A Monetary System That Is No Longer Monetary

Story Stream
recent articles

In September 2010, Brazil's former Finance Minister, Guido Mantega, made international headlines for first declaring the "international currency wars." Marking the old developed/developing divide, Mantega was pointing out the one-sided nature of monetary politics, proclaiming, "advanced countries are seeking to devalue their currencies." To counteract might offer complication, as his country's monetary regime was and remains a rather complicated and entangled structure, with the central bank rooted in both the public sector (mutually the National Treasury and the Bureau of Currency and Credit) and the private (the central bank was co-founded and sponsored by South America's oldest and now largest bank, Banco do Brasil).

In early 2011, there were no disqualifying conflictions of interest or format, as the central bank (which I usually refer to as Banco alone, for many reasons) was intent upon halting the real's appreciation against the growing tide of Mantega's currency wars. By mainstream accounts, Banco (the acting agent) initiated auctions for 20,000 contracts of a "reverse swap" arrangement whereby Brazilian monetary authorities (of whichever end) promised to pay the overnight rate in reals against a set, fixed rate in dollars.

The Brazilian dollar network node is a bit of an odd arrangement, compared to other places, which isn't all that surprising given the setup here. But what are taken as currency swaps by the central bank aren't really that, instead they are rate swaps intended upon influencing the onshore "dollar" rate, really a spread - the cupom cambial. The intended effect of what Banco was doing in January 2011 was to reduce the cupom cambial in order to make it less profitable for Brazilian banks or foreign subs operating in Brazil to "import" "dollars."

The real's appreciation eventually did halt, but instead of providing the utopian monetarism Banco sought has turned into an ongoing nightmare in the opposite direction. In August 2013, there was more cupom auctions to be had only this time not "reverse swaps" but of the straight variety, as much as they may be in Brazil. Rather than try to influence "dollars" away from Brazil to halt appreciation, the central bank was getting desperate to induce Brazilian banks to attain them. And so the bank began a series of auctions, historically large, which had the practical effect of making Brazilian banks even more "short" the "dollar."

It's an exceedingly weird and difficult concept, as in convention almost everyone talks as if there is actual currency in all this - there is not. The wholesale system does not operate on such platitudes and anachronistic arrangements that make for currency as it was always known. What happens are bank exchanges among, and only among, various forms of ledgered liabilities. When Brazilian companies need dollars to engage in foreign trade (on both sides, to buy and in reception during a sale) Brazilian banks source those "dollars" via the eurodollar market and then lend them internally, pocketing whatever spread they can find after whatever influence is acting wherever. That means the "dollars" they obtain are eurodollar bank liabilities typically of small duration - they are synthetically short the "dollar."

In the context of summer 2013, then, Banco's intentions were clear and even understandable at least in the very narrow orthodox conception but well more than a little dangerous. By incentivizing Brazilian banks, through the cupom cambial rate, to increase "dollar" exposure the central bank was, in effect, having Brazilian banks "short" the "dollar" to a much larger extent than they already were. It seemed like a worthy gamble, as every economist in the world proclaimed both global recovery and placidity in global finance as a result; the FOMC itself meant time and again to reinforce how "taper wasn't tightening."

But in every meaningful respect, in the wholesale world, which is all that really matters, taper (and just the talk of it) had already been tightening and not just in emerging market's short "dollar" position. The MBS market inside the dollar-denomination was decimated that summer, as were other fixed income spaces. So Brazil's position was essentially that it was all a one-off, spectacular rout that wouldn't be repeated, certainly not surpassed.

For a while, that seemed to be the case. The real halted its "devaluation", stability looked to have been found and the world deemed itself poised for those promises. By early September 2014, Banco felt confident enough to begin unwinding those prior year swaps (since those auctioned swap contracts come with a stated maturity, the central bank has to either roll them over or allow them to expire without replacement). It is usually left out of commentary that these kinds of monetary influences are, in the end, highly inefficient and thus expensive - which is why they are typically reserved for only the direst circumstances.

