Easy money in the United States, a falling dollar and growing flows of funds seeking better returns in emerging markets are touching off a new round of capital controls in hot emerging markets, a trend that could accelerate and will at the very least increase market volatility.

It shouldn’t be a surprise, really; loose money in the developed world is helping to spur investment into emerging markets, driving currencies up and making local exports less competitive for countries which, unlike China, aren’t hitching a free ride as the dollar declines.

Inflation may be a threat for many of these, but with the global economy still struggling, it certainly won’t feel that way to policy makers.

Russia on Wednesday joined the list of countries eyeing new measures to stem currency speculation and appreciation. Moscow was careful to say it would not impose actual capital controls, which seek to regulate flows of funds into or out of an economy, but the measures they are considering would have exactly that effect, making it tougher or more expensive for money borrowed abroad to be brought into Russia.

Kazakhstan, which has been intervening actively to slow the ascent of its tenge currency, has introduced legislation allowing capital controls, but so far has not used them.

Indonesia said this week it will consider curbs on foreign holdings of short-term official debt, sending its rupiah into a brief swoon until central banker Hartadi Sarwono damped things down by saying currency moves based on such flows were so far manageable.

Elsewhere all across developing Asia central banks have been intervening to cap gains in the value of their currencies, with Taiwan going so far as to ban foreign funds from investing in local time deposits.

Brazil last month announced a 2 percent tax on foreign investment in stocks and fixed-income securities to limit the strengthening of the real.

International Monetary Fund chief Dominique Strauss-Kahn gave the fund’s standard line to the Financial Times: “The IMF would not recommend them as a standard prescription … as they carried costs and were usually ineffective”.

FIGHTING OVER SCRAPS

Ineffective over the long run they may be, but tempting they are in the short term. The very fact that India and China have emerged relatively well from the crisis and have resumed growth in strong fashion gives courage to those considering their own measures. And really, the very idea of an orthodox allegiance to free flowing markets ensuring the best outcome for all now looks pretty 1999. Malaysia attracted a firestorm of criticism when it imposed controls in the wake of the Asian crisis in the 1990s. There was much talk of how investors would go away and not come back, how development would be retarded and Malaysia ultimately would rue the day. None of that has come to pass, and those same investors proved quite willing to come back if the returns looked good enough, as indeed they did.

But Malaysia, along with Chile, were outliers when they imposed capital controls. What will it mean if it becomes not a tool of desperation but a standard policy when hot money flows? There must be a risk that capital controls become part of an escalating series of beggar-thy-neighbor steps taken by countries fighting over the scraps of a diminished U.S. and European appetite for imported goods.

If, in other words, these controls are a temporary phase to ease the transition to stronger currencies, the risks might not be that high. I’d worry that developed market interest rates are going to stay low for a very long time. That means that the grand emerging markets carry trade of borrowing in dollar to speculate for appreciation elsewhere will, as it did in Japan, build and build.

At the same time you have to look at why interest rates will stay so low for so long. My bet is that it is because consumption in the developed world will be under structural pressure as debts are repaid. So the money flows into emerging markets and drives up currencies, but unless domestic consumption in China and India really takes off there will not be a very good market for exports. That will make newly strong emerging market currencies all the harder for those countries to tolerate, economically and politically. If China does not do its part and allow its currency to appreciate, the argument will be all the more stark.

It may or may not be a good idea, but one thing I would not count on is coordinated and globally sanctioned capital controls, as espoused by Arvind Subramanian, a senior fellow of the Peterson Institute.

The U.S. simply won’t wear it.

Look then for more unilateral controls and more volatility as speculation of all kinds grows.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

Stocks and other risky assets are rallying around the world this week because the Group of 20 nations said on the weekend they would keep the economic stimulus flowing, a state of events which illustrates where we are and what a very strange place it is.

The G20, the only group of big hitters that matters because it is the only group which includes the Chinese, met in Scotland over the weekend and, as is the way of these things, did very little with immediate consequences for anybody.

In the communique they issued, the Group of 20 finance ministers, after congratulating themselves on the recovery, more or less admitted that the measures we once thought of as heroic are in the process of becoming commonplace.

