Central Bankers Are Always the Last to Find Out

Central Bankers Are Always the Last to Find Out
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Way back in September 2012, the day after Ben Bernanke panicked into QE3, the IMF and World Bank announced that both organizations’ annual board meetings for the year 2015 would be held jointly in Lima, Peru. The concurrence of those two events may not have been intentional but the juxtaposition was poignant. It had become conventional wisdom, thus yet another QE, that though the developed world economies would continue to struggle the future was assured in emerging.

Officials would make a big deal out of it, creating The Road to Limaas a multi-year, major project. The last time these annual meetings had been held in Latin America was 1969 in Rio. They hadn’t been back largely because the seventies didn’t turn out the way it had been hoped. People back then struggled to realize what was going on, though a good many others had foreseen the future. Nobody wanted to listen.

Earlier in 1969, the Federal Reserve’s policymaking body, the FOMC, was trying to come to terms with one major monetary change pointing more and more toward impending uncertainty. There was this thing called a eurodollar creating all sorts of havoc. Worse, foreign central banks were starting to get agitated about it.

This eurodollar disruption was partially an outgrowth of outdated (and misapplied) government intervention. Regulation Q had prevented banks from paying competitive money rates. It hadn’t mattered up until the late sixties because rates remained low. By 1968, however, most had reached their statutory max.

The eurodollar market didn’t have any restrictions because it was offshore not just from the US but from everywhere. In the spring of ’69, US banks began to lose large chunks of especially time deposits (CD’s). Except, they didn’t actually lose them, it only appeared that way to dinosaur policymakers whose statistics and accounting can’t ever catch up to constant change.

Instead, a US bank customer who was interested in those higher offshore rates would simply call up his NYC banker and have them move the CD to the bank’s foreign subsidiary operating offshore (oftentimes nothing more than a brassplate on some nondescript office door in the Caribbean). The customer received the higher interest and the bank kept the customer and his money. To make up for the lost funding for the domestic bank arising from that liability transfer, the foreign sub would then “lend” eurodollars back to its US parent.

As it began to work out more and more this way, it ended up causing some relatively significant domestic disruption, particularly for the smaller US banks (still called “country” banks in those days). In February 1969, it almost appeared like a bank run, which is why there was suddenly so much discussion about eurodollars (officials had tried to avoid the subject for its entire history to that point).

From the FOMC Memorandum of Discussion that month:

“These funds were then channeled through the Euro-dollar market to the largest banks, with an actual basic reserve surplus developing in New York City banks last week and a record level of borrowing by country banks. These twin developments had the result of taking some of the pressure off the Federal funds market as the most aggressive bidders had less urgent needs and country banks made greater use of the discount window. This in turn helps explain last week’s anomaly of the highest level of net borrowed reserves in 16 years and a relatively comfortable Federal funds market.”

To the accounting of the time, it didn’t make much sense this divergence of Discount Window volume from the federal funds rate. Normally, the two would be in sync; if there was a growing liquidity problem the fed funds rate would go up as borrowing at the Discount Window did.

Rather, in 1969, the domestic system was beginning to align itself with the foreign system for redistribution. US dollar growth and expansion wasn’t really a domestic issue any longer. The banking system was being creative.

Chicago Fed President Charles Scanlon is noted to have been “impressed by the ingenuity of people engaged in the Euro-dollar market who had already worked out various methods of escaping the constraints of a possible imposition of reserve requirements–including the use of brokers and repurchase agreements on Euro-dollars.”

At the same time, some members of the FOMC recognized the blind spot being developed by this “ingenuity”, with the minutes of that meeting recording some appropriate angst; “[the exploration or use of other monetary devices is] casting increasing doubt on the validity of the regular bank credit statistics that we follow.”

As usual, it was Open Market Desk Manager Charlie Coombs who saw the full range of possibilities, positive and negative. In April 1969, Coombs would warn:

“The situation could be particularly serious because the Euro-dollar market had become an increasingly important source of financing for industrial and commercial enterprises not only in Europe but in the whole world. One bankruptcy could attract a lot of attention, and if it led the European commercial banks that had been supplying funds to the market to reassess the credit risks they faced, the result might be a sudden scramble for liquidity.”

