FOMC Widens Scope Of Possible Interest Rate Changes

Tuesday, August 30, 2005

A slight change in the wording on future monetary policy is the most outstanding paragraph from the FOMC minutes from the latest Fed meeting three weeks ago. Until now the Federal Reserve's key point was to tighten monetary policy at a measured pace; i.e. 25 basis points at a time. Now, after 10 equal steps to a Fed Funds Rate of 3.50 percent, the FOMC puts more emphasis on containing inflation in times of runaway oil prices. While staying on a measured pace is still tantamount, participants were of the opinion, that the pace and extent of policy adjustment would depend to a high degree on economic developments. Oil prices rose to a record of $70 bpd today, raising fears of a global economic slowdown.
From the FOMC minutes:
"In their discussion of current conditions and the economic outlook, meeting participants noted that aggregate spending appeared to have picked up in recent months by more than anticipated and that current estimates of slack were narrower than those reviewed at the June meeting. In addition, high and rising energy prices were adding to pressures on overall inflation, and energy price increases probably would feed through, at least temporarily, to core measures of inflation. Nonetheless, core inflation recently had been relatively low and inflation expectations remained well contained. Moreover, participants thought that some slowing in final sales was likely later this year as net exports resumed their decline and purchases of automobiles fell back with the expiration of special discount programs. In these circumstances, it appeared that, for now, continued removal of policy accommodation at a measured pace still would likely be sufficient to keep inflation contained, but participants also recognized that the pace and cumulative extent of policy adjustment going forward would depend importantly on economic developments."
The FOMC members also cautioned about the total effect of increased tax collections on the federal budget deficit this year.
"Regarding the federal budget, a recent narrowing of the deficit was noted, but the improvement appeared to be attributable to cyclical factors and to increases in the level of tax collections that were not likely to be repeated. Few signs were evident that greater fiscal discipline in the budget process would emerge any time soon. As a result, federal deficits were expected to continue to act as a considerable drain on national saving over the longer run."
The rest of the minutes resembled an uninspiring round-up of recent economic indicators, painting a slightly positive picture for the time being.
The wording on the housing market , which had changed from "hot" on May 3 to "robust" and "cooling in certain areas" this time.
The next FOMC meeting is scheduled for September 20.
Far more interesting appears the September 15 meeting of the Fed New York with the top-brass of derivatives trading of 14 major banks, Reuters had reported last week, citing a letter which bankers had received. Regulators from Britain, Germany and Switzerland will be attending the meeting too. Such a big event is unprecedented in economic times which the FOMC has been describing rather complacently.
The Federal Reserve has earlier this year repeatedly voiced concerns about the growth in credit derivatives, highly complex and difficult to price investment instruments. Both Fed chairman Alan Greenspan and governor Donald Kohn have asked banks to advance to more stringent risk measurement systems and increase their stress testing procedures.
Increased inflation pressure and the threat of slowing economic growth narrow the choices for the Fed, it seems. But maybe the American consumer will help. Insurance payouts in the wake of hurricane Katrina are very likely to get invested in household goods as soon as they will be distributed.

Will Greenspan Lose His Wreath Of Honour Before He Retires?

