Vijay Kumar Gaba: Reserve Currency

Wednesday, June 17, 2020

Investors Beware - 2

The rise in equity indices in the wake of global pandemic and its long term socio-economic consequences is keeping most experts busy. The central bank bashing is the favorite theme of market participants, like anytime in past 33years, ever since Alan Greenspan took over the Chair of US Federal Chairman and assumed the role of the "champion of stock markets" after 1987 market crash. Since then the markets have been overwhelmingly depending on the central bankers to support any fall in stock prices.

Greenspan is criticized for both creating and causing the burst of dotcom bubble in 2000. It is popularly believed that the easy monetary policy unleashed by him during 1990s to support Clinton's deficit reduction program led to creation of massive dotcom bubble. It is also a popular belief that hiking rates many times by Greenspan in 2000 led to bursting of dotcom bubble. Both the popular beliefs are however contradicted by the empirical evidence. Greenspan was actually a monetarist who religiously followed the Taylor Rule of inflation targeting. In 2000 also, he started raising the rates only after the bubble had already burst. Till the party was on, he neither hiked rates nor tightened the margin requirements. He again supported the markets by a series of cuts post 9/11 incident and was widely blamed for rise in asset prices, especially gold and building of sub-prime crisis.

The detractors of present Fed Chairman are criticizing him for taking the economy for a tiger ride. They fear that the ride could end only in one way, i.e., the tiger jumps off the cliff taking the economy into the deep abyss with it.

(Strangely, back home RBI is being criticized for not emulating the central bankers like US Federal Reserve, European Central Bank and Bank of Japan etc.)

As an investor, I am carefully watching the global monetary policy actions and taking note of the following:

(a) The printing of new money by Fed, ECB and BoJ may not be too much of a problem as yet, as presently the money velocity is at lowest in recorded history, and any new dollar printed does not augments the money supply in any measure. So one should be watching money velocity more closely rather than the amount of new dollar/EUR/JPY printed.

(b) As per the Bank of International Settlement recent data, the current total international debt securities outstanding is over USD25trn. Out of this about 50% debt is denominated in USD terms, and about USD2trn of this USD denominated debt is maturing in next 12 months. Despite the unprecedented amount of load on the printing presses, there may not be sufficient USD available in the world to discharge these liabilities.

One should be watching this space closely to see how this debt is discharged or rolled over and at what price. Shortage of USD in international markets for discharging these liabilities could result in temporary spike in USD exchange rates. The borrowers who are not fully hedged against their USD liabilities could face serious solvency issues. Also the effort to develop an alternate reserve currency, preferably a neutral currency, shall also accelerate putting pressure on USD. This game of push & pill might lead to heightened volatility in currency market raising the cost of hedging. The impact on exporters' earnings needs to be observed closely.

(c) More than USD11trn worth of bonds are presently yielding a negative return. This means the low rates are here to stay for longer; and the central bank shall continue to pump in cash in the system to grease the wheels of economy. The COVID-19 led deeper recession shall require even more new money to fill the larger fiscal gaps. For next couple of years this should not be too much of a worry for asset owners. But one needs to be prepared for the eventual collapse of the fragile mountain of debt.

....to continue tomorrow

Wednesday, May 6, 2020

Investment Strategy - 2

Continuing from yesterday (see here)

Before I share my thoughts on USD and Gold, I would like to make it clear that I am a simpleton who:

(a) does not understand the economics beyond its first lesson which says all economic decisions involve a trade off and price of things having economic value is determined by their demand and supply at that given point in time;

(b) does not know how to play with data on Microsoft Excel Sheet;

(d) seriously believes that numbers invariably follow the good story.

In my view, the currency of any country is nothing but an “unsecured zero interest bond” issued by the respective central bankers. This bond usually loses its value with the passage of time due to inflation.

Since 2008 global financial crisis, central bankers in the developed world, especially US Federal Reserve (Fed), European Central Bank (ECB), Bank of Japan (BoJ) and Bank of England (BoE), have created enormous amount of virtual currency (not physical) under various QE programs.

In the second step of QE, the central bankers have exchanged this virtual currency with interest bearing sovereign and corporate bonds. This way while the banks are saddled with the virtual currency that cannot be put in the ATM machines for the savers to withdraw and spend; the central bankers are able to earn additional income by way of interest on the bonds bought by them from the banks and fearful savers. This additional income has helped the governments in extending a variety of stimulus payments to the citizens. Moreover, this enormous buying of securities by the central bankers has also created an artificial scarcity in the debt market and hence allowing the governments to borrow at significantly lower cost. It may be pertinent to note that over US$17trn worth of bonds are now trading at negative yield.

In the third step of QE, the central bankers of developed countries have tried their best to create an acceptable level of inflation in their respective economies so that they can also make some capital gains as the “virtual currency” rotting in the bank accounts depreciates in its value.

While this is the usual mechanism of monetary policy since 2008-09, the case of USD has another manifestation. Besides being the medium of exchange and "unsecured zero interest bond" for the US citizens, the USD is also used as a medium of exchange for a large part of the bilateral global trade. Accepting USD status as an unchallenged global currency, many countries have pegged the exchange rate of their local currencies to the exchange rate of USD. So, even if an Indian trader agrees to sell some goods to a buyer in Dubai and accept payment in AED (UAE currency), in effect his transaction value is measured in USD terms as AED exchange rate is pegged to USD.

The exchange rate of USD in relation to other world currencies is influenced by the physical USD in circulation. The enormous amount of virtual USD created by Fed has helped reducing the supply of physical USD to the world and hence increasing the relative value of USD. For example, the US asset prices (especially equity and bonds) have seen material rise in prices thus attracting investments from world over; and the large fiscal stimulus enabled by QE has made businesses in US relatively more profitable thus reversing the current account deficit trends (large US CAD traditionally has been a major source of physical USD supply to the world).

So far so good for US as it's all win-win for businesses, government and common people. But unfortunately all good things must come to an end.

Taking advantage of low interest rate on USD funds and plenty of liquidity, many global borrowers had borrowed money in USD. As per some estimates, about US$13trn of this debt will come up for repayment in next few years.

As institutional market research at Global Macro Investor, succinctly puts it—

"the $13tn short dollar positions (foreign dollar debt held mainly by foreign corporation and investment vehicles) is the largest position ever taken in the history of global financial markets. It can only mean a massive, uncontrolled dollar rally.

QE will not fix this. Swap lines will not fix this. A debt jubilee would fix this or multiple trillions of dollars in write-downs and defaults.

It is the dollar strength that brings to world to its nadir (just like the 1930s). It is the dollar system that is the really big problem.

This eventually breaks the dollar after a super-spike as global central banks are forced to find alternatives. They are already working on digital currencies for exactly this.

The biggest event of all of our lifetimes has now begun to come clear. We are still only in the first phase – the panic. It will most likely play out in three acts over several years:

First, the panic, which is the liquidity phase.
Then the hope, which is the correction phase.
And finally, the insolvency, the brutal phase that changes everything, including the system itself."

In my view, these phases will play out in much shorter span of period (may be 5-6years).

The strength of USD itself will divert the global trade away from USD, as the commodity producers may not be able to manage their local economies with their produce priced in expensive USD. We shall see more bilateral trade and multiple smaller trade blocks. The first signs of this trend shall emerge from rise in volumes of oil traded in CNY; de pegging of Arab currencies; more jurisdictions granting legal tender status to cryptos, etc.

US government defaulting on its debt obligations to China, as reported by a section of media (see here), may further expedite the process of USD cessation as global reserve currency.

...to continue tomorrow