Category Archives: International Reserves

When Safe Assets Are No Longer Safe

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The U.S. has long benefitted from its ability to issue “safe assets” to the rest of the world. These usually take the form of U.S. Treasury bonds, although there was a period before the 2008-09 global financial crisis when mortgage-backed securities with Triple A ratings were also used for this purpose. The inflow of foreign savings has offset the persistent current account deficits, and put downward pressure on interest rates. But what will happen if U.S. government bonds are no longer considered safe?

The word safe has been used to describe different aspects of financial securities. The U.S. government in the past was viewed as committed to meeting its debt obligations, although the political theater around Congressional passage of the federal debt limit has introduced a note of uncertainty. In an extreme case, the U.S., like other sovereign borrowers with their own currencies, has the ability to print dollars to make debt payments. However, there is also a constituency of U.S. bondholders who would vehemently object if they were paid in inflated dollars.

Safety has also been linked with liquidity. U.S. financial markets are deep and active. Moreover, there is little concern that the government will impose capital controls on these portfolio flows (although FDI is now being scrutinized to deny access to domestic technology). Therefore, foreign holders of U.S. Treasury bonds can be confident that they can sell their holdings without disrupting the bond markets and contributing to sudden declines in bond prices.

However, there has always been another implicit component of the safety feature of Treasury bonds. Bondholders expect that they can claim their assets whenever they need to use them. The decision by the U.S. and European governments to deny the Russian central bank access to its own reserves has shown that foreign holders of assets placed on deposit in the U.S. or the other G7 countries (Canada, France, Germany, Italy, France, United Kingdom) may not be able to use these assets at precisely the times when they are most needed. The Russian central bank had accumulated about $585 billion, but approximately half of that amount is no longer available. The central bank still has access to about $80 billion held in China and $29 billion at international institutions, as well as its holdings of gold. But the latter will be hard to convert to foreign currency if potential buyers are concerned about retaliatory sanctions.

The loss of access deprives the Russian central bank of foreign currency that could have helped the government deal with sanctions on its foreign trade. Moreover, the monetary authorities have not been able to use their reserves to halt the rapid decline in the ruble’s value. The other sanctions, therefore, will have a deep impact on the Russian economy. The Institute of International Finance has issued a forecast of a drop in its GDP of 15% in 2022 and another decline the following year.

The use of sanctions to cut off a central bank’s access to its own reserves raises questions concerning the structure of the international financial system. Other central banks will reassess their holdings and consider alternatives to how they are held. But what other country has safe and liquid capital markets that are not subject to capital controls and are not vulnerable to U.S. and European sanctions?  The Chinese currency is used by some central banks, but it is doubtful that there will be a wide-spread transition from dollars to the renminbi.

Another concern has arisen regarding the ability of the U.S. government to meet its obligations. In order to satisfy a continued demand for safe assets, the government will need to continue to run budget deficits. But increases in the debt/GDP ratio leads to concerns about the creditworthiness of the government. This problem has been called a “new Triffin dilemma,” similar to the problem that emerged during the Bretton Woods era when the U.S. was pledged to be ready to exchange the dollar holdings of foreign central banks for gold. Economist Robert Triffin pointed out that the ability of the government to meet this obligation was threatened once the dollar liabilities of the U.S. exceeded its gold holdings. The “gold window” was finally shut in the summer of 1971 by President Richard Nixon.

These long-term concerns are arising just as the market for U.S. Treasury bonds has entered a new phase. The combination of higher inflation and changes in the Federal Reserve’s policy stance have led to increases in the rate of return on U.S. Treasury bonds to about 2.5%. With an annual increase in the CPI minus food and energy of approximately 6%, that leaves the real rate at -3.5%. Several more increases in the Federal Funds Rate will be needed to raise the real rate to positive values.

