Monetary policy

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See also quantitative easing.


Unconventional monetary policies: an appraisal

"The recent global financial crisis has led central banks to rely heavily on “unconventional” monetary policies. This alternative approach to policy has generated much discussion and a heated and at times confusing debate.

The debate has been complicated by the use of different definitions and conflicting views of the mechanisms at work.

This paper sets out a framework for classifying and thinking about such policies, highlighting how they can be viewed within the overall context of monetary policy implementation. The framework clarifies the differences among the various forms of unconventional monetary policy, provides a systematic characterisation of the wide range of central bank responses to the crisis, helps to underscore the channels of transmission, and identifies some of the main policy challenges.

In the process, the paper also addresses a number of contentious analytical issues, notably the role of bank reserves and their inflationary consequences.

BIS study says low interest rates can risk financial stability

Central banks should allow financial stability to play a role in monetary policy as low interest rates spur banks to take on too much risk, according to a study by the Bank for International Settlements.

The risk of banks defaulting jumped by more in economies where interest rates remained low for an extended period before the recent financial crisis, the report by the Basel, Switzerland-based organization said.

“The main implication of these findings is that monetary policy is not fully neutral from a financial stability perspective,” wrote economist Leonardo Gambacorta. “It is important that monetary authorities learn how to factor in the effect of their policies on risk taking.”

The BIS report comes as policy makers debate whether central banks should play a greater role in stabilizing financial markets, either through monetary policy or regulation. Federal Reserve Chairman Ben S. Bernanke said on Dec. 3 he doesn’t rule out using interest rates to pop asset-price bubbles, while stressing that financial regulation is his preferred approach.

Low interest rates encourage banks to take risk either to secure greater returns on their investments or by affecting valuations and cash flows, which in turn help shape how they measure risk, Gambacorta said.

Lack of Evidence

The study showed several ways in which low borrowing costs over an extended period can cause banks to take on more risk. It found that if market interest rates are kept below the benchmark rate for 10 straight quarters, the probability of an average bank defaulting increased by 3.3 percent. An inflation-adjusted house price gain of 1 percentage point above the long-run average for six consecutive years before the recent crisis increased the probability of default by 1.5 percent, it said.

Central banks may have previously ignored the effect that low interest rates have on risk-taking because of a lack of empirical evidence that such a link existed, Gambacorta said. That left them to focus instead on a strict inflation goal or believe that financial innovation would allocate risk more effectively and so strengthen their economies, he said.

The study was contained in the quarterly report of the BIS, which serves as a central bank for central banks. It found that with economic recovery still in its early stages, investors did “not foresee any tightening of monetary policy for some time.”

Markets and surveys suggest “price pressures in the largest advanced economies were expected to remain well contained,” it said. Still, questions about the central banks will exit from their unconventional monetary policies added uncertainty to markets, it said.

When central banks crack down, “financial instability” will ensue

"... While policy makers, including Bernanke, oppose specific targets for assets, they may be more willing to raise rates if markets begin to signal there is too much liquidity, said William White, Cecchetti’s predecessor at the BIS, which serves as the bank for central banks. They’re also looking to back tougher regulation by curbing leverage and pursuing so-called macro-prudential supervision to constrain lending excesses and monitor economic risks instead of focusing on individual banks.

Economic Fundamentals

Some central banks are eager to see assets rise to boost their economies, said Richard Batty, global-investment strategist at Standard Life Investments Ltd. in Edinburgh. The challenge remains how to conclude when prices no longer reflect economic fundamentals and whether anything can be done about it, he said.

“The major central banks will need to keep policy loose for some time, so it’s premature to start worrying about what to do with asset prices,” said Batty, who helps oversee about $200 billion. “Deciding whether an asset is cheap, fairly valued or expensive is a difficult proposition.”

When Bernanke was a Fed governor in 2002, he sided with Greenspan by saying “monetary policy cannot be directed finely enough to guide asset prices without risking severe collateral damage to the economy.” He’s now likely to maintain a preference for revamping supervision such as by enforcing stricter capital rules on large banks to curb their risk-taking and leverage. Federal Reserve Bank presidents appear divided over whether interest rates should be used.

