Hoping for Some Positive Monetary Factors in 2018

Hoping for Some Positive Monetary Factors in 2018
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There is a certain majesty to it, an unmistakable appeal that draws you in to its web. If the eurodollar were something else, an art piece or some ancient scroll of poetry, there would be no denying both its beauty and its significance. From the standpoint of an outside observer, it is oftentimes hard not to get lost in the thing as a stunning wonder of mankind’s creation, easily forgetting in the process all the rest.

It’s been ten years now, more than ten years, and what counts is that “all the rest” keeps coming at you with regularity. Repo fails in the middle this month, the week of December 13, registered an astonishing $832 billion. That’s the third straight week at more than half a trillion, and fourth at more than $400 billion. It was the fourth highest weekly level of collateral strain since 2009.

But that’s only the beginning. During the very same week last year, the week of December 14, 2016, the tally for UST fails was $832 billion (actually it’s $832.4 billion last year in the same week vs. $832.2 billion this year). Repetition of this kind is not an indication of strictly free market behavior (self-similarity characteristics aside).

If you plot the trend in repo fails 2017 on top of those from 2016, you get an unmistakable duplication. Not only did fails spike in late November to crescendo the middle of the next month, there was also a clear escalation both years starting in the middle of each September. The totals in those weeks were not nearly so exact as the most recent for December, but close enough such that this seasonality becomes too obvious to miss.

It’s only for the past two years, though, that this pattern emerges. If we take repo fails by a moving eight-week average, smoothing out the tendency toward volatility, the average right now is the highest since the panic nine years ago. What’s more, that average started rising the week of August 12, 2015.

What many people might remember about that particular week seems to have had nothing at all to do with US$ repo, particularly the part using US Treasuries as collateral. But China’s devastating “devaluation” at that very point had everything to do with it, as it was never truly devaluation to begin with. Western economists may be stumped as to what China has been up to, seeing and projecting what they want, but it’s nothing at all like that.

Even more disturbing (or beautiful, if you can become so dispassionate) is that this specific seasonality recorded now in US$ repo fails is one associated with China. The September then December spikes of illiquidity are found in advance of both that country’s Golden Week celebrations. In banking, that has always meant a tightening of liquidity as their spare monetary resources are pooled in advance of weeklong holiday closing.  

The past two years, 2016 and 2017, the phenomenon has hit Hong Kong where it had never before.  If we look at CNY’s August 2015 drop properly as a “dollar” issue, then the reason why becomes clear. In a bid to stabilize the yuan, Chinese banks have been using Hong Kong banks almost as collateral for surreptitiously obtaining eurodollar funding; trading on their reputation as fiscally sound, monetarily healthy institutions to create backdoor funding channels for Chinese firms no longer viewed anywhere close to that positive.

Seasonal bottlenecks like what we find here are choke points that reveal systemic weaknesses, that in the hidden shadow world of the eurodollar offer us a brief glimpse of what’s going on still in darkness.  None of it is really good, which is really the overriding issue no matter the otherworldly exquisiteness of its sometimes elegance.

The eurodollar simply doesn’t work any longer. It hasn’t for a very long time, of course, but to keep seeing these kinds of things pop up consistently (and escalate, just like 2014) makes one wonder how much longer it has before somewhere someone seeks to get out from underneath it and start over.

Right at the top of any list for doing just that are the Chinese. Much has been made of their most recent attempt at a beginning, the introduction of the so-called petro-yuan. Denominating crude in CNY would be a terrific ability for them to have if for no other reason than it would reduce their (synthetic) short “dollar” position.

After that, however, the world of global reserve currencies isn’t nearly so straightforward. Many economists and politicians have observed and recognized a petrodollar, revolved around an agreement between the United States and particularly Saudi Arabia to trade American military protection for Saudi purchases of UST’s with excess dollars obtained in the oil trade, and thus the world pricing crude in dollars, but none have done so correctly.

The petrodollar is really a subset or effect of the eurodollar cause. There is no recycling of crude dollars into UST’s anymore than there is in the merchandise surplus of China into the same instruments. The holding of so many trillions of treasury bonds in foreign official hands is the direct effect of linking to the eurodollar system. Period. The presumed petrodollar system is nothing more than what has been most visible of the eurodollar.

Because of that collateral displacement, though, it has placed a huge amount of emphasis on the repo market – particularly in the years since August 2007 when this offshore eurodollar element almost totally rejected the other equally major part of repo collateral. Starting with and around Bear Stearns nearly ten years ago, offshore “dollar” holders of every type began disposing of their agency debt.