Monday, August 29, 2005

Exhausted by the myriad of reports from the Fed-weekend in Jackson Hole I managed to follow at least partly - while "clearing the brushes" on my modest plot of land - one core issue arose that did not get covered in those blogs who otherwise did an outstanding job of bringing us everything newsworthy from the event. Hat tips to Mark Thoma, David Altig, Tim Iacono, and Michael Shedlock. Sorry, I adhere to a 5-day week.
Will chairman Alan Greenspan, once even hailed as "the maestro" be able to save his wreath of honour into retirement which is 155 days away? Given the developments in the energy sector, the housing market, the non-core inflation outlook and the delicate fragility of economic growth lately it could as well happen that the public (and especially politicians with plummeting approval ratings) will look for a target that they can aim their rotten apples, eggs or tomatoes at.
Why is it that the echo of all the voices and writings about Greenspan suddenly sounds far less reverential than it did only a few weeks ago? Half the world has been abuzz the housing bubble in the US for quite some time. Greenspan has only recently strenghtened his speech from tame "regional bubbles" to "froth" and now to "the bubble" when he was talking about the property boom.
It seems as the world is finally coming face to face with the fact of record oil prices, the federal, local and personal indebtedness in the US, a wealth illusion built on low interest rates and a decaying infrastructure while under competitive pressure from the two emerging Asian giants China and India. Compiling these facts and several handful more listed in the post "FRB's Kohn: When the Unexpected Inevitably Occurs" it is understandable that people will begin to look for excuses.
Looking for a scapegoat is quite easy in hindsight. "Easy Al", so the maestro's new nickname has done too little, too late, a concern voiced first by his predecessor Paul Volcker who said in April, "Altogether the circumstances seem to me as dangerous and intractable as any I can remember, and I can remember quite a lot. What really concerns me is that there seems to be so little willingness or capacity to do much about it." In a TV interview Volcker then had also warned about "the lot of dollars we recently printed."
There is a growing concern that the acting Fed chairman was too accommodating in removing the accommodative interest rate policy of the new millennium with his 25 basis point hikes.
Greenspan's final days at the Fed could now indeed become a race with history. At $60 per barrel Greenspan said this could shave 0.75 percentage points of GDP growth. So what will $70 oil do to the economy, assuming the official forecast still stands at 3.5 percent growth in 2005, before taking into account adverse oil effects?
As there are more reasons for seeing oil trending still higher or at least plateauing on the current levels than for anything else, Greenspan faces the difficult task of balancing adverse growth effects with a worldwide desire to reduce dollar holdings. Russia has again rebalanced its currency basket to 30 (20) percent Euros in August and the Chinese were even better at that game, announcing a currency basket for the Yuan exchange rate without giving so much of a hint about the individual weightings. Korea is diversifying out of the dollar and so is Indonesia and several other Asian nations. This is bad news for the happy spenders in the White House. The US has to attract $3 billion every day (!) just to keep running. You don't get that kind of money when investors begin to think about uncertainty of the greenback's fate.
Greenspan will not be able to have the cake and eat it too. Either he keeps the dollar propped up by making it more attractive to foreign investors through higher interest rates and risks to pop the housing bubble and with it consumer spending; or he delivers to the economy and will stop raising Fed Funds above the 4-percent mark which is considered the lower end of the neutral zone. But that does not leave enough ammo in the holster for his successor in order to even out the next downturn of the economy that seems to be written on the wall.
NOTE I: I am overwhelmed by the emails that are still filling my in-box regarding the widely read post "Iranian Oil Bourse Could Kill The US Dollar" which also appeared in Asia Times, Financial Sense Online and spread from there onto still more websites. Please be patient; I hope to have answered all email by the end of this week.
NOTE II: Thank you to all my readers as I have crossed the 50,000-page load mark today. From my hometown to Mongolia, from NY to LA, from South Africa to Burkina-Faso or from Mexico to Chile, The Prudent Investor has gained a readership spanning the whole globe, including a good part of the Wall Street firms, countless federal authorities and governments as well as several central banks. A special salute goes to all fellow bloggers who helped me in this process by linking to my blog.

The Shortest Possible Investment Advice

Friday, August 26, 2005

Buy what China buys. (Commodities, Machinery)
Sell what China sells. ($, Finished goods)

BIS Warns Of Asset Price Deflation

Wednesday, August 24, 2005

William White, chief economist of the Bank for International Settlements (BIS), has voiced concerns that fighting inflation alone might be too little to save the global economy from a severe downturn. In an interview with the German daily "Frankfurter Allgemeine Zeitung" he pointed out that there was no significant threat of inflation in the USA in the 1920's but exuberant asset prices nevertheless led to deflation and the Great Depression.
"All central banks are focused on fighting inflation. Obviously they think containing inflation is enough to keep things orderly. But that does not have to be the case as history shows," White said.
According to White close to zero real interest rates worldwide may have led to an asset price inflation as loans have been funneled into financial investments and real estate instead of production and services. He thinks that prices of longterm bonds and corporate bonds could be due for a correction that could spill over into equity and housing markets.
White does not see a single-handed solution to these problems. Praising the Federal Reserve for its tightening he added that monetary policy is only one measure. A far better way would be if the USA would steer towards a more restrictive fiscal policy as this would also take off the pressure from monetary policy, he said.

