The Shanghai 2-Step

by: Adam Whitehead


Capital markets have accepted that a stealth re-pegging of the yuan to the dollar has just occurred.

Unilateral economic actions have brought the global economy to a negative tipping point.

It is accepted that greater cooperation and coordination of economic policy is needed at the global level.

The IMF is nudging policy makers towards a global accord on exchange rates and economic policies.

The OECD advocates a novel alternative solution to rebalance the global economy.

The last report suggested that President Xi Jinping was ready for a global currency accord. The entry of the yuan into the IMF SDR basket was seen as a necessary precursor.

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(Source: Seeking Alpha)

The pegging of the yuan to the US dollar envisioned in the previous January article, as a precursor to an accord, now seems to be widely accepted as having occurred.

(Source: The Daily Shot)

The current failure of developed nation central banks to hit their 2% inflation targets, by unilaterally applying QE in rotation, provides the context and catalyst underlying the perceived need for an accepted global accord. The evidence so far suggests that their unilateral behavior is actually undermining rather than supporting the collective effort to boost global economic growth.

QE is creating capital market liquidity bubbles which have failed to spill over into the real economy. This seems to be because the transmission mechanism, in the agency of commercial banks, is broken. The banking system maintains a legacy of bad assets that have been covered up, by the layering in of another tranche of inflated yet income generating assets, in order to present an image of current profitability.

Central banks have undermined the global economic system further by driving interest rates, down to levels at which there is no yield cushion for the underlying lending risks taken. Burdened with legacies that do not have adequate yield protection, banks are unwilling to extend credit further. This unwillingness is exacerbated by the new rules on capital adequacy, which oblige them to hold even more expensive capital in reserve on their balance sheets. This risk capital is a shareholder or bondholder liability, which cannot be covered by income generated from the assets. This liability can only be covered by capital gains; which effectively turns the banks into hedge funds.

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The move into negative interest rate territory has effectively removed any such yield cushions permanently however small; and systemically destabilized the banking system. This can be understood conceptually through the prism of Exter's inverted pyramid. The application of negative interest rates, in effect removes the valuation parameters of any of the layers above gold and cash. This occurs because the central banks ultimately buy all the higher layers of the pyramid, as their mandate expands from government bonds into riskier assets. The BOJ's QQE process is a classic case in point. With no rational valuation parameters, these asset classes get dumped on the central banks, as investors head down the pyramid into cash and gold.

(Source: Bloomberg)

It is worth noting that central banks have only just got started buying up the successive risk asset classes above T-Bills and T-Bonds. The next phase of QE will involve them taking credit risk, thereby disintermediating the commercial banks. QE has a long way to go. Central bankers will not stop until they have either convinced or brainwashed private investors to stop going the other way and follow them up the pyramid. In the absence of juicy yield premiums, this is a difficult exercise however. The Fed , which is the great creator of Exter's pyramid, understands this problem.

The Fed had hoped to bring some normality, to the term structure of interest rates, in order to support this shaky debt funded global asset pyramid. Unfortunately, the behavior of the ECB, BOJ and PBOC has frustrated the Fed's attempts at normalization. The Fed is now being dragged in the opposite direction on the term structure of interest rates by a global Tsunami from the BOJ and ECB, with other nations such as Sweden joining the negative interest rate crusade.

The net result is that the global financial system is once again at breaking point. In order to avert this, it was suggested that financial markets would accept a well-structured and clearly articulated accord on foreign exchange rates; and coordinated economic policies between the developed nations. It was also observed that unfortunately the democratic electoral cycles in the developed nations are frustrating attempts to get policy makers around the table currently to hammer out an accord. It was therefore suggested that the IMF would serve as the proxy platform to achieve such an accord, in the absence of the major players.

The signal that Christine Lagarde's run, for an extension of her position at the head of the IMF, would go unchallenged was a key signal that perhaps the IMF is going to act as the platform through which an accord is achieved. Her appointment was a formality. The developing nations, who had been so militant in demanding a change at the top of the IMF have become silent. Suddenly all IMF members want to have seamless continuity. US Treasury Secretary Lew also recently endorsed her.

BOJ Governor Kuroda, after consulting with Prime Minister Abe, has also come out in support of an accord at the G20 level. Kuroda has now understood that a unilateral expansion of QQE will not work, unless there is a global coordinated monetary stimulus framework in place. He is supported by the Japanese Finance Minister Taro Aso, who has said that neither G7 nor G20 view the current currency volatility as acceptable. Such an accord requires an agreement on the level at which currencies should trade relative to each other. All nations then ease monetary policy within a coordinated program that maintains the agreed currency parities.

(Source: IMF)

The last report suggested that the IMF should be watched carefully to see if it is changing its own doctrine and dogma in relation the heresy of capital controls. Such a change would give an implicit nod of acceptance of the recent stealth moves by China to enforce capital controls, to defend its currency reserves and peg the yuan to the US dollar. Such an implicit nod would be an even greater nod to the conditionality required to implement a global currency accord.

Almost immediately the IMF's intellectuals have begun opining that capital controls have been getting an undeserved bad press. One senses that the IMF is giving China the nod and preparing the groundwork for a global currency accord.