“However, the recovery is uneven and remains dependent on policy support, and high unemployment is a major concern,” the statement said. “To restore the global economy and financial system to health, we agreed to maintain support for the recovery until it is assured.”

Let me put that in human terms for you:

“We’ve spent untold trillions saving the economy, but, er, we’ve really only saved the financial system and that only to the extent that we keep on saving it. Jobs, well, not so much. We therefore pledge to continue doing this thing that may or may not be working until we are sure that it is.”

Global stock markets then went off on a stonking rally on Monday, which major media attributed to the pledge of continued stimulus. I suppose we shouldn’t dismiss the possibility that the financial media was, as we often do, mistaking coincidence for causation, but professionals were citing it too.

So, what are they promising to do? Will they be able to do it? And why do the risk markets like it so much?

There are at least two aspects to the stimulus - continued easy money from central banks and actual government spending.

The easy money part - low interest rates and unconventional measures - clearly will continue. It will be politically very difficult to raise interest rates while unemployment is still so high, and given the wan nature of the recovery, unemployment will take a long time to fall.

The actual government spending part is a lot harder to bank on, as it were. One reading of the Japanese experience in the 1990s is that their stimulative measures worked but they lost heart and withdrew them for mostly political reasons, thereby bringing on a relapse from which they never really properly recovered.

The politics of another stimulative spending binge will not be easy, especially in the U.S. and especially given populist backlash. That’s not to say more stimulus won’t be needed, it very likely will, but you can’t count on it arriving. Deleveraging takes a long time and we very likely would have been better off just writing the debt down in the first place.

MARKETS LOVE CERTAINTY

Investors have decided, and I think they are probably right, that so long as the authorities are hell bent on reflation it is foolish to get in the way.

As analyst David Merkel has pointed out, the statement of the Federal Reserve meeting, released last week, characterized financial markets as “roughly unchanged” since they last met in September, revealing that they pay far more attention to equity markets than debt markets.

Because of course equity markets were going more or less sideways in October but many of the riskier parts of the debt markets were rallying strongly. Wasn’t this whole crisis, and its expensive fix, supposed to be about “unfreezing credit markets”? Not anymore, apparently.

That is because the Fed realize that they have got to keep equity markets up, indeed have got to force them to rise. It is the only way to float the equity above the debt, make the banks and the holders of debt whole, and allow the financial system to weather the crisis.

There were other options - default, temporary nationalization - but that is not the route we went down. So, within this context the rally makes great sense.

Notice how equity markets have been on a huge tear since last week, going up on news that implied that the Fed would remain on hold for a long time, going up on unemployment rising through 10 percent in the U.S. and, funnily enough, going up on faith that the G20 would stick with stimulus measures.

This brings us to the crazy part. While it may be individually rational for everyone to hitch a ride on the policy train and follow asset prices higher, I would argue that the project is collective folly.

The risks are inflation and a rapidly falling U.S. dollar which leave banks and debtors solvent in nominal terms but not better off. Those risks are best observed now through the dollar, which is falling, and gold, which is at record highs.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

The discrediting of the efficient markets theory in the aftermath of the financial crisis appears to have been accompanied with growing support for the view that rather than efficient in nature, financial markets are predisposed towards the formation of bubbles.

A bubble can simply be defined as an occurrence that begins when the price of an asset has been driven significantly above it "fair" value. According to the efficient markets theory this would not happen.

If bubbles are a natural outcome of financial market activity it is relevant to ask whether the very loose fiscal and monetary policies of many central banks and governments are presently sowing the seeds of the next bubble.

Even though the real economies of the U.S., UK, Eurozone and Japan continue to be defined by expectations of rising unemployment and falling real wages, access to cheap money has already helped restore the profitability of many investment banks.

In turn, this has fed risk appetite which is evident in the rally in stocks since the spring, increased demand for "risky" currencies and a recovery in commodities prices. Brent oil has rallied by 128 percent from its 2009 low. The ability of oil to rally despite the existence of oil supplies well above the seasonal average suggests there is already speculative element in this market which could be in danger of driving prices above their fair value.

