The Foreign Policy of Monetary Policy and its Implications

Conflicts Forum Weekly Comment, 15 April 2016 

It is now fairly common currency that US conventional foreign policy is conflicted, and lacks strategic coherence. This is clear, whether in Syria, where one arm of the American government has been delivering three thousand tons of weapons and ammunition to insurgents (half of which, according to Foreign Policy, has ended in the hands of al Qaida), at the same time that another arm has been committed to imposing a ceasefire; and where US-supported armed groups are reportedly fighting each other. Or, in Yemen, where the US and the UK are lending full support to the Saudi assault on Yemen, at the same time that other arms of the US government are engaged in attacking al Qae’da, with whom Saudi Arabia is indirectly allied – in the hope of weakening Ansar Allah.

Indeed, there are various other inherent tensions and contradictions, which taken together, suggest that either the US is conflicted concerning its objectives (i.e. in Syria or Libya or the region generally), or that the ‘big beasts’ of the US government are pursuing their separate policies as independent fiefdoms (i.e. Brennan and Kerry locking horns in Syria); or indeed that both these factors are in play concurrently. Whatever the direct cause, it is a source of rising tension as third parties look on the dissonant signals emerging from Washington with growing distrust and confusion.

What is less noticed perhaps is that US Treasury and Fed policies are throwing up similar tensions and contradictions in terms of US monetary policy. Although ostensibly serving domestic interests (employment and inflation), it does impinge directly into foreign policy too. In short, just as with conventional foreign policy, US monetary policy (as reserve currency hegemon is centrifuging out its own tensions and contradictions into the global sphere). In short, there is more than a whiff of ‘loss of control’, of an empty policy ‘tool box’ wafting out from both spheres.

The inherent ‘tensions’ of the Central Bankers’ policy increasingly are roiling and polarising European politics – the management of the sovereign debt ‘overhang’ (generated by decades of easy credit policies) has set the (largely protestant) north of Europe at the throats of (largely Catholic) southern Europe. It is decimating the European middle classes, who are turning viciously on their own élites. And the zero/negative interest rate policy is eating at the social fabric of even the thrift and prudence-leaning northern societies: it is the German public which is leading the revolt at the miniscule returns on savings accounts and on retirement policies, which are upending the social balance in society. The contradiction is plain: the policies were supposed to provide ‘prosperity for all’, but actually are generating poverty and distress in many societies. (None of this is intended to exonerate the European élites from their share in the responsibility for this débacle).

Here, we are not touching the question of financial sanctions, per se, used, quite explicitly, as a foreign policy tool. Nor are we entering into the politically contentious debate as to whether QE or negative interest rate policies does indeed serve the US national interest. But rather, we hope to focus more on how the policies in respect to zero, and now negative, interest rates, the management of exchange rates, and the splurge of Central Bank generated credit (and therefore debt), cannot be but a branch of foreign policy – even if they are disguised as ‘technical issues’ stemming solely from market conditions. (Early economists were frank in calling their subject political economics – for good reason.)

It seems, though, that something of the underlying crisis is percolating through. Something is ‘afoot’ in the world of monetary policy with (this week) two secretive, emergency (‘expedited’) meetings at the Fed, a Fed ‘summit’ with the US President, and just about every major banker and finance minister due in Washington this week, for a G20 finance ministers meet and, later in the week, for an IMF get-together.

In fact, Fed policy is no longer centred on its ‘mandated’ tasks: full employment and low inflation plainly is no longer the primordial Fed objective. It has morphed into maintaining the asset value of ‘the market’, which is now too big, (too bubbled), and to influential, to fail, yet is now teetering on the high wire, glancing nervously downwards towards possible adverse financial events originating externally to the US – especially at a moment when ‘fundamentals’ are shading towards the negative.

Why has policy morphed so far away from concern for the real economy towards propitiating the goddess of market. One compelling response from Andrew Lapthorne of SocGen is that every dollar of incremental debt issued in the twenty-first century has gone to fund stock buybacks (i.e. corporations buying back their own shares or equity, in order to inflate their values): “Aggressive central bank monetary policies have created artificial demand for corporate debt which we think companies are exploiting by issuing debt they do not actually need … The effect on US non-financial balance sheets is now starting to look devastating … The reality is US corporates appear to be spending way too much (over 35% more than their gross operating cash flow, the biggest deficit in over 20 years of data) and are using debt issuance to make up the difference.”

