Update: China SAFE Report

From Zerohedge: China's State Administration of Foreign Exchange (SAFE) has released its breakdown of 2010 international investments. In summary: financial assets abroad rose 19% last year to $4.126 trillion from $3.457 trillion. That includes the country's $2.914 trillion of foreign reserves at the end of 2010 as well as other assets such as direct investments, securities, and gold. As for gold, it increased by $11 billion from $37.1 billion to $48.1 billion, or a 29.6% increase (it is unclear if this number is at a fixed gold price or accounts for MTM). On the liabilities side, which increased from $1.946 trillion to $2.335 trillion, the biggest change was as a result of a surge in Foreign Direct Investment into China which increased by $162 billion to $1.476 trillion. Netting liabilities against assets leads to a net position of $1.79 trillion in external net assets.

Full breakdown of China's foreign-held stash:

The History Of The World's "Reserve" Currency: From Ancient Greece To Today

This is probably one of the most educational article that I came across in a long time:

Probably the most interesting part of the previously discussed 174-page World Bank report on the future of world currencies, is, ironically, the part that deals with the past. In its discussion of why "Historically, one national currency has played a global role—or at most, a few national currencies", the WB analyzes the history of the "reserve" or dominant currency from ancient times, through today. It is an engrossing narrative which ebbs and flows with the rise and flow of the dominant superpower (no surprise there). The bottom line of course is whether or not the US will retain its superpower status in an increasingly multipolar (and developing-led) world. And whether it will be replaced by China...or nobody. The implications for the next reserve currency of choice are substantial.

Historically, one national currency has played a global role—or at most, a few national currencies

Historical records indicate that the silver drachma, issued by ancient Athens in the fifth century B.C.E. was likely the first currency that circulated widely outside its issuing state’s borders, followed by the gold aureus and silver denarius coins issued by Rome, even though the Athenian and Roman currencies circulated simultaneously for some time (see figure B3.1.1). The dominance of the Roman-issued coins was brought to an end as the long cycle of inflation that characterized the economy of the Roman Empire from the first century C.E. through the early fourth century led to a continuous devaluation of the Roman-issued currency, causing it to become increasingly less accepted outside the Roman Empire. Ultimately, the aureus became valued according to its weight rather than its imputed “face value,” trading more as a commodity than a currency outside the Roman Empire and making way for the Byzantine Empire’s heavy gold solidus coin to become the dominant currency in international trade in the sixth century.

By the seventh century, the Arabian dinar had partially replaced the solidus in this role, although the solidus continued to circulate internationally at a debased value (reflecting the high financing needs of the Byzantine Empire) into the 11th century. Large fiscal costs also led to a gradual devaluation of the Arabian dinar starting at the end of the 10th century.

By the 13th century, the fiorino, issued by Florence, was widely used in the Mediterranean region for commercial transactions, only to be supplanted by the ducato of Venice in the 15th century. In the 17th and 18th centuries, the dominant international currency was issued by the Netherlands, reflecting that country’s role as a leading financial and commercial power at the time. At that point, paper bills began replacing coins as the international currency of circulation, even though they were not backed by the Dutch government or any other entity under sole sovereign control.

It was only when national central banks and treasuries began holding gold as reserves, beginning in the 19th century, that bills and interest-bearing deposit claims that could be substituted for gold also began to be held as reserves. This development coincided with the rise of Great Britain as the leading exporter of manufactured goods and services and the largest importer of food and industrial raw materials. Between the early 1860s and the outbreak of World War I in 1914, some 60 percent of the world’s trade was invoiced in British  pounds sterling.

As U.K. banks expanded their overseas business, propelled by innovations in communications technology such as the telegraph, the British Pound was increasingly used as a currency of denomination for commercial transactions between non-U.K. residents—that is, the pound sterling became a more international currency. This role for the pound was further enhanced by London’s emergence as the world’s leading shipper and insurer of traded goods and as a center for organized commodities markets, as well as by the growing amount of British foreign investment, of which a large share was in the form of long-term securities denominated in pounds sterling.