OPEC Sees No End In Oil Price Rise

Inadequate refining capacity and geopolitical issues will propel record crude oil prices even higher, OPEC's secretary general Adnan Shihab-Eldin said in an interview with the Austrian daily "Kurier" on Wednesday. "Oil prices will not remain high, they will rise further," he said, adding that the little slack between supply and demand has led to a "fear premium" that falls and rises in the wake of any news about a change in supply. Shihab-Eldin said that OPEC members will be able to increase their daily production from a current level of 30.3 million barrels per day (bpd) by ten percent to 33 million bpd by the end of 2006. By the end of the decade OPEC should be able to pump 38 to 39 millions barrels per day, he said.
Approaching the colder season the OPEC secretary general sees little chances for oil prices to turn south as the bottleneck in refining is here to stay for some time. In addition to this he pointed out that growth in Russian oil production will fall to 100,000 bpd this year after Russia ramped up its production by 700,000 bpd last year.

Iranian Oil Bourse Could Kill The US Dollar

Tuesday, August 23, 2005

Can the Iranian Oil Bourse become the catalyst for a significant blow to the position of worldwide power the US Dollar enjoys? Manifold supply fears have driven the price of crude oil nearwards its recent highs of $67.10 which are also only a notch below historical records in real dollar terms. With the world facing a daily bill of roughly $5.5 billion for crude oil at current price levels it becomes apparent that sellers and purchasers of the black gold are looking into all ways that could lead to a financial improvement on their respective side.
While the worldwide bottleneck of inadequate refining facilities and partly dramatic declines in production - for example in the North Sea - are two factors that cannot be eliminated in the short term there is one area left which could result in smiling faces of oil producers and (most) buyers likewise. Non US dollar thinkers are the victim of a transaction cost in the oil trade. The necessary conversion of local currencies into greenbacks can be considered a hidden tax, charged and enjoyed by the banking sector.
Until now oil is solely priced, traded and paid for in the greenback on both markets in London and New York. The Treasury Inflow Capital data from mid-2005 show that OPEC members have parked only a skimpy $120 billion in direct dollar holdings which are almost equally split between equities and debt paper. This is a clear indication that oil producers are investing their windfalls elsewhere. The yield spread between US and EU debt papers in favor of the EU is clearly another hint where the petrodollars might flow after conversion.
The Iranian Oil Bourse (IOB) will become a factor that could unsettle the dollar's dominant position.
Especially in the case of Iran it does not make sense to accept dollars only for its much desired commodity. Being seen as a hostile country by the USA for the intention to build its own nuclear reactors one wonders whether the new IOB will not try to attract other buyers than Americans who are particularly unwelcome in that corner of the globe. Iran has recently announced that the new oil exchange will start up its computers in early 2006.
The IOB can count on two sharp arrows in their holster. It can - and probably will - lure European buyers with oil prices quoted in Euros, saving them transaction costs. And it can strike barter deals with oil-hungry giants like China and India who have a lot of products and commodities to offer. I doubt that hamburgers and legal services will be considered adequate collateral for the world's most aftersought resource.
A Renunciation Of The $ Is Worse Than An Iranian Nuclear Attack
Steering away from the almighty commodity, currency and commodity currency - the US dollar - can have a deeper impact on the US economy than a direct nuclear attack by Iran. The permanent demand for dollar denominated paper stems to a good part from the fact that until now almost all resources of the world are quoted in it.
While this has led to the Eurodollar market in the 1970's new terms of trade could ring in the demise of the dollar as the premier reserve currency. With the world economy depending so much on oil, the black gold itself can be seen as a reserve currency that will be handed out only against the best collateral in the future. The Fed San Franciscos's recent paper about the progress of the diversification of international central bank's reserves shows that the dollar position is on the decline in many countries. NOTE: China has officially declared to diversify a part of its forex holdings into oil here.
Iran holds a strong hand as the #2 producer of crude behind Saudi Arabia. Politicians there will also keep in mind that dollar deposits might become a burden in the future when the US will step up its current war of words to the level of economic sanctions in the crusade against nuclear power plants. Money in the bank does not help when you have no access to it.
An abdication from the current status quo has only one real enemy: the USA, where less than five percent of the global population consume roughly one third of global production. Oil in Euros would benefit several million people more in the EU and its trading partners though.
And it would loosen the grip the USA has on OPEC members. Thinking of the rapid growth of hostilities between the USA and Arab nations in recent years a renunciation of the dollar appears to be more than just a wish in Arabic dreams.
As this development poses a very real and big danger to the superior status of the greenback and the interests of the USA the "president of war" can be expected to steer a close reach against the winds blowing from the Middle East. One may be reminded that the Iraqi despot Saddam Hussein had entered into discreet talks with the EU, proposing to sell his oil for Euros. That was in the year before the first oil war of this century.
In my conclusion the IOB this way could help the Euro to become the interim primary reserve currency before China and India will rise to the first two slots in the global economic ranking in the next few decades, an issue discussed in the post "What will be the next big reserve currency."
A decline of the dollar's position in oil trading might also open the floodgates in other commodity markets where the dollar is the medium of exchange but where the USA has only a minority market share. A global economy driven by tough efficiency demands in the light of thin profit margins almost everywhere is a good primer for accounting changes in other commodity markets. This process could begin in resources like steel and energy and spread to all other resources that are marketed globally. The world outside the USA has a lot to gain and nothing to lose from it.
UPDATE: For more recent news on the IOB follow this link.
UPDATE February 2008: The Iranian Oil Bourse started trading in February 2008.

