… Until Accumulation of FX as reserves reverses (Read Japan MoF), while China does not recycle its trade surplus into US debt.

There are a couple of misconceptions about the monetary system of FX as reserves today. A lot of people think that it has always been the case, that there was always a dominant currency. But they confuse FX as reserves with a preferred currency, which is fundamentally different.

As Henry Thornton explained, in the late XVIIIth century, a lot of foreign merchants would gladly use BoE notes for transacting business. Did it mean that BoE notes would be accepted as assets in foreign banks in France, Hamburg, Italy, or in the remote United States? Absolutely not.

Those notes were just a means of circulation that merchants liked to use, given that, according to Henry Thornton, the BoE was reluctant to lend funds too liberally to the British Government, making it a suitable currency for trade before the war-induced convertibility suspension of 1797.

To continue the clarification, a reserve currency is a form of colonial money system that was indeed practiced in India by the UK and later by other colonial powers. In 1922, this system was expanded worldwide by the Genoa Convention, which decided, under the helm of a League of Nations conference, to force the acceptance of GBP and USD as reserves in foreign central banks through Resolution 9 of this conference in May 1922.

To understand the novocain-ed consequences of this system, we have to contrast it with the system before it, where banks did not accept foreign currencies as assets.

In a pre-1922 world, either under the Gold Standard post-1873, or the multiple standards before that, which included a Gold bloc, a Silver bloc, bimetallic systems, and even fiat money for the US after the Civil War, things worked differently.

In a metallic standard with convertibility at a fixed price, a trade deficit would be balanced mainly by gold. Juglar explained that a country has to pay for its imports either through exports, its gold, or through debt and financial assets. But in practice, creditors would not hold the bills of exchange of a foreign currency unless they expected a short-term re-equilibrium to occur.

That is exactly what Henry Thornton described: speculators in Hamburg willing to acquire Bank of England notes. So most of the time, the gold would be “drawn in London,” and that meant there would be an external drain.

In other words, the trade imbalance would directly result in a contraction of M0 (a QT, if you will) and force interest rates higher. This, in turn, would put a progressive brake on credit expansion and internal prices, which would continue until the terms of trade were restored and the imbalance between overconsumption and production (which is the same thing as a trade deficit) was corrected. That is a broad-brush approach, but it is fundamentally how things would work.

However, in 1801, the UK was not under a redeemable currency system, but under a fiat currency system since 1797 due to the Napoleonic Wars. (And you could argue that fiat money and permanent war are intricately linked because funding wars makes it extremely difficult to maintain a fixed parity.)

But even under this system, the credit structure would be affected by its trade deficit. A dumping of gold in a floating currency system would make the currency of the debtor fall versus gold and the commodity complex, which in turn would result in high nominal interest rates during the fall, as explained brilliantly by Thomas Tooke under the concept of “return in money versus return in kind,” linking the fall of a currency versus the commodity plane to interest rates. (It was “rediscovered,” in poor terms in my opinion, by Gibbons and Keynes. They should have read the original text, if you ask me.)

And, by the way, this is what China is doing today. They do not need dollars to bid up gold; they have an exchange of precious metals denominated in local currency.

In what seems unrelated, Kenneth Rogoff explains that he is expecting a de-dollarization of Asia in a similar way to what happened in Europe in the 1970s, and he is expecting much higher rates and a weaker dollar. Well, I guess, with this first explanation about what China is doing, it might resonate in relation to what has happened in recent years regarding:

a) Lower value of the USD versus the commodity complex (precious metals, soft commodities, etc.)

b) Higher rates

But let’s come back to the mechanics of the FX-as-reserves system.

The Losers Get Their Stakes Back

This above simply explains the disconnect between trade balances, interest rates, and credit that occurs when FX is accepted as reserves and redeployed into the debtor’s debt securities. It explains that the deficit can continue for as long as this deficit does not impact the credit structure of the US.  