This week’s meetings of the Federal Reserve, the Bank of England and the European Central Bank have focussed attention not so much on rates, but on the extraordinary policy decisions taken by these central banks in the wake of the financial crisis and whether conditions are ripening in favour of a gradual withdrawal of some of these policies.

The Fed last week ended its $300 billion treasury bond purchasing plan, though it will carry on buying mortgage backed securities. The Bank of Japan last week announced that it will stop buying corporate bonds at year end. The Reserve Bank of India also removed emergency support measures last week.

This week there is speculation that the ECB could announce that it will hold no more 12-month cash tenders next year. By contrast the Bank of England is expected to increase quantitative easing at the November 5, Monetary Policy Committee meeting. Supporters of quantitative easing continue to stress that the lack of clear inflation pressures suggests there is room for these plans to be extended.

However, the lack of response in either money supply or inflation indices could equally be illustrating that these plans are not having a significant impact on the real economy and are therefore no longer appropriate. The paring back of these plans are likely to have an impact on the ability of some banks to turn an easy profit and thus should rein in risk appetite and limit speculative and "bubble" forming activity.

Unfortunately, a bubble can only be truly confirmed after it has burst; a characteristic with clear destabilising consequences. If bubbles are natural phenomena within financial markets, the need for tighter regulation and ongoing reviews of processes that oversee the financial system are absolutely necessary.

This conclusion, while in complete contrast to the implications of the efficient markets theory, ties in very well with the political desire to reform the banking regulatory framework in order to protect the tax payer from future hefty bank bail-out costs. The banking landscape, while already vastly different from just two years ago could continue its transformation for years.

researchEMEA@forrex.com

Dollar bears have been disappointed by the G20.

Talk of re-balancing remained just talk; the bears can discern nothing substantial. Some risk is being taken off and dollars bought back selectively. While the dollar’s general downtrend is intact, there are risks of a temporary reversal, with some seeing the euro temporarily back to $1.4500/50.

Traders can contrast G20 with the Plaza Accord in 1985 which was driven by U.S. Treasury Secretary James Baker’s persistence. But he only had to convince four peers. G20 is and will be a different story. Dealing with the G20 must be like herding cats.

Disappointment over G20 has come at an inauspicious moment. Extensive short dollar foreign exchange positions have been underpinned by the unparalleled provision of dollar liquidity by the world’s central banks.

The market has used that dollar liquidity to fund purchases of other currencies and assets. Currency speculators raised their bets against the dollar in the latest week to the most since March, 2008, data from the Commodity Futures Trading Commission on Friday showed.

But the market is realising that the major central banks are contemplating the initial steps in their exit strategies, which would naturally reverse the dollar-funded carry trade.

The liquidity bonanza that has ignited the asset market rallies is going to be pared back. Last week’s withdrawal of some emergency facilities that are deemed to be no longer needed was the first step.

Federal Reserve Governor Kevin Warsh added fuel to the fire asserting “policy likely will need to begin normalisation before it is obvious that it is necessary, possibly with greater force than is customary”.

Seemingly Warsh is not expecting the “softly softly” approach of former Fed Chairman Alan Greenspan in his post-dot com bust tightening cycle that started in mid-2004 and lasted for two years.

Market players who are using the dollar as a carry currency will note Warsh’s comments and may trim back their short dollar positioning.

The yen’s strengthening to 88.23 yen against the dollar today should be seen in the same context, as a trimming back in carry trades by Japanese retail investors, who by and large remain wedded to the U.S. currency.

The market will ultimately want to target the year’s low of 87.15 yen and ultimately the all-time low of 79.80 yen, seeking to tempt Japan’s Ministry of Finance into a reaction.

In an atmosphere where the new Japanese government seems somewhat indifferent to yen appreciation, the market has delivered general yen strength. The headlines focused on dollar/yen but traders reveal that much of the emphasis was on the liquidation of cross yen trades such as euro/yen.