At one time in the middle 2000’s, GSE paper was as good as…a UST. In some ways it was better, more liquid and distributable due to the true Wall Street genius of that age. MBS with that Fannie or Freddie imprimatur were easier to customize and design in ways that straight federal government debt just never will be. It was a benefit then, but a curse after Bear.

And in the downfall of offshore agency collateral, what took up the massive demand for that dimension? At first it was sovereign OECD debt of all kinds, but that turned into a second disaster in some ways equal to the first. European banks in particular sold their US agency bonds often to the Federal Reserve in one of its first two ineffectual QE’s in order to buy up Portuguese, Italian, and, yes, even Greek debt – until 2011.

What has followed has been a clear tiering of collateral terms, starting with an enormous premium on what is called “pristine” in the industry.  US Treasury bonds are irreplaceable no matter how ridiculous the US deficit or outstanding debt. There is just no other instrument that can perform this vital, nay deal-breaker, function in the modern global monetary system. With collateral lists contracted and compacted as they are now, this is no trivial matter.

If “dollars” are such a chronic headache (for this reason and others), it makes perfect sense to investigate any possible way to alleviate or even replace them for international economics. As Time Magazine’s Michael Schuman put it:

“The yuan is showing up a lot more often in trade and finance.

“The implications of that new reality are potentially huge. As China rises in economic power…it seems inevitable that its currency will rise in importance as well, simply because the Chinese economy is becoming so large and so crucial in world trade. Recent advances in the yuan also show how much progress China could achieve in turning its currency into a major international player.”

Rather than refer to the looming petro-yuan, Mr. Schuman wrote that in February 2011. The Chinese have made repeated attempts at establishing offshore RMB as a possible competitor to eurodollars (which are just offshore dollars).  It had become fashionable then, as now, to view anything the Chinese did in that regard as the first step in the assured direction of an RMB sort of world.

The Chinese had first allowed one of its policy banks to issue an offshore RMB bond all the way back in July 2007 (perfect timing, too).  China Development Bank was given official government permission to float a small RMB bond in Hong Kong, inaugurating what’s now called the Dim Sum bond market. Total volume remained slim for years as the Chinese were reluctant to give Chinese corporates unfettered access even in RMB to the outside world.

After 2008 and the reappearance of eurodollar problems in 2009 and 2010, the government relented. Issuance which had been RMB 10 billion initially in 2007 and still just RMB 16 billion by 2009, jumped to RMB 36 billion in 2010 and then RMB 153 billion for 2011. It was that “progress” which convinced a great many others beside Mr. Schuman that China was on its way to at least establishing a bipolar global reserve system. King Dollar had finally met its challenger.

It wasn’t just the apparent rapid growth of the market that tickled so much Western fancy, but also who was in there seeking to borrow RMB in Hong Kong. Not only were Western banks like HSBC issuing Dim Sum bonds, so, too, were household American corporate names; Caterpillar and McDonald’s just to name a couple.

In fact, the Dim Sum market flourished – until 2014. According to Bloomberg, offshore corporate RMB issuance peaked that year at around RMB 453 billion (other sources claim more, some less; that’s another problem, nobody seems too sure just how much was ever floated out there). That’s still just a drop in the global bond bucket, but the experts often extrapolate in straight lines: from RMB 16 billion in 2009 to RMB 453 billion five years later surely meant RMB 12 trillion by 2019 and a CNY-denominated world, right?

It didn’t quite work out that way.  Starting in 2015, the Dim Sum market began to wither away, suffering a more than 40% decline that one year alone. In 2017 through just about the end of the year, Bloomberg figures less than RMB 90 billion will have been issued.  At one-fifth of its prior peak, there are whispers Dim Sum will be a distant memory in a few years (though it’s also dangerous to extrapolate the same way in the other direction).

China has tried to resurrect the idea of RMB-centric bonds, a necessary component to practical rather than imagined global reserve status, with what’s called the Panda bond market (RMB bonds of foreign companies issued onshore inside mainland China). It explains part of the Dim Sum reverse, but the mere fact that the government feels compelled to support this other market rather than offshore RMB means that all is not well for more universal CNY acceptance.

There it is again, the year of global change in monetary terms. Dim Sum was doing fine, perhaps more than fine, until 2015. The “rising dollar” seems to have ended the dream at least so far as Western corporates go. And like UST repo collateral, that’s no small thing. Western corporatesare the trade and monetary world.

It seems almost backward. The eurodollar was the primary problem for much of the rest of the world during that period, this “rising dollar” part of the wider, intractable eurodollar decay that began in August 2007. You would think it would have represented the perfect opportunity (if 2011 wasn’t) for a competing currency regime; yet it was the Chinese who stumbled, having to sell off nearly half a trillion dollars in their combined UST holdings just to get by (and then inaugurating a risky and now clearly problematic ad hoc Hong Kong “dollar” bypass) and absorbing the serious, politically dangerous economic blow such monetary insufficiency delivered to their doorstep.

It wasn’t some big surprise, either. While it was and remains so for Economists here, as regrettable as it is to constantly write the Communist Chinese know more about the dollar than any American official, those at the PBOC were well-aware of the problem right from that initial drop in CNY early on in 2014. The Wall Street Journal characterized it in typical myopic mainstream fashion, writing in March 2014, “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…”

Yeah, that’s not at all what it was, as I wrote at the same time partially in response:

“What all this data shows, as opposed to conjecture about the supernatural powers of central banks, is that yuan’s devaluation may be directly tied to dollar shortages. In fact, as I argue here, it is far more plausible that a dollar shortage (showing up as a rising dollar, or depreciating yuan) is forcing the PBOC to allow a wider band in order that Chinese banks can more ‘aggressively’ obtain dollars they desperately need. Worse than that, the PBOC itself cannot meet that need with its own ‘reserve’ actions without further upsetting the entire fragile system.”

That’s ultimately why the Dim Sum market fell apart, as did further eurodollar flight (destruction with regard to increasing reluctance to lend “dollars” to Chinese corporates, particularly financials, as the situation kept worsening in a self-reinforcing spiral). CNY may not be the eurodollar, but it’s not the dollar, either. China is risk, an original sin derived from the way in which the Chinese chose to modernize decades ago. They embraced the eurodollar as their own monetary basis, and rode more than anyone its rise to their very economic “miracle.”

In doing so, they are now highly susceptible to its dysfunction, and in ways that aren’t very well understood given the nature of the eurodollar plus the way in which internal Chinese parameters stand.

To now replace eurodollars with CNY or some RMB offshore derivative requires first replacing RMB itself. That’s not just a tall order, given the risks of China’s current situation it may very well be impossible. I think that more than anything explains the careful baby steps the Chinese have taken despite being forced now to have absorbed years of eurodollar-based abuse.  They stick with it and do (seemingly) weird things around it because they have to. PBOC Governor Zhou Xiaochuan complained about it all the way back in March 2009, so eight years is more than enough to ask, “what’s taking so long?”

The whole thing represents one more part of the inertia holding global monetary reform back. The world economy is stuck between the rock (Economists in positions of authority at Western central banks, Finance Ministries, and the US Treasury Department who have no idea what a eurodollar is) and this hard place (no ready and reasonable alternative yet sufficiently developed and deep enough to begin an organic, therefore more orderly, transition to something else). As I wrote last week, the eurodollar may be broken but at the very least it keeps the lights on. If China could have they would have long before now.

What should be remembered about 2017 is how these things weren’t supposed to have mattered, just like the previous nine before it. Repeating 2014, however, they clearly do. This was the year “globally synchronized growth” was going to overtake all the past decade’s persisting problems and lead to something unmistakably better. It hasn’t quite worked out that way, and in some cases, more than just UST collateral repo, it’s worse now than at any point since 2008. The former merely follows the latter.

All is not lost, however. As is customary at New Year’s we can hope that 2018 will be the year some positive factors start to click into place. For one, also as I wrote last week, it may dawn on someone that though the eurodollar is broken the dollar isn’t. Appreciating that distinction (hard as it may be to believe, more people are) can lead the world back toward a solution that may actually be the path of least resistance (the world already runs on dollar denomination, what’s at issue is where and how those “dollars” come into play). 

The Chinese want out. We should, too. There’s remarkable agreement and deeply sympathetic positions available on all sides, avoiding in the process a whole bunch of dangerous and really stupid acrimony; if only someone over here would take that first step toward realizing what credit-based dollars have truly meant, and will continue to mean so long as “we” keep doing nothing about them while others are left flirting with futility. That's not at all beautiful or elegant, it's unnecessary ugliness. 


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

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