When Bondzilla Comes Out of the Trenches

So, in the context of Japan, what Jacques Rueff explained above is that the trade deficit of the US versus a creditor nation like Japan is basically a non-issue. The dollars received by Japan are converted into USTs and put in some sort of box, locked away and thrown at the bottom of the deep trenches of the Japanese Sea—or at the FRBNY; both work the same way.

There is just a slight problem with the assumption that USD FX reserves can remain there forever.

At some point, the MoF needs the money, and since its liabilities are in yen, it cannot use the USTs to pay them. So it has to sell the USTs for USD and then sell those USD for yen. The round trip has already been explained in a previous post. It is neutral for Japan in terms of dollars since the Japanese reacquire the dollars; neutral in M0 since it is just a round trip on M0 reserves that banks send to the MoF while JPY bondholders redeposit their yen back into the banking system. But it is not neutral for banks, whose profitability surges since their cost of swaps rises, who become more liquid as a result. Nor is it neutral for the credit structure, as Rueff explained, because Japan is selling duration.

What the MoF is doing is neutral dollar-wise for Japan and neutral M0-wise for Japan, but it is putting pressure on the US base-rate curve. And in a context where private credit explains that its single biggest concern is the base rate, it is not going to help credit.

And that is your credit structure impact that Rueff is talking about. The accumulation phase looks like a deficit without pain, but when the MoF needs the money? Ouch for the curve.

And then we come back to Kenneth Rogoff’s point: de-dollarization of Asia, a weaker USD, and higher rates. I have provided some short explanations using classical economists, but I have no doubt that Mr. Rogoff, as former Chief Economist at the IMF, could articulate them very eloquently.

Now, the BIS is not too bad either when it comes to economic analysis, and they have issued a warning about what they see with the energy transition. There is an inherent contradiction in contemplating the cut-throat price competition that solar panel manufacturers are going through as older-generation manufacturers are phased out while new-generation solar panels are coming in, and simultaneously concluding that solar panels present no threat to fossil fuels.

I repeat the two words: price competition.

Make no mistake: the electrons that run through electric wires do not know whether they were produced by natural gas or by solar panels. When you have a cartel, you suspend the economics of price competition. When a cheaper substitute is available, buyers will shift.

In fact, this is exactly what is happening today in Japan, where Sharing Energy Co., Ltd. (“Share Denki”), Tokyu Land Corporation (ReENE Energy), and TEPCO Home Tech are doing precisely that.

The first two companies are part of the fintech sector aggressively going after utility customers to install and manage solar panels on customers’ rooftops, cut their utility contracts, and instead pay those fintech companies a lower price per kWh of electricity per month. This has forced TEPCO, the utility, to promote its own solution in order not to lose too many customers who would otherwise simply terminate their utility contracts.

That has obvious consequences for the demand for natural gas and for USD necessary to buy those fossil fuels.

The Credit Structure Impact of MoF De-Accumulation

What we explained in a previous post is that what the MoF is doing is basically neutral to the USD and neutral to the yen because it is a round trip. But it is far from neutral on the curve because the move from the MoF selling USTs for USD—which are then acquired by commercial banks and invested into T-bills—is a net short of duration.

And what was the single biggest concern of private credit according to a survey last year?

BASE RATES. Here you have your credit structure impact explained by Jacques Rueff. 

Separately, China is conducting an external drain, which bypasses the USD entirely. It means that China is accumulating gold from its trade surplus, not USD to be recycled into USTs. Therefore, it is neither neutral on the USD (and the CNY, unlike the JPY, has been rallying steadily) nor neutral on base rates.

So when Kenneth Rogoff expects a de-dollarization of Asia in a similar vein to what happened in Europe in the 1970s, and when he expects a lower dollar and higher rates, he is referring precisely to the dynamics described above.

https://finance.yahoo.com/news/americans-not-prepared-says-harvard-131557213.html

When the deficit is getting felt in the credit structure of the US, as it is increasingly so based on the mechanics explained above, the result is higher rates (all else equal and evidently a plunge in energy prices would help ) AND a lower currency.