Risk trades have buoyed equity markets as well as fuelling short dollar positions on the foreign exchanges. Risk trades are predicated on the assumption that government economic stimuli will promote self-sustaining recoveries. If that assumption is faulty, then the positions will need some unwinding.

However, traders are now realising that programmes like “cash for clunkers” are merely cannibalising future purchases. Consumers will respond to incentives, but without those incentives they prefer thrift. Lengthening job queues are keeping purse strings tight.

There is therefore a growing belief that the dollar may find passing strength as positioning is adjusted, which traders would see as an opportunity. Proprietorial traders will welcome the unwind and look to take advantage of any such move. Their longer-term view of further dollar weakness is undimmed.

The U.S. national interest remains focused on re-balancing. The exclusion of Mexican trucks from U.S. roads and the imposition of tariffs on cheap Chinese tyres may be dismissed as sops to President Obama’s union backers.

Yet they betray a wider agenda to revive American industrial activity. A lower dollar, even if that hasn’t worked in the past, will be an integral part of that re-balancing act.

While the dollar may therefore draw some transient strength from position adjustment, dollar bears will see the euro around $1.4500 as opportunities to buy the single currency. Moves above $1.5000 are still envisaged.

It just won’t go away, this needling worry about the U.S. dollar losing its coveted top-dog status.

No matter that there are plenty of reasonable arguments to support the dollar as the world reserve currency — namely there’s just no alternative — for perhaps decades to come.

Yet, in a world where once-rock-solid assumptions quickly turn to dust, investors should keep an eye on the dollar since changing perceptions are chipping away at its cherished status as currency to the world.

Much of the debate so far this year has centered on creating an alternative to the U.S. dollar, championed by China and Russia as a way to wean the world off its dependence on the U.S. as well as buffer individual nations against the missteps of those in developed world. Most recognize creating a new currency will take years and the chances of an existing currency, like the yuan, usurping the dollar anytime soon are remote.

But that doesn’t mean big money isn’t starting to prepare for world in which the buck isn’t the currency of choice.

Curtis Mewbourne, a portfolio manager at PIMCO, has suggested that investors diversify away from the dollar and to move into other currencies, especially those in emerging markets.

“And while we have not yet reached the point where a new global reserve currency will arise, we are clearly seeing a loss of status for the U.S. dollar as a store of value even in the absence of a single viable alternative,” he wrote in an article published on PIMCO’s website.

Notwithstanding its big bounce during the financial maelstrom last year, the dollar has been on downward trajectory for most of this decade. The U.S. dollar index, which currently stands around 78, once traded well above 100. In the early days of the dollar’s decline, currency traders worried about general diversification where central banks with big dollar reserves would begin to shave off a small portion of their holdings and exchange them for something else like euros.

The financial crisis, however, woke the world up to just how vulnerable those squirreling away dollars — like China and Russia — were to the fortunes of the United States. The bulk of the world’s currency reserves are in dollars, with the euro still a distant second. Foreign central banks, however, could hardly start selling dollar-denominated assets to limit their exposure because such sales would cause prices on their remaining holdings to fall further.

So far, calls for alternative currencies have been seen as political posturing for both international and domestic audiences alike, but the United States. has a lot to lose if it ever turns into something more concrete.

That’s because the loss of reserve status means, among other things, that the United States would lose a crucial crutch that has allowed it to borrow its way into prosperity as well as out of depression with relative impunity. Foreign investment in dollar assets have helped keep a cap on interest rates even though the government’s borrowing binge in recent years has brought new meaning to the word stimulus.

In an op-ed published in the New York Times today, Warren Buffett railed against the flowing red ink that will push the nation’s debt to roughly 56 percent of GDP from 41 percent in this fiscal year.

Presumably this is something that has also caught the eye of foreign investors.

While the greenback is likely to stay on top for some years, persistent concerns about its reserve status and moves to diversify away from it could usher in a new era for U.S. borrowers, public and private alike — a more painful one where debt costs can no longer be offset by the kindness of foreign investment.

The recession will soon be dead, laid to rest alongside the idea of the “Great Moderation”, a set of hopeful assumptions that underpins expectations about economic growth and asset valuations.