All These Geopolitical Issues - See Crude Advance Further

Monday, August 22, 2005

Last week's shortlived pullback of crude oil prices into the 63-dollar range seems to have been the golden opportunity to go long again. Summing up all geopolitical and demand issues it appears as the next round mark of 70 dollars for a barrel of the black gold is just around the corner - maybe as early as by the end of this month.
The most important issues that will nullify the chances of another significant drop in prices span around the globe:
Amidst all these dire news there is only one glimmer of hope left. Due to rapidly rising gasoline and diesel prices individual demand may slow down a little. Go to any online edition of newspapers from around the world and you will notice there are stories telling that drivers are cutting back on their car rides virtually everywhere. Even a good part readers of the Wall Street Journal, hardly a lower-income group, answered in poll last week that they have already changed their driving habits.
Federal Reserve chairman Alan Greenspan had said in July he expects consumers to shift from their gas-guzzling SUV's to more energy efficient cars. Just check when used car prices take a downturn and you will be able to pinpoint the beginning of that move.
Jokes aside, it looks as if the economy is finally getting dented from higher oil prices. Although experts do not tire to point out that oil is still cheaper than in the early 1980's in real dollar terms one has to remind readers that we are only an inch away from those levels as this slightly outdated chart from Oregon State University for gasoline prices shows. For a crude oil price chart in 2004 dollars click here.