‘Slippery Slope’

“In certain circumstances, the answer as to whether monetary policy should play a role may be a qualified yes,” Janet Yellen, of San Francisco, said in June. By contrast, Philadelphia’s Charles Plosser said in an Oct. 22 Bloomberg Radio interview that trying to identify and head off asset bubbles is a “very slippery slope” and rates are a “very blunt instrument.”

In Asia, the central banks of South Korea and India are already signaling they may boost rates next year. South Korean home prices rose for a sixth month in August, while India’s Mumbai Stock Exchange Sensitive Index is up about 75 percent since January.

“Monetary policy must not neglect asset-price movements,” Qin Xiao, chairman of China Merchants Bank Co., China’s fifth- largest bank by market value, wrote last week in the Financial Times. It is “urgent that China shifts from a loose monetary policy stance to a neutral one,” he said.

Assessing Risks

The European Central Bank is studying asset prices as it reviews what to include when monitoring developments in money and credit growth as part of an assessment of the risks to price stability.

“Experience and developments in the literature appear to support a shift in favor of the adoption of some form of leaning against the wind,” PresidentJean-Claude Trichet said Aug. 22, adding he doubted it could be done in a “mechanical way.”

Bank of England Chief Economist Spencer Dale said last month he favored limiting its so-called quantitative-easing plan in August because he worried that spending more than 175 billion pounds might stoke asset prices too much.

Officials are “very doubtful” monetary policy can tame credit cycles, arguing that doing so in the last boom would likely have triggered a prolonged recession, Deputy Governor Paul Tucker said Oct. 22. A forthcoming discussion paper will instead outline instruments such as tighter collateral standards and risk measures banks could adopt to make their industry more resilient, he said.

Inflation Fighting

While tackling asset increases “may undermine” inflation fighting, a central bank can bolster its credibility by adopting a price-level target, requiring it to make up for past misses in the inflation goal, says Bank of Canada Governor Mark Carney. The bank is considering whether to introduce such a strategy after 2011.

A survey of 147 clients published last week by New York- based Goldman Sachs Group Inc. found 75 percent think low rates are triggering “too strong” climbs in assets.

When central banks crack down, “financial instability” will ensue as investors gauge their pain thresholds, said Ignis’s Thomson, who helps manages about $100 billion.

“Central banks will be more inclined than they were before to look at whether asset prices have gotten out of line,” White said. “We’ve seen what happens when markets go wrong.”

At Davos, Sarkozy calls for global finance rules

France wants to use its presidency of the Group of 20 next year to create a new international monetary system, President Nicolas Sarkozy said on Wednesday, adding that he believed the dollar should no longer be the primary reserve currency in the global economy.

In an expansive and lofty speech to the business and political leaders gathered here at the annual World Economic Forum, Mr. Sarkozy also called for a “revolution” in international regulation that would make labor, health and environmental standards as enforceable as trade rules.

Like Prime Minister Gordon Brown of Britain, he backed a tax on financial market transactions. But Mr. Sarkozy, pursuing his call for a more moral form of financial capitalism, suggested the proceeds be used to combat climate change and create a World Environment Organization as powerful as the World Trade Organization.

Mr. Sarkozy also took a hard line on bankers’ bonuses, saying that lavish rewards should be denied to those who destroy wealth and jobs.

But before an audience that contained many Americans and many Chinese, his comments on currencies may have had the greatest resonance.

“We need a new Bretton Woods,” Mr. Sarkozy told a packed auditorium. “We can’t have on the one hand a multipolar world and on the other a single reserve currency on a global level.”

In a thinly veiled reference to China keeping its currency at an undervalued level, he added: “We cannot on the one hand laud free markets and on the other tolerate monetary dumping.”

During its 2011 presidency of the Group of 8 — the leading Western industrial powers plus Russia — and the wider G-20, which includes several important developing nations, France “will put the reform of the international monetary system on the agenda,” Mr. Sarkozy said.