This, when investors, bankers and executives ultimately realise it will cause them to pull in their horns, take less risks and be less willing to pay high prices for assets.

Economists, observing that since the 1980s recessions have been mild and short and expansions long and robust, developed the theory that better economic management, namely cutting rates in the aftermath of bubbles, globalisation and, get this, improvements in financial markets, had led to a sort of best-of-all-possible-worlds “Great Moderation”, in which economic volatility fell and with it the risk premia required for holding financial assets.

This little theory has, needless to say, come somewhat unstuck during the current downturn which has been great but far from moderate.

This raises the uncomfortable possibility that the last 25 years of good times were just a bit of luck, or even worse, an artificially engineered consumption binge with central banks and governments playing a role similar to what Chicago tavern keepers used to do — opening up early so last night’s patrons can have a quick nip to take the edge off on the way into work.

It’s a debate which is far from academic and its outcome will influence much more than the actions of central bankers and regulators.

While financial market volatility has been a feature during the past decades, the idea, or at least the feeling, of the Great Moderation has seeped into the culture, influencing the behaviour of actors across the economy.

A corporate manager is going to be more likely to leverage up and go for the big hit if he feels as if most recessions are mild and short, in the same way that a consumer will buy a boat on credit or an investment property for the same reasons. If the weather never gets that cold why waste money on insulation?

What if these people now decide that the universe is a less friendly place and that they ought to, heaven help us all, save a considerable amount against the day?

This is really about volatility, which, because it can tend to ruin you, is expensive. Most investment or economic management strategies have at their heart attempts to limit or cushion volatility. And so, if we really can expect more volatility in the economy we can expect it to find expression in a lower ceiling for economic growth, leverage and asset prices.

IT AIN’T NECESSARILY SO
Of course, the current debacle may be just one data point rather than a trend, a view financial markets seem to have adopted. That is more or less the argument of Larry Summers and the U.S. administration, who are betting that this is the kind of thing that happens only very rarely.

This is a version of the 100-year storm argument beloved of company managers trying to explain why their results are so poor; the implication is you could not have been expected to plan for a freak storm and once it is past it is back to the good times.

This thinking lies behind the strategy of making financial conditions so easy that people are tempted to borrow and invest. It just might work, and we just might have a sharp and long recovery which generates enough revenue to pay off the public debts we are now racking up.

But two other possibilities, both speculative, spring to mind.

One is that deleveraging proves to be not just an event but a state of mind. As in Japan, people may simply decide that they’ve had enough risk, thank you very much, leading to a weak recovery, a relapse and then a quandary about how best to pay off the bills we’ve recently run up.

The other is that the current mix of policy, deep cuts in interest rates, deficit spending and quantitative easing, the effects of which are little understood, ends up breeding volatility of its own, probably in inflation.

The cost of that volatility will be an unpleasant surprise to the investors now bidding up the prices of shares and managers now preparing to invest for expansion, and one that might lead them to at last act more conservatively.

Add to arguments for a new “Great Immoderation”  that emerging markets will almost certainly be more of a driver of global economic growth under most of the reasonable scenarios in the coming decade. Emerging markets historically are more volatile and if as they grow to be a bigger piece of the pie are likely to make overall growth more volatile.

None of this takes away from the essentially good news that the recession looks to be ending soon, but higher economic volatility will hang heavy over the recovery and the cycle to come.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.–

The bond market’s adverse reaction after the Fed announced no new asset purchase facilities or bond buyback programs highlights the fundamental difference between interest rates and quantitative easing (QE).

Rate cuts provide ongoing support for an indefinite period until the Federal Open Market Committee chooses to reverse them. In contrast, QE programs provide a one-off, time-limited boost that has to be continually reapplied to have the same effect.

With interest rates a decision to leave rates alone represents “no change” in policy; with QE, a decision to leave the scale and duration of the buyback program unchanged is a “tightening”.

QE is time-limited because it drives up bond prices and cuts yields only as long as buybacks continue, or are expected to do so. Once planned buybacks have been completed, or are not expected to be extended, the market will revert to its natural clearing equilibrium. Repeated doses of QE are needed just to keep yields unchanged.

