Draining the Global Liquidity Pool

September 2nd, 2015 10:59 am | by John Jansen |

Robert Sinche of Amherst Pierpont Securities has written an excellent bit of commentary on the consequences of foreign central banks reversing a multi year process of buying dollars and selling their own currencies. Many central banks are now in the mode of selling dollars to limit the gains of the dollar against local currencies. In that process they are tightening financial conditions as they reduce the size of their balance sheet.

Via Robert Sinche at Amherst Pierpont Securities:

Often when the popular press writes about Central Bank actions they get it wrong. This is not new…the nuances of CB actions have been confusing for decades. When in graduate school many decades ago we often discussed what we called “Brunner’s Rule”, named after the late pre-eminent monetary economist Karl Brunner.  At its core, Karl taught us that a CB does not influence overall monetary conditions unless it buys or sells an asset. Any asset will do, of course, whether it be domestic government bonds (QE), foreign assets (FX intervention) or general supplies, like copy paper or a desk (ok, a LOT of copy paper or MANY desks to be meaningful). Importantly, however, to have an impact on the balance sheet such activities must be unsterilized – in other words, to have an impact on their balance sheet the Central Bank needs to NOT undertake offsetting domestic money market operations to “sterilize” the impact of the asset purchase or sale. That part usually trips up the non-economists.
So what does Brunner’s Rule tell us now? While the Fed has not yet begun to decrease its balance sheet, many other Central banks may have.  Think of the PBOC. For many years they were intervening to support the USD (limit CNY appreciation), a process that included buying USD assets and creating new CNY, an injection of liquidity into the global financial system. As reserves grew, many CBs around the world were doing the same thing to limit appreciation and, by extension, expanding their domestic liquidity through USD reserve accumulation. On the face of it, that meant the creation of a huge potential source of liquidity floating through global markets…assuming there was not an offsetting drain of liquidity.
As the article below notes, that process now is reversing. We know that  countries like Russia and Brazil have been reducing their reserves in an effort to support their currencies for over a year as the USD recovery began. There is now the potential that China and a number of other EM countries have been intervening to limit USD gains versus their currencies, a process that would involve selling USD assets and buying in domestic liquidity. Such activity would drain global liquidity, but only to the extent that there is not an offsetting expansion of liquidity through open-market operations. If no sterilization, than the claim of the article below that $12 trillion in liquidity has been sucked from global markets would be accurate. However, in the case of China, there have been numerous reports of liquidity-adding activities over recent weeks, suggesting that they have been sterilizing at least part of the drain of liquidity from international operations. I would assume that many CBs would have undertaken operations to at least partially sterilize the drain of liquidity.
The chart below shows the IMF estimate of World Reserve Assets, and estimate because China only releases its reserve asset data quarterly. While it is true that reserve assets have fallen about $12 trillion, it is not correct to conclude that all $12 trillion represents a drain of global liquidity, as an undisclosed amount may have been added back through CB open market operations through their domestic economies. As a result, while estimated reserve ARE lower – and since they are measured in USDs some of the drop is related to mark-to-market declines in non-USD asset valuations –  it is NOT correct to assume that the full $12trillion drop in measured reserves represents a drain of liquidity from global markets as there is no estimate of offsetting sterilization through domestic monetary operations. As I started, often when the popular press writes about CB action they get it wrong.
Welcome to Quantitative Tightening as $12 Trillion Reserves Fall
2015-09-02 07:44:40.3 GMT
By Simon Kennedy
(Bloomberg) — The great global monetary tightening of 2015 is under way, but it’s not being led by the Federal Reserve. Even as U.S. policy makers ponder whether to raise interest rates this month, one recent source of central bank liquidity in financial markets is drying up and the loss of it partly explains August’s trading volatility. Behind the drawdown are the foreign exchange reserves run by the central banks. Bolstered following financial crises in the late 1990s as a buffer against capital outflows and falling currencies, such hoards fell to $11.43 trillion in the first quarter from a peak of $11.98 trillion in the middle of last year, according to the International Monetary Fund. Driving the decline is a combination of forces including the economic slowdown and recent devaluation in China, the Fed’s pending rate hike, the collapse of oil and decisions in Switzerland and Japan to cease intervening in currencies. Each means central banks are either paring their reserves to offset an exit of capital or manage currencies, have less money flowing into their economies to salt away or no longer need to sit on as much. Whichever it is, the shrinking of reserves means much less money flowing into the financial system given authorities tended to recycle their cash piles into local currency or liquid assets such as bonds. In the words of Deutsche Bank AG strategist George Saravelos and colleagues, welcome to the world of “quantitative tightening.”
Reserve Peak
They predict 2015 will mark the peak of reserve accumulation after two decades of growth with China in the vanguard as its new currency regime means it has to pare reserves to avoid a freefall in the yuan. It has already reduced its holdings to $3.65 trillion from $3.99 trillion in 2014. For markets, Deutsche Bank says less reserve accumulation should mean higher bond yields and a rising dollar against rivals including the euro and yen. There are implications too for other central banks if the resulting rise in market borrowing costs hampers their ability to tighten monetary policy.
“This force is likely to be a persistent headwind towards developed market central banks’ exit from unconventional policy in coming years, representing an additional source of uncertainty in the global economy,” Saravelos and colleagues in a report to clients on Tuesday. “The path to ‘normalization’ will likely remain slow and fraught with difficulty.”



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