French President Nicolas Sarkozy speaks about the financial crisis, global governance and the future of capitalism. He speaks at the opening plenary session of the World Economic Forum's annual meeting in Davos, Switzerland. (This report includes translation. Source: World Economic Forum)

Mother of all carry trades faces an inevitable bust

Since March there has been a massive rally in all sorts of risky assets – equities, oil, energy and commodity prices – a narrowing of high-yield and high-grade credit spreads, and an even bigger rally in emerging market asset classes (their stocks, bonds and currencies). At the same time, the dollar has weakened sharply, while government bond yields have gently increased but stayed low and stable.

This recovery in risky assets is in part driven by better economic fundamentals. We avoided a near depression and financial sector meltdown with a massive monetary, fiscal stimulus and bank bail-outs. Whether the recovery is V-shaped, as consensus believes, or U-shaped and anaemic as I have argued, asset prices should be moving gradually higher.

But while the US and global economy have begun a modest recovery, asset prices have gone through the roof since March in a major and synchronised rally. While asset prices were falling sharply in 2008, when the dollar was rallying, they have recovered sharply since March while the dollar is tanking. Risky asset prices have risen too much, too soon and too fast compared with macroeconomic fundamentals.

So what is behind this massive rally? Certainly it has been helped by a wave of liquidity from near-zero interest rates and quantitative easing. But a more important factor fuelling this asset bubble is the weakness of the US dollar, driven by the mother of all carry trades. The US dollar has become the major funding currency of carry trades as the Fed has kept interest rates on hold and is expected to do so for a long time. Investors who are shorting the US dollar to buy on a highly leveraged basis higher-yielding assets and other global assets are not just borrowing at zero interest rates in dollar terms; they are borrowing at very negative interest rates – as low as negative 10 or 20 per cent annualised – as the fall in the US dollar leads to massive capital gains on short dollar positions.

Let us sum up: traders are borrowing at negative 20 per cent rates to invest on a highly leveraged basis on a mass of risky global assets that are rising in price due to excess liquidity and a massive carry trade. Every investor who plays this risky game looks like a genius – even if they are just riding a huge bubble financed by a large negative cost of borrowing – as the total returns have been in the 50-70 per cent range since March.

People’s sense of the value at risk (VAR) of their aggregate portfolios ought, instead, to have been increasing due to a rising correlation of the risks between different asset classes, all of which are driven by this common monetary policy and the carry trade. In effect, it has become one big common trade – you short the dollar to buy any global risky assets.

Yet, at the same time, the perceived riskiness of individual asset classes is declining as volatility is diminished due to the Fed’s policy of buying everything in sight – witness its proposed $1,800bn (£1,000bn, €1,200bn) purchase of Treasuries, mortgage- backed securities (bonds guaranteed by a government-sponsored enterprise such as Fannie Mae) and agency debt. By effectively reducing the volatility of individual asset classes, making them behave the same way, there is now little diversification across markets – the VAR again looks low.

So the combined effect of the Fed policy of a zero Fed funds rate, quantitative easing and massive purchase of long-term debt instruments is seemingly making the world safe – for now – for the mother of all carry trades and mother of all highly leveraged global asset bubbles.

While this policy feeds the global asset bubble it is also feeding a new US asset bubble. Easy money, quantitative easing, credit easing and massive inflows of capital into the US via an accumulation of forex reserves by foreign central banks makes US fiscal deficits easier to fund and feeds the US equity and credit bubble. Finally, a weak dollar is good for US equities as it may lead to higher growth and makes the foreign currency profits of US corporations abroad greater in dollar terms.