After her swift rehiring, Lagarde swiftly opined that the next task for the G20 is a coordination of its monetary and fiscal policies at the upcoming meeting in Shanghai. She is concerned about what she terms policy "asynchronicity"; and went on to say that: "The G20 I think, is going to have to focus on spillovers, on spillbacks and on the combination of various policies in play at the moment."

Reading between the lines, this sounds very much as though the unilateral beggar thy neighbor easing of the past is off the global agenda table. Policy makers will now collectively stimulate their economies in a coordinated manner; and in such a way as to avoid the harmful "spillover" through the agency of the foreign exchange markets. This is the basis for a global accord.

It will be premature to have a comprehensive agreement achieved by Shanghai however, since the American and European contingents have to face their electorates. If their leaders can give Lagarde their proxy to work on an IMF brokered accord however, they will have something that they do not need their electorates to buy into since they are already IMF member nations. In the absence of populist intervention, Lagarde has got a free hand. She must therefore deliver something that appeals to populism, in the developed nations, in order to preserve the current political status quo.

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(Source: South China Morning Post)

In what has got to be the most diplomatic savaging witnessed to date, Lagarde then dealt with China and put it in its global place. She opined that clear communication is now required from China going forward; in order to prevent the negative "spillovers" that global policy makers will no longer tolerate.

She then congratulated China (and specifically the PBoC) for adopting such a clear communication policy in relation to the yuan; by underlining that it no longer needs to depreciate. Evidently Lagarde is referring to the kind of disclosure recently evinced by PBoC Vice Governor Yi Gang. His latest remarks could almost have been scripted purely for Lagarde's edification. According to him "too loose" monetary policy is to be avoided because it leads to dangerous asset bubbles and "downward pressure" on the yuan.

Readers of this series of articles will understand that China was forced to peg the yuan to the dollar, after its attempts at devaluation backfired through stimulating dangerous capital flight. The PBoC Governor was also observed to have disappeared from the scene, whilst the capital flight was occurring. His absence was strongly correlated with the more direct intervention of the President in economic policy making decisions; and the stealth re-pegging of the yuan to the dollar.

PBOC Governor Zhou Xiaochuan returned from his quiet period of contemplation of the abyss, to announce ex post that neither the yuan will decline further nor will the PBOC be forced to administer exchange controls. Lagarde was therefore politely rebuking the Chinese for initially trying to be unilateral; and then congratulating it for eventually getting with the global agenda.

Governor Zhou's latest confident rhetoric is the stock in trade for central bankers, who only have their credibility as any true backing for their currency. The note of confidence should therefore be expected. Further evidence to support or refute that this confidence and the sudden reappearance of the missing governor are linked to any move towards a currency accord should now be sought.

Evidently Governor Zhou is not going to be blamed for the failed policy to weaken the yuan. Neither would it seem is Premier Li Keqiang. The President has chosen to shoot the messenger, in the form of head of the Chinese Securities Regulatory Commission. The message in the form of red prices and his inability to make them go green, with various rules and regulations available to him , singled him out to be the fall guy for an economic policy failure further up the chain of command.

Interestingly Governor Zhou announced that the reflex action of policy makers to intervene, in the face of market crises, is a legacy of the past. Presumably this was done to address Lagarde's criticism; and also to signal that China has changed. His words imply that some new form of interventionism is on the way. A precondition for this something new, is a calm period in the capital markets. In the absence of a globally coordinated approach to the markets, such a period of calm and Chinese policy maker inertia is impossible to imagine.

BOJ Governor Kuroda, who has already advocated that China should implement currency controls, has also signaled that Japan is ready to negotiate a global accord at the G20 level. Even the OECD's Chief Economist Catherine Mann got in on the act, with gloomy predictions about future economic growth and the need for a stronger collective policy reaction.

What the OECD has advocated is something far more insidious however. It advocates counting developed nation military spending as a contribution to global economic aid development quotas. Developed nations can therefore meet their global aid targets by stimulating their defense industries and then giving away their products as aid.

Whilst the arms factories are humming and the developing world is going up in flames, the OECD also advocates that the developed nations fiscally stimulate their economies with infrastructure and capex deficit spending. All the developed nations' industrial capacity, that had been lost to the developing world, thus returns to the developed world through the tried and tested strategy of war and pork barrel spending.

The onshoring of industrial capacity will also mean that multinationals will find it harder to dodge taxes, so that the fiscal deficit problems in the developed world will swiftly rebalance themselves. It all sounds like a plan and clearly the OECD things that the end justifies the means.

Momentum for the grand global bargain is gathering steam as the global equity markets collapse. All this implies that a consensus and common global agenda has formed that a global accord is desirable. After staring into the abyss, all the players now conclude that it is in their own interest to act collectively. The devil however will be in the negotiated details of the new global accord. Based on the comments of Chinese finance minister Lou Jiwei, there is still no collective agreement on the details or the form of collective action to be taken. Any hopes for a Plaza II are too ambitious. A quick and dirty temporary fix, which then serves as a prototype to be crafted by Lagarde into something more robust seems the best that policy makers can do right now.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.