Holiday Impression: UK For Sale

Tuesday, August 16, 2005

Being overwhelmed by all those negative US economic indicators having hit the wires today and which are exhaustingly commented by most bloggers in my blogroll in the sidebar I want to focus on some impressions from my recent vacation that took us on a very pleasant drive from Austria through Germany, France and England to Scotland.
  • Impression #1: Prices have become outrageous.
  • Impression #2: Gasoline prices have become even more outrageous.
  • Impression #3: UK Real estate is for sale on a massive scale.
  • Impression #4: Don't wear a backpack in the UK.
My observations on inflation or higher prices are purely anecdotal, but gasoline prices for premium gas (95 octanes) rose from 1.06 Euros in Austria to 1.24 Euros in Germany and 1.30 Euros in France to 1.37 Euros (0.94 pence) in the UK. Converted into US gallons (3.785 litres) and dollars this equals a price range between 3.24 and 4.49 dollars a gallon.
Being observant of at least the most basic health rules I cannot offer a BigMac comparison. Thanks to the healthy food we enjoyed I was able to avoid a heart attack when being presented with the bills in food joints which one can consider modest. Travelling with my teenage daughter the bill never contained much more than a pint of beer, water and two main courses. Indian restaurants will set you back roughly 25 British Pounds or 45 USD. Go to a pub and you will end up with a bill of roughly 30 GBP or 54 USD. Eat in a restaurant and 50 GBP or 90 USD are the minimum you will get away with. And I am not talking of city center hang-outs but only places off the beaten track.
Visiting the sights is another important factor in a vacationer's budget. Settle on an average 10 GBP or 18 USD for an adult and a child to gain entrance to one of those beautiful castles and palaces Scotland is known for.
If these sticker shocks haven't done it, your lodging bill will certainly keep your heart-pace in the upper end of the spectrum. Bed & Breakfast can run from 50 GBP or 90 USD for a nice place in West Scottish Kirkcudbright with en-suite baths and a magnificent breakfast to a 60 GBP or 109 USD for a dirty twin room without bath in Inverary. Maybe it would have been a bit less costly hadn't I parked my garage queen in the sight of the host who certainly knew that the village had no more vacancies.
Hotels are top-dollar. Don't expect to find anything halfway decent for less than 120 GBP or 217 USD and don't expect breakfast to be included if you're staying at a Holiday Inn.


PHOTO: Unfortunately the dozen of onlookers went on before I got my camera out.
While prices between England and Scotland don't vary that much the scenery certainly does. Anecdotal evidence only; but I estimate that at least 15 percent of the properties we passed on our drawn-out ride displayed a "For Sale" sign. This rate declines to approximately 10 percent the farther north one travels.
Despite the most recent cut in British interest rates people seem keen to get rid of their houses. Maybe the record number of personal bankruptcies that was reported in the Financial Times two weeks ago has got to do something with it.
Property prices have shown impressive rises in the recent past with some areas gaining on average 20 percent within a year. And this is the point where we come to question the "real value" of houses. A truly unscientific comparison between Austria, where housing prices are less than half of those in the US, and the UK rises the question whether badly insulated UK houses with single glazed windows are really worth that much more, taking into account that a lot of these properties are located in areas where it will be difficult to find employment with a halfway decent remuneration.
We visited a friend on the Isle of Skye, professional futures trader Duncan Robertson, who has seen the value of his two house property (with a truly great view) rising some 150 percent in the last three years. Him being a very sober analyst of financial matters, I can understand that he sees the time ripe to sell and move. As he said such gains are not sustainable and I agree on this one.
Turning south again the "For Sale" signs become more prominent again. Whether Blackpool, Liverpool or Shakespeare's home town Stratford-upon-Avon, property can be had anywhere and it will only be a matter of time until buyer's financial resources will converge with seller's expectations. My guess is that sellers will have to scale back their expectations at a distinct measure.
A last note: When you consider travelling to the UK think of something different than a day-pack as a carry-around. Carrying my small backpack that could probably easily be stuffed with several pounds of explosives I found myself at the center of attention in every shopping mall we entered.

