by their dollar experimentations. So as much as trade concerns, particularly with regard to China, are being expressed as dissatisfaction over the "inflationary" dollar, it may be more likely that it is just this total instability in either direction. A reserve currency is supposed to provide the opposite, though it has not for some time now, and may not for some time yet.

 

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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