The reckless US policy that is feeding these carry trades is forcing other countries to follow its easy monetary policy. Near-zero policy rates and quantitative easing were already in place in the UK, eurozone, Japan, Sweden and other advanced economies, but the dollar weakness is making this global monetary easing worse. Central banks in Asia and Latin America are worried about dollar weakness and are aggressively intervening to stop excessive currency appreciation. This is keeping short-term rates lower than is desirable. Central banks may also be forced to lower interest rates through domestic open market operations. Some central banks, concerned about the hot money driving up their currencies, as in Brazil, are imposing controls on capital inflows. Either way, the carry trade bubble will get worse: if there is no forex intervention and foreign currencies appreciate, the negative borrowing cost of the carry trade becomes more negative. If intervention or open market operations control currency appreciation, the ensuing domestic monetary easing feeds an asset bubble in these economies. So the perfectly correlated bubble across all global asset classes gets bigger by the day.

But one day this bubble will burst, leading to the biggest co-ordinated asset bust ever: if factors lead the dollar to reverse and suddenly appreciate – as was seen in previous reversals, such as the yen-funded carry trade – the leveraged carry trade will have to be suddenly closed as investors cover their dollar shorts. A stampede will occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a co-ordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments.

Why will these carry trades unravel? First, the dollar cannot fall to zero and at some point it will stabilise; when that happens the cost of borrowing in dollars will suddenly become zero, rather than highly negative, and the riskiness of a reversal of dollar movements would induce many to cover their shorts. Second, the Fed cannot suppress volatility forever – its $1,800bn purchase plan will be over by next spring. Third, if US growth surprises on the upside in the third and fourth quarters, markets may start to expect a Fed tightening to come sooner, not later. Fourth, there could be a flight from risk prompted by fear of a double dip recession or geopolitical risks, such as a military confrontation between the US/Israel and Iran. As in 2008, when such a rise in risk aversion was associated with a sharp appreciation of the dollar, as investors sought the safety of US Treasuries, this renewed risk aversion would trigger a dollar rally at a time when huge short dollar positions will have to be closed.

This unraveling may not occur for a while, as easy money and excessive global liquidity can push asset prices higher for a while. But the longer and bigger the carry trades and the larger the asset bubble, the bigger will be the ensuing asset bubble crash. The Fed and other policymakers seem unaware of the monster bubble they are creating. The longer they remain blind, the harder the markets will fall.

Credit and quantitative easing in advanced economies

"With policy rates close to the zero bound and the economies still on the downslide, major advanced country central banks have had to rely on unconventional measures to stabilize financial conditions and support aggregate demand.

The measures have differed considerably in their scope, and have inter alia included broad liquidity provision to financial institutions, purchases of long-term government bonds, and intervention in key credit markets.

Taken collectively, they have contributed to the reduction of tail risks following the bankruptcy of Lehman Brothers and to a broad-based improvement in financial conditions.

Central banks have adequate tools to effect orderly exit from exceptional monetary policy actions, but clear communication is central to maintaining well anchored inflation expectations and to ensuring a smooth return to normal market functioning."

Credit booms gone bust

This is one of the most comprehensive papers linking monetary, credit and leverage cycles I have read so far. It is written by Alan Taylor and Moritz Schularick and what a paper.

The crisis of 2008–09 has focused attention on money and credit fluctuations, financial crises, and policy responses. In this paper we study the behavior of money, credit, and macroeconomic indicators over the long run based on a newly constructed historical dataset for 12 developed countries over the years 1870– 2008, utilizing the data to study rare events associated with financial crisis episodes.

We present new evidence that leverage in the financial sector has increased strongly in the second half of the twentieth century as shown by a decoupling of money and credit aggregates, and we also find a decline in safe assets on banks’ balance sheets.

We also show for the first time how monetary policy responses to financial crises have been more aggressive post-1945, but how despite these policies the output costs of crises have remained large.

Importantly, we can also show that credit growth is a powerful predictor of financial crises, suggesting that such crises are “credit booms gone wrong” and that policymakers ignore credit at their peril. It is only with the long-run comparative data assembled for this paper that these patterns can be seen clearly.

The linkages between rise in various monetary aggregates – credit, assets, money- across two periods of globalization is fascinating stuff.