Your New Guide For Interest Rates Sits In Beijing

Monday, August 15, 2005

The Far Eastern Economic Review features an interesting piece about the future course of the People's Bank of China (PBoC). Author David Green, senior economist at Hongkong's Standard Chartered Bank outlines the gaining importance of China's central bank in financial markets.
Zhou Xiaochuan, governor of China's central bank, is an influential figure. But he is not as important as Alan Greenspan. His successors will be though. Global financial markets will hang on their words - once they’ve been translated. This is because monetary policy will soon work as effectively in China as it does in the United States, and that will give the people who influence rates enormous power.
Mr. Zhou's limited influence is easy to understand. China's monetary policy still does not work as it might- bank-interest rates are mostly administered and many state firms do not worry about the cost of funds when they borrow. That means the People's Bank of China does not have anywhere near as much leverage over its economy as the Federal Reserve does.
In addition, the PBoC is currently caught on the back foot trying to cope with China's large foreign-exchange inflows, rather than being allowed to set rates to suit the needs of the domestic economy. A stable currency is of course not without its merits, but it falls upon the PBoC to stop any unpleasant inflationary fallout. And lastly, unlike Mr. Greenspan, Mr. Zhou works within a central bank that lacks institutional independence.
However, this is all changing. Interest rates in China are rapidly becoming freer, the PBoC is busy putting the infrastructure of modern monetary policy into place, and wider structural changes in the economy mean that rates already have more of an impact than they once did. Once the peg to the dollar is relaxed, and structural reforms are completed, then monetary policy will, over the next decade, become the main means by which China’s economy is managed, as it is in the United States.
So, here are three questions: First, why does monetary policy not work that well in China at present? Second, is the pegged exchange rate really causing the authorities serious monetary problems, as standard macroeconomic theory predicts? And what will a China with "free" interest rates and a more flexible currency look like?
In mature market economies, the interest rate is the main means by which the authorities moderate aggregate demand, calm inflation and, depending on their mood, reassure or petrify financial markets.
In China, it doesn’t quite work like this - at least not yet. Take two examples. In the late 1990s, China’s economy was in a rough way - real growth was probably plumbing the lows of 4% to 5%, and by some estimates it actually stopped. Deflation was everywhere, and the government was worried. In response, the PBoC brought bank interest rates down sharply. (The PBoC controls the overnight borrowing rate, but at present this is ineffective, so its rate policy is mainly achieved through adjusting the rates at which banks lend and borrow.) The one-year loan rate, for instance, fell to 6% in June 1999 from 15% in July 1995.
Nothing happened. In fact, credit growth actually fell. In order to get the economy going again, the government had to resort to a big fiscal stimulus. Treasury-bond issuance rose, and in 2001 many analysts suspect the central bank simply asked the banks to lend more. That marked the beginning of the huge credit expansion and investment boom that we are only now nearing the end of. The lesson that many economists took from this debacle: Fiscal policy works; monetary policy does not.
Fast-forward three years to when the government needed to calm things down. Year-on-year annual M2 growth hit 21.6% in August 2003, overall bank credit grew at 23.9%, and annual fixed-asset investment was booming at 30% to 40%. Overinvestment, officials worried, was going to create overcapacity and saddle the banks with a new wave of nonperforming loans. Something had to be done.
But what? Since monetary policy was apparently ineffective, raising rates was not a realistic option. Instead, the government curbed its fiscal stimulus and opened up its planned-economy toolbox. In April 2004, a "macro-economic adjustment" program was rolled out. This was targeted at several heavy industries, including steel, cement and charcoal. The National Development Reform Commission was given power to authorize (or not) a large swathe of investment projects, control over land development rights was tightened, and banks were advised to curb their lending appropriately. Instead of making funds more expensive through raising rates, the government chose to make them harder to obtain.
By June 2004, M2 growth was back below 16% year on year, domestic credit growth had fallen back, and consumer price inflation was heading downward. The PBoC was allowed to raise bank rates just once, in October 2004, by 27 basis points, perhaps just enough to signal rates could rise - but apart from that it has played a subsidiary role in macro-policy over the past 18 months.
Given this experience, it would be easy to be pessimistic about the prospects for monetary policy in China. Will fiscal policy always win out?
