Submitted by Jeffrey Snider – Alhambra Investment Partners
You can kind of get a feel for where we are by days like today. In the morning, a foreign central bank in almost grand standing (for now) is obliged to crash a money market of its own making and the world responds, initially, by cheerful enthusiasm. As O/N HIBOR was making its way up to 66%, oil prices (February 2016 contract) were back up toward $33 again, pulling with it the global narrative machine that passes for stock analysis. The relief was short-lived, and WTI actually traded under $30 for the first time in a very, very long time (closing back somewhere in the middle).
I doubt very much that reversal had anything to do with conscious appreciation for convertibility, but deep within the mechanics of money and global liquidity it was certainly there. When I wrote yesterday about liquidity preferences under something like the eurodollar system, it was this that I had in mind; there is no defined mechanism for convertibility in a wholesale system that has banished hard money properties. As such, banking and monetary agents are forced to incorporate a different approach to liability management and prudence (modeled with and on volatility at its core).
It’s a very difficult concept to grasp largely because mainstream economics treats money as if it were still present; even if only as the Federal Reserve’s ability to create liabilities on its own balance sheet. This is the ancient world of the money multiplier.
There was something of that in the eurodollar system, but only in its earliest days where connections between onshore and offshore “dollars” were cumbersome and almost visceral. When Milton Friedman answered eurodollar confusion with some stark accounting in 1971, it was to define the basis of the money multiplication system then at its core. But even at that point, there were already signs that the eurodollar was something even more intangible and, frankly, incredible.
At the FOMC meeting on February 11, 1964, the members were briefed on a paper presented via the BIS about the relatively new (and wondrously unknown) eurodollar and euro-currency market that had really developed only about five or six years before seemingly out of nowhere. The paper overall was positive in tone about offshore currency and banking flung out beyond the discretionary borders of nationalistic central banks, to which several FOMC members voiced their displeasure in “challenging” the “favorable flavor” of the paper’s positive conclusions (the FOMC at the time considered eurodollars to be a part of the “capital outflows”, a primary monetary problem of that age for economists asserting a managerial economic doctrine; that which led, of course, to the Great Inflation not long thereafter).
However positive the BIS paper might have been, it did contain something of a warning, at least in the form of citation about the potential for eurodollars to explore new ground.
The Euro-dollar market is today a substantial source of international credit. It brings many lenders and borrowers together on more favorable terms to both, and therefore more efficiently than would otherwise be the case. Moreover, the impetus towards equalization of money rates which it has given has been useful, not only to individual lenders and borrowers, but in the broader context of international monetary equilibrium. Some observers have stressed certain adverse consequences which the market may have and it would seem that these observations have their element of truth. From the standpoint of official policy, however, it does not seem that the possible dangers of Euro-currency credit are of a different order from those of other movements of short-term funds. Maybe, because of its efficiency, the Euro-currency market has an exceptional potential for expansion which may create a special problem for monetary authorities in the future; but so far this does not seem to have been the case and on the whole it appears clear that the market has served a useful purpose. [emphasis added]
In a prior FOMC discussion, that of March 24, 1962, the Committee again considering the topic of eurodollars and outflows, it was noted that in conversations with dealer banks that London dollar markets were especially advantaged over NYC even when most traditional rate metrics suggested the opposite (in this specific case, the FOMC was discussing T-bill rates in comparison to the forward discount rate on sterling).
Actually, however, comparison based on Treasury bill rates can be misleading because the London money market offers higher rates on certain investments that are, rightly or wrongly, considered by some investors the equivalent of prime investments in New York, especially deposits with local authorities and with finance companies. On a covered basis, these rates still show an advantage of nearly one per cent over investments in the New York money market. Euro-dollar rates in London also are still quoted at 3-1/2 per cent, at least 1/2 per cent higher than returns on prime money market paper in New York.
The reason New York dollar rates were so uncompetitive was not just the fact of domestic regulation absent in offshore London, but that money dealers in this new global dollar market could (and did) operate on incredibly thin spreads and margins that nobody could match on this side of the Atlantic.
According to oral information, some London financial institutions are willing to operate in the Euro-dollar market with a margin of only 1/16 of 1 per cent, and therefore will always be able to out-compete New York banks for international deposits.