At the beginning of the 20th century, however, the composition of foreign exchange holdings by the world’s monetary authorities began to shift, as sterling’s share declined and the shares of the French franc and the German mark increased. The beginning of World War I in 1914 is widely viewed as signaling the end of Great Britain’s leading role in the international economy and the breakdown of economic interdependence.

Despite attempts to revive the gold exchange standard after World War I and to restore an international monetary order based on fixed exchange rates, the restored system lasted only a few years. The U.S. dollar’s use internationally as a unit of account and means of payment increased during the interwar period, particularly during the 1920s, reflecting the growing role of the U.S. economy in  international trade and finance. Although gold was officially the reserve asset (and the anchor) of the international monetary system following World War II, under the Bretton Woods system of fixed exchange rates, the dollar took on the mantle of dominant international reserve currency. By the early 1970s, however, following the breakdown of the system because of its inherent Triffin dilemma, the major economies moved to implement floating exchange rates.

During the 1980s, the global economy showed indications that it was moving to a multicurrency system in which the Deutsche mark was taking on an expanded role as a key currency, both in Europe and globally. This was due to a combination of factors—low and stable German inflation; credible government policies; deep, broad, and open financial markets; and a relatively high share of differentiated  manufactured exports in Germany’s trade. The introduction of the euro in 1999 and its adoption by a growing number of EU countries in the intervening years has only revived the debate about the dollar’s future role as the dominant international currency.

Chinese Bond Auctions Fail... Not one, but two?

Zerohedge today: And while the US is no longer allowed to auction off debt, in China the PBoC appears to be no longer able to auction off debt. As Business China reports, "the central bank scheduled the auction of RMB 20 billion worth of one-year treasury bonds and RMB 10 billion in six-month bonds on the country’s interbank bond market for May 13. But banks, faced with tight liquidity, only purchased RMB 11.71 billion worth of one-year bonds and RMB 9.63 billion worth of six-month bonds, the report said." In other words, there was a nearly 50% miss on the 3 month auction.

The key reason: "The reference yield of one-year treasury bonds was raised to 3.0246% from the previous issuance, while the bond yield of 182-day discounted treasury bonds was 2.91%, the paper said." It appears investors don't agree with the central planners that 3% is an appropriate rate to compensate them for surging inflation. That, and also the fact that banks suddenly have no liquidity: "Tighter liquidity was behind the under-subscription, as the central bank resumed selling three-year notes on May 12 after a hiatus of more than five months, a bank analyst who was not named was cited as saying. The central bank also raised banks’ RRRs by 0.5 percentage points on the same day, effective May 18, the fifth consecutive month its has raised RRRs this year." And so the Catch 22 emerges: the more China fights inflation through RRR or rate hikes, the lower the purchasing power of domestic banks to purchase bonds (and yes, the US deficit is just a few hundred billions dollars too wide for it to come to China's rescue). Should the "15 minute" inflationary conundrum continue to express itself, and China be forced to rise rates even longer, very soon the country, just like the US to which it is pegged monetarily, will also be unable to raise any incremental capital.

The End of the USD Depreciation: Part II

Over the past couple of days, I received a few calls and email from some of you asking about my Yen/USD trade idea that I mentioned in my previous post, for those of you that didn't get the quarterly publication, here was the FX trade strategy that I wrote up back in April:

First off, I will start with some history and fundamentals for those of you who aren’t active in the foreign exchange market. The popularity of the USD/JPY trade has come a long way. In the 1980s, during the Carter and Reagan era, the US was going though a time of high inflation and high interest rates and the Americans were unhappy with the strength of the USD (1 USD = 260 JPY) so during the Plaza Accords, James Baker and the Japanese government agreed to let the USD freefall against the JPY. The JPY settled at around 130 JPY/USD in 1990 and this let to huge strength for the Japanese economy. Along with deregulations in the Japanese financial industry and speculation of the housing market supported by the government, the real estate bubble exploded, banks that were “too big to fail” went under and it drove the Japanese economy into the lost decade (Doesn’t that sound similar to subprime 2008 huh?). This was when the original quantitative easing tool was first applied to fight the severe recession. For over two decades, Japanese’s bond yield hovered near 0% and therefore it was very popular for traders to build carry trades with the USD/JPY pair due to the carry from the interest rate differentials.

