Hoping Looming Downturn Moves Monetary Economics Forward
In May 2013, Mark Carney, Governor of the Bank of Canada, was at the University of Alberta lecturing Canadians on what went wrong. A lot of things, he said, though he would spend the vast majority of his speech diagramming what central bankers were going to do about it. At least in Canada, if not specifically Mr. Carney. He had been appointed Governor of the Bank of England in November 2012 and by May 2013 was merely awaiting his promotion to take place two months later.
The Great, Grand, Global Financial Crisis of 2008 was appreciated that way in Canada. Among a few other spots on Earth, there wasn’t any other way to take it. Like Japan, Germany, or China, Canada’s economy and markets are quite susceptible to the whims of global flows. Not just in terms of trade also basic finance.
In Alberta half a decade after, Carney came close to getting it right:
“It is safe to say that most policy-makers didn’t see the crisis coming. In part this was because central banks underappreciated the scale of endogenous liquidity creation in the system. In addition, while central banks may have lamented the large and persistent global current account imbalances that had emerged in the pre-crisis period, we failed to make the link between these flows and rising financial imbalances in many advanced economies.”
So close. It certainly was “endogenous liquidity creation” but not with respect to the Bank of Canada, Bank of England, nor the Federal Reserve. From their outdated, outmoded points of view, it truly was an exogenous crisis because, as Carney struggled to point out, the global banking system had developed its own monetary language which central banks just weren’t privy to.
Not that they wanted to be, which was Carney’s chief point. Even if he didn’t quite fill out the whole picture, he did allow that maybe central banks shouldn’t have been so complacent (derelict, my word not his) on the monetary front. These “large and persistent global current account imbalances” might well persist further on even if central bankers like Carney in Canada or England never gets around to exactly why.
To their credit, the Canadians almost alone on the planet set out to do something about it. The renewal of global monetary imbalance in 2011 seems to have lit a fire under somewhat reluctant politicians.
During the crisis, a lot of different things happened that were never supposed to have happened. Things that as late as late 2007 or even early on in 2008 would have been thought ridiculous and preposterous. Central banks in particular were always in the background, not the foreground up front blazing away with all sorts of programs, liquidity auctions, and wild experiments.
The Canadian experience was similar in that way, the Bank of Canada under Carney becoming ever-so-bloated as authorities futilely attempted to stop that which they didn’t understand.
In the month of August 2008, the Canadian government held about CAD 2.8 billion on deposit with the central bank, whose assets totaled no more than CAD 55 billion. Three months later, by November, the government’s balance ballooned to CAD 26 billion while the Bank of Canada’s total assets surged to nearly CAD 79 billion (a 43% increase for the latter).
There had been, surprise, surprise, a liquidity crunch in Canada which took on the same sorts of multi-dimensional proportions as they had everywhere else. To put it simply, Canada had a collateral problem, too, and authorities tried to tackle it in the same ways as others were doing.
Like German or English banks, Canadian banks had stocked up on “toxic waste” during the precrisis period, one key piece of the undetermined “endogenous liquidity creation.” These were used in repo to fund those as well as other positions (including EM corporate and sovereign junk). Collateral transformation was as popular North as South, East, and West.
The government of Canada didn’t need the excess funds created during the crisis, rather Canadian banks needed solid paper that they could not otherwise obtain as global collateral chains disintegrated. Just as the US Treasury Department essentially created collateral out of thin air (Supplementary Finance Program) using the US central bank as intermediary (reverse repo), the government of Canada sold bills to BoC that were then redistributed via the latter.
This isn’t to say that the government didn’t appreciate nor want the liquidity cushion created as a byproduct. They did as things were tough especially in the provinces. Authorities in the aftermath vowed they would never let it happen again.
Perhaps when the crisis in 2011 struck it struck a little too closely for their comfort. The idea of again wasn’t some far off future date. Whatever ultimately the short-term justification, government and monetary officials would agree later in that year to build up Canada’s liquidity position. It needed to be done because, as the 2011 emergency made plain, those global monetary imbalances sure were persisting.