It was an entirely bank-centic monetary ecosystem, operating far outside the authority of any central bank. And yet, it was already in 1969 causing menace inside the domestic monetary systems of many of the world’s largest economies. These weren’t all malignant changes, some far from it like the rise of wholesale financing that would eventually work itself out even to those country banks shocked into the Discount Window by this transition.

But Coombs’ cautionary admonishment was also a bit understated. He had said almost half a century ago that this credit-based monetary system would be at risk when “one bankruptcy could attract a lot of attention.” The illiquidity spiral from there would not be left at eurodollar markets’ borderless borders. This was, obviously, what happened in 2008.

Bankruptcy need not be the specific trigger, though. In the several crises since 2008, two so far, and now a third emerging, there hasn’t been anything like that. The closest was in November and December 2011, when several European banks were rumored on the verge of collapse (this is what provoked a third QE in the US, a further misinterpretation of events and circumstances). But in 2014, bank failures or even fears for them played no role whatsoever.

The eurodollar system has become vulnerable to much smaller irregularities which might trigger “the market to reassess the credit risks they faced” having most assuredly led to “a sudden scramble for liquidity” to which no central bank anywhere might answer.

The Federal Reserve has taken the same approach since 1969, a doctrine of “benign neglect” which is no longer benign (but it is neglect). In April of that year, despite Coombs and several others pitching what amounted to total global monetary revolution, the Memorandum of Discussion answers it meekly with, “Fortunately, we don’t have to reach a conclusion today.” Fifty years later, and now they’ve completely lost track of eurodollars.

Along those lines, the IMF and World Bank are more image consultants than effective supranational financial organizations. Their 2015 Annual Meetings in Lima were perfect examples. Rather than understand the nature of the world, why a third QE in the US might have to have been contemplated at all, or what was really going on with China’s sudden strain, the two bureaucracies were busy with photo and essay contests intent on engaging especially young Latin Americans.

Their 2015 Youth Photo Contest as part of the Road to Lima was conducted “through the eyes of youth in Latin America.” The essay challenge was “shaping Peru’s national agenda: a youth perspective.” And so on.

There’s nothing wrong with attempting to convince (cajole?) the next generation of emerging market residents that the status quo of globalization is good for everyone. But that effort is futile if it begins under a doctrine of global monetary neglect, international money which is really those two organizations’ primary purpose. Maybe get that one thing right before the fluffy, fuzzy PR stunts?

By October 2015 when the Road to Lima finally reached Lima, global turmoil was the common buzzword though no one could answer why. The myriad official officials who attended, along with the numerous official statements sent to be read into the official record, were all careful to skim past the topic.

The Chair of the 32nd Meeting of the International Monetary and Financial Committee was Mr. Agustín Carstens, Governor of the Bank of Mexico. All he would say was, “The global recovery continues, but growth remains modest and uneven overall. Uncertainty and financial market volatility have increased, and medium-term growth prospects have weakened.” It sounds eerily familiar. Governor Carstens would then claim, “emerging market and developing countries are generally better prepared than earlier for a less favorable environment.”

I’m sure Latin America’s youth were thoroughly unimpressed by the attention to window dressing as their economies, most of them, were being decimated. Presumably Banxico’s official representative meant foreign reserve stockpiles when he said “generally better prepared”, the very thing the IMF was supposed to support and understand. Most EM nations had been gaining in official “reserve” assets for years, decades, attaining truly impressive balances by 2015.

One of those, by far the greatest example, was China. According to Chinese statistics, those compiled by the State Administration of Foreign Exchange (SAFE), reserves had peaked in June 2014 at just shy of $4 trillion. In the October 2015 IMF/World Bank tradition of being disingenuously understated, China’s representative in Peru, Yi Gang, now the head of the PBOC, wouldn’t really have all that much to say about it:

“China has recently experienced some capital outflows. Several factors have contributed to such outflows. First, companies and individuals adjusted the currency composition of their assets and liabilities as the expectation of the RMB exchange rate changed. Second, companies reduced their foreign financing and repaid foreign debts, which helped lower leverages and address currency mismatch. Third, domestic companies increased their hedging against exchange rate risks, which translated into more demand for foreign exchanges.”