The answer has to be no. Ongoing structural changes mean that China’s economy is more sensitive to interest rates than a decade ago. State companies now often have to repay their loans, and so care more about the cost of funds. As more state firms are sold off, they will lose their lobbying power to keep rates low. Private companies are increasingly accessing credit, and they are sensitive to rates. Banks now lend much more to consumers - they account for 11% of today’s outstanding loans - and these customers will be sensitive to rate changes.
Many economists believe that rates could, and should, be used now to moderate excess demand in China. Consumer inflation may have calmed, but only because utility prices have been controlled through administrative measures. Upstream raw materials' inflation is much more serious than CPI - these prices are increasing at 5% to 6% a year. This is a problem since real rates (calculated by taking expected inflation away from the nominal rate) are still very low, and this has kept up investment demand during the 2001-04 boom.
Put aside all the controversy over whether the yuan is hurting the U.S. economy. Instead, let us look at the domestic consequences of the peg, and assume that the yuan is undervalued (which the rapidly growing current account surplus indeed suggests is the case). Usually, undervalued currencies cause inflation. This is because a cheap currency means more exports than imports, and the resulting current account surplus causes net inflows of money from overseas. These inflows add to the monetary base, banks lend all this money out to new customers, and before too long prices are rising because there is too much money chasing too few workers and goods.
In China's case, these inflows have been coming thick and fast - $206 billion last year, $101 billion in the first half of 2005, a 50% year-on-year growth rate. The PBoC has relied on three tools - and some good luck - to cope with these inflows.
The first tool is open market operations, mainly using PBoC bills. These allow the PBoC to take money off the commercial banks' books, giving them bills instead. The banks cannot lend out these bills to customers, thus stopping the creation of new money by issuing loans.
Net bill issuance accelerated in late 2004 to cope with forex inflows of $20 billion to $30 billion a month, and remains at high levels. During 2004, the PBoC withdrew a total of 616 billion yuan ($74.5 billion) from the monetary base through bill issuance in the interbank market. This was the equivalent of 36.1% of forex inflows for the year. In addition, the PBoC appears to have secretly issued 196.6 billion yuan ($23.8 billion) in PBoC bills sometime in May-June 2004 to the four state banks. In total, the PBoC sterilized 812.6 billion yuan ($98.3 billion) during the year, equivalent to 47.5% of forex inflows during 2004. This year, bill issuance has been ramped up more. In the first half of 2005, Standard Chartered Bank estimates there was an increase in outstanding PBoC bills of 645 billion to 672 billion yuan, soaking up the equivalent of $78 billion to $81 billion worth of the forex inflows. In other words, the PBoC sterilized 68% to 71% of the inflows.
The second tactic to control forex reserve inflows has been higher required reserve ratios, which are prudential requirements on banks to place a certain proportion of their deposits with the central bank. On September 21, 2003, the RRR was raised to 7% from 6%, and to 7.5% on April 25, 2004. These moves had the effect of withdrawing 203 billion yuan ($24.5 billion) and 111.2 billion yuan ($13.4 billion) from the system.
Moral suasion has been the PBoC's third tool. Officially, this involves guidance on which sectors banks should lend to - less to cement and real estate, more to agriculture and small- and medium-sized enterprises, for example. However, in practice many suspect it also involves the PBoC guiding the banks on how much to lend. The fact that overall credit growth has so closely cleaved to the PBoC's target strongly suggests that the big banks are coordinated.
The degree to which this has taken place, however, is difficult to judge. That's because the PBoC had a stroke of good luck. At just the right time, China's commercial banks are trying to meet the new capital-adequacy ratios of 8% by January 2007 that the bank regulator has imposed. Investments in PBoC paper and most other forms of debt, which carry no capital requirement, are now preferable to loans to corporates, which demand a capital equivalent of 100% of the value of the loan. This is apparently causing the banks to draw back lending, helping the PBoC out.
All this has important consequences for the costs that China has to pay to defend the peg. With big forex inflows, fast growing bank deposits and few other investment options, commercial banks are keen buyers of PBoC paper. This has meant that there are large amounts of liquidity in China's money markets, which has driven yields low. The overnight borrowing rate in the market is now hovering around 1.2%, and one-year PBoC bills sold for 2% in late May, down from an average in 2004 of 3.2%. The second chart shows the overnight repo rate just above the floor provided by the excess reserve rate of 0.99%.
This means that sterilization is surprisingly cheap in financial terms - it only cost the PBoC an estimated $3.2 billion last year to pay for all its bills, compared to some $15 billion to $18 billion of returns it would have made from investing the country’s massive reserves overseas. Even on a marginal basis, the widening rate gap between China and the U.S. means that the PBoC is making money on the deal.
This has implications. The government has shown it can cope with the forex inflows, at least so far. The scale of PBoC bill issuance - outstanding bills are now equivalent to 12.5% of GDP - is cause for concern, but again it is being managed. This weakens the case for a big one-off revaluation - more than 6%, say. Certainly, more flexibility - an initial band widening of 3% to 5% - would be welcome (and a consensus appears to be emerging in favor of such a move). But the danger of undermining export growth with a big revaluation currently outweighs the danger of sparking more forex inflows with a small first move.
Now assume for a moment that the government reforms the currency regime successfully and over the next decade manages to complete its interest-rate liberalization program. By 2015, the renminbi trades against a basket of currencies, and capital flows in and out of China more or less freely. The PBoC sets the overnight borrowing rate at regular meetings, just like the Fed, and the commercial banks set their own lending and deposit rates. An active bond market, populated with decent private companies as well as government paper, means that a full yield curve can be calculated. What would all this mean for the economy?
Here are five things to expect:
The PBoC will quack like a modern central bank, but it won’t quite walk like one. Its team of in-house economists will be world-class, and its monetary-policy committee will enjoy much greater sway over economic policy than today. With state-owned industry marginalized, there will be less need to keep real rates low and stable. With monetary policy in play, the planned-economy tools - and their institutional sponsors - will wither away. Rate changes will be more regular. Firms and China’s 400 million-strong middle class will react when they rise. People will have to cope with higher mortgage costs.
One caveat: The PBoC will still be a government organ, with its governor appointed by the Communist Party leadership. Up till now, the PBoC has not suffered the usual problems associated with nonindependence - the government, for instance, has not told it to finance public debt, thus triggering inflation. This is likely to continue given the Party's strong preference for stability, both social and monetary. However, by 2015 the government will likely have built up more debt, which higher rates of inflation would erode, so the temptation for higher inflation will be there. Too low rates will also be a temptation.
A more flexible yuan will give more independence to monetary policy, but it won’t be total since exchange-rate considerations will still influence the rate decision. Over the next 10 years, interest rates will rise and fall more in relation to China's own economic cycle. However, it will not be all that easy since the PBoC will have to cope with structural pressure for yuan appreciation. China's rapid productivity growth - some 2.5% a year over the last 25 years - will be sustained if privatization, social security and financial sector reform are forced through over the next decade. Currencies tend to appreciate as productivity, particularly in the export sector, improves.
However, the importance of the tradable sector to China's GDP and job creation means that the currency will have to be managed much more, at least over the medium term, than in other continental-sized economies. This means that the yuan will appreciate against all of its trading partners over 2005-2010, but in order not to derail growth it will move only gradually. The yen's appreciation vis- a-vis the dollar from 1985, which led to an asset bubble and then the lost decade of the 1990s, is exactly what China wants to avoid. With an undervalued currency, the PBoC will likely continue to have to cope with net capital inflows. We expect the reserves to hit $1 trillion in June 2006. The central bank may well find that hiking rates at home exacerbates forex inflows, and this will constrain its monetary independence. The problem then will be that low rates will predispose the economy to asset bubbles.
Moving interest and exchange rates will drive the development of China's financial markets, as companies seek to hedge themselves against risks they've never had to face before. China's currency forwards market is currently small, with only a small number of local banks allowed to offer contracts, with price guidance from the PBoC. In May 2005, the PBoC released rules that expand the ambit of forwards, allowing interbank members the right to trade bills on a forward basis. Expect rapid development in these markets once there is exchange-rate flexibility.
Expect a few banks to experience some rate-related distress. A recent PBoC survey despaired of banks' inability to price and manage credit risk. This is holding back rate liberalization. As rates are relaxed, despite everyone's best efforts, a few of the smaller banks will likely experience problems as a result of mispricing loans or underestimating credit risks. Lower limits on bank loans and upper limits on bank deposits will remain in place for quite some time - perhaps until 2010.
Mr. Zhou's successors will not enjoy their new-found influence. China's PBoC will be the only developing country central bank with the power to move global markets like the Fed, the European Central Bank and Bank of Japan. That is all well and good. However, given the relative volatility of China’s economy, the lack of transparency of the decision-making process and the fact that the PBoC still has to learn how to manage the market's expectations, this will be a challenging job.

Wikinvest Wire