The first coin is a 10 cent coin from Hong Kong minted in 1959. The picture shows the reverse with the name of Hong Kong in both English and Chinese, the year of minting and the value. The other side has a portrait of the British Queen Elizabeth The Second.

In 1959, Hong Kong was a British Crown Colony. The city, which one hundred years earlier had been inhabited by about 32,000 people, had a population of 2.3 million. Floods of refugees from war and civil war in China provided the labour force for Hong Kong’s strongly growing industry.

Compared to the more than 2000 years of Chinese coins, Hong Kong’s currency history is a short one. The city had long had no local currency. When it became a British trading port in 1841, there were only foreign coins such as Indian rupees, Spanish or Mexican silver dollars (ocho reales) and the Chinese cash or wén. In 1863, the silver dollar became the official legal tender for Hong Kong and in 1966 a special Hong Kong version was issued.

The first coins were minted at the Royal Mint in London. In 1866, a local mint was established but closed down again after two years with the machinery sold to Japan to mint yen in Osaka. After that episode, all in all five different mints minted Hong Kong coins at various times. Our ten-cent coin has no mintmark. This means it might have been minted either in the Royal Mint in London, in the Hong Kong branch mint or at James Watt & Co. Soho, Birmingham.

Hong Kong coins are issued by the Hong Kong Monetary Authority (HKMA) on behalf of the Government of Hong Kong. Ten-cent coins like the one in the picture were issued since 1948, first showing the portrait of  George VI and later that of his daughter Elizabeth II. Since 1993, there is a new series, and under a coin replacement programme around 585 million coins featuring Queen Elizabeth II have been withdrawn from circulation. But they are still legal tender.

In its short history Hong Kong has seen several currency regimes. A crisis in the silver market forced it to abandon the silver standard in 1935 and it pegged its currency to the pound sterling instead. When the British government decided to float its currency in 1972, the Hong Kong dollar was linked to the US dollar until end of 1974 when it was allowed to float freely. Since 1983, it is linked again to the US dollar in a most rigid form under a currency board: Hong Kong dollars can only be issued in exchange to US dollars against which the rate is fixed – with the consequence that Hong Kong’s foreign exchange reserves are among the highest worldwide.

How did a foreigner in Hong Kong in 1959 perceive the city? The following links give the impression of a buzzing crowded place, which faster than others had overcome the woes of war, a city in a process of rapid industrialization on its way to become one of the four Asian Tigers beside Singapore, South Korea and Taiwan. They also show a society in transition where the old and new coexisted under difficult conditions. The idea of the city a visitor from the west had may also have been influenced by a famous US movie which came out the same year, Ferry to Hong Kong, featuring Curd Jürgens and Orson Welles.

These are the links:

Video  A brief visit to Hong Kong in 1960 香港  by MichaelRogge

Video HongKong 1950 to 1960 by MrHklive

Ferry to Hong Kong (movie, USA 1959)

and here is a view on Hong Kong the foreigner might have had from the plane at his or her arrival before landing at the newly built Kai Tak Airport.

In the Economics of Contempt piece, there is a lot of ranting about fictitious analysis, ridiculous claims, bizarre attempts, genuine fright  and the authors’ prominence as finance professors which make the motives hard to judge for an outsider.

Studying texts and interview I got the impression that both Taylor and Cochrane had a point which refers to the TBTF problem. In order to show you what I mean I would like to quote a few examples:

After the Bear Stearns bailout earlier in the year, markets came to the conclusion that investment banks and bank holding companies were “too big to fail” and would be bailed out. But when the government did not bail out Lehman … everyone reassessed that expectation. “Maybe the government will not, or cannot, bail out Citigroup?” Suddenly, it made perfect sense to run like mad. (Cochrane)

… the central financial problem revolves around the expectation that banks will be bailed out. (Cochrane)

… there is nothing inherently “systemic” about the behavior of Lehman Brothers or other large banks.What is systemic is the expectation of a bailout. The policy question is simply how to escape this horrible moral-hazard trap. (Cochrane)

… if there had been a clear policy put forth whereby people could have expected the possibility at least of Lehman being put through bankruptcy, then there could have been some preparation. (Taylor)

.. there is at least as much evidence that the panic was caused by the response as distinct from that particular event at Lehman Brothers. (Taylor)

… the responsibility of Wall Street in this crisis, and it still hasn’t been resolved is the dependence of the financial institutions on the government for bailouts and interventions. (Taylor)

… government needs to find a way for it to get out of this bailout business. (Taylor)

The only way to limit expectations of a bailout is for the government to give up the legal authority to do it. (Cochrane)

To give government officials the power to bail out firms at their discretion, especially if those officials are elected or political appointees (my emphasis), is practically to guarantee a bailout. In a crisis, everything looks systemic. … (Cochrane)

If I got it right I see these authors’ views  as support and endorsement of a claim for damage control instead of bank bailout I made not long ago elsewhere in another context. To me they seem neither bizarre nor ridiculous. But maybe my interpretation is wrong. Since the topic is too important to pass unnoticed decide for yourself. Here are the links again:

Paul Krugman

Economics of Contempt

John Taylor

John H. Cochrane

reszatonline

A comparison of currency denomination in bond markets in the euro area and other regions (table 1) at first view is reassuring. The share of local currency in Europe is lower than in Japan and other Asian countries, but with around 90 per cent it has been constantly high in recent years – and much higher for example than in Latin America.

Source:  Philip Turner:  Weathering financial crisis: domestic bond markets in EMEs.

However, the picture is misleading. Less than in other world regions, in the euro area “local currency” also means “local investor”. Intra-European investments are high and shares of foreign investors differ considerably among countries.  Das indicates that in Greece 91 per cent of government debt is held by foreign investors, in Ireland, Portugal and Italy the numbers are 61, 53 and 51 per cent respectively, and even in France (50 per cent) and Germany (41 per cent) they are high.