The Brazilian economy had taken a hit from that 2013 "devaluation", but in autumn 2014 it didn't appear to be a fatal blow and the real's steadiness was tantalizingly assuring. As soon as Banco expired about one-quarter of their maturing swaps, the real suddenly began to sink again, this time much more forcefully than even the worst days of 2013. Whereas the real dropped from 2.00 to the dollar to 2.44 in that first eruption, by the end of 2014 the real was trading at just 2.73 (a rising currency exchange rate quoted in this manner means that the dollar can "buy" more reals, and thus the real is "worth" less in devaluation).

By March 2015, the real was trading at an "unthinkable" 3.30 to the dollar, but Banco decided to end its swaps program in its entirety. Somehow, the central bank portrayed this as a great victory and tremendous success in doing so. Central bank President Alexandre Tombini reported to lawmakers that the swaps had "played an important role in promoting financial and economic stability as well as reducing currency volatility." Nothing in that statement can be considered true, in particular the last as the real has continued to sink, reaching almost 3.60 to the dollar more recently. Banco bowed out because it had no choice, recognizing too late its folly on all counts.

As a result, "inflation" in Brazil is anticipated to move above 9% in the near-term, far, far above Banco's 4.5% target, and more than meaningfully above its 6.5% upper bound range. As is usual in these highly volatile circumstances, Brazilian GDP is expected to fall almost 2% in 2015 (estimates continue to decline), which would be the worst showing in decades going back to the highly inflationary 1990's.

By that account, the Brazilian central bank has been really (pun intended) a non-factor for the real - and not just since mid-2013, going back at least to 2010 and really, I would argue, for much longer than that. It isn't taken that way, especially in the short run when trading often affords central banks credibility that just isn't earned or appropriate. What is clear in that regard is Banco was essentially steamrolled by the eurodollar; on the way up and then back down.

The fact that this version of the real's "devaluation" has been much worse than the first eruption in 2013 is due to the fact that Brazil's central bank had, as an attempt to arrest the decline, invited Brazilian banks, under artificial cover that would not be maintained, to increase the imbalance that was creating all the fuss in the first place. If you are stuck in a short squeeze the last thing you want to do is increase your short, yet that is what happened between 2013 and 2014 at Banco's policy behest. The premise was simple, that the "tightening" of 2013 would not be repeated.

Obviously, that was a big mistake and one that should have been obvious even then. The eurodollar system is coming apart, and there are and have been an inordinate number of clues bolstering that interpretation. In June 2014, the dollar repo markets experienced a sudden and sharp seizure, with delivery fails spiking well out of any proportion to prior operation; taking on an immensity that was reminding of 2011, at the very least. The eurodollar curve had already been flattening despite repeated, and repeatedly over-emphasized, commentary from the FOMC and economists that there would be a close rate hike because the economy was so damn good.

When Banco looked to unwind itself last September, there was enough evidence in the eurodollar that it was going to be a disaster - which has, inappropriately for Brazilians, not disappointed.

Brazil has not been alone in that regard, as "dollar" conditions have steadily worsened everywhere in its exhaustive doman. There was October 15 where, despite the Fed and Treasury's insistence upon only analyzing 12 specific minutes that day rather than why those minutes mattered or what has become thereafter, a global disruption rippled to every financial corner. The Russian ruble collapsed in early December and only a month later, the Swiss National Bank broke its peg to the euro which everyone still assumes was the problem even though SNB was explicit about the very dollar nature of its actions.

Now there is China.

The list of central banks being rendered powerless in the face of "something" is growing and is taking greater proportion (by weight of each central bank in that list) with each instance. Mainstream commentary continues to get this one backward, as the PBOC is not executing an "export stimulus" or devaluation but rather has been forced into disruption by what increasingly looks like a localized "dollar" run consistent with the same terminus as what broke the SNB and Banco (and the Central Bank of Russia, twice).

At least in the case of the PBOC, there appears to be a much richer understanding of what they are up against; even if that might amount to little in the end. Anyone with eyes can see that the "dollar" was the problem this whole time, as any recent chart of the yuan/dollar exchange blares the obvious interventions starting March of this year; the yuan simply stopped moving to the point in the past month or so, before this week, the variability in daily trading was nearly nil. The PBOC was doing something, what they were doing, specifically, remains unclear, but it was undoubtedly an attempt to keep the yuan from, as the eurodollar raged through the globe, acting the real, ruble or franc.