This creates something of a dilemma for policymakers in both the United States and the United Kingdom. The Bank of England’s program to buy 75 billion pounds worth of government and corporate bonds will be completed in mid-June. The Fed’s program to buy $300 billion of medium and long-term U.S. Treasury securities finishes in September.

Once the current round of purchases are complete, both central banks will have to decide whether to embark on another one (intensifying criticism about inflationary financing of public debt) or end it (triggering a sharp yield increase).

In fact, yields will start rising well ahead of the formal end of the programs, unless the Bank and the Fed give a clear signal they will undertake further purchases.

The dilemma is especially pressing for the Bank of England given the imminent expiry of the current round. Officials will come under pressure to clarify their intentions at next week’s Monetary Policy Committee meeting. But the Fed too will face growing pressure over the summer to signal whether the existing programme will be extended beyond September.

It was the Fed’s failure to announce new and larger QE programs yesterday, and the implication that current support might expire in a few months, that caused the bond sell off overnight. Yields on 10-year U.S. Treasuries jumped to 3.16 percent, the highest since Nov. 2008 on Thursday, undoing all of the gains since the Fed announced its QE programme last month.

Terminating QE programs and not replacing them would amount to a sharp tightening of policy and trigger a large, destabilising rise in yields. So the central banks might opt to scale them back instead — continuing to buy debt, but in progressively smaller quantities — as a smoother way to withdraw exceptional support.

The problem is that if QE programs are not withdrawn fairly soon, they risk breaking down anyway under the weight of their own internal contradictions. Because the longer programs run, the more debt central banks will monetize, and the more fears of an eventual inflationary breakout will grow.

Eventually upward pressure on yields caused by increased fears about inflation will offset the downward pressure from QE purchases, neutering the programs’ effectiveness. At that point, ever larger quantities of QE will be needed to achieve the same degree of yield reduction or stabilization.

QE may have bought the central banks a little time but returns will diminish later in the year. The sooner they can articulate a managed retreat the more likely they are to retain some influence over the back end of the yield curve.

The G20 leaders failed to come up with any concrete policy steps to pull the global economy out of recession at the London summit. The leaders vowed to restore growth and jobs, but lacked specifics about fiscal measures by each country and there were no binding promises.

There were expectations that the summit would tackle the issue of rising protectionism, but the summit is not an appropriate place to discuss international trade and investment. We saw a measure of results in expanding assistance to emerging economies, but it made the summit look as if it were a mere international conference on aid to emerging economies.

Since the collapse of Lehman Brothers last September, G20 countries have been trying to stabilize the financial markets with central banks taking exceptional action and cutting interest rates aggressively. The governments’ focus now appears to have shifted to restoring growth and protecting jobs from reacting to contingencies arising from the financial crisis.

The G20 leaders vowed fiscal stimulus totalling $5 trillion and to raise output by 4 percent by the end of next year. However, it failed to break down how much spending each country would bear. There is no indication that there are any binding targets. Since the financial crisis erupted, it has become increasingly difficult to coordinate policy given differences in the economic, fiscal and financial situations of the member countries.

Japan fleshed out its own $150 billion economic stimulus package on April 10, but the impact on boosting gross domestic product remains to be seen. The Japanese government had previously dished out economic packages with spending totalling 12 trillion yen ($120 billion). Government spending in the last fiscal year ended in March, however, only increased by 2.6 trillion yen (equivalent to about 0.5 percent of GDP). The “real water” spending will likely be limited even with the new stimulus package.

On the concern that world trade is falling for the first time in 25 years, the G20 leaders promised to extend the pledge made last year to “refrain from raising new barriers to investment or to trade” by one year to the end of 2010. Certainly, protectionist measures in any country will not protect jobs, but rather hinder economic growth. Moreover, economic model analysis on the economic effects of liberalizing trade and investment shows that “free-rider” gains from other countries’ free-trade policy would be limited. The analysis also indicates that it is important to liberalize the domestic market to maximize the benefits of global trade and investment.

