Adrian Ash

From Credit to Money, Part I

“Wouldn’t life be much simpler for everyone if the U.S. raised interest rates and didn’t spend more than it had overseas?”

ONE U.S. DOLLAR USED TO BUY NEARLY four Brazilian reals at the start of 2003.

Today, it buys fewer than half as many. Which you might think implies higher travel, energy and food costs to come for U.S. consumers.

But it seems to bother the central bank of Brazil much more than it fazes the Federal Reserve:


The United States bought nearly one-fifth of Brazil’s total exports in 2006 — primarily transport equipment, base metals and raw foodstuffs such as soybeans, meal and oils.

Then in March 2007, George W. Bush signed a biofuel deal with Brazil, the world’s largest producer of ethanol, worth at least $8 billion.

On the other side of the ledger, the U.S. accounts for more than 16% of what Brazilians buy from abroad. So you’d expect a weak dollar to make the perfect ingredient for low inflation growth in Brazil. Right?

Yet two days after the U.S. Fed slashed its key lending rate by 0.75% in last week’s “emergency” action, the Banco Central do Brasil called a “snap auction” of its own currency, the real. And bidding only for greenbacks, the Banco sold reals at a rate of 1.7879 per dollar on Thursday, claiming that the dollars were needed to build up its currency reserves.

Which was an odd excuse for trying to suppress the real’s relentless rise versus the greenback.

Brazil has grown its overseas trade so fast since the start of 2003 — and most notably to China, which now buys well over 6% of Brazil’s exports — that its current account balance with the rest of the world went from a deficit worth 4.6% of its annual economic turnover to a surplus of 1.3% of GDP in 2006.

Hence the record $185 billion in foreign currency reserves it’s already got. And if it really fancied extending its reserves further with a bundle of super-cheap dollars last week, it should have waited until Friday. Because by Thursday’s close in Brasilia, the dollar had dropped another 2% of its value despite the central bank’s purchase. The real has now risen by almost one-fifth versus the U.S. currency since this time last year.

“The bank resumed buying dollars in early October after a two-month hiatus from the currency market,” explains Reuters. “It had previously bought greenbacks daily for months, helping lift Brazil’s reserves to an all-time high of about $185 billion.”

“The yield differential is a factor supporting the real in these times of crisis,” according to one forex analyst in Sao Paolo — and Brazilian interest rates were kept on hold at 11.25% when the Banco Central do Brasil met last Wednesday.

So even without a weakening dollar, you could now pick up an easy 7.75% profit per year simply by selling dollars for reals. And that’s exactly the situation that Brazil’s central bank faces, only in reverse. It’s earning less on its huge dollar holdings than it pays out in yield on its own sovereign bonds. So, too, do most of the rest of the world’s export-rich countries.

“Things just got a lot more complicated for the managers of China’s economy,” for example, as Stephen Green, an analyst at Standard Chartered Bank in Shanghai, noted last Wednesday. They’re already in way up to their necks thanks to the ongoing flood of dollars into China, sent to pay for 15.5% of what the U.S. now imports.

Yes, Canada tops the U.S. imports list, with 16.4% of America’s trade; Mexico comes third, with 10.7%. But they both have a land border with the USA, whereas Chinese goods, on the other hand, have to cross 6,590 miles of sea to get from Shenzhen to the Port of Long Beach, Calif. — just like the dollars that flow back to pay for them.

But the export firms that then collect all these dollars don’t have much use for them back in the Middle Kingdom. And rather than simply selling them yuan in exchange for these greenbacks — which would only plug America’s flood of cheap dollars straight into China’s money supply — the People’s Bank of China tries to “sterilize” them before they cause any trouble.

“Sterilize,” as in scrub clean. Because otherwise, all those dollars might infect China’s economy with something nasty…something like, say, inflation. The disinfectant, for what it’s worth, is a regular issue of Chinese government bonds.

These soak up the cash flooding in from the States. Trouble is they cost much more in interest than what the dollars they sterilize bring in.

“The trend is clearly accelerating as the reserves continue to grow faster than GDP,” says Hong Liang, China economist for Goldman Sachs. She reckons the People’s Bank of China is now losing some $4 billion per month trying to cover the gap between what it pays on its own government bonds and what it earns on the mountain of U.S. Treasuries it has built up.

Just this month, the PBoC sold off some 5 billion renminbis’ worth of short-term notes in one day, sucking cash out of the economy to “sterilize” the money coming in from the U.S. But by issuing short-dated notes, rather than longer-term bonds — because the buyers prefer cash, which is what they got in the first place — the bank finds its obligations mounting.

“It has more than a trillion RMB’s worth [$137 billion] due to mature over the course of this month alone,” according to The Telegraph — enough to keep any central bank busy, even before you figure in the $4 billion lost on interest disparity and the ongoing loss of value in the U.S. dollar.

What to do? The PBoC has now lifted its interest rate eight times since the start of 2006, but still the economy grew by 11% last year and consumer inflation hit an 11-year high. It’s also told Chinese banks to keep 15% of their cash deposits in the PboC’s vaults, taking them out of circulation in an attempt to cap lending.

Indeed, it’s even forced the banks “to hold at least part of their new required reserves in the form of dollars at the PBoC since August,” reports Michael Pettis, finance professor at Peking University’s Guanghua School of Management. At least that saves the Beijing policy wonks the trouble of arranging auctions and paying out more in interest on renminbi-denominated bonds! But it also transfers the loss of wealth inherent in the tumbling dollar onto China’s private banking sector, forcing lenders to share the pain with the state…and doing nothing to release the upward pressure on the value of the Chinese currency itself, according to Pettis.

“It seems to me that forcing banks, instead of the PBoC, to hold dollars says nothing about pressure on the currency,” he writes in his blog. “I would argue that the total net inflows are exactly the same, except for one thing — commercial banks have been asked to assume part of the PBoC’s normal functioning (i.e., to buy dollars so as to maintain the country’s foreign currency regime), and as they assume this function, the resulting purchases of dollars are whisked off the PBoC balance sheet. But nothing real has changed, except that now banks, instead of the PBoC, will be forced to assume the foreign exchange losses.”

Surging inflation…soaring interest rates…a merry-go-round of bond auctions and redemptions that costs $4 billion per month in the meantime…

Wouldn’t it just be simpler if the U.S. raised (instead of cut) its interest rates, thus reducing its consumptive excesses?

And wouldn’t the problem of sterilizing all those sick dollars vanish if the world had only one kind of money?

Adrian Ash
January 29, 2008

Adrian Ash

Formerly the City correspondent for The Daily Reckoning in London and head of editorial at Fleet Street Publications Ltd, the U.K.'s leading financial advisory for private investors. Adrian Ash is also the editor of Gold News and head of research at BullionVault. SPECIAL REPORT- The Endless PAYCHECK PORTFOLIO: In three simple steps, unleash a steady flow of work-free income... starting with up to 75 automatic "paychecks" deposited directly into your account.

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