So, what is a carry trade?  In a carry trade, an investor borrows in a currency with low interest rates and re-invests in a currency with higher yield. But in 2010, due to the appreciation of the JPY (if you read my previous papers you would know why), which had a 15% gain versus the USD, those who pursued a yen based carry trade strategy suffered huge losses on their P&L. (Below is a table explaining the JPY based carry trade with the 2011 YTD return and the last 12 month’s return)

I mentioned to many of you that when the JPY broke 80 against the USD last week, the appreciation of the Japanese Yen is coming to an end, especially against the USD and EUR. Not long ago, the Japanese government intervened to depreciate the currency to support its economy, but as we all know, that didn’t last too long before the climb continued. However, this time around, it’s going to be different due to two main reasons:

1. Interest rate differentials from the inflation pressure at the FED and ECB
2. The reversal in trend of monetary base due to the recent earthquake.

Inflation: if we take a look at the global economic situation, central banks are facing growing pressure to tighten up monetary policy from the inflationary pressure. The CPI projection for 2011 in the US is at 2.7, the CPI for the Euro Zone is near 2.5 while the Japanese CPI is projected at 0.1. Not only is food inflation creating a problem, the expansion of balance sheets due to the recent financial crash are forcing the long term yields to rise. Rates are at their historical lows for the FED and the ECB and the market has already priced in for the Fed to shift 25 bps by Aug 12^th and the ECB to equally shift 25bps by April 11^th. Now, as the Japanese economy remains deflationary in 2010 and 2011 (FYI, Japan’s core CPI excluding energy and food fell 0.7% year over year in December 2010)  this earthquake will only force the BOJ to keep rates at this historical low to boost economic development. For those who are active in the F/X market, the two year US/Japan swap rate differential moved from the low of 9bps to 46bps today.

Monetary Base: interest rate differential and the Japanese/US Monetary base ratio are two main macro factors that explain the currency movement between the two countries. While the FED expanded its balance sheet to about 2.5$USD Trillion with the two QE programs, the purchases is expected to end in June and we will most likely see the Fed reversing its actions to reduce the monetary supply in the system. Before the earthquake, the ratio of the Japanese monetary base to the US settled at 51.8 at the end of 2010. After the earthquake, the BOJ decided to increase the size of its asset purchase program to 40 Trillion Yen and this will boost its monetary based by 5% while the Fed is expected to do the contrary in June. Based on a simulation done by Bloomberg, this will reverse the recent decline of the ratio from 45.1 in February 2011 to about 48.1 when the BOJ purchase will be completed. Last and not least, on March 18^th, the G7 central banks coordinated an effort to flood the Yen in the global market by injecting 15 Trillion yen to stop its appreciation (So for you smart ones, hope you figured that there is a floor here!).

Dylan Grice On The Coming Japanese Hyperinflation

So here is a resume from zerohedge and a chart from one of my favorite, Dylan Grice from SocGen in his paper about his views on the upcoming Japanese Hyperinflation:

