The Yuan as Reserve Currency?

Reform of the architecture of the international financial system will be crucial in the near future. The economic shifts that have been taking place, most notably regarding emerging economies have not yet been recognized in terms of financial architecture. China sits on the worlds' largest stock of reserves and Russia is now third. Capital flows now not from the rich to the poor countries but from the emerging market economies to the industrialized ones. The financial system has to accommodate these flows and reforms are needed to facilitate the process. This is one important research item for our new center, CRIFES.

There has been some talk of the yuan replacing the dollar as a reserve currency. This is partly motivated by politics, and partly by the desire for the Chinese to diversify their dollar holdings. As Sebastian Mallaby describes it:

China's other approach is to promote the global use of its own currency. Its central bank has offered yuan to Indonesia and Argentina in return for rupiah and pesos. It hopes more trade will be denominated in yuan. Its contribution to the new IMF-like East Asian reserve fund may one day mean that a crisis-prone country in the region borrows partly in yuan.

All this is intended to buy China's currency some respectability. But as an escape from China's dollar trap, it is laughable. The idea is that once the yuan goes international, foreigners may be willing to borrow in it. That way, China can keep running a trade surplus and exporting capital, but instead of accumulating bonds denominated in dollars it would be able to accumulate bonds denominated in yuan.

Mallaby notes that for this to work all the currency risk would be shifted to China's debtors. Why would they be willing to accept the currency risk? This is not negligible given that most consider China's currency to be undervalued. So a debtor would be faced with a non-negligible risk of their debts appreciating with the yuan.

This suggests a more fundamental problem. How can the yuan become a reserve currency when investors believe that its value is determined by domestic political concerns? The cost of being a reserve currency is that, at least to some extent, domestic concerns are subordinated to international ones. When the US failed on this score in the late 1960's it brought the Bretton Woods system down, though not the dollar's status. While the US is not perfect, the value of the dollar primarily depends on fundamentals, not central bank policy.

As long as China manipulates it currency, or is perceived to do so, it will be impossible for it to become widely held as an international store of value. Nor do China's capital controls help.

The Dollar

The NYTimes reports that the dollar is weakening:

The dollar skidded to its lowest point in five months this week, battered by creeping fears that Washington’s costly efforts to stimulate the economy are growing harder to finance and may set off an unwelcome bout of inflation. Analysts are increasingly concerned that a rise in prices could hurt consumer spending, deepening the recession.

While the facts are undisputed, some of the analysis is weird as is the title:

As Dollars Pile Up, Uneasy Traders Lower the Currency’s Value

This makes the movements sound almost like some conspiracy, or a mystery. One analyst is quoted to the effect that this is all psychology. But this cannot be right. The dollar has been on a slide for almost a decade due to our excessive borrowing from the rest of the world. The financial crisis caused a temporary reversal in the process -- that was psychological -- fear caused people to hold dollars. But fundamental factors mean the dollar has to decline. While the article presents a graphic for the dollar for the last three months, look instead at the last 6 years.


When you look at the dollar against the euro since 2002 you can see that the economic crisis caused a temporary halt to a longer term problem. And nothing we have done to deal with the recession -- big deficits, lots of central bank credit -- is going to make the dollar stronger in the future.

Chrysler Dealers

In most communities auto dealers are among the local power elite. I wonder how many auto dealers vote Democratic. I ask this question after reading this article about how Chrysler dealers are being treated in the auto bailout. The disaffected have formed

the Committee of Chrysler Affected Dealers, who are contesting the company’s action. Next week and on June 3, the bankruptcy judge handling Chrysler’s case will consider their objections.

Many of those fighting the hardest are dealers who recently spent huge amounts of money to stay in the company’s good graces, who sacrificed their own profits to help keep the company intact or who otherwise thought they had bent over backward to ensure that Chrysler could survive, only to learn that they were the ones who would not.

Now I am certainly not contesting the view that Chrysler and GM have too many dealers. It is just that Chrysler and GM had too much of everything, but given electoral politics it seems that the President's auto task force is listening to the electoral polls as it distributes the burden among workers, bondholders, and dealers.

This has led to complaints from a group of Congressmen who argue (according to this article in the Post) that

the auto task force is waging a "war on capital" by favoring the United Auto Workers, who are being offered a 39 percent equity stake in the new GM, over bondholders, many of them small investors and retirees, who are being offered 10 percent.

The irony here, of course, is that most of the same Congressmen voted against any bailout when this issue was before the Congress. Given that they punted the ball to the President is it cool now to complain and demand that the ball be returned?

More bailouts

The Federal Government is set to offer more TARP money to GMAC. According to this article in the WSJ:

The GMAC injection is designed to firm up the auto-financing company's battered balance sheet and allow it to continue making loans for car purchases at GM and Chrysler LLC. The Treasury already put $5 billion into GMAC in December.

The GMAC funding is an illustration of how rapidly the government effort to rescue the U.S. auto industry is escalating in cost and scope. What began as an emergency batch of loans to GM, Chrysler and GMAC in December -- totaling just over $20 billion -- now looks likely to balloon well beyond $50 billion and could approach $100 billion by the end of the year.