Does this mean that in an acute crisis in some countries about half of the government debt is particularly prone to fear and panic, or – to put it the other way around – can at least half of it be expected to remain comparably stable and less affected? This idea disregards the special nature of the common currency in Europe. The euro differs from a “domestic” currency in the traditional sense in a very important way: It is the currency of the euro area, not of its individual parts. Initially, at its introduction, the distinction did not matter. Conceptually, since all member countries adopted the euro and none kept its former currency, the euro was thought to become an equally perfect substitute for drachme, lira, D-mark, French franc and others.

In the current crisis, however, with economic and financial differences between member countries becoming more and more apparent the question seems no longer too far-fetched whose currency the euro is. With rising tensions within the euro system it is becoming increasingly difficult to think of the euro as home currency, say, of both Greece and Germany at the same time. The consequences would become immediately apparent at a breakup of the euro zone when values of the new national currencies would drift apart. But even in the current state, dangers are looming on the horizon.

There is a growing overall awareness that the European currency is not appropriately representing member economies. The situation can be compared with Akerlof’s market for “lemons” (faulty used cars whose defects are unknown to potential buyers; see below):

Assume the strength of the euro is reflecting the average of member countries’ economic conditions and investors have no information about their true state. While the stronger ones are undervalued, the weaker members are unduly overvalued. Since this is not apparent, in analogy to the Akerlof example, money and finance should flow to the comparably “cheap” stronger economies and to the weaker overvalued economies alike –as actually happened in the EZ for many years.  (However, Akerlof’s suppliers of the undervalued products withdraw from the market, as the compensation they are offered is insufficient, and only the overvalued ones – the lemons – are left.)

With increasing awareness of market inefficiency one would expect financial flows to be redirected from weaker to stronger economies until a new equilibrium is reached which would reflect true economic conditions and, after a period of possibly painful adjustment, the euro area would come out of the crisis strengthened like a phoenix from the ashes.

At this point, however, the analogy breaks down. In Europe, money does not – or only to a limited extent – flow from Greece to Germany (to stay with this example). There are several reasons. The euro zone is an open system. There are ample investment opportunities outside. Moreover, weak and strong countries in the euro area are exposed to the same risk of default and insolvency which is not rooted in individual countries’ economic weaknesses but in the failure of the common currency system. In addition, there is another option within the system which is risk-free and widely used. This is the  European Central Bank. In contrast to individual member countries, the ECB with its currency-issuing capacity cannot become insolvent. Thinking about it, the fact that money is deposited there instead of elsewhere in the region appears perfectly consistent: The ECB is the monetary institution representing the whole of the euro area, the one which most closely matches the “currency of the average”.

In the current situation, no member of the euro area has a home currency. Furthermore, since none of them can issue its own currency, and the ECB is not willing to fill the gap, in principle, all face a risk of insolvency. The euro is increasingly regarded as non-sustainable, and fear and panic is a threat to each market and product denominated in this currency.  A member’s default or exit from the euro zone would not only intensify pressure on the next link in the chain, but jeopardize all debt in the area, both foreign and “domestic”. Greece would immediately be perceived as country of the drachme, Germany as D-mark country, and so on. The euro has long become a foreign currency to all of them.

Source:  BBC News,  18 November 2011,  Reuters, 15 November 2011.

In the beginning I wrote that foreign debt increases countries’ vulnerability to crises. In Europe, the amounts at stake rise considerably if we take into account that the distinction between “foreign” and “domestic” has become mostly obsolete. Furthermore, the ranking of crisis candidates changes. Table 2 shows the figures for both foreign and government debt to GDP and the shares of euro zone gross government debt. Apparently, not Portugal and Spain are the next weak links behind Greece, but Germany, France and Italy. There is no safe haven left in the euro zone.

there ain’t nowhere to hide,
waiting for the hurricane     Chris De Burgh

…

___

Here is a dummies guide to what went wrong in Europe:

Helga is the proprietor of a bar.

She realizes that virtually all of her customers are unemployed alcoholics
and, as such, can no longer afford to patronize her bar.

To solve this problem, she comes up with a new marketing plan that allows
her customers to drink now, but pay later.

Helga keeps track of the drinks consumed on a ledger (thereby granting the
customers’ loans).

Word gets around about Helga’s “drink now, pay later” marketing strategy
and, as a result, increasing numbers of customers flood into Helga’s bar.

Soon she has the largest sales volume for any bar in town.

By providing her customers freedom from immediate payment demands, Helga
gets no resistance when, at regular intervals, she substantially increases
her prices for wine and beer, the most consumed beverages. Consequently, Helga’s gross sales volume increases massively.

A young and dynamic vice-president at the local bank recognizes that these
customer debts constitute valuable future assets and increases Helga’s
borrowing limit.

He sees no reason for any undue concern, since

he has the debts of the unemployed alcoholics as collateral!!!

At the bank’s corporate headquarters, expert traders figure a way to make
huge commissions, and transform these customer loans into DRINKBONDS.These “securities” then are bundled and traded on international securities markets.

Naive investors don’t really understand that the securities being sold to
them as “AA” “Secured Bonds” really are debts of unemployed alcoholics.

Nevertheless, the bond prices continuously climb!!!, and the securities soon
become

the hottest-selling items for some of the nation’s leading brokerage
houses.

One day, even though the bond prices still are climbing, a risk manager at
the original local bank decides that the time has come to demand payment on
the debts incurred by the drinkers at Helga’s bar.

He so informs Helga.

Helga then demands payment from her alcoholic patrons, but being unemployed
alcoholics they cannot pay back their drinking debts.

Since Helga cannot fulfil her loan obligations she is forced into
bankruptcy.

The bar closes and Helga’s 11 employees lose their jobs.

