FASCIST OVERREACH OR ROUTINE REPO -- DEBUNKING THE HYPERBOLE AROUND THE US-JAPAN DOLLAR LIFELINE
The next China post is about how the country did the plumbing to fix the problems of their financial system, how fixing one leak creates another leak elsewhere. It's about how errors in policy can lead to serious structural problems in the economy. This Japan story is a good prelude to the next post as it deals with the difficult tasks of plumbing the system.
In early August US Treasury reportedly provided the bank of Japan USD5Bn-USD10Bn to help prop up the Yen. There are lots of rhetorical comments in legacy and social media. If a country sucks up to Donald Trump, the US will jump in to help. US helps Japan by printing money, and in the end, takes away Japan's US Treasuries, thus clearing the American debt without paying anything. Trump admin is fascist and bulldozing the Fed's independence with Treasury Secretary Besset acting out his hedge fund management expertise. Trump hate is injected into every event in the most negative ways possible, befuddling clarity of thought.
Recall the Plaza Accord of 1985. The mighty USD had weakened due to persistent trade deficits brought about by the astounding recovery of postwar Germany and Japan. G-5 countries gathered to solve the problem. Germany and Japan agreed to weaken their currencies to let the USD recover. It is not just a US problem because the dollar was the world reserve currency. The G-5 was not helping US - they were trying to solve a global plumbing problem.
Today, Japan has reached the point where they need to act to strengthen the Yen which had weakened over 3 decades. To strengthen the Yen, the Bank of Japan (BOJ) has to buy large amounts of it. And to do so they need lots of foreign currencies. BOJ has a huge Official Foreign Reserves (OFR) which they can liquidate to pay for Yen purchases. On BOJ's ledger, opposite the asset OFR is an equally huge amount of liabilities of sterilised central bank bills. It is the same story of the monstrous "carry trade" of MAS and PBOC described in my previous post. Of this OFR, BOJ has slightly more than USD1Tn in US treasuries, the largest holder of American debt. Japan can sell US treasuries to buy Yen. Wholesale selling of vast amounts of US treasuries will impact bond yields, thus an external problem becomes a US problem. The usual Trump, American, capitalist haters see this as a situation where US has to assist Japan for selfish reasons of own financial security. The reality is bond yields is a pillar of the world financial system. A chaotic capital market leads to a global financial distress. Japan is not having a solvency or bankruptcy issue. It is having a liquidity issue. It is not about bailing Japan out. Helping Japan is helping the US is helping global economy.
In a foreign currency liquidity situation, the US has 3 mechanisms:
Under swap mechanism:
The Fed buys spot Yen, sells forward Yen. BOJ as counterparty receives USD and use it to buy Yen in Japan to neutralise the domestic liquidity, hoping to strengthen the exchange rate.
Both Fed and BOJ balance sheet ↑.
For the Fed, Assets (Due from BOJ - Yen) ↑ : Liabilities (Deposits of Central Banks - USD) ↑.
For BOJ Assets (Cash - USD) ↑ : Liabilities (Due to Fed Yen) ↑.
The US printed dollars for BOJ to use, but there is no increase in domestic liquidity which is inflationary. This is because the cash sits in Central Bank Deposit a/c, not Bank Reserves a/c which will be used by banks and have a multiplier effect. When BOJ draws on the USD, the funds will be routed into Bank Reserves at the Fed. This is because all USD transactions eventually end up at banks reserve accounts at the Fed via the network of Correspondent Banks. However, the dollar is merely an utility. Nobody will let their money sit idle at the Fed. The USD is moved around the world to service global trade and other financial settlements, so it has a very high velocity moving in an out of the Fed Reserves. Thus it has no impact on US domestic liquidity.
For Japan, BOJ prints the Yen to pay the Fed. This Yen sits in BOJ's book "Due to Central Banks", not bank reserves account, thus does not affect Yen liquidity. The US does not use the Yen at all, except to settle the currency buy back at the end of the swap, which is about 7 days, but for the pandemic was extended by 88 days.
The US has no limits swap lines with 5 core countries. Japan is one of them. These lines had worked through 5 administrations -- Bush, Obama, Trump, Biden, Trump. The idea that Japan carries the jock for Trump that's why the US rushed in to help Japan is ridiculous.
The Fed buys spot Yen, sells forward Yen. BOJ as counterparty receives USD and use it to buy Yen in Japan to neutralise the domestic liquidity, hoping to strengthen the exchange rate.
Both Fed and BOJ balance sheet ↑.
For the Fed, Assets (Due from BOJ - Yen) ↑ : Liabilities (Deposits of Central Banks - USD) ↑.