So we are increasing subsidies to the automakers at the same time that higher CAFE standards make them less competitive. At the same time, the head of the UAW believes that the equity of GM and Chrysler is worthless, and he should know since he has the discretion to make it so. See this article (hat tip to Falkenblog):

UAW president Ron Gettelfinger said the union hopes to sell its stake in both companies quickly because he is more interested in raising cash to cover retiree health care costs than having an ownership stake in GM (GM, Fortune 500) and Chrysler.

"Let somebody else take the stock. Give us the money," Gettelfinger said at a recent press conference. "We are trading debt for equity, and what is the value of the equity? Let's be honest, it's zero today."

What scares me the most is that while rationality says ignore sunk costs, politically sunk costs matter. I doubt we are close to the end of these subsidies.

Meanwhile, the big banks want to give back their TARP money. Of course, one reason for this is just to avoid government interference in their operations. A second reason is to signal their strength. The fear is that they may need the money again in the future. Essentially, the government would like them to keep the TARP money so the likelihood of a future bailout is reduced, but the government cannot refrain from using its leverage to make them miserable, so they don't want to keep the funds.

CAFE standards

I find the whole discussion of the Obama administrations new rule on CAFE standards to be strange. First, they talk as if these restrictions impose no costs on consumers. Second, as if they will have significant environmental effects. And third, that they will make it better for the auto industry. Perhaps for the Japanese automakers as the domestics are driven down even further in market share and profitability. But since the Federal government owns Chrysler and soon will own GM I guess they can survive even without making profitable cars.

Fortunately, there is an interesting analysis of the rules here.

More on AIG

The Times of London has an intriguing article on the collapse of AIG. The whole article is interesting, but he most fascinating part concerns an analysis of the valuation of the company back in 2001. The Economist apparently commissioned a study to assess the valuation of AIG.

The research, which took five months, was the work of a team led by Tim Freestone, who is speaking here for the first time. Most analysts are upbeat: their colleagues’ bonuses depend on fees from the company under scrutiny. But Freestone’s firm (now called Crisis Economics) is independent. He judged that AIG was highly overvalued, and he would later realise that its shares were supported by an ability to stifle criticism. In his report for The Economist, however, he was tactful. To justify the share price, he said, “it would have to grow about 63% faster than [its] peers for the next 25 years. If investors believe that AIG can sustain this type of performance for that period of time, then AIG is properly valued”. Any investor who believed that would need to be certified.

The implication is that AIG was seriously over-valued, perhaps even a zombie insurance company. In that context, the excessive risk-taking of the Financial Products Group at AIG, selling vast quantities of credit default swaps might have been an attempt to double up bets.

The conventional explanation for AIG's collapse is that it did not reckon on a perfect storm caused by the collapse of the housing bubble. But this article suggests that perhaps officials knew the risks but were motivated by the need to find profits to support the valuation of the company.

Last Temptation of Risk

Barry Eichengreen has an interesting article on the Last Temptation of Risk over at National Interest Online. The point is to explain how economists did not forecast the crisis. His argument is that the problem was not theory. Rather,

the problem lay not so much with the poverty of the underlying theory as with selective reading of it—a selective reading shaped by the social milieu. That social milieu encouraged financial decision makers to cherry-pick the theories that supported excessive risk taking. It discouraged whistle-blowing, not just by risk-management officers in large financial institutions, but also by the economists whose scholarship provided intellectual justification for the financial institutions’ decisions. The consequence was that scholarship that warned of potential disaster was ignored. And the result was global economic calamity on a scale not seen for four generations.

Think of agency theory. This certainly predicts the conflicts of interest between shareholders and management that induced excessive risk taking. And information theory suggests that market prices may have plenty of noise, and that sellers will know more about assets they sell than buyers. The ingredients for understanding the crisis was there. So why were they ignored?

Eichengreen argues that we were seduced. Agreeing with the de-regulatory zeitgeist led to lucrative speaking fees and consulting gigs. The Shillers of the world only prosper after the fact, the facilitators during the boom. Hence, he writes:

What got us into this mess, in other words, were not the limits of scholarly imagination. It was not the failure or inability of economists to model conflicts of interest, incentives to take excessive risk and information problems that can give rise to bubbles, panics and crises. It was not that economists failed to recognize the role of social and psychological factors in decision making or that they lacked the tools needed to draw out the implications. In fact, these observations and others had been imaginatively elaborated by contributors to the literatures on agency theory, information economics and behavioral finance. Rather, the problem was a partial and blinkered reading of that literature. The consumers of economic theory, not surprisingly, tended to pick and choose those elements of that rich literature that best supported their self-serving actions. Equally reprehensibly, the producers of that theory, benefiting in ways both pecuniary and psychic, showed disturbingly little tendency to object. It is in this light that we must understand how it was that the vast majority of the economics profession remained so blissfully silent and indeed unaware of the risk of financial disaster.

Eichengreen then argues that the increased popularity of empirical economics may help us avoid this problem in the future. I am less convinced by this argument. It is just as easy to cherry pick empirical work as theory. But the major thrust of the article is well worth reading.