Overnight, DRINKBOND prices drop by 90%. The collapsed bond asset value
destroys the bank’s liquidity and prevents it from issuing new loans, thus
freezing credit and economic activity in the community.

The suppliers of Helga’s bar had granted her generous payment extensions and
had invested their firms’ pension funds in the BOND securities. They find
they are now faced with having to write off her bad debt and with losing
over 90% of the presumed value of the bonds.

Her wine supplier also claims bankruptcy,

closing the doors on a family business that had endured for three generations, her beer supplier is taken over by a competitor, who immediately closes the local plant and lays off 150 workers.

Fortunately though, the bank, the brokerage houses and their
respective executives are saved

and bailed out by a multibillion dollar no-strings attached cash infusion from the government.

The funds required for this bailout are obtained by new taxes levied on
employed, middle-class, non-drinkers who have never been in Helga’s bar.

Now do you understand?

Stabilizing markets in Asia

Asian financial markets and policies are in a process of transition. Strategies to promote economic growth by reforming banking systems and developing and opening capital markets are overshadowed  by fears of contagion and of being drawn into financial turmoil in Europe and the US. The wish to decouple the region from outside influences and to establish a line of defense is a strong driving force behind recent approaches to closer monetary and financial cooperation. Efforts focus on two aspects: a) to increase the ammunition beyond national stocks of foreign exchange reserves to shelter Asian financial markets and b) to establish a regional anchor to stabilize currencies.

Despite recent setbacks, the process of European monetary integration serves as a model in many respects. One lesson is that it takes time to build trust and that  policy cooperation can only succeed in small steps. A Chinese proposal to set up an ASEAN bank, which caught the headlines in October 2011, is a reminder that recent Asian initiatives must be seen in a broader context: Step by step, Asian countries have begun to build a common roof for the developing and opening of national financial markets, and even if those efforts will not result in a “new global monetary order” tomorrow the longer-term consequences may be far-reaching.

The Chinese agreement with Japan rests on three pillars: a) Chinese and Japanese trading companies will start  to directly trade their currencies without using the US dollar as intermediary; b) Japan’s government-affiliated Japan Bank for International Cooperation (formerly Export-Import Bank of Japan) will issue yuan-denominated bonds in mainland China and c) Japan will buy up to $10 billion worth of Chinese government bonds in an effort to diversify (an admittedly tiny part of)  its foreign exchange reserves.

The agreement is by far not the only Chinese initiative:

-  In December 2011, the People’s Bank of China (PBoC) signed a bilateral swap agreement with the State Bank of Pakistan amounting to yuan 10 billion plus Rs 140 billion ($3.124bn).
-  China also announced a 70 billion yuan ($11 billion) currency swap agreement with Thailand as part of a plan outlined in October to promote the use of the yuan in the Association of Southeast Asian Nations.
-  In October, too, China and Korea doubled an existing bilateral currency swap to 64 trillion won ($56.65bn) and
-  central banks from Thailand to Nigeria announced plans to start buying yuan assets.

All in all Beijing has signed a dozen swap agreements with other economies in order to promote the use of the yuan since 2008 – the biggest one with Hong Kong of 400 billion yuan in November 2011.

Recent activities of other Asian countries include

-  a $15bn currency swap agreement of Japan and India which, too, was signed end of December 2011  replacing an older $3bn swap deal.

-  A swap agreement of Pakistan and Turkey signed the same month amounting to $1bn in equivalent local currencies, and

-  an agreement signed by Japan and Korea in October 2011 to extend an existing currency swap from $13bn to $70bn.

Beside, Japan has also bilateral swap deals with other countries such as Indonesia and the Philippines.

Financial markets feel the winds of change as the following examples demonstrate:

-  In July 2011, the CME announced to revamp its renminbi-based futures contracts denominated in US dollar terms, in reaction to the fact that the renminbi is now being used for business transactions in multiple off-shore locations which include Hong Kong, Singapore, Korea, Australia and other areas around the world.

-  In April 2011, the first renminbi-denominated initial public offering outside mainland China took place in Hong Kong.

-  In October 2011, Hong Kong’s Gold & Silver Exchange Society started officially trading gold denominated in renminbi.

-  Largely unnoticed by a wider public, the Dubai Gold and Commodities Exchange offers an Indian rupee/dollar future with investors so far mostly drawn from the UAE’s large population of Indian expatriates.

-  India just announced to allow individual foreign investors direct access to its stock market from January 15, 2012. Previously, those were limited to investing indirectly through mutual funds or institutional vehicles.

International foreign exchange statistics show a steadily rising share of emerging market currencies with the yuan accounting for 0.3% and the Indian rupee even for 0.9%, and there are official ambitions to include both currencies in the calculation of Special Drawing Rights (SDR).

International currency?

Reserve currencies such as the US dollar and the euro fulfill international functions beyond bilateral relations and are widely used beyond national borders. Many observers see the Chinese yuan moving slowly but steadily in the same direction. This raises the question what it takes to become an international currency.

As general prerequisites experts stress the importance of political stability of the issuing country, a comparably stable purchasing power, the existence of broad and deep financial markets in the respective currency and the absence of capital and exchange controls.

A more systematic list of criteria traditionally follows the line of argument of Kenen 1983. Accordingly, a currency fulfills three basic functions: as unit of account, means of payment and store of value. In an international context, for each of these it is useful to distinguish between private and public use as the following table does. This gives six cases and the question is how the Chinese yuan is performing in each of them.

The extent to which a currency serves as a unit of account for the private sector can be seen in its use as an invoice currency in international trade. With respect to this measure, the first impression is rather modest.