On the issue of building a new order for the global economy, there are concerns about leadership struggles between industrialized economies and emerging economies. Although emerging economies may be gaining influence in the field of trade, it is unlikely that their competence in financial matters will match that of industrialised economies anytime soon.

We saw some advancement in extending assistance to emerging economies at the G20 summit. Japan pledged an additional $22 billion to assist with trade and to expand official development assistance (ODA) to other Asian countries to about $20 billion. But the biggest contribution Japan can make for the sake of the global economy may simply be pulling itself out of recession.

The dollar is, and will remain, the U.S.’s currency and its own and everyone else’s problem.

The idea of creating a global currency, as espoused by China earlier this week, is interesting, has a certain amount of merit and is simply not going to happen any time soon.

U.S. desire for free access to the cookie jar that being the world’s reserve currency represents will be too strong, especially given its need to finance huge amounts of debt reasonably cheaply. As well practicalities are fearsome, even if consensus was more or less there.

Chinese central bank head Zhou Xiaochuan on Monday called for the creation of a new “super-sovereign” global reserve currency, advocating building on an International Monetary Fund instrument called Special Drawing Rights.

Zhou echoed a call by Russia last week, when it indicated it would raise the issue at the upcoming Group of 20 meeting in London on April 2, saying the idea had support from emerging market economies including Brazil, India, South Korea and South Africa.

There is no doubt that the current system breeds instability, but it enjoys the great advantage of entrenchment and sticking with it allows the U.S., and others, to avoid making hard choices and paying true market prices for their economic decisions.

No surprise then that President Obama knocked the idea down in blunt terms. “I don’t believe that there’s a need for a global currency,” Obama said, terming the dollar “extraordinarily strong right now.”

Exactly. Too strong by some margin, especially when one considers the coming effects of both quantitative easing and a massive long-term need to fund the costs of the debt binge that exploded and the ever increasing bailout to clean up the aftermath.

In fact you could say the dollar’s “extraordinary” strength can only be fully explained when you take into account the fact that foreign central banks keep piling up huge reserves of the thing and that it is the international medium of exchange for commodities and energy, well really for global trade and financial intermediation.

Treasury Secretary Timothy Geithner said on Wednesday the U.S. dollar is still the world’s reserve currency and will remain so for a long time, but expressed openness to greater use of IMF SDRs.

The dollar’s central role has two main implications, both rather ugly but also very seductive for those involved.

For the U.S. it’s a bit of a free ride as far as debt financing goes. People buy and hold treasuries more and the U.S. gets cheaper financing that would otherwise be the case. Of course that’s a bit like an alcoholic bartender getting a discount at work; a real benefit, but not a true one.

It also means that even if the U.S. has the will to take away the proverbial punchbowl or drive the dollar down, it doesn’t always have control, as what it does at the short end of the interest rate curve can be confounded by foreign purchases that keep the long end and financing costs down and the dollar up.

SOVEREIGN OVER US ALL?

The U.S. reserve status also opens up the opportunity for mercantilist countries, like, say China, to keep its own currency cheap, building up huge dollar stocks and force-feeding the American milch cow with cheap credit with which to buy imported goods.

That may not work any more anyway, as all of the cow’s stomachs are full and the milk’s gone thin.
There is a temptation also to build up reserves as protection against bad times and bitter IMF medicine.

Many Asian leaders seem to have vowed after 1997 that they would do what was needed, which often included building up dollar reserves, to avoid having to meet an IMF director’s plane at the airport and accept the accompanying prescription.

That rather indicates that the old system, with the U.S. as global reserve currency, is dying, but I doubt it will do so without a fight and with cooperation among nations willing to cede part of their sovereignty, even for a greater good.

It is amazing and encouraging that China speaks of ceding control of a portion of its foreign reserve assets to IMF management, but I have a hard time seeing it happening widely soon.

So, we will have to get through the next year or two without a super-sovereign currency and with global imbalances being worked out, or around, under the current system.