A fall in the demand for U.S. Treasury bonds by foreign banks and private holders would contribute to lower bond prices and higher yields. All this could affect the Federal Reserve’s policy moves if the Fed thought that it needed to factor lower foreign demand for Treasury bonds into their projections. Moreover, a shift from U.S. bonds would affect the financial account of the U.S., and the ability to run current account deficits.  The exchange rate would also be affected by such a transition.

None of these possible changes will take place in the short-run. Central bankers have more pressing concerns, such as the impact of higher food and fuel prices on domestic inflation rates, and foreign central bankers will focus on the changes in the Fed’s policies, as well as those of the European Central Bank. But the sanctions on the use of foreign reserve assets will surely lead to changes over time in the amounts of reserves held by central banks as well as their composition. The imposition of these measures may one day be seen as part of a wider change in the international financial system that marks the end of globalization as we have known it.

The Changing Fortunes of the Renminbi and the Dollar

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Last fall the International Monetary Fund announced that China’s currency, the renminbi, would be included in the basket of currencies that determine the value of the IMF’s reserve asset, the Special Drawing Right (SDR). The IMF’s statement appeared to confirm the rise in the status of the currency that could at some point serve as an alternative to the U.S. dollar as a global reserve currency. But in retrospect the renminbi is a long way from achieving widespread use outside its regional trading partners, and recent policies will only limit the international use of the currency.

It has been widely speculated that the drive to include the renminbi in the IMF’s currency basket was a tool by reformers such as People’s Bank of China governor Zhou Xiaochuan to move their country towards a more liberal economic regime. The SDR currencies are supposed to be “freely usable” by foreign and domestic investors, so capital controls were eased in the run-up to the SDR announcement. But Chinese authorities are loath to give up their ability to control foreign transactions.

This has become particularly true as a result of China’s recent capital outflows. These have in part reflected outward foreign direct investment by Chinese firms seeking to expand. But the outflows are also due to Chinese firms and individuals moving money outside their country. These movements both reflect and contribute to a continuing depreciation of the renminbi, particularly against the dollar. Chinese authorities have burned through almost $1 trillion of their $4 trillion in foreign exchange reserves as they sought to slow the slide in the value of their currency.

To reduce pressure on the renminbi, the authorities are imposing controls on the overseas use of its currency. But these regulations to protect the value of the currency reduce the appeal of holding the renminbi. As Christopher Balding of the HSBC Business School in Shenzhen points out, monetary authorities can not control the exchange rate and the money supply while allowing unregulated capital flows.

Even if the authorities manage to weather the effects of capital outflows, the long-term prospects of the renminbi becoming a major reserve currency are limited. Eswar Prasad of Cornell University has written about the role of the renminbi in the international monetary system in Gaining Currency: The Rise of the Renminbi. After reviewing the extraordinary growth of the Chinese economy and the increased use of the renmimbi, Prasad evaluates China on the criteria he believes determine whether it will graduate to the status of a global currency. China had until recently been removing capital controls and allowing the exchange rate to become more flexible, benchmarks followed by foreign investors. Its public debt is relatively low, so there are no fears of sovereign debt becoming unmanageable or inflation getting out of hand.

On the other hand, the rise in total debt to GDP to 250% has drawn concerns about the stability of the financial sector. This is troubling, because as Prasad points out, this is the area of China’s greatest weakness. This vulnerability reflects not only on the increasing amount of private debt but also precarious business loans on the books of the banks, the growth of the shadow banking system and stock market volatility. Prasad writes: “China’s financial markets have become large, but they are highly volatile, poorly regulated, and lack a supporting institutional framework.” This is crucial, since ”… financial market development is likely, ultimately, to determine winners and losers in the global reserve currency sweepstakes.”

The growth in the use of renminbi has not eroded the primacy of the dollar in the international monetary system.. An investigation by Benjamin J. Cohen of UC-Santa Barbara and Tabitha M. Benney of the University of Utah of the degree of concentration in the system indicates that there is little evidence of increased competition among currencies. The dollar is widely used as a vehicle currency for private foreign exchange trading and cross-border investments, as well as for official holdings of reserves. Expectations for the euro have been scaled back as the Eurozone area struggles with its own long-term stability.

Carla Norrlof of the University of Toronto examines the sources of the dominance of the dollar. She investigates the factors that contribute to “monetary capability,” the resources base necessary for exercising currency influence. These include GDP, trade flows, the size and openness of capital markets, and defense expenditures. Norrlof’s empirical analysis leads her to confirm the status of the U.S. as the monetary hegemon: “The United States is peerless in terms of monetary capability, military power and currency influence.”

Cohen and Benney stress that their analysis holds for the current system, which could change. What could undermine the status of the dollar? Benjamin Cohen worries that President-elect Trump’s policies may increase the government’s debt and restrict trade, and possibly capital flows as well. These measures need not immediately demolish the role of the dollar. But Cohen writes, “…the dollar could succumb to a long, slow bleeding out, as America’s financial rivals try to make their own currencies more attractive and accessible.”

The renminbi, therefore, does not represent any short-term threat to the dollar’s place in the international monetary system. But the U.S. itself could undermine that status, and a potential opening may spur Chinese efforts to establish a firmer basis for the use of its currency, just as it has done in international trade in the wake of the demise of the Trans-Pacific pact. The transition could take decades, and during that period the global system could disintegrate into regional alliances that encourage unstable trade and financial flows. Those in the U.S. who voted for change may rue the consequences of President-elect Trump’s efforts to deliver on that electoral promise.

The Stars and Stripes Forever?

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Global imbalances are once again a focus of discussion. This time, however, it is Germany, not China, which is identified as the major surplus country and an obstacle to economic recovery.  The German surplus, it is alleged, makes adjustment harder in the Eurozone’s periphery countries.

Much less attention has been paid to the other side of the imbalances: the deficits in the U.S. current account. The U.S. balance of payments position reflects the dollar’s role as a global reserve currency. Andreas Steiner has shown in “Current Account Balance and the Dollar Standard: Exploring the Linkages” (Journal of International Money and Finance, in press) that the demand for reserves lowers the U.S. current account by one to two percentage points of GDP.

The demand for those reserves is not likely to diminish any time soon. Rakesh Mohan, Michael Debabrata Patra and Muneesh Kapur, in an IMF working paper, “The International Monetary System: Where Are We and Where Do We Need to Go?”, analyze the increase in reserves by major emerging market countries who may turn to reserve accumulation to expand their central bank balance sheets. They project the demand for foreign exchange reserves for seven emerging markets ((Brazil, Hong King, China, India, Korea, Russia, Saudi Arabia) under different scenarios for the mix of domestic and foreign assets, and estimate that their holdings of net foreign assets will increase from $6 trillion in 2011 to between $7.8 trillion and $14.9 trillion by 2017.  They caution that other emerging markets, such as oil exporters, are not included in their projections, and the demand for foreign assets may be higher.

The use of the dollar as an international currency appears in private markets as well. Mohan, Patra and Kapur present data that show the dollar with a 44 percent share of the global foreign exchange market. The dollar’s predominance in the foreign exchange market is matched by its use in international banking and bond markets.

Joseph Gagnon in “Global Imbalances and Foreign Asset Expansion by Developing-Economy Central Banks” has argued that the demand for dollar-denominated assets by central banks drives the balance of payments surpluses in many emerging markets.  If the dollar retains its status as a reserve currency, then there will always be a demand for dollars that feeds into the balance of payments. Until there is a credible alternative (or alternatives), global imbalances that include U.S. deficits will be an inherent feature of the international monetary system.

What could threaten the dollar’s special status? Emmanuel Farhi, Pierre-Olivier Gourinchas and Hélène Rey argue in their Reforming the International Monetary System that the “backing” of the dollar, which took the form of gold under the Bretton Woods system, now exists in U.S. Treasury securities. If there is a change in perception about the reliability of this backing, then the transition to a multipolar reserve currency system may be more abrupt than desired.