Some capital outflows? Good God, in early October 2015 SAFE had reported that in September China’s official reserve balances had dropped by $479 billion cumulative, almost half a trillion since the middle of 2014. And that was just what could be reported. These “capital outflows” would continue so that by January 2017 China had shed an incomprehensible $995 billion in all, very nearly a full trillion from the official count.

Rate hikes and the Federal Reserve had nothing to do with any of this, apart from straight up dollar dereliction.

Did it work as advertised? Of course not. It was the most conclusive example of “they really don’t know what they are doing” ever conceived. As I wrote elsewhere this week, if you can’t rescue your currency and economy after blowing through $1 trillion, then NO ONE can anywhere.

All that stuff Yi Gang used to downplay the massive disruption, companies adjusting their currency composition, lower leverages and currency mismatch, as well as hedging, these are all actually different forms of the same thing Charlie Coombs was talking about in the spring of 1969. It’s nearly 2019, and Chinese officials are facing the same problem all over again.

Not only has CNY plummeted this year, SAFE reports that in the past two months China’s official reserves have declined by a sharp $57 billion. In October 2018 alone, it was the largest monthly “outflow” since 2016. The two-month reduction is, alarmingly, every bit like 2015.  

The major problem is not just that it happens but that it keeps happening. The global banks that make up the eurodollar are far greater than any single nation, even China and its $4 now $3 trillion. Even the United States. I’m not talking about political power but monetary creation and ultimately destruction. The IMF as well as all the rest of wider officialdom keep referencing “outflows.” So long as they do, they will keep getting it wrong.

It’s not so much outflows as it is offshore. Eurodollars flow in to a place but since they are nothing more than the product of decades of bank ingenuity, as Charles Scanlon noticed long ago, these aren’t like currency and traditional money. It’s just numbers on a bank computer screen. And if they are just numbers, they can, actually, disappear once that bank starts acting like Coombs warned. Not outflow, offshore dollar destruction.

While eurodollar evolution altered the domestic arrangement in very complex ways, in places like China it was far simpler. I’ve recounted this flow many times before; external money defines internal money. In other words, as China “loses” eurodollars it must restrict its own monetary condition. Tight offshore dollars become tight onshore RMB.

Therefore, given what’s already happening there, all these negative pressures are just now starting to converge – like in 2015. The PBOC has moved to try and offset internal RMB tightness with RRR cuts, three so far totaling 250 bps. And now SAFE reports accelerating eurodollar destruction, Coombs’, “European commercial banks that had been supplying funds to the market to reassess the credit risks they faced, the result might be a sudden scramble for liquidity.”

In short, this is just getting started. No bankruptcy required. The eurodollar has become just that fragile.

The major central banks around the world along with the IMF and World Bank they are still clinging to their idea of an inflationary global breakout. Yet, all the symptoms are in place again for the exact opposite. This is renewed deflation, and the further we go in 2018 the more it can’t be denied by honest analysis.

Last Friday, even Bloomberg was forced to consider, “The world’s major economies that entered 2018 accelerating in sync risk entering 2019 decelerating in sync.” That’s putting it charitably. Central bankers are always the last to find out.

The Road to Lima should have been paved by an unshakable devotion to studying honestly what really happened in 2008. With three years between September 2012 and October 2015 they may actually have figured it out in time. Eurodollar, not dollar; Lombard Street, not Wall Street. If officials really want to make this about the children, as they so often do for their own ends, they should commit to basic competence with an open mind.

If nothing else, someone please tell the youth of Latin America and the rest of the world how China could so squander an entire, mind-boggling $1 trillion and here the whole world is facing the same deflationary prospects with especially Latin America having yet to recover from the last one. Heck, just go back and read some of the things that were being discussed half a century ago. There’s a cruel irony in the Road to Lima.

Ultimately, it’s their future being that is being set afire. Somehow, a photo contest doesn’t seem a fair trade for the world’s youth. The Road to Lima was an obstructively meaningless gesture, just like QE3.

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

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