The head of the PBOC, Zhou Xiaochuan, has been uniquely (for central bankers) aware of this global construction in actual blunt terms. I have written many times that it is itself damning how the Communist monetary apparatus is so much more attuned to the monetary system of the "free world." In March 2009, Zhou delivered an essay through the BIS (which I have referred to before, and should be required reading not for political purposes as it was taken) which left little doubt as to wholesale awareness and specificity:

"The outbreak of the current crisis and its spillover in the world have confronted us with a long-existing but still unanswered question, i.e., what kind of international reserve currency do we need to secure global financial stability and facilitate world economic growth, which was one of the purposes for establishing the IMF? There were various institutional arrangements in an attempt to find a solution, including the Silver Standard, the Gold Standard, the Gold Exchange Standard and the Bretton Woods system. The above question, however, as the ongoing financial crisis demonstrates, is far from being solved, and has become even more severe due to the inherent weaknesses of the current international monetary system."

It is the paramount issue which no central banker or economist seems to fully comprehend. What replaced Bretton Woods? Invariably the answer is the dollar, or even the petro-dollar. Neither is correct as Zhou makes plain in his written thoughts on the matter, "The acceptance of credit-based national currencies as major international reserve currencies, as is the case in the current system, is a rare special case in history." The key words to all of this are "credit-based." There is a world of difference between an assumed petrodollar function and "credit-based" wholesale finance globally, a fact that seems to escape all these central bankers but which they are receiving, a second time, an abject lesson through continued failure.

Reviewing history of monetary policy, in close detail, this is in many ways an odd consequence. At various points along the way, central bankers have expressed fleeting grasps of monetary evolution which you think might at minimum auger curiosity in further following those thoughts to completion; or at least further down the rabbit hole to see the system in all its horrifying splendor rather than the piecemeal, incomplete version that predominated out of deference to ancient economic dogma. That was my own journey of discovery, taking place from the most ordinary of circumstances as an outsider; no special knowledge just an open mind and a willingness to not just accept the status quo ignorance as a barrier.

Everyone remembers Alan Greenspan's speech in 1996 for two words that, in hindsight, were almost extraneous. He launched upon "irrational exuberance" but before he spoke that now-infamous phrase he came so frustratingly and provocatively close to feeling out the real undercurrents of the age; before falling back once more into rigid ideology:

Unfortunately, money supply trends veered off path several years ago as a useful summary of the overall economy... There are some indications that the money demand relationships to interest rates and income may be coming back on track. It is too soon to tell, and in any event we can not in the future expect to rely a great deal on money supply in making monetary policy. Still, if money growth is better behaved, it would be helpful in the conduct of policy and in our communications with the Congress and the public. In the absence of simple, summary indicators, we will continue our detailed evaluation of economic developments. As we seek price stability and maximum sustainable growth, the changing economic structures constantly present more analytic challenges.

As the serial asset bubbles now lay totally bare, he never did figure it out even though he saw the glaring discrepancy. By 2005, he, along with Bernanke, were fingering a "global savings glut" that was nothing of the kind, because that was all they could acknowledge without admitting the monetary system was no longer the monetary system at the core of their beliefs - the dollar was gone, replaced by "credit-based" currency of wholesale design, the eurodollar "dollar." If only he had put that together with his 1996 recognition of "something" altering money behavior, history might have been different (though by 2005 it was certainly too late).

As if to demonstrate that self-imposed philosophical restraint, the FOMC privately communicated both their preferences in the growing financial crisis and how those were completely inappropriate of category as well as philosophy. In September 2007, the month immediately after the eurodollar system was fatally wounded, the FOMC was using real-time events to essentially undergo freshman orientation into the eurodollar standard:

"One complexity in this whole period is that there is a surprisingly large demand for dollars in Europe, which of course is early in the day. So the fed funds rate was opening very, very high, very tight, and then there were judgments about how to bring it down during the peak trading period of the U.S. markets. That led to guesses about how many reserves to inject before the end of the day. So the dysfunction in the normal interbank market process-precautionary demand for dollars in Europe-led to some very unusual stresses early in the day, which complicated Bill's job considerably."