As part of its June 2011 Budget Process, the Canadian government announced that it would raise CAD 35 billion over a three-year period. This was not a fiscal situation, rather a clear desire to gain some insurance as to global monetary risk (they didn’t mention the poor performance of US QE’s, two of them by that point, but they needn’t have since the failure of both was laid bare by the very fact our immediate neighbors were forced into something like this).
The purpose was “to safeguard [the government’s] ability to meet payment obligations in situations where normal access to funding markets may be disrupted or delayed.” So much for Ben Bernanke. Or Mark Carney, for that matter. Of that CAD 35 billion the government would raise, CAD 20 billion was to be held on deposit at the Bank of Canada, CAD 5 billion as sort of pocket change kept in the hands of private Canadian banks, and the balance, CAD 10 billion, allocated to something called the Exchange Fund Account (EFA).
Canada’ EFA is tangled up with Canada’s central bank, too. The latter manages the former on behalf of the Finance Minister of Canada. In fact, the fund’s accounts are literally held in the Finance Minister’s name. EFA policy is therefore the responsibility of the government but largely carried out under advice from the central bankers.
The fund has a lengthy history which has seen its mission change as the global system has evolved along with Canada’s place within it. It started out as a vehicle by which authorities might manage the Canadian dollar’s float. It gained assets in the eighties as CAD was on the rise, then was depleted of them in the nineties while the official sector tried to cushion its fall.
It had been largely static in the years before the crisis, finally getting some appreciation by about 2006 through August 2008. From that particular August through October, however, it wasn’t US$’s that were disappearing from assets; it was an enormous drain of “other” currency assets.
The EFA, as other sovereign funds of this nature, doesn’t work really in the way you might think. We are all taught that these governments hold “reserves” of foreign currency, conjuring up images of central bank vaults filled with notes of all colors and shapes, physical currency bills belonging to various governments from all around the world.
There are no stacks of cash in this modern system.
Canada’s EFA gets its “reserves” through currency swaps. It borrows them in FX markets, occasionally cross-border repo. That changes things immensely, an “underappreciated scale of endogenous liquidity creation in the system” to which the government of Canada as others around the world are complicit. Yes, they really don’t know what it is they do.
In other words, it doesn’t really matter how much Canadian dollars the government might raise, it will always be at the mercy of the global banking system with which these are swapped. If the government of Canada claims it has CAD 48 billion worth of US$’s, as it does in its latest statement of foreign “reserve” liabilities, that’s technically true but practically worthless as practical experience has shown.
Instead, the government of Canada has CAD 48 billion in global bank liabilities denominated in dollars that may not be as easy and simple as the theory covering this activity would like you to believe. There are times when swapping FX is a devilishly costly affair, usually those same times when you need those eurodollars, or euroeuros, the most.
This is another element of “underappreciated” “endogenous liquidity creation in the system” at least the Canadians have tried to manage. Four months after Carney departed Canada for England, the Finance Ministry as well as the Bank of Canada opened “bilateral” discussions with private “market counterparties” (thus, it could only have been bilateral if the government and BoC were acting as a single party). Why?
“The discussions will focus on the Government’s margining and collateral policy for cross-currency swaps to allow the Government to fund its reserves more cost-effectively and reduce its counterparty credit risk on these swaps.”
If ever there was a phrase that most aptly described the eurodollar system, this is it: “to fund its reserves.” The entire planet’s monetary arrangements are “funded.” That means banks and bank balance sheet capacity.
You would think that it would be just this easy for central bankers to realize what they are dealing with; alas, once you realize the nature and structure of this system you also have to come to grips with how there are no central bankers in it. They are exogenous. This is what prevents them from appreciating on an intellectual level how things actually work, even if occasionally some of them gain even useful technical competency from time to time.
To put it bluntly, Canada has US$’s only so long as some bank somewhere (offshore of both Canada and the United States, most likely) wishes to swap them some which aren’t really dollars in either denomination. They are pure bank liabilities that both parties (bilateral, including BoC on the one side) simply agree have to be US$’s (or euros, as they probably were in the late summer and early fall of 2008).
But if one of those parties decides it is more costly or difficult to provide them, what might happen to Canada’s official reserve stock? This is no mere rhetorical exercise, as you can probably guess.
Canada’s Finance Ministry reported that in the middle of March 2018 the country held CAD 87.3 billion in total “reserves”: CAD 51.6 billion in US$’s; CAD 25.4 billion “other”; CAD 8.2 billion in SDR’s; and CAD 2.1 billion other IMF reserves.
By the week of May 23, Canada’s reserves had dwindled to CAD 80.6 billion. The whole country “lost” nearly 9% of its official reserves in nine weeks. Not just any nine weeks. Between mid-March 2018 and May 23 it was the big jump in the exchange value of the US dollar, this last eruption of EM currency crisis.
Except it wasn’t strictly EM’s, was it? It has been talked about that way, to be sure, though it was a global monetary disruption that struck a lot of different places. And it culminated, at least this one stage, which appears to be only the first stage, with the wild trading in global sovereign bond markets up to May 29. Yes, collateral.
Last week, the Bank of Canada announced a new policy for how it would fund its own balance sheet. On its liability side, the money side, there is mostly currency in circulation and then these government deposit balances. But in order to have either of those the central bank requires assets of some kind. BoC had purchased only government debt before.
Now, Canada’s central bank has claimed the authority (I can’t speak for or against their legal and statutory justifications as they are spelled out currently) to include mortgage debt in their basket.
Some people are claiming a government attempt to bail out Vancouver and Toronto, housing markets that were on fire (to put it mildly) but are more suspect of late. Maybe, but more likely is the reason included within the central bank statement. When the liquidity buffer was built up between December 2011 and July 2013 it required the BoC become a very large buyer of Canadian government bonds, maybe too large of a buyer.
When the Bank of Canada like the Federal Reserve owns a lot of these kinds of high value sovereigns, it leaves perhaps too few for collateral purposes. If Canada’s central bank can spread out its asset side among MBS (technically “Canadian dollar federal government guaranteed debt securities issued by federal Crown corporations”) that could leave more float for reasons of private modern money factors.
“The expansion of assets the Bank can acquire for its balance sheet is done to provide the Bank with more flexibility in the range of high quality assets it can acquire to offset the continued growth in bank notes. It also allows the Bank more flexibility, should it be necessary, to further reduce its participation at primary auctions of Government of Canada bonds to help increase the tradeable float of those benchmark securities and hence support their secondary market liquidity.”
It could also leave the government of Canada more options to quickly raise new deposits and liquidity buffers “should” the need ever arise (again) without having to strip federal government debt markets of the paper in order to do it. It might seem in certain perceptions they are more a little concerned about collateral perhaps for reasons beyond strictly collateral.
To be clear, that’s not what Canadian officials at either the BoC or Finance Ministry are claiming. In every official release the justification is always “growth in bank notes”; i.e., currency in circulation within its borders.
Canada is more fortunate in that one sense; its external monetary problems aren’t encoded directly upon its internal requirements. Other places aren’t so lucky, though luck really has nothing to do with it. I’m writing, of course, about China. There are more than a few parallels between the Canadian and Chinese experience with the eurodollar system despite some key structural differences.
As expected, in October Chinese currency growth ground to a halt. The “growth in bank notes” for China was on average the lowest on record. Bank reserves collapsed, dropping nearly 8% year-over-year having become a situation that was very much like late 2015 and early 2016.
That about sums up October across global markets.
If Mark Carney had been able to follow through on his Alberta summation, taking it to its logical conclusions stripped of so many ideological decades, he may have taken with him to England the ability to influence global monetary understanding the way it needed to be just before the third eurodollar squeeze in 2014. It might have saved China the trouble of their terrible experience, and the rescued what might’ve been the only real path for the whole world toward full recovery.
I don’t want to give up on that possibility, and in some ways there is call to be encouraged. Speaking from experience, compared to 2013 there is a whole lot more interest in the “underappreciated the scale of endogenous liquidity creation” and the “large and persistent global current account imbalances” that aren’t really about the current account. The eurodollar remains an obscure topic, sure, but offshore is in some places now at least topic. The shadows a little less shadowy.
We can hope that this looming fourth downturn in the series will be enough to reach a critical mass to move monetary economics forward, and that maybe the economic retrenchment featured for it will be mild enough so that unlike 2014-16 it leaves us no more lasting scars. Like 2014, I wouldn't bet on it, though.