In 2010, China’s exports amounted to an estimated $1.581 trillion, with its main partners being the US (18%), Hong Kong (still considered foreign trade, 13.8%), Japan (7.6%), South Korea (4.4%) and Germany (4.3%) (see for all statistics here). Imports were about $1.327 trillion with the main partners Japan (12.6%), South Korea (9.9%), US (7.3%), Germany (5.3%) and Australia (4.3%).

Currency convertibility for trade purposes is limited. In April 2009, China began experimenting with yuan trade settlement for few selected firms in Shanghai and four cities in the Guangdong province which was restricted to trade with partners in Hong Kong and selected countries. In mid-2010, permission was widened to 365 firms in 20 provinces and (above all coastal)  towns. End of 2010, the number of exporters that can use the yuan to settle international transactions increased to nearly 70,000. Since August 2011, yuan trade settlement is allowed throughout China. Furthermore, since July 2010 the buying and selling of yuan is no longer confined to mainland China but open to trading in Hong Kong with the result that daily trading volumes soared from zero to $400bn.

China has a sort of crawling-peg currency regime. Its currency is pegged to the US dollar within a preset range that may vary daily. After keeping it tightly linked to the dollar for years, in July 2005 China revalued the yuan by 2.1% against the dollar and announced to move to a basket of currencies as reference. From mid-2005 to late 2008 there was a cumulative appreciation of the Chinese currency against the dollar by more than 20%, but after that the exchange rate remained virtually pegged to the dollar from the onset of the global financial crisis until June 2010, when Beijing allowed for another gradual appreciation.

The yuan does not necessarily trade at the same rate onshore and offshore. Currently, the offshore market acts as a parallel market without influence on the official rate set in Beijing. However, big Chinese companies with subsidiaries in Hong Kong, which are often backed by the state, as well as foreign financial institutions with desks to trade yuan in Hong Kong, usually guarantee for functioning arbitrage which hinders the offshore rate to deviate much from its onshore equivalent. Hong Kong’s market seems for China to serve as a sort of laboratory where the government is able to control the terms separate from mainland conditions.

In 2011, about 9% of China’s total trade has been settled in yuan. In the first half of 2011, 84% of this was carried out by Hong Kong banks. The tendency is rising and only limited by currency convertibility: Trade settlement is strictly regulated. The Bank of China Hong Kong (BoCHK) is the yuan designated trade settlement clearing bank and as far as yuan trade settlement goes it is the only settlement agent between banks in Hong Kong and the People’s Bank of China (PBoC), China’s central bank.

Although the use of yuan for foreign trade is globally allowed now, the Chinese government imposes quotas which determine how much foreign trade in yuan is settled by the clearing bank. Currently, the official quota is 8 billion yuan annually. Once this is reached BoCHK informs participating Authorized Institutions (AIs) at short notice that further trade settlement services cannot be provided (example).

Coming to the second criterion, the public function of a currency as a unit of account, one indicator is the role a currency plays in defining parities, for example as part of an exchange rate arrangement including a currency basket. China’s claim to include the yuan in the SDR must be seen in this context. The IMF is due to conduct its next review of SDR composition only in 2015, but China observers are optimistic about an earlier adjustment.

Largely as the result of limited convertibility, so far the yuan plays no noteworthy role as international vehicle in foreign exchange markets or in official foreign exchange interventions. However, the numerous swap agreements listed in the beginning and recent announcements demonstrate a potential of future significance.

Missing markets

Given the size of global financial markets compared to trade flows, these days maybe the last two functions  in the table – private store of value and official use as reserve currency – are the most important ones. For those criteria to be met broad and deep markets with a wide range of financial products and maturities, and sufficient liquidity to allow for both IPOs and secondary trading,  must exist.

So far, China has been reluctant to allow capital to move freely across borders. Restrictions on residents to take capital out of the country have been eased in recent years, for example, increasingly allowing Chinese companies to buy foreign firms with yuan (with government approval). But foreigners still face strong barriers to investing yuan in China. Investment in onshore bond markets is restricted to overseas renminbi clearing banks and foreign central banks under narrowly defined conditions and subject to an undisclosed quota. Some “qualified” foreign investors are allowed to buy mainland securities, but for these, too, quotas exist:

Investment quotas are granted under the Qualified Foreign Institutional Investor (QFII) program. Launched in 2002 the program allows licensed foreign inverstors to buy and sell yuan-denominated shares (A-Shares traded in Shanghai and Shenzhen, in contrast to B-Shares, issued and traded in foreign currencies in mainland China – in Shanghai in US dollars and in Shenzhen in Hong Kong dollars). The current list of 88 QFIIs includes international banks and investment companies, insurance and asset management companies, but also the Bill & Melinda Gates Foundation and universities such as Harvard and Yale.

Decisions about the size of quotas are influenced by the yuan/dollar exchange rate in the offshore market. When the yuan faces pressure to appreciate, the Chinese government tends to slow or suspend quota approvals. In times of capital outflows and weaker yuan, approvals are easier to get. In 2011, combined quotas granted under the scheme totaled $1.92 billion, nearly $1 billion alone since October. From 2002 to December 2011 a total of $21.6 billion have been granted under the program.

A similar system exists for  approval of fund outflows: The Qualified Domestic Institutional Investor (QDII) program has grown more rapidly than the QFII scheme, amounting to $74.95 billion in December 2011. Furthermore, there is a Renminbi Qualified Foreign Institutional Investor (RQFII) program which was established to encourage Hong Kong subsidiaries of Chinese brokerages and fund houses to raise offshore yuan to invest in mainland China. For RQFIIs a quota of 20 billion yuan was announced in August 2011.

Aware of the “missing markets” problem of the yuan on its way to become an international currency, China hesitantly started to promote the development of a yuan offshore bond market. In 2007, the first “dim sum” bond, denominated in the currency of mainland China, but sold in Hong Kong, was issued by the China Development Bank. More than 80 issuers followed, including the World Bank, McDonald’s and Volkswagen. But usually size is small and maturities range from two to three years. Furthermore, non-financial foreign companies shun the market (although this is changing as European firms face increasing difficulties to raise funds economically at home due to the euro crisis) because they still face difficulties getting the necessary permission to bring the cash raised into China. As a consequence the sale of 20 billion yuan ($3.1 billion) by China’s Ministry of Finance  in August 2011 attracted considerable attention. In an effort to further boost market development it came with the announcement that non-financial Chinese firms would be allowed to raise yuan offshore, a privilege previously reserved for mainland banks.

Why should a country with an annual budget deficit of 1.6% of GDP and a public debt of 16.3% of GDP (2010 estimates) issue government bonds? One reason is that usually in financial markets government bonds serve an important function as benchmarks. Up to the eurozone crisis they were essentially considered as risk free and still are generally regarded as superior to other sorts of debt. Markets are highly efficient and liquid. Large borrowing needs and a long life enable governments to offer a wide range of maturities which, in turn, facilitates the construction of a yield curve. For a currency gaining an international reputation without a well-developed and efficient market for government debt seems inconceivable. As Izabella Kaminska observed: “Most of the time it will be countries with the largest public debt … that will have preferred reserve currency status thrust upon them.”

Can it happen?

An international currency cannot be built from the scratch. Policy will is no substitute for investors’ demand and the existence of broad and deep financial markets. An international currencies is not footloose: As a rule, to be accepted it needs a big economy and a strong “hinterland” which provide for the neccessary credentials. In addition, although being a global phenomenon, international currencies have roots. They are strongly tied to regional financial centres: The US dollar to New York, the European currency to London and the Japanese yen to Tokyo. A greenback is a greenback. Financial centres, their history and culture, as well as the myths surrounding them, create a web of “tales” which become anchored in collective memory  supporting the image of the currency in the eyes of the international financial community thereby increasing its significance.

In many respects, China’s financial system is still in its infancy. Should full convertibility be introduced now, the yuan as an international currency in fact would appear built from the scratch. Yuan markets and products exist only briefly, many of them still in a rudimentary state. The same holds for most bilateral official agreements. As an international currency it would seem largely a political construct.

From another perspective, however, the yuan is much more than this, showing a strong potential for rapidly winning international status: China is a big economy (the third largest behind the US and the euro area) and a strong hinterland for the yuan. It is the second largest exporter (behind the euro area). Many current financial market imperfections would – after a period of transition – automatically vanish with convertibility. Demand is there. Observers agree that markets want this currency. Supply will come: In one respect, the yuan differs from other aspirants from emerging market economies: Financial markets and instruments in this currency need not be developed painstakingly starting at zero. On the contrary: Not one but two (!) highly sophisticated international financial centres in the region are competing for the role to become an international hub for trading yuan:

In Singapore banks are already offering yuan deposits and bond funds. Although Hong Kong has a privileged role, many expect this only to last as long as China maintains strict capital controls. Under a fully convertible yuan, electronic brokering would make national borders largely irrelevant and Singapore’s advantage as the world’s fourth largest centre of foreign exchange trading would strengthen its position and add to the yuan’s potential.

In studies refering to China’s underdeveloped domestic financial markets this location aspect is often overlooked. Both Hong Kong and Singapore are highly developed and competitive financial places with a long history and market culture, and there is a web of tales and images surrounding them, of which the Chinese currency has always been part, anchored in the collective memory of the financial community. As a consequence, establishing yuan markets will pose few acceptance problems. In the range of financial products these places offer, despite strong rivalries, both rather complement each other. For instance, while Singapore is a leading foreign exchange centre, Hong Kong is strong in equities. After foreign exchange and capital liberalisation their combined market volumes could easily outnumber those in the traditional leading centres in other world regions, in particular, since large-scale yuan trading could be expected to trigger what Paul Krugman once called “centripetal forces” attracting business in other currencies, too.

It can happen, and sooner or later will happen – and the result might well surpass even the wildest prophecies. Currently, there is a huge global investor demand for exposure to China.  Not only from ailing markets in Europe and the US, and from Asian neighbours eagerly awaiting a regional alternative to the dollar and the euro. The worldwide Chinese diaspora which according to rough estimates amounts to over 40 million people can be expected to welcome opening and boost market growth.  Furthermore, their demand may become a stabilizing element in markets at the mercy of the ups and downs of western China fantasies and contribute to establish a safe haven in the region for both local and international investors. It is all out there – waiting for the signal.

#gfc2

There’s An Easy, Fair Solution To The Global Debt Crisis — Too Bad No One Ever Talks About It (@hblodget)

Video: The Euro Bailout Explained (The Guardian)

Coppola Comment: Managing Collapse (@Frances_Coppola)

William K. Black on fraud and “calculated dishonesty” (via @aliegorey)

Ken Loach: Rioters were ‘working class kids without work’  (BBC News)

David Harvey on the Crises of Capitalism (from RSA Animate)

umair haque: From Opulence to Eudaimonia (@umairh)

Lists 

“The list is the origin of culture. It’s part of the history of art and literature. What does culture want? To make infinity comprehensible. It also wants to create order — not always, but often. And how, as a human being, does one face infinity? How does one attempt to grasp the incomprehensible? Through lists, through catalogs, through collections in museums and through encyclopedias and dictionaries. There is an allure to enumerating how many women Don Giovanni slept with: It was 2,063, at least according to Mozart’s librettist, Lorenzo da Ponte. We also have completely practical lists — the shopping list, the will, the menu — that are also cultural achievements in their own right.”  Umberto Eco (via @SPIEGEL_English, @brainpicker)

The 11 best psychology and philosophy books of 2011 (via @brainpicker)

20 Great Visualizations of 2011 (Drew Skau) (via @ZBW_MediaTalk)

The Most Important Graphs of 2011 (The Atlantic)

Top economists reveal their graphs of 2011 (BBC News)

2011′s best articles, according to Longform (via @Presseurop)

Best longreads of 2011 (via @kottke)

50 best photos from The Natural World – The Big Picture -(via @cristobalvila)

An interactive page with this year’s top stories, pictures and more (@Reuters)

And finally: The Best And Worst Of Everything In 2011: A Mega, Meta Mashup, by Adam Penenberg (via @ramanuj_shastry, @zite)

Weekend links you liked

Some of you contacted me on Twitter to tell me of the weekend links of this blog which you liked best. Here are some examples:

Guitar strings

Richard Feynman on Jiggling Atoms

Kansas City Hornpipe

and, of course: Lovely Owl

Not to forget that lively exchange on Twitter which developed after one enthusiast proposed to get into the ratings business: Let’s do rating!

And much more. I would suggest you take some time to browse through my pages and find out. The biggest question now, end of 2011, is about the future of Europe and the euro. This question will clearly stay with us in 2012 and I found two comments in pictures on Twitter:

European Prospects

Policy view (via @zerohedge)

Function is value (@kkoolook)

Christmas Nativity Story

Nativity Story Birth to Cross Line Drawing (YouTube)  

Christmas 2012 (YouTube)

Christmas Greetings

The Christmas Card (Terry Gilliam) 

Choir It Yourself  Interactive christmas card (webguerillas Zürich)

The Snowdog (Jacquie Lawson)

Christmas Songs

Adeste Fidelis & Herbei o ihr Gläubigen (Regensburger Domspatzen)

Es ist ein Ros’ entsprungen (Mainzer Domchor)

Maria durch ein Dornwald ging (Add9)

Schroeder – Jingle Bells

and:

Evidence

Take a look at the following figure. What you see is settlement balances in the European payment and settlement system TARGET2 at the end of 2010.

The first thing you may notice is differences. A few countries have positive balances. These are Germany, Luxembourg, the Netherlands, Finland and Italy. Many others have negative balances.

Source: Deutsche Bundesbank, Monthly Report, March 2011, pp 34 f.

The next thing we notice is strong differences in size. With more than €300bn Germany has by far the highest positive settlement balance while Ireland, Greece, Portugal and Spain have noteworthy negative balances, although no individual balance is below – €150bn. Apparently there is no 1:1 correspondence between positive and negative balances of countries in that the excess of claims of one country equals an excess of liabilities of another one.

These figures are accumulated net balances. They show large variations in accumulated differences between cross-border claims and cross-border liabilities of countries. Obviously, end of 2010 in Germany and Ireland the gap between claims and liabilities was much bigger than, say, in Italy where the match was almost perfect. What do these numbers tell us?

Let me emphasize what they do NOT tell: They give no information about gross cross-border payments and their determinants. Hypothetically, these may have been much higher (or lower) in Italy than in Ireland – we do not know. Further, the numbers allow no conclusion about net or gross cross-border payments in subperiods which for example may have been higher, say, in Greece than in France, at least temporarily.

The last point we have to find out is what kind of activities are behind these payments. The Bundesbank mentions three major components with payments carried out via the banking system: foreign trade transactions, securities transactions and lending transactions. All three are reflected in interbank claims or liabilities vis-à-vis the rest of the world and can be settled using TARGET2.

Keeping in mind these points, in principle, we now have all information we need to approach the question who is paying for whom or what in Europe , and how TARGET2 becomes involved, and the time has come to have a closer look at the functioning of a payment and settlement system.

Real-time-gross-settlement in Europe

The Trans-European Automated Real-time Gross settlement Express Transfer (TARGET) system is used to settle cross-border payments individually as soon as orders are sent. The system allows for what is called intra-day finality which is the certainty that transactions will not be unwound if a party fails to settle. Real-time-gross-settlement or RTGS-systems have the disadvantage that, in contrast to former systems, they require a lot of liquidity since during the day orders are not accumulated and netted befor payments are made. RTGS-systems were established in reaction to several incidents which threatened to severely destabilize the international financial system. One of them was Barings. As I wrote elsewhere (Reszat  2005, Chapter 4):

“When in February 1995 one of the oldest British merchant banks, Barings Bank, went bankrupt after one of its traders had lost about ¥850 million on the Singapore and Osaka futures exchanges one widely unnoticed effect was a resulting problem in the then existing ECU clearing system. This threatened to block settlement of ECU50 billion of payments. Barings itself was involved in less than one percent of those payments. The case is a classic example of the systemic risk inherent in large-value net settlement systems. These systems are constantly keeping track of banks’ net positions including thousands of payment instructions in the course of the day. At day’s end the net amounts owed are settled. If clearing becomes impossible for one party, settlement between all participants  is blocked and no payments are taking place at all.”

In contrast to a net settlement system in TARGET2 both legs of a transaction are settled independently of each other via the national central banks. Take the example of the unwinding and repayment of a Greek position by a German investor: Assume a Greek bond falls due for repayment and the German lender wants the money back instead of reinvesting it in Greek bonds again. In this case money is flowing from Greece to Germany including the following steps:

-          A Greek bank is transferring the amount of money to the German investor’s German bank via the Greek central bank. This means that the amount will be credited to the account of the German bank at the German Bundesbank.

-          Technically, now the Bundesbank has a new liability (equal to the amount from the Greek investment on the central bank account of the German bank).

-          But at the same time, the transaction generates a claim for the same sum of the Bundesbank on the sending Greek central bank.

-          The Greek central bank in turn debits the central bank account of the originating Greek bank.

In my interpretation the third step is what observers think they see in the figures for the German TARGET2 settlement balances: Claims of the Bundesbank on Greece. What they overlook is

a) that the position in our example is not a claim on Greece, or on the Greek central bank, but on the  Eurosystem, on TARGET2. The source of the misunderstanding is probably the fact that TARGET2 does not provide a central counterparty which would serve as a seller to all buyers and a buyer to all sellers. Instead, the participating central banks are directly offsetting the positions as soon as orders are reaching them.

b) that such a claim is only one of two legs of a transaction that is merely settled via central bank cooperation. The other leg is the liability the Bundesbank has to the German bank which is receiving the payment.

Payments via TARGET2 in general involve four parties: two central banks and the initial payer and receiver. The payment may result from an export or import of goods or services, from a securities sale or purchase or from cross-border lending and borrowing. In these and other cases the principle is always the same: four legs with a match of claims and liabilities. As the Bundesbank writes:

“From a euro-area perspective, TARGET2 balances largely disappear, just like the national current-account balances within the euro area. The claims of the Bundesbank (and other national central banks) on the ECB are offset by the liabilities of other national central banks”.

Volumes and Values of Transactions in EU Payment and Settlement systems

Source: ECB: Statistics Pocket Book, September 2011.

The Role of the ECB

The ECB comes into the picture by the fact that it is the keeper of the TARGET2 balances within the Eurosystem: Usually, the claims and liabilities generated at the national central banks by thousands of transactions (as the above table shows the monthly volume of transactions between 2005 and 2009 ranged from about 300.000 to 400.000 payments) do not fully balance out over the course of a day. The outstanding claims and liabilities of all national central banks are then transferred to the ECB at the end of the day and netted out.

Why is the TARGET2 settlement balance for Germany so high? The Bundesbank states that, above all, this is due to the current tensions in the money market and the financial sector. Currently, Germany’s cross-border payments are far from balanced reflecting, for example, changes in banks’ refinancing operations in the euro area. While funds tend to continue to flow into Germany from non-bank payments from current-account surpluses and securities transactions as well as from banks’ own operations, there is a growing unwillingness or inability of German banks to lend funds to foreign financial institutions. The result is that there are more payments channeled through TARGET2 in one direction than in the other.

Which are the risks? There is always a danger that one leg of the transaction is paid and the counterparty is not willing or able to fulfil its part of the business. For this eventuality banks have to provide collateral. Assume, in the example the Bundesbank has paid out the amount to the German bank, but the Greek bank fails and the Greek central bank is not able to collect the money because collateral is insufficient to realize the full amount. In this case an actual loss occurs, but this is not borne by the Greek or the German central bank alone, but by the Eurosystem as a whole. The cost of the loss is shared by national banks in line with the capital share. Accordingly, the Bundesbank has to pay 27% of a loss no matter in which country it occurs.

Confusion partly stems from the dual role of the ECB as central counterparty for TARGET2 balances and as central bank for the euro area. In the latter function it offers member banks the opportunity to both posit cash there and get cash against collateral establishing borrower/lender relations. Both types of activities trigger payments which are settled using TARGET2. Again the question is: Which are the four legs?

Assume an Italian bank is getting a loan from the ECB against collateral. Four parties are involved: the Italian bank, the Italian central bank, the ECB in its role as loan-granting central bank of the euro area (only in this role money is owed to it by the Italian bank) and the ECB as participating member central bank of TARGET2 which is processing the related payments.

Conclusion

So, as Robert Peston asked in a recent article about TARGET2 balances, what’s all the fuss about?

The answer is that those “experts” and observers obsessed with the idea that against official claims the Bundesbank forces German taxpayers to pay for the debt of Italy, Greece and other countries simply confuse money flows generated from debtor/creditor relations with the processing and settlement of related payments. Claims and liabilities in a payment and settlement system must not be regarded isolated for individual members. There is one recipe to pick one’s way through this jungle of positions and activities: Search for the four legs! Then it becomes clear where the money flows, who gives it and who takes it.

_____

* Thanks to Tim Coldwell for generous friendship and help.

The basic idea is that countries whose economies are linked by trade and other economic relations could eliminate the related risk of exchange-rate fluctuations by adopting a common currency. The theory has three assumptions: For a country joining a common currency it makes sense if

- economic integration is high;

- capital is mobile and prices and wages are flexible enough to adjust to changing circumstances (unforeseen “shocks”);

- and the shocks that economies in the area are exposed to are symmetric by nature, so that no conflict of interest about which policy to adopt to fight a disturbance will arise.

In searching for an answer to why the euro experiment failed the first criterion, which at first view seems maybe the least suspicious, requires closer inspection.

Economic integration

Although there are other motives, the integration criterion is THE rationale for adopting a common currency. In policy debates, integration is usually understood as integration of markets for goods and services: Cross-border trade and direct investment is exposed to currency risk. Hedging is costly, not always possible and fraught with uncertainties with respect to positions and maturities (see here for various hedging concepts. Remember also in another context the debate about hedging under the Volcker rule). A common currency rules out exchange rate volatility, speculative pressures and competitive devaluations thereby, for example, making the price of an imported or exported good a calculable and foreseeable number.

The current crisis in the eurozone demonstrates that for a currency union to function not only goods markets but also (and perhaps more importantly) financial markets must be integrated. As I explained elsewhere it is with the advent of Credit Default Swaps (CDSs) which allow hedging and betting against sovereign default that, for the first time under the common currency, differences in the riskiness of supposedly equal and risk free government debt in the eurozone became visible rendering the system unsustainable. Further, with sovereign CDS spreads already at record highs it comes as no surprise that market interest is increasingly shifting to private sector businesses and banks in crisis countries. The fathers of the euro did not take into account that in principle each non-integrated financial market segment is an invitation for markets to test policy commitment to the common cause.

These days, markets for goods and services are dwarfed by financial market size: In April 2010 the estimated daily foreign exchange turnover worldwide was $3,981bn. Market capitalization of world exchanges around that time was $57,107bn, total issue of international debt securities amounted to $26,751bn and foreign consolidated bank claims worldwide were $34,906bn. By contrast, world annual exports in 2010 were $14,950bn.