In a nutshell, that one quote is everything about where we are today; a new dollar market arises, outcompetes domestic dealers to turn in incredible growth and expansion and the Federal Reserve has to hear about it all from “oral conversations” with some of its members (while debating for years on years its meaning). Central banks are always behind the curve because that is their very nature, and further they aim to keep it that way. Over the years it would turn out that the BIS’s warning in 1964 came true not just in terms of quantity expansion, but far more so in moving and erasing the traditional boundaries and the very definitions of banking and global money. The reason London “dollar” dealers could operate on such thin spreads was that there was no currency in that market; nothing to hold over as physical “reserves” of cash and nothing with which to bother about having to move around (even from vault to vault).
Again, it’s an incredibly difficult concept to grasp and understand, and perhaps even more so to accept, but the issue of convertibility is truly separate from what the eurodollar started out as. In other words, eurodollars were not, as the Fed decided in 1979 all on its own, a competing investment choice for money as a “store of value” for ultimately domestic use but, at least in its earliest days, they were almost completely a payment processing system for global trade as the Bretton Woods system died out (slowly). As noted last week, in a more purely payment processing function nobody really wants to hold dollars except as an efficient medium through which various currency systems could be brought together in a standardized format.
The eurodollar market, then, was simply a way to manage global finance as global trade all by claiming not that there were actual dollars contained within it but rather that banks could possibly obtain them “from the market” if ever pushed to (banks, for their part over the decades, simply assumed they never would be). The key change, and that which plagues us today (and is a whole other story), was in the 1990’s as eurodollars shifted dangerously from financing global trade as a matter of pure payment system to underpinning what was really a parallel banking system including lending, credit, securities and the full range of banking transformations.
But without actual currency, the BIS warning was turned inward starting in August 2007 (echoing the prescient 1979 warning about eurodollars with no central access point should convertibility suddenly become an issue). We can actually see the eurodollar market start to question convertibility, and we can further see how this intangible conceptual form does not carry well under such questioning.
My discussion about money market fragmentation from a few weeks ago contained these elements, as the inability of the Federal Reserve to maintain its loose “corridor” at that time highlighted the fact that money markets were actually plural. That shouldn’t ever truly be a problem because all money markets, as the name itself directly implies, should always be further reducible to money itself; in the case of 2007 assumptions, that would be at least some deposit account at the Federal Reserve. What we saw then, however, was very much like liquidity preferences in and among these money markets; repo, eurodollars, federal funds and elements of derivatives, especially CDS.
So the bank panic then was truly different in that it was only banks panicking; there was no convertibility issue with the general public seeking to turn deposit balances on an ATM receipt into actual, physical cash (the traditional understanding of convertibility and bank runs). Instead, it was various banking constructions trying to sort out the distribution of monetary liabilities of far different forms and not being able to – all because there was no central axis of convertibility. Without that, banks resorted to what was really a hierarchy of liquidity preferences dictated by individual bank perceptions rather than systemic incentives for normal and useful flow. That is why, for example, LIBOR (eurodollars) would shoot upward to 5.62% on August 10, 2007, while federal funds would be effective at just 4.68% (with a target, meaning Fed Open Market promises to defend, 5.25%) and numerous trades actually being booked at 0.00%. Eurodollar banks were looking for “dollars” and not finding them since they were parked idle in New York; and all of it just bookkeeping( and in many ways just ancillary to further debasing circumstances where dealers were truly desperate to find CDS and hedging in order to avoid capital charges and OTTI writedowns).
The Fed, for its limited role, could only promise to supply dollars in New York, but in practice couldn’t even do that (which is why we eventually got QE’s). Wholesale bank “convertibility” truly deserved (and deserves) the quotation marks around the word (just as “dollars”).
So it is increasingly curious (with a hint of grave concern) that reports and anecdotes of a physical currency shortage around the world have continued to come up. Just today there was story out of China in the Wall Street Journal (thanks to Jason Fraser of Ceredex Value Advisors) about a literal “dollar shortage.”
During the weekend, ICBC [Industrial & Commercial Bank of China] received an urgent notification from China’s central bank warning of a dollar shortage, he said. The tight supply means ICBC customers applying to change yuan for dollars on Tuesday have to wait four days to complete the transaction, rather than the normal one day, he said.
That would be the very definition of a dollar run, though not in the place anyone would expect to find one. People are quick to chalk that up to capital controls and the Chinese being overly concerned about “outflows.” And that might very well be the case, or some of it, but then yesterday there was the same thing out of Nigeria:
Nigeria’s central bank is halting dollar sales to non-bank foreign exchange operators and letting commercial banks accept dollar deposits with immediate effect, its governor said on Monday, in an effort to shore up dwindling foreign reserves.
Godwin Emefiele said the sale of foreign exchange to bureaux de change would be discontinued because they were using up the country’s foreign reserves for illegal transactions and selling the dollar at 250 naira compared to the official central bank rate of 197 naira. [emphasis added]
Again, the shortage of dollars is written off as purely a function of oil prices, but the Nigerian central bank is suddenly reversing a very public policy restriction put in place last year in order to “curb currency speculation.” On August 6, 2015, actual cash dollar deposits were banned from Nigeria’s banking system.
Nigeria’s central bank banned banks from taking foreign-currency cash deposits and will boost supply of dollars to money changers this week as it seeks to bolster the currency of Africa’s biggest oil producer and economy.
Only wire transfers to and from foreign-exchange accounts, also known as domiciliary accounts, are now allowed, the Abuja-based Central Bank of Nigeria said in a statement on its website on Wednesday. The move will help “efforts to stop illicit financial flows in the Nigerian banking system,” it said.
In other words, they stopped the flow of physical dollar cash in early August in favor of ledgered deposits of “dollars” (wire transfers), but now the central bank has had to reverse course entirely in order to allow physical cash back into the country. What is odd and concerning is that Nigerian banks reported in August an overwhelming surplus of physical cash:
Some Nigerian banks including Guaranty Trust Bank Plc and Fidelity Bank Plc sent messages to customers at the weekend informing them that they will no longer accept foreign currency deposits in cash, citing large volumes of such funds in their vaults which they can’t place with the central bank. The step will curb speculation on the naira, Ibrahim Mu’azu, a spokesman for the central bank, said Aug. 2.
We are left to wonder where it all went; not that it did. Physical foreign cash had become inconvertible for Nigerian banks with their central bank, but apparently not so elsewhere! Again, mainstream commentary is quick to blame oil prices and the oil trade, but that doesn’t immediately suggest why physical dollars in overflowing fashion that were there and available in August are now completely gone so as to force the central bank in Nigeria to undo what it thought then was desperately necessary to save its own currency.
The suggestion in the global context which includes China seems to be one of increasing appeal of physical cash somewhere which would make sense only in the severely diminished capacity of the inconvertible, non-cash “dollar” form. It doesn’t seem quite Gresham’s Law, in that the “undervalued” money disappears from circulation while the “overvalued” money floods the market, but it may share some similarities at least in the running disappearance of physical dollars globally.
The final act of the eurodollar system may be, in fact, convertibility; coming full circle from evolution to devolution right back again. That was an important point of my suggestion yesterday about the death of money as in yield curves (and even the futures curve of oil). Liquidity preferences rule, badly, in the wholesale format. If physical dollars are becoming the primary expression of that in what looks like an actual dollar (no quotes) run, then the wholesale system has reached backward into a new plane of further falling apart.
I have to emphasize that this is conjecture on my part, based only upon the curious nature of physical dollars seemingly disappearing from all over the world (not just Nigeria and China, but use in Venezuela, Argentina and others so far). Maybe this was to be expected, however, if eurodollar banks are no longer providing fluid and liquid use of the intangible eurodollar form, the new kind of interbank money that so perplexed the Fed throughout the 1960’s (and 1970’s, and 1980’s, and 1990’s,…). At some point in that deconstruction global banking might have no choice but to revert to its physical precursor – the eurodollar market might deny you a repo rollover but a physical Federal Reserve Note is under no obligation of any kind so long as you can get your hands on it. If that is indeed the case (again, a big “if”), it’s not good. You do have to wonder, however, with all that is taking place right now as related to all that did around the world in 2015; something to at least keep an eye on.