To those who follow Dylan Grice's writings closely (and everyone should), his proposal that the only possible outcome for Japan, where stunningly tax revenues no longer ever cover non-discretionary expenditures - a sad fate that awaits none other than the US eventually, is to hyperinflate its way out, is not new. Nonetheless, during the just completed annual CFA Institute annual institute held in Edinburgh, he gave an updated presentation which indicates that he has not yet changed his opinion that if forced to pick between the lesser of two defaults, the only option is that of unbridled printing, now that the US has firm leg up in the global fiat race to the currency bottom, which we predicted back in 2009, will be the key feature of the macro theme until the end of the Keynesian experiment. So, as before, Grice's recommendation, away from the natural trade of shorting bonds (a negative carry trade which has cost the likes of Kyle Bass a pretty penny over the years) as one awaits this only possible outcome, is to actually discount the future, something the market has completely forgotten how to do, and buy stocks, in advance of the Weimar Rally for the Rising Sun. Below we present "Hoping for the best, preparing for the worst...in Japan" - Grice's presentation of an upcoming Japanese hyperinflation, which explains not only why Japan can't afford higher JGB yields, but why its to-date favorable demographic are now looking uglier by the day, and the only outcome for Shirakawa is to finally bite the bullet and beat the Chairsatan at his own game, in the process forcing the Bernank's own hand if he wishes to retain the USD's place at the head of the FX devaluation race.

 

For the really ADHD afflicted, here is the "CDS trader" abridged version:

• Japan’s unprecedented predicament: A large creditor nation, a bankrupt government, and a shrinking population
• Competing forces in the hyperinflation template: An unsustainable public debt profile with persistent current account surpluses
• Protecting portfolios: How investors can cheaply hedge against the risk of an extreme scenario

CHART 1: Japanese government tax revenues no longer cover discretionary expenditure:

So, is this going to be the end of the USD depreciation?

Well here are 2 charts posted by Bloomberg today. If you read my articles in April about the USD/YEN trade recommendation, you'll know what I am talking about...

Treasury Cuts Its Borrowing Need Estimate By Half, To Suspend State, Local Gov't Funding Due To Upcoming Debt Ceiling Breach

Here is a pretty interesting article posted by zerohedge today: After announcing it issued $265 billion in marketable debt to fund $445 billion in financing needs (including the wind down of $195 billion in SFP cash management bills), the Treasury has just announced it expects to need just $142 billion in Treasury issuance in the April-June quarter. This ridiculous amount is more than 50% lower than the previous estimate of $299 billion disclosed on January 31, and confirms that the Treasury is now scrambling to appear prudent to Congress with its debt needs. That it will need far, far more at the end of the day is beyond question. The reason for the over 50% plunge in borrowing needs "largely relates to higher receipts and lower outlays." Well, that's great - perhaps the treasury can explain why its preliminary cash need for the July-Sept quarter are $405 billion (compared to $396 billion a year earlier). Altogether, this advance estimate is ludicrous and shows that Geithner has totally lost a grip on reality. Yet on the other hand, in order to make his point, the market needs to crash (just like the May 6th crash killed any hope of an Audit the Fed bill). Looks like risk is duly nothing its duty to act appropriately when record 2011 bonuses are at stake.


Here are some parts of the letter from our man Timmy Geithner since its too long to post the entire thing:

"In my last letter, I described in detail the set of extraordinary measures Treasury is prepared to take in order to extend temporarily our ability to meet the Nation’s obligations if an increase is not enacted by May 16, when we estimate the limit will be reached.  Because it appears that Congress will not act by May 16, it will be necessary for the Treasury to begin implementing these extraordinary measures this week. "

"On Friday, May 6, Treasury will suspend until further notice the issuance of State and Local Government Series (SLGS) Treasury securities.  SLGS are special-purpose Treasury securities issued to states and municipalities to help them conform to tax rules that restrict the investment of proceeds from the issuance of tax-exempt bonds."

"If Congress does not increase the debt limit by May 16, the Treasury Department will be forced to employ further extraordinary measures on that date to provide headroom under the limit.  Therefore, on May 16, I will (1) declare a “debt issuance suspension period” under the statute governing the Civil Service Retirement and Disability Fund, permitting us to redeem existing Treasury securities held by that fund as investments, and to suspend issuance of new Treasury securities to that fund as investments and (2) suspend the daily reinvestment of Treasury securities held as investments by the Government Securities Investment Fund of the Federal Employees’ Retirement System Thrift Savings Plan.  (Under the law, Federal employees are protected by a requirement that both funds be made whole after a debt limit increase is enacted.) "