For BOJ Assets (Cash - USD) ↑ : Liabilities (Due to Fed Yen) ↑.
The US printed dollars for BOJ to use, but there is no increase in domestic liquidity which is inflationary. This is because the cash sits in Central Bank Deposit a/c, not Bank Reserves a/c which will be used by banks and have a multiplier effect. When BOJ draws on the USD, the funds will be routed into Bank Reserves at the Fed. This is because all USD transactions eventually end up at banks reserve accounts at the Fed via the network of Correspondent Banks. However, the dollar is merely an utility. Nobody will let their money sit idle at the Fed. The USD is moved around the world to service global trade and other financial settlements, so it has a very high velocity moving in an out of the Fed Reserves. Thus it has no impact on US domestic liquidity.
For Japan, BOJ prints the Yen to pay the Fed. This Yen sits in BOJ's book "Due to Central Banks", not bank reserves account, thus does not affect Yen liquidity. The US does not use the Yen at all, except to settle the currency buy back at the end of the swap, which is about 7 days, but for the pandemic was extended by 88 days.
The US has no limits swap lines with 5 core countries. Japan is one of them. These lines had worked through 5 administrations -- Bush, Obama, Trump, Biden, Trump. The idea that Japan carries the jock for Trump that's why the US rushed in to help Japan is ridiculous.
The Covid pandemic caused a severe global trade shut down. As much of global trade is conducted in USD, there was a severe liquidity problem in the dollar. Through 2020/2021 US swap lines were drawn by 14 participating central banks and the Fed printed USD449Bn during the week of May 27, 2020 alone. During the Covid pandemic, 9 additional central banks, including MAS, were each provided a temporary line of USD60Bn. At its peak, Japan drew down USD225Bn. MAS was resilient and drew only USD3.2Bn. The US was playing out its role as lender of last resort for a world reserve currency.
Under the ESF mechanism:
Treasury intervenes in the FX market to purchase Yen. The Fed does the execution on behalf of Treasury. This happened on July 30. US collaborated with Japan to intervene in the FX market together. US purchased about USD5-10Bn of Yen using Euros.
The Exchange Stabilisation Fund (ESF) is similar to OFR. The ESF is a basket of currencies, US Treasuries, gold and IMF Special Drawing Rights. It is meant only to be used to stabilise exchange rates. The Jul 30 purchase of Yen resulted in simply a re-allocation of currencies in the ESF. There is now more Yen and less Euro in the ESF. The Gold Reserve Act of 1934 gave the Secretary of the Treasury the responsibility and authority to manage the ESF, subject to the approval of the President. The ESF mechanism is constrained because the fund only has about USD30bn equivalent of currencies they can use.
The Jul 30 market intervention had nothing to do with fascist Trump or interfering in the independence of the Fed, or Treasury Bessent doing his hedge fund thing. Bessent was doing what he was authorised and supposed to do.
Under FIMA mechanism:
Repo is a very ordinary collaterised short term advance facility that central banks use as lender of last resort to their domestic banks for liquidity purposes. The USD is the prime world reserve currency, so the Fed ends up with the additional responsibility of managing the lender of last resort function to the world central banks. The mechanism is the Foreign and International Monetary Authorities (FIMA) facility. FIMA is authorised by the Federal Open Market Committee (FOMC).
A USD60Bn FIMA line is automatically provided to all central banks which use the Fed as custodian for their US treasuries. Japan has a line, so does MAS. When the facility is drawn, the Fed transfers the equivalent of the borrowing central bank's US treasury account into the Fed's System Open Market Account (SOMA) account. The US makes a short term advance, but now holds a risk free security as collateral. Again, the money printing by Fed to fund the advance will not have impact on domestic liquidity for the same reasons mentioned abive, the USD is used as an utility, the velocity of its use in the global market, all these means offshore problem remains external to US market.
On August 2, US loaned Japan a sum about of USD5-10Bn, per market guesstimate, In this case, BOJ drew on a Foreign and International Monetary Authorities (FIMA) Repo Facility.
Japanese Finance Minister Satsuki Katayama announced that Japan would utilize the FIMA advances. It had nothing to do with fascist Trump, nothing to do with Besset. It was Fed who received BOJ's request to utilise the FIMA facility.
The way to see it is:
The ESF = Treasury's ammunition.
Swaps and FIMA = Fed plumbing global dollar liquidity.
All the 3 mechanisms were designed for the purpose of assisting foreign central banks avoid selling US treasuries when they have a liquidity crisis, thus preventing external shocks impacting the US domestic financial system as well as global markets.