There are all sorts of financial markets: Capital and credit markets are supplemented by a large variety of exchange-traded and OTC derivatives markets and markets for synthetic instruments. Maturities range from fractions of a second up to thirty years and even longer. Money markets allow policy a direct grip via central banks at the short end although recent examples of Japan, the US, and increasingly the eurozone, demonstrate that their influence is limited. The same holds for financial regulation: As a rule, banning or restricting activities in one market only risks triggering shifts to other markets or even the creation of new products to circumvent rules – with often unforeseen and highly undesirable consequences.

Limits to policy influence

The theory of Optimum Currency Areas knows only one capital good: money. In the case of countries with different currencies money is exported and imported depending on its price or interest rate and, at the same time, serves as one of two policy instruments (the other is government spending or fiscal policy). By assumption, domestic and foreign money are perfect substitutes which only differ by their respective price.

The limited arsenal of policy instruments leads to a phenomenon known as The Impossible Trinity. It states that it is not possible for a country to have a fixed exchange rate, monetary policy autonomy and open capital markets at the same time.  Assume monetary policy is directed at achieving price stability. In this framework, fixing the exchange rate would require domestic and foreign interest rates to be equal. Any attempt of monetary policy to influence domestic prices would result in a change of the domestic interest rate which immediately would trigger arbitrage movements:

Under perfect capital mobility, money is borrowed at the lower interest rate and flows to the area with the higher rate to be invested there. A rising demand for money in the country under consideration raises the lower interest rate (an additional supply of money lowers a higher rate) until the domestic rate has adjusted to the foreign so that both are equal again and the policy effect is annihilated. Under a common currency there is one central monetary policy for all member countries which aggravates the Impossible-Trinity problem in case several countries have a need for individual policy responses (for example, this is the rationale behind the assumption of shock symmetry).

There are several implicit or explicit assumptions behind this concept. One is the small-country assumption: Compared to the rest of the region the country is too small to exert an influence on foreign economic conditions and the foreign interest rate. In money markets it is a price taker. Without this assumption the effect of a monetary expansion or contraction would be felt in the foreign country or the region as well, the policy problem would become a strategic one taking into account interactions of both sides and the outcome would become negotiable for all parties.  As a consequence one country would probably end up with a slightly higher and the other with a slightly lower interest rate with both economies feeling an influence. To take an example from the eurozone: Policy decisions in France could change economic conditions in Germany and vice versa.

Another crucial assumption is capital substitutability. This is NOT the same as capital mobility. The latter means that capital may flow unhindered to wherever return is the highest. Substitutability means that except for price differences there is no reason to prefer one financial product over the other. There is only one financial product, which is money, and in investors’ view there is no difference between German money and Greek money. Both must cost the same.

By contrast, a region with a whole range of financial markets and products with characteristics, risk profiles and degrees of uncertainty differing between and across countries offers opportunities for policy influence which so far are theoretically widely unexplored and which may explain why at times policy effectiveness appears higher than expected. Central banks intervening in derivatives markets in support of their currencies and debates about providing the EFSF with a lever to strengthen its capacity are two examples of policy makers and monetary authorities beginning to exploit the opportunities markets offer beyond theory.

Theory deficiencies

Why is the variety of financial markets and products neglected by theory? One explanation is found in history. In the 1950s when the Canadian Robert Mundell wrote his seminal paper (see here for a genesis of the article) many exchange rates were fixed under the Bretton-Woods System. An exception was the floating Canadian dollar. Capital movements were strongly restricted and mostly related to international trade. Economic relations between countries were bilateral by nature. Neither the political nor the technical prerequisites for globalization or only internationalization (see here for the difference between the two) of banks and businesses as is known these days existed.

In Europe countries were in the process of forming a common market for goods and services. There as elsewhere macroeconomists were more interested in the “real” side of the economy. Financial markets were, and still are, widely considered as a microeconomic issue.  The unfortunate dichotomy between “real” and “monetary” phenomena set the course for the deplorable failure to develop a strand of research to understand and explain the crises which again and again plague the region and hamper the integration process.

Financial markets seem the poor cousin of macroeconomic research. Even money was and still is widely regarded with suspicion: Isn’t it only the veil disguising real processes? Does it matter at all for economic developments? Do we need to understand the transmission of monetary policy to the economy in all detail or is it a “black box” of which we only need to know what is put in and coming out?

The result of this neglect is a flood of misunderstandings and misinterpretations which stand in the way to meaningful crisis analyses and solutions. To give an example: In a recent BIS article, Claudio Borio and Piti Disyatat argue against singling out global current-account imbalances as key factor contributing to the global financial crisis as several authors do. They stress the failure to distinguish sufficiently clearly between “saving” as defined in national accounts as income not consumed and “financing” as a cash-flow concept describing access to purchasing power in the form of money and borrowing.

To cite from the paper’s abstract: “… the main contributing factor to the financial crisis was not “excess saving” but the “excess elasticity of the international monetary and financial system: the monetary and financial regimes in place failed to restrain the build-up of unsustainable credit and asset price booms (“financial imbalances”).”

Optimum euro area?

Is there an optimum currency area in Europe? Would a North/South divide help calm markets and regain confidence in the euro? To which extent and in which form could eurobonds contribute to a crisis solution in this context? An enlarged EFSF? A fiscal union?

The answer is: no one knows. Theory’s failure to provide a solid frame for analyzing these and other questions uniting the financial and “real” sphere of regional economic relations leaves policy makers and analysts confronted with a black hole sucking in every new plan and concept without response. Under these circumstances the only sensible strategy is retreat to the last secure line of defence against market attacks before all powder is shot: The retreat to national currencies.

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