Global Authorities Appeal to the Bizarre and Nonsensical

Global Authorities Appeal to the Bizarre and Nonsensical
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It was American retailer Sears & Roebuck who finally pressed Japanese authorities into action. In February 1979, the company announced that through its Overseas Finance Division it would be the first corporation to issue a Samurai bond. These were securities allotted in Tokyo and denominated in yen. The first Samurais had been floated years before, with the Asian Development Bank inaugurating the market in 1970.

The Japanese government had placed stringent controls on issuers throughout that early history. Eligibility requirements were strict, leaving only supranational organizations and other sovereign issues access. Australia raised yen there in 1972, as did Mexico and Brazil. Few others followed.

The participation of Sears represented an evolutionary step. The company insisted on the same no-margin or collateral basis it would get issuing bonds in any other major market. The Japanese government had prohibited any unmortgaged bonds within its borders since 1933. Domestic securities firm Nomura Yamaichi lobbied Japanese regulators for a year or more in order to obtain these relaxed restrictions. It was expected to open a flood of demand from other global corporate names.

For Sears, the attraction was simple and familiar to our 21st century experience. Yen interest rates were unusually low. Compared to the rest of the developed world in 1979, money was cheap in Japan.

For Japan’s government, though they may have been reluctant to relax regulations the figured it could be worth it if this represented the initial move toward a long-sought goal. There was, almost everyone anticipated, the opportunity particularly during that specific decade to turn the yen into a global currency.

Two years before Sears’ Samurai, the European Investment Bank had issued the world’s first euroyen bond. As with eurodollars, euroyen have nothing whatsoever to do with Europe’s modern euro. The term “euro” when applied to a currency simply means “offshore.”  Thus, EIB’s 1977 float was a debenture denominated in yen but issued outside of Japan in Europe.

Japanese banks weren’t particularly thrilled over these developments. In many ways, the bond market is a banking system bypass, a competitor of sorts. Japan more than any other country has depended heavily on its banking system throughout its modern history. A virtual credit monopoly, depository firms actively argued against securities firms entering their business, though that business more and more had less to do with strictly Japan.

Banks had been very active in offshore currency markets since almost the very beginning (whatever those actual origins may have been). A consequence of the country’s postwar reality, capital flows were highly restricted. When Japan capitulated to the Allied powers in August 1945, it also surrendered all its foreign assets.

It was left for the government to purchase exportable goods at elevated prices in yen in order to turn around and sell them internationally at whatever lower price could be obtained. On the import side, food and other necessities were bought at whatever overseas costs and then sold very cheaply to a starving population. This subsidization on both sides required huge inflows of foreign exchange initially financed by the United States through the Supreme Commander of the Allied Powers (SCAP).

In 1948, however, SCAP ordered the subsidies to be curtailed requiring severe fiscal and monetary restrictions to complete. In later 1949, the Foreign Exchange and Foreign Trade Law was implemented virtually outlawing private foreign exchange transactions, with the exception of large export firms. Japanese residents who obtained any foreign currency were required to immediately sell it to specifically authorized special purpose “foreign exchange banks” operating on behalf of monetary authorities.

Thus, foreign exchange banks would build up over time a balance of reserves in the name of the government but available for wider external use. One of those was the former Yokohama Species Bank which had been established in 1880 but was reorganized in 1946 as the Bank of Tokyo.

Once Japan was granted full independence in 1952, it became solely responsible for its own current account. The Foreign Exchange Bank Law of 1954 had been created in response to an acute foreign currency crisis (shortage) the prior August. Not only would foreign exchange banks be permitted to more freely engage in those transactions, any that registered with the government under that law would also be eligible to open foreign branches abroad.

For banks like the Bank of Tokyo, originally the only Japanese bank that registered via the act, it was an opportunity to grow in these relatively new offshore spaces. For Japan as a whole, it was hoped this would aid in deepening monetary flow so that its imbalances wouldn’t derail what was becoming a powerful and sustained export-driven economic revival.

Bank of Tokyo would set up offices in London and New York, as well as taking a particular interest in California. The bank even obtained the highly unusual distinction of employing more non-Japanese than Japanese workers.

In 1956, there were about 15 foreign bank offices in operation, all of which belonged to the Bank of Tokyo. A decade later, in 1966, there were 56. By the time the euroyen bonds were being discussed along with the outlines for eventual Samurai bond liberalization in 1976, foreign exchange banks in Japan reported 116 foreign offices.

What was going on in these offshore currency markets wasn’t the usual stuff, nor was it anything like what would have been recognizable as banking and foreign exchange as the textbook described(s) them. In its 34th Annual Report written and published in 1964, the BIS finally got around to taking a look.

“In addition, it is claimed that long chains of interbank transactions may result in excessive stretching of the periods for which ultimate borrowers obtain funds as compared with the maturities for which original depositors place them, partly because narrow interest rate spreads may push the banks to seek higher yields through longer-term lending.”

This describes pretty well what would become standard procedure for the modern shadow bank. Much within those “long chains of interbank transactions” included swaps and derivatives, nearly all of which were untraceable in any official accounts, foreign or domestic. The term shadow is, for once, perfectly applicable as I wrote a few years ago with regard to one episode that drew in Japanese institutions:

“At the end of 1963 due to events partially related to Italy and Switzerland, Japanese banks found themselves ‘short’ by some $200 million in denied eurodollar rollovers. The Bank of Japan responded by ‘selling’ ~$200 million in US Treasury bills which was then only reflected in NYC money markets despite origination all over the place and across many seemingly unrelated formats.”

Given what actually goes on in eurocurrency markets, the yen was particularly ill-suited for them. The Japanese government, forever careful and conservative on fiscal and monetary matters (Bank of Japan in later experience obviously excluded), just wasn’t going to let the yen be transformed and transfigured as would have had to have happened if it was ever to become a true global rival; meaning, a euroyen as full alternate to the eurodollar.

But even as that general philosophical constraint would help to impede the wider adoption of Japan’s currency, Japan’s foreign exchange banks were more and more unimpeded. They had developed highly sophisticated networks, invested tremendous resources, and cultivated necessary and cutting-edge capabilities. Their offshore capacities would not sit idle.

Ironically, the euroyen and Samurai bond markets wouldn’t start to take off until just after Japan’s bubble collapse in 1989 and 1990. Again, the reason for that was simple; interest rates. The so-called carry trade of more myth than reality was born as the Bank of Japan pushed yen money rates further toward zero through the middle nineties.

In 1994, euroyen issuance skyrocketed reaching a peak in 1996. In that one year, there were nearly 1,100 issues floated amounting more than ¥6 trillion. By 1999, however, it was nearly all gone. In between, the Asian flu.

Though that particular event is always described as an overseas affair, while that is technically true it leaves out the important part. It wasn’t strictly overseas as much as offshore, as in eurodollars and euroyen.

This all occurred just as the fully mature eurodollar system was itself taking off, at least it was outside of Asia. Thus, if Japanese banks weren’t about to become the center of a euroyen orbit, they could at least fulfill another eurocurrency role as being a primary redistribution point of eurodollars especially across Asia. Though the dreams of a global yen died as Japan’s economy was increasingly mired in the first of its several lost decades, Japan’s banks would end up with an outlet outside of Japan for all their enormous capacities (those that still functioned).

The story of the 2008 Panic is still told from the point of view of the dollar, or even just Wall Street and stocks. Yet, the week after Lehman had failed, closely followed by those other quite related firms being bailed out or forced into mergers, it was the Bank of Japan who was so prominent on the receiving end of Federal Reserve dollar swaps.

For the week of September 24, 2008, FRBNY reported $29.6 billion in swaps with BoJ.  That was nearly three times as much as the balance with the Swiss National Bank and about the same as that exchanged with the Bank of England. During the worst of it, in the third week of October, BoJ had swapped into $70 billion ($20 billion 88-day; $50.2 billion 28-day) – more than the Bank of England, far more than Switzerland, and second only to the ECB.

Despite that perilous experience, something remarkable occurred in the aftermath. Whereas European banks began to reassess their participation in offshore dollars across all its dimensions (meaning “dollars”), and Swiss banks simply began to exit, Japanese banks rushed forward. They aimed to fill what they could only have perceived was going to be unfulfilled opportunity.

We can’t know for sure what any of them were thinking, though reasonable suspicion abounds. One clue is provided by the Bank of Tokyo in its recounting of its own history (now Bank of Tokyo-Mitsubishi UFJ).

“In 1954, the Bank of Tokyo turned itself into a specialized foreign exchange bank in line with the Foreign Exchange Bank Act. It has since been active on financial markets in New York, London, and elsewhere, taking the lead in internationalization of the Japanese economy and Japanese banks. The bank explored ways of raising funds in foreign currencies. It created a yen-yuan settlement system to help normalize trading ties with China at a time when payments were not allowed in U.S. dollars.”

Despite historical animosity, Japanese banks had been welcomed into Chinese markets long before anyone in the West believed there was any reason to try. These longstanding ties, it seems, proved crucial for what happened starting in 2009.

We don’t have much good data about what these banks are ever up to, especially, again, if the bulk of those long interbank chains remains forever overseas. If a bank in Tokyo, not necessarily just the Bank of Tokyo, transacts in eurodollars with a bank in Shanghai, no US statistics will record any transfers. At most, market prices and more so currency exchange rates will adjust accordingly. These are not just the shadows but pitch black dark spaces.

The best we can hope for are any residuals as they may show up somewhere domestically. In that line, this is why the US Treasury Department’s Treasury International Capital (TIC) data is extremely helpful. While most people see it as little more than recording the buying and selling of federal bonds, bills, and notes overseas, there is so much more detail underneath – including a good deal that pertains to the cross-border activities of US banks.

In this area we find that US bank “dollar” trade with Japan increased substantially right at the start of 2009. It had suffered in 2007, where TIC reports a peak of $140 billion (US banks’ collective claims on Japanese institutions payable in dollars) falling to just $63 billion in December 2008. Thus, large dollar swaps between FRBNY and BoJ.

By the time the 2011 crisis broke out that summer, TIC data shows more than $231 billion in liabilities with Japan. Somewhat undeterred, the reported level wouldn’t peak until October 2016 at just more than $420 billion.

Anecdotally, we know that Japanese banks had come to see China as the one big Asian opportunity left to them. That Japanese industrial firms were interested more and more moving capacity to China during this same period would only have further invited the trend.

With global recovery in the developed world, including inside of Japan, at best sluggish, it was widely believed and fully expected that emerging market economies, China’s in particular, would continue to grow at or indistinguishably close to precrisis levels. That would mean for China and EM’s a continuous even greater dollar need – and now fewer European banks willing to supply them at reasonable terms and volumes, followed on the retreat after 2011 by Caribbean banks.

This opportunity, as Japan’s banks clearly saw it, would only hold up if China did. Starting around 2012, that was no longer so certain. The pace of growth surrounding Japanese “dollar” redistribution slowed as uncertainty rose. Then came 2015.

From Japan’s perspective, China’s substantially depressed growth meant a very different set of circumstances, particularly given the eurodollar basis for the close relationship. The “rising dollar” had meant those “dollars” were more expensive and more trouble to secure, especially within the realm of more purely FX interbank chains (not just swaps but cross currency basis swaps). Coupled with a much different Chinese economic background, risk, it was becoming a precarious situation.

Yet, the “rising dollar” ended and global recovery from it quickly proclaimed. Reflation gripped many markets in anticipation of meaningfully better circumstances. Rhetoric rose still further, where market prices merely hoped that eventually growth rates might simply come close to the narrative.

It appears as if Japan’s banks were initially onboard with all that, even from the earliest of the “rising dollar.” As with most orthodox economic thinking, they were willing to ride out the 2015-16 downturn as a temporary issue to be eventually overcome, no matter that it became ridiculously expensive to redistribute dollar funding toward and around Asia.

Of course, there are no fairy tale endings in this continued eurodollar world. Rather than acceleration, depressed conditions remain. In China, that’s an understatement. The core of China’s modern industrialization is Fixed Asset Investment, the supply side capital investment that had transformed a backward agrarian nation totally closed to outside money apart from the Bank of Tokyo into an almost superpower.

What’s so far missing from China’s arsenal is yuan (RMB). To complete the economic conversion would require CNY becoming a true global currency, the very dream Japan once pursued. Given the thrust of eurodollar decay for nearly eleven years running, there is further urgency to the matter from not just the perspective of China’s authorities.

The Chinese have made significant strides in that direction, including the unveiling in 2012 of an RMB border trade payment system. Certain bilateral transactions can more easily be settled in RMB.

Earlier this year, after a great deal of excitement and also delays, the so-called petro-yuan debuted.

And still CNY is as it was. Worse, Japan is actively, purposefully, and excitedly getting out of the “dollar” business. And it is doing so at a pace that exceeds its scaling up in 2009 and 2010.  That seems like it should be good for the Chinese who clearly wish CNY would accomplish what JPY never could. If there are fewer willing to offer eurodollars, might they be more willing to offer euroyuan?

That’s just not how it works. According to TIC, US bank claims on Japanese banks were still about $419 billion at the peak last September, a month that registers for all the wrong reasons (repo and CNY primary among them). The balance had declined to $374 billion by November, rebounded somewhat in December, and then dropped catastrophically in January and February 2018.

At just $317 billion at the end of that month, what it indirectly indicates is an enormous and sudden withdrawal from offshore money by Japan. I have little doubt that the coincident timing of global liquidations during those same two months was anything but, well, coincidence. Those were visited in Chinese markets every bit as much if not more than elsewhere.

Authorities around the world have increasingly appealed to the bizarre and nonsensical to try and explain why they are experiencing so much dollar tightening. The answer is simple, eurodollar. The location of the epicenter, Japan and China.

The Chinese have thoroughly studied the Japanese example, both for the similarities in economy (which is proving all-too-apt from China’s perspective) as well as to learn what might have gone wrong with yen that yuan could do right. Just a few years ago, there was an intense effort to get offshore yuan going in Hong Kong (CNH) and a global RMB bond market (Dim Sum offshore; Panda bonds onshore) off the ground, too. Not so much anymore.

The goal is not really to challenge the dollar but to add the term “euro” in front of something else that could then be in position to reface the global credit-based system. Ultimately, this may be the very thing that’s wrong. It’s not the denomination that’s unstable, it’s the arrangement at its very fundamental core.

Fixed Asset Investment as of May 2018 was for China the lowest on record (dating back to 1997). The probability of a meaningful and sustained economic rebound for the Chinese economy with that as a background is practically zero, especially as much of the deceleration was due to the clear withdrawal of activity via State-Owned businesses. In other words, not even the Chinese authorities are trying to pump up the economy any longer.

If I was a Japanese bank, I would run, too, and let the global eurodollar dominoes fall as they may (as some already have).

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

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