My best guess is that things actually go in the right direction, more or less. The dollar should weaken as a result of U.S. policy even without a deliberate push downhill from the Chinese. Asian exporting nations will see slowing reserve growth generally, which should translate into diminished flows into the dollar and Treasuries.

That’s going to be painful all around. The Chinese and others will see their investments dwindle, even as they have to resist the impulse to sell into the fall. For the U.S. the process of implementing monetary policy and paying for fiscal policy will be made that much more difficult.

So, goodbye and perhaps good riddance to dollar hegemony, but don’t expect a stable system of global cooperation to rise easily and quickly in its place.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund –

The shadow banking system in Europe isn’t so much dead as being kept on life support by banks and central banks in what amounts to a desperate but risky attempt to avoid the reckoning.

You might be forgiven for thinking that the biggest single month ever for securitization in Europe and Britain was sometime before we all realized that we were in a credit bubble, sometime like the sunny days of 2006.

In fact, the biggest month ever, by some margin, was December 2008, when more than 212 billion euros of securitizations were issued in Europe.

One small problem however is that there was almost no demand for them, with only about 8 billion euros in public deals intended to be bought by actual investors wanting to take on actual risk.

The rest were “retained” deals, almost always structured so they were eligible for financing by central banks under repo arrangements.

The numbers involved are staggering, with more than 750 billion euros of these retained deals having been created in 2008, according to Unicredit Group data. Retained securitizations in Spain total about 144 billion euros, according to UBS, or the equivalent of 14 percent of annual GDP. Before the deluge, banks in Europe and Britain pursued risky strategies of either originating and distributing — making loans and then selling them on via securitization to some bigger chump — or relying on wholesale funding so they could grow their balance sheets beyond their ability to gather actual deposits from bona fide savers.

When that dispensation fell apart, central banks stepped in as “emergency” sources of funding, with the argument being that the banking system needed liquidity to get it through an unforeseeable storm. Central banks will repo, or finance, securities that meet certain criteria, applying a discount to the face value to protect them but exchanging good old cash for hard-to-sell securities.

That storm is now about 20 months long and what were once emergency measures are now, more or less, the business model for banking.

Banks now lend money to homebuyers, businesses and consumers, turn those loans into securities, park the security with a friendly central bank and get cash back, thus allowing them to effectively take on more risk and continue lending despite balance sheet pressure.

This suits central banks, especially the ECB, as it keeps credit flowing and arguably supports asset valuations that would otherwise crush bank balance sheets and result in far more banking failures. Details of exactly how much and what kind of securitizations are parked with the ECB and other central banks are not available.

But like what came before, it is an inherently unstable arrangement, however convenient or useful.

“The structure-to-repo model is not sustainable. Repo-financing will be limited in 2009, or at least will not experience the same growth of 2008,” said James Zanesi, an analyst at Unicredit Group in Munich.

WHO BEARS THE RISK, WHO HOLDS THE BAG?

This strategy, which amounts to lending into a deteriorating collateral environment, is by definition riskier for the banks than originating and selling it on. After all, mortgage loans in Spain or Britain, where prices may fall another 15-20 percent and where unemployment is rising rapidly are probably not the world’s best risk right about now.

Bank investors will bear this risk, and you only need to look at the equity prices of European banks to see what the market thinks of it. It is also possible that people above equity holders in the capital structure could end up being hurt, though market orthodoxy now is that to hit bond holders would be suicidal.

Central banks and taxpayers may be on the hook as well, if banks with securities they’ve financed fail and the collateral proves worth less than they thought it would be.

The banks, for their part, are engaged in a Darwinian all-or-nothing bet. If they stop lending they are probably toast anyway, so may as well lend and hope that they are amongst the survivors and can then grow rich on fat margins.

Need I mention that there is a fair amount of moral hazard here. Banks have every incentive to make as many loans as ever they can, take on as much risk within the framework as can be managed and park as much as possible with their central bank.

The risk may bring with it the money they need to earn out of their problems and if things come apart, well then, the authorities have all the more reason to keep them alive if they are looking at an ugly loss if they fail.

Who says the days of big leveraged bets are over.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund –