'Billion' Now Seems So Quaint As a Mere Rounding Error

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There had been two speculative attacks only a few years previous against the Thai baht, successfully defended by monetary officials in Bangkok. Related to the Mexican peso crisis, in January 1995 the baht started to drop against the floor set by the peg to the US dollar. It followed up again in March 1995, this time as the yen began an astonishing turn upward in the face of a stalled economy in Japan. In both cases the speculators were unsuccessful in forcing a devaluation.

The Bank of Thailand approached both episodes exactly the same. Encased in an economy dubbed one of the "Asian Tigers," the Thai central bank had, it believed, sufficient margin to defend the dollar peg by raising interest rates. An increase in short term spreads of 300 basis points (to 800 basis points over US dollar LIBOR) made the baht more attractive for new investment, but it also dramatically (and fatally for some speculators) increased the cost of shorting the baht. Since shorting requires borrowing, the extra 300 basis points made it prohibitively expensive to maintain and initiate short positions.

By late 1996, however, the economic picture was far less assured. The Thai stock market, one of the prime emerging market wonders of that decade, had already fallen 45% from its high earlier that year. So much of the economic "miracle" was simply the application of "hot money" into the property sector through domestic financial conduits. Easy money, as we well know, portends bad investments in alarming disproportion.

To maintain the dollar peg, initiated in 1985, the Bank of Thailand was forced to buy dollars in the open market and sell baht into the domestic economy. While that maintained the export competitiveness of its manufacturing sector, it also blew a huge bubble not unlike that seen in Japan only a few years before. Over the course of the early 1990's, the Bank of Thailand had accumulated some $30 billion in foreign currency "reserves", nearly all in US dollars.

While that seemed like an ample war chest to fend off any additional speculative attacks on the baht, the Thai central bank found itself on the brink of crisis in early February 1997. Somprasong Land, a large property developer, failed to honor a relatively small $3.1 million coupon on a eurodollar loan and thus effectively defaulted. It was quickly followed by a liquidity crisis as fears of losses spread to other financial conduits, including the systemically important Finance One.

After the Bank of Thailand failed a "cold fusion" of Finance One with another small Thai bank, shares in the troubled firm fell 70%, hastening another decline in the overall Thai stock market. Throughout this period, there was renewed and fierce speculation against the baht as foreigners withdrew from Thailand and the "evil" hedge fund "vultures" circled.

Initially, the Bank of Thailand responded by supplying dollars, running its reserve balances down. But that February, it changed tactics and engaged in forward swap operations. For some reason that still has not been adequately explained, the swaps were conducted not with other regional central banks (that had a stake in what was transpiring) but with the "market", ie., the speculators themselves.

By selling forward future baht against dollars, and doing so without increasing interest rates (the Bank of Thailand was now caught without a margin of safety since an increase in rates would only destroy other ailing financial firms), the Bank had no chance for success. It is estimated that these forward contracts (a large portion were for three month terms) depleted, off the books, Thai reserves to only about $1.5 billion.

Three months later, on May 14, 1997, the first wave of renewed depreciation speculation commenced. Without sufficient reserves and with the added problem of renewing matured forwards, the Bank was forced to allow the baht to trade outside of the peg on July 2. It lost 16% that day, and eventually devalued some 50% by January 1998, plunging Thailand into depression.

As it did, the baht's devaluation destabilized the entire Asian economic system. The other Asian Tigers were forced into the storm of devaluation, eventually destroying business and economy in nations all over the western edge of the Pacific. By 1998, one-fifth of Korea's thirty largest businesses were in bankruptcy. In Japan, Sanyo Securities became that country's first brokerage firm to file for court protection against creditors in the postwar era. It was followed closely by the insolvency of Yamaichi Securities, Japan's fourth largest brokerage firm, and Hokkaido Takushoku, one of its largest banks.

The Asian "flu" even pressed the Bank of Japan in November 1997 to essentially "beg" the Federal Reserve Bank of New York for dollars to distribute to its liquidity-challenged members. There were swap lines to be extended in all directions, to no avail as the depression dragged in economy after economy.

What is supremely odd about the entire episode is not that central banks made mistakes or that massive bad debt problems were coming to light at domestic banks, it was that reserve balances were viewed as sources of strength rather than what they really are - sources of instability. In 1996, Thailand was confident about the baht because it had accumulated so many dollars as national "reserves." Likewise, it is odd to think the Bank of Japan would need to find dollars for its banks having carried a current account surplus with the United States for so many years.

According to the IMF, in 1960 there existed about $62 billion (current dollars) in total reserves across the globe. About $40 billion (65%) was gold; $18.6 billion (30%) consisted of currency of various countries, largely dollars and sterling. The remainder was reserve positions at the IMF.

While there was not much change in global reserves between 1960 and 1970, by 1990, more than two decades after the swap standard was initiated, foreign reserve balances had grown to $1.3 trillion. Because it was an age of debt-based international finance (where debt balances never self-extinguish) lacking in the basic element of self-correcting trade and current account imbalances, countries all over the world began accumulating paper "currency" debt of their trading partners rather than suffer the natural adjustment of trade forces created by the gold standard (in whatever form). Of that $1.3 trillion, the proportion of gold had declined to 28%.

The distribution of those reserves had also begun to change radically. By 2000, total reserves worldwide had again grown significantly to $2.2 trillion. But whereas emerging nations held only 19% of reserves in 1960 and 1990, their share grew to 34% by the end of the 20th century. Increasingly, paper flowed to emerging nations as a means to avoid settling trade imbalances - only 12% was gold.

The decade of the 2000's, however, was simply astronomical in terms of paper reserve accumulation. Owing both to the emergence of China as an industrial player and the US dollar devaluation, total global reserves spiked to $12.1 trillion by 2011. And in proportion, the shift flowed again into emerging nations, now "owning" 60% of those paper reserves, some $7.3 trillion. While gold still accounted for 12% of the total across the globe, emerging nations' proportion of gold in their reserves was a negligible 4%.

So we see the great and massive trade and current account imbalances correspond with the decades of the Great "Moderation." It is easy to overlook this coincidence, particularly as it exists after both the implementation of interest rate targeting by the US Federal Reserve and the emergence of shadow banking in the wake of widespread adoption of the Basel bank rules.

In 1977, the monetary powers throughout the developed world, those responsible for the "rules of the game" regarding foreign exchange absent any part of the gold standard regime, worked through the IMF to establish exchange framework for floating fiat currencies. Article IV of the IMF rules was revised to include the notion of floating currency exchange under conditional agreement. Those conditions included a promise to avoid manipulating exchange rates to prevent balance of payments adjustments and an exhortation that IMF member countries take into account (no pun intended) the interests of other member nations when conducting interventions. It is not clear from the documents if participants had to pinky swear or engage in secret handshakes to fully codify these "rules".

Prior to the floating exchange world of the swap standard, markets were the primary forces behind global exchange balancing. The financial means of correcting imbalance was the private demand and supply of gold. That limited balances through scarcity. Scarcity in gold meant a hard upper limit against financial and trade imbalance, as well as paper devaluation and printing across national boundaries - the very limit central banks and economists loathe in their appeal to "flexibility". Flexibility is nothing more than the political process' intrusion into international currency markets, thus the need for IMF members to politely promise not to do interventions contrary to market forces.

To go from $62 billion to $12.1 trillion is not really just inflation, it is an episode of money printing of biblical proportions. The only reason there has not been a full-scale outbreak of hyperinflation is simply the mechanism of transfer among nations - the pile of paper gets passed from one to the next, broken only by episodes of extreme depression such as we saw in Thailand. As "speculators" forced the baht to devalue, they simply withdrew from the accumulated dollar pile in Thailand and moved it to the next target.

Each time there is an outbreak of depression associated with this badly imbalanced monetary system, the attempted self-correction of this gold-less exchange world is undone by further currency debasement. Since banks are the primary means through which "money printing" is conducted, their failures and retrenchments represent the non-gold method of repealing massive debasement. But modern economics does not suffer "deflation," and so central banks simply fill the void and maintain the rise of paper imbalance.

That is the mechanism of depriving the world of adjustment post-1990 and why the last two decades have seen such a dramatic surge in paper reserve balances. Interest rate targeting is the implicit liquidity backstop of central banking against the relentless creation of credit by both the traditional and shadow banking systems. The eurodollar market is the means to transmit it all globally through the creation and trading of debt and derivatives (collateral creation and transference), as mega-banks have been unambiguously the primary beneficiaries of the removal of the gold standard. That backstop simply becomes explicit in attempts at self-correction, such as the 2008 global meltdown. Adjustments are never really made across the system, only transferred because the swap standard simply cannot survive without the banking/speculator transfer mechanism. Thus it continues to treat the banking system as equivalent to the real economy.

While this mal-adjusted system is most evident in the financial economy, it also has played a significant role in suppressing the free flow of "capital", ie., productive capacity. Instead, free trade in the financialized era of the global swap standard is captured and directed by the imbalanced flow of paper. It leads not to the enrichment and creation of durable wealth in the countries and regions that derive the most flow, it creates speculative bubbles that burst in spectacular episodes of market and economic crashes. It is, once again, the illusion of prosperity that eventually is withdrawn once the "money" literally runs out. Those regions exposed to it end up impoverished by that exposure, crushed under the weight of a hollow real economic system unable to carry that burden. So on come the bailouts, largely with the IMF out front, to maintain the pile of paper.

I have said many times that the Federal Reserve has accumulated much power and control over not just the domestic banking system, but the global economy, simply because consumer inflation in the United States has been relatively "tame." But in using that as the exclusive means to judge successful monetary policy is being willfully blind. There is absolutely no way that global reserve balances corresponding to what appears to be structural trade imbalance could have risen without severe debasement.

Of course, the Fed is not alone in this respect; it is joined by the cheers of modern conventional economics. The Bank of Japan, despite five recessions and nine or ten QE's in fifteen years, aims to itself greatly influence global monetary and reserve flow by yet again adding a few trillion to the reserve pile. Should any new Thailands fall to their efforts as they stir the volatility inherent in such instability, at least they long ago promised to take it into consideration. Billion, once the standard for the limits of imagination, now seems so quaint as a mere rounding error in individual swap operations. The string of depression and collapse that has marked the past forty years, including that Great "Moderation" and Great Recession, is nothing more than the hidden strain of severe inflation manifested through nonconventional channels.

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

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