The point here (and the explanation why the authorities are so adamant to keep stock prices high) is that this deficit will need to be financed in continuation (unless corporates opt for a major cost cutting, which would embed recessionary trends) – and for this to be possible, their stock valuations must be maintained. Here lies the essential fragility (falling earnings combined with a negative operating cash flow) that requires the Fed to pump up the market.

But a pumped-up, high wire balancing act cannot be disturbed by a (possibly fatal) momentary loss of concentration: Market attention must be held true to the Central Bankers’ ‘jawboning’ of market ‘confidence’. A crisis in China, Japan or in the Gulf, can have the artiste tumbling from his wire.

And the external shock? The most obvious would be a Yuan devaluation. China has massive manufacturing over-capacity: really huge (and China basically is in a debt deflation trap, with earnings dropping more rapidly than nominal interest rates). The obvious answer would be devaluation of the Yuan. But a substantive reduction in export prices would either lead to cheap Chinese exports laying waste to American and European corporate profits – or to tariff wars (a prospect equally haunting). It is not clear that a fragile global economy – or ‘Mr Market’ – would cope with a Yuan devaluation.

A top adviser to the Chinese government in an interview with the Daily Telegraph on 11 April warned:

“that Beijing risks a currency blow-up akin to Britain’s traumatic ordeal in 1992, if it continues trying to defend its exchange rate peg amid a deepening deflation crisis.” Yu Hongding, a director of the Chinese Academy of Social Sciences, said China is caught in two concurrent “deflationary spirals” that are feeding on the other…
“They must stop intervening on the exchange market. China needs to devalue by 15pc. They are creating conditions for speculators,” he told the Daily Telegraph, speaking at the Ambrosetti forum of global policymakers on Lake Como.
“Prof Yu, a former rate-setter for the central bank (PBOC) and currently a member of the national planning committee, said the government is making a serious mistake in trying to defend the Yuan by burning through foreign exchange reserves, already down to $3.2 trillion from $4 trillion in mid-2014.
“He warned that the slowdown in capital outflows in March may prove fleeting: “Reserves will continue to fall until we devalue. Once we get towards $2 trillion the markets will start to panic. They won’t believe that the government can control it any longer,” he said.
Prof Yu said Beijing had been caught off guard by the relentless slowdown over the last five years: “In 2011 we thought the economy would stabilize, and we thought the same thing in 2012, and again in 2013, and it continued to slide,” he told Ambrose Evans-Pritchard.

Evans-Pritchard notes that “fears of uncontrollable capital flight and a Yuan devaluation were key reasons for the plunge in global equity markets earlier this year; and are clearly what prompted the US Federal Reserve to delay rate rises” [and thus to allow the dollar to soften, on the foreign exchanges. Its object being to lessen the pressures on the Yuan that a strong dollar would create].

It also prompted the G20, meeting in Shanghai, to agree amongst themselves to abstain from rounds of beggar-my-neighbour competitive currency devaluations. But here’s the rub:

China needs a weak dollar, but Japan needs precisely the opposite: a strong dollar (as it has sought to weaken the Yen in order to stimulate Japanese exports and boost inflation). The Fed cannot have both ways: It has to choose. In mitigating risks vis à vis a China devaluation (with a weak dollar), it is increasing the risk of a Japan blow-out (by causing the Yen to appreciate). This is not just a matter of technicals: the choice, the policy decision, will determine the future of Asia.

Olivier Blanchard, the former chief economist at the IMF, has warned that [with a soaring Yen], “Japan is heading for a full-blown solvency crisis as the country runs out of local investors, and may ultimately be forced to inflate away its debt in a desperate end-game”, according to the Daily Telegraph. And that means global knock-on, since many investors have borrowed in low-interest Yen, to invest in higher yields in non-Japanese markets.