The entire framework of Bernanke's commentary is just wrong but, again, so very emblematic; I would not be so concerned about Bill's (Dudley, head of the Open Market Desk at FRBNY) ability to do the job as he understood it, but rather that the Open Market Desk should have been aware, long before September 2007, that Europe might be so heavily short of "dollars." That would have led to a stark but no less pressing conclusion; that the eurodollar system was irretrievably broken and wasn't positioned to engineer either a financial comeback or allow an economic one to follow beyond that.

Everything, and I mean everything, that has ensued in the now eight years since August 9, 2007, derives from that one factor. The marginal economy throughout the world was built upon this new "dollar" and its pressing factor of debt, debt and more debt. How else would a credit-based monetary system actually work? The only issue was whether that monetary/credit expansion was due to "demand" or solely to mispriced risk and harmful redistributive reallocation. Given the asset bubbles and their economic aftermath, this can hardly be claimed to be a natural, market-based process of efficient and sustainable operation. That is the essence of too-big-to-fail; bank balance sheets are the whole works.

Thus the responsibility of central banks for all of it, serial asset bubbles and the stunted growth in them, isn't really in the manner that is commonly assigned. In other words, it wasn't Greenspan's ultra-low interest rates that pushed the housing bubble to its final bubble proportions, though that did not in any way help. The real culpability was in that Greenspan believed his own press, that he could control the whole working mess, despite his own admissions of a less than complete picture of it, with quarter point ups and downs in a federal funds rate that had already been surpassed, greatly, by other financial factors (what he, and the rest of the orthodoxy, failed to take out of at least the LTCM disaster about what I have called dark leverage).

They built, or at least "allowed", a global economy to be marginally premised upon expanding "money supply" which was in reality credit-based eurodollars - and then took credit for it on the way up. Without that growth, which it has been shrinking since August 2007, accelerated immensely after the 2011 reflaring "dollar"/euro crisis, this debt marginality is just toast. The global economy slows, including the US, in what was clearly a related 2012 slowdown. It hasn't picked up since even though central banks all over have been trying to counteract these forces continuously throughout - their futility is all the evidence you need for this economic and financial devolution.

Just over a year ago, in March 2014, the Wall Street Journal caught this eurodollar degeneration in just the Chinese version of it, though they obviously did not put all these factors together then and still now.

"The band-widening announcement came as China's central bank in recent weeks has engineered a decline in the yuan's value to drive out speculators betting on the yuan's continued rise and to introduce greater two-way volatility into its trading, in a bid to pave the way for expanding the band. The PBOC has done so by guiding the parity rate lower and by instructing big state-owned Chinese banks to aggressively purchase dollars."

Against that interpretation, I wrote:

As much as the PBOC is sitting atop a multi-trillion dollar "reserve" excess, meaning that it seemingly should be easy for Chinese companies to obtain US dollars, there are enormous obstacles to mobilization, not the least of which is the daily currency band. Thinking about this in terms of eurodollars and global wholesale finance, the Journal's theory about punishing speculators does not explain enough to be compelling, amounting to more of a latent PR backstory. Instead, Chinese banks "aggressively" purchasing dollars, in quantities sufficient to cause notice, might rather be indicative of a dollar shortage among Chinese companies (and banks that lend those dollars to the corporate sector).

Given the behavior in copper, and the foreign distance from default rumors, the dollar shortage actually makes more sense, and more complete sense. This liquidity shortage is bad enough that the PBOC has been forced to widen its currency band enough so that banks can rollover sufficient quantities to avoid dollar insolvency. Thus, the Chinese banks are not being directed to bid "aggressively" for dollars, but rather their own survival, and really the survival of China's economically planned "miracle", is driving them to desperation.

The yuan at that moment was also "devaluing", hard and fast, but curiously no one classified it as export "stimulus" (for all the good that would do, then or now, as exports have, unsurprisingly since then, only gotten worse). Some things never change. Unfortunately that includes a credit-based monetary system long since crumbling that nobody, especially those that should be, seems aware. I should then clarify what I wrote above, in that all these central banks are not being steamrolled by the eurodollar but really by its persistent and one-way descent that economists and central bankers had, until only recently, preposterously tried to refer to as "strong."


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

Show commentsHide Comments

Related Articles