The choice for FIMA was made by Japan. The reasons were never explained. Perhaps it is very simple backstop getting US as a lender of last resort without having to go into any exchange deals with the Fed. Perhaps it is the cost. Swap arrangements is normally priced at OIS+50 basis points (for Covid pandemic it was reduced to +25bp). Perhaps it is the carry cost. Recall in the past 2 posts I described the central bank's balance of earning assets (OFR) and the sterilised central bank bills as basically monstrous carry trades. When Japan choses FIMA mechanism, they still own the US treasuries which continues to earn them a yield to pay for the carry cost of all those central bank bills in their ledger liabilities side. BOJ is monetising their investment without divesting. It allows Japan to transform their enormous stock of US treasuries into intervention capacity without being forced to sell them.
Because FIMA has a USD60Bn cap, Bessent's suggestions to the Fed to raise the cap was taken by all those with a political grinder to accuse the admin of arm twisting Fed independence. The argument is Treasury's purview is foreign exchange, the Fed deals with liquidity. The question boils down to whether BOJ is having a liquidity or exchange rate problem. Yes it is trying to strengthen the Yen to fight inflation driven by the Covid pandemic lockdown. But it is also a USD liquidity problem as BOJ needs foreign currencies to buy Yen. So Bessent is saying to the Fed, for financial security interest of the US, why don't you up the FIMA cap so BOJ can raise more collaterised USD without selling down their US treasuries and give you a big headache later when it impacts USD bond yields?
I shall cover in another post how BOJ did their plumbing to get them to the current situation, how they went from Asian Tiger to the Lost Decades of stagnation and emerging from the Covid lockdown to today's inflation.
In closing, I like to expand on Singapore's paranoia about the secrecy of national reserves in light of Japan's experience.
The Singapore government never stops reminding the public the reason d'etre for the secrecy of the national reserves is to protect the SGD from attacks by currency speculators. What we are watching in realtime is in a way a currency attack on the Yen. There are lessons to be learnt.
First and foremost, it is the OFR that is used in defence of the currency. What is needed is liquidity of foreign currencies -- the very liquid tranche of the OFR that is kept in central bank deposits or government treasuries, especially US treasuries because it is the most liquid market. MAS will need these foreign currencies within 24 hours. A trillion shares in SpaceX in Temasek's portfolio cannot allow MAS to act quickly during an attack.
Secondly, speculators do not attack a currency because a country has a low OFR. They attack a currency because they identify a weakness that they see the central bank is not addressing or unable to address. In other words, they see structural weakness in the financial system. In Japan's case it was the low interest rates of the Yen.
Thirdly, when most people think speculators, they think of the George Soros kind - someone with lots of leverage who just swooped in one day. Speculators could be hundreds of thousands of investors who had built up some positions on the currency. In the case of Japan, there is an enormous Yen carry trade. The size of this trade depends on how the trade is defined because hidden in this are all sorts of derivatives. Industry estimates put the figure across narrow-medium-broad definitions from USD250Bn to USD7Tn. They include the country's own nationals, individuals, organisations and commercial corporations. The aggregate positions may be so high these investors push back at weak attempts to strengthen the Yen. In May/Apr BOJ intervened in the FX market to buy USD113Bn of Yen, On June 16 BoJ raised interest rates by 25bp - current policy rate is 1%. Then the July 30 ESF intervention followed by the Aug 2 FIMA loan. All attempts to strengthen the Yen failed. The rates strengthened for a short while and then weakened again.
Fourthly, more important than showing how much OFR a central bank has, it is investor perception that is most important. For this, the government must project great resolve. It must amplify the intent to support the Yen by all means all way -- pressers, interviews, talk shows, podcasts, etc. At the Camp David cabinet meeting on Jul 31, Secretary Bessent had a "To-do note" in which he scribbled "Buy Yen - USD5-10Bn". It was meant for the Press who look over his shoulders. And sure enough, every media from Reuters to our Straights Times, all showed this image. Bessent joked that he was tempted to put other to-do list like "invite Putin for lunch".
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Fourthly, more important than showing how much OFR a central bank has, it is investor perception that is most important. For this, the government must project great resolve. It must amplify the intent to support the Yen by all means all way -- pressers, interviews, talk shows, podcasts, etc. At the Camp David cabinet meeting on Jul 31, Secretary Bessent had a "To-do note" in which he scribbled "Buy Yen - USD5-10Bn". It was meant for the Press who look over his shoulders. And sure enough, every media from Reuters to our Straights Times, all showed this image. Bessent joked that he was tempted to put other to-do list like "invite Putin for lunch".
This platform has withdrawn it's subscriber widget. If you like blogs like this and wish to know whenever there is a new post, click the button to my FB and follow me there. I usually intro my new blogs there. Thanks.
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