In short, the FX market which trades $5 trillion a day may, at some point in the coming months, blow up – leading to plunging currencies: Since mid-2014, the dollar has appreciated by 20% (which is why the formerly pegged Yuan may need to devalue) and pari passu, the Yen and Euro have weakened by 20% with many developing-economy currencies falling off a cliff, suffering 40 – 50 % declines against the dollar.

The trigger to this situation however, may already be being pulled: China is pursuing a stealth devaluation. On the one hand, as noted here, the dollar has been trading at a relatively stable band against offshore Yuan. “But when compared to the collapse of the Yuan “basket” – as PBOC [Chinese Central Bank] devalued against the rest of the major trading partners – the ‘stealth’ devaluation is obvious … Is it any wonder that the Japanese Yen is surging?”.

[See graph:


This has drawn a notably strong reaction from the Treasury Secretary Jacob Lew, who has condemned what he described as ‘unacceptable’ FX practices. China’s situation, however, is not so easily ‘managed away’ by some G20 FX ‘understanding’ to avoid competitive devaluations: The seemingly endless wave of cheap labour that helped propel the extraordinary growth in the Chinese economy is coming to an end. The movement of peasant farmers to the city, estimated at 277 million in 2015, represents the biggest exodus in human history. This migration has created 250 cities of more than 2 million people, (which is the equivalent of 88 Londons) — but now the supply of cheap labour is coming to an end.

As Wolf Richter notes, “As the cost of labor has soared [migrant wages have doubled in the last seven years], the manufacturing base is now migrating to cheap-labor countries like Vietnam, leaving less work in Chinese cities for migrant laborers. With few options left, they’ve started to return to their villages.” We are dealing here with a major inflection point in economic history: the migratory (and easy) productivity ‘dividend’ on which the globe largely has depended for its material gains since the eighties (Chinese migration to the cities), is coming to an end. There will be huge repercussions. Many of our base financial premises may need to be adjusted. Predictions for future energy demand may need to be re-visited too.

A recent IMF report shows (reported here) that the ratio of gross debt to corporate earnings in China has doubled to a factor of four since 2010; and ‘debt at risk’ – where earnings do not cover interest payments – has risen from 4pc to 14pc in five years. It has reached 39pc for steel, 35pc for mining and retail, and 18pc for manufacturing and transport.

Until recently, the market narrative has been one of the risk of a China ‘melt-down’; but that fear has been yo-yo’ed back back into optimism with another splurge of credit and soaring money supply. It may do for a while, but essentially we are dealing with “the stoking another mini-cycle, to put off the day of reckoning” as Evans-Pritchard notes.

The global FX sparring is the ground on which the ‘titans’ have been engaged in some preliminary skirmishes, but the tensions and structural distortions have not been addressed. The day of reckoning is held at bay, but not gone; and when it comes (as surely it must for China and Japan), one way or another the societal shifts must be addressed through painful economic transformation — Middle Eastern states (including Turkey) will suffer more than most.

Gulf states are no longer the providers of resources (petrodollars) — ‘the creditors’ to western markets — that they once were. Instead they are set to become its ‘debtors’ and ‘supplicants’ (and a new report shows that whereas most of the world increased its defence expenditure last year, the world’s biggest oil producers, by contrast, drew down on their expenditures: that is to say, they will no longer be the high rolling defence spenders, they once were either). The six GCC states are expected to borrow between $285 – $390 billion through to 2020. And this is before any future turmoil in the FX markets is factored in, and in this latter respect, Saudi Arabia looks to be more than a little vulnerable: “Something happened [very recently] in Saudi Arabia’s banking system that was largely uncovered by anyone in the mainstream … overnight deposit rates exploded to their highest since the financial crisis in 2009…”, noted the leading ego-finance blog, Zerohedge:

“It is clear that that the stress in Saudi markets has spread from the forward derivatives markets to actual funding problems.” [See graphs at link above].

Zerohedge continues: “This suggests one of the two main things: either Saudi banks are desperately short of liquidity or Saudi banks do not trust one another and are charging considerably more to account for the suspected credit risk. Either way, not good.” In fact, the Gulf, it seems, will not be, what it once was – in many various ways.

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