2010-07-28

Central banks could go broke as well

Now let us stress-test the central banks
Consider Asian central banks, with their total of $5,000bn in foreign reserves. These assets are often mistakenly seen as a sign of strength. As the vast bulk of liabilities against these reserves are denominated in local currencies, a prolonged period of US dollar and/or euro weakness would generate unprecedented marked-to-market losses. A 20 per cent appreciation of the renmimbi versus the People’s Bank of China’s owned foreign assets would thus result in a hit to Chinese federal finances of some 10 per cent of domestic GDP. Similar appreciation of the Singaporean or Taiwanese dollar would generate losses nearly twice this amount measured in Singaporean or Taiwanese GDP. Losses would be even greater for those institutions – such as the Hong Kong Monetary Authority – where dollar pegs are in place.

Currency mismatches are not a concern only for Asian central banks, however. Over the past 14 months the Swiss National Bank spent more than SFr150bn ($143bn, €110bn, £92bn) – some 30 per cent of Swiss GDP – accumulating euros, all in a futile attempt to stem the rise of the Swiss franc. Marked-to-market losses on these positions are estimated to have exceeded SFr20bn recently, or about SFr3,000 for every Swiss citizen. A further 10 per cent appreciation of the Swiss franc versus the euro would generate additional marked-to-market losses of 3 per cent of Swiss GDP. Such losses are politically unsustainable, if not financially.
Michael Pettis discusses the box the PBOC finds itself in.

The PBoC can’t easily raise interest rates
In fact they may do what they did the last time the currency revalued – engineer a reduction of real interest rates and a rapid expansion of credit. This will counteract the contractionary effect of revaluing the currency – competitiveness lost because of a higher currency will be counterbalanced by competitiveness gained by lower costs of capital.

This of course will also put more upward pressure on the trade surplus, allowing China to continue to use the external sector to absorb excess capacity. Of course it will also sharply increase the asset misallocation problem – as Japan demonstrated after 1985 when, in response to the appreciating yen, they reduced interest rates and expanded credit.
Governments and central banks are weakening their fiscal positions. Global financial risk is rising, not falling.

No comments:

Post a Comment