There are three views of money and credit:

The experience of the late nineteenth and early twentieth century, including the disruptions of the 1930s, formed the foundation of the “money view” which is indelibly associated with the seminal contributions of Friedman and Schwartz (1963). In this account, the level of the narrow and broad money supplies strongly influences output in the short run.

In the second half of the twentieth century the “irrelevance view” gained influence, associated with the ideas of Modigliani and Miller (1958) among others, where the details of the debt-equity financial structure of firms was inconsequential. Finance was a so-called veil. In this view, real economic decisions became independent of financial structure altogether.

Starting in the 1980s, the “credit view” has gradually attracted attention and adherents. In this view, starting with the works of Mishkin (1978), Bernanke (1983) and Gertler (1988), and drawing on ideas dating back to Fisher (1933) and Gurley and Shaw (1955), the mechanisms and quantities of bank credit matter, above and beyond the level of bank money.

In their analysis they look at the two eras of financial capitalism. First from 1870 to 1939 and then 1945 onwards. Findings:

during the first era of finance capitalism, up to 1939, the era studied by canonical monetarists like Friedman and Schwartz, the “money view” of the world looks entirely reasonable. Banks’ liabilities were first and foremost monetary, and exhibited a fairly stable relationship to total credit. In that environment, by steering aggregate liabilities of the banking sector, the central bank could hope to exert a smooth and steady influence over aggregate lending.

The relationships changed dramatically in the post-1945 period. First, credit began a long recovery after the dual shocks to the financial sector from the Great Depression and the war. Loans and bank assets took off on a very rapid upward trend in the Bretton Woods era as seen in Figure 1, and they managed to surpass their pre-1940 ratios, compared to GDP, by about 1970. Second, credit not only grew strongly relative to GDP, but also relative to broad money after WW2, via a combination of higher leverage and (after the 1970s) through the use of new sources of funding, mainly debt securities, creating more and more non-monetary bank liabilities.

The authors also point how credit has delinked from money growth from 1970 onwards and has zoomed. Read the whole thing. Plenty of graphs and interpretations.

This is what Paul De Gruawe et al also say in their paper on ECB strategy. The increase in money supply did not show in inflation as much of it was going in credit and assets. So ECB was complacent.

Federal Reserve's approach to monetary policy

  • Source: Vice Chairman Donald L. Kohn At the Federal Reserve Conference on Key Developments in Monetary Policy, Washington, D.C., October 9, 2009

"In many respects, central banks, including the Federal Reserve, have drawn heavily on important threads of monetary policy research in responding to the financial crisis over the past two years. For example, many of our efforts have involved the provision of liquidity to financial markets and classes of institutions facing funding pressures--a key prescription for central banks as far back as the classic writings of Thornton and especially Bagehot, whose message was that to avert panics, central banks should lend early and freely to solvent institutions, against good collateral and at high rates.4

Although flight to liquidity and safety may be rational behavior on the part of an individual market participant when uncertainty runs high, there is a danger that, left unchecked, such behavior can spiral into a damaging loss of confidence in solvent firms and in the financial system as a whole. In these circumstances, central banks are in a good position to provide liquidity to solvent firms without taking much, if any, risk.

By lending freely, the central bank can accommodate spikes in demand for liquidity, avert fire sales of assets that weaken other firms' net worth positions, and facilitate continued lending by financial institutions. By lending only to solvent firms with sufficient collateral and at a penalty rate, the central bank mitigates the moral hazard problem and other distortionary effects of its provision of assistance. To be sure, these important central banking principles have needed to be interpreted and applied in the real world, where the line between insolvency and illiquidity may be blurry. But the extraordinary actions taken so far during the financial crisis by the Federal Reserve and other central banks have closely adhered to these basic principles of central banking.

Another body of research that I believe has been valuable for the formulation of monetary policy over the past couple of years is the work that has examined the implications of the zero lower bound on nominal interest rates. The zero lower bound challenged monetary policy in Japan during the late 1990s, triggering a large volume of research. One of the main insights from this literature is that even when policy rates already stand at a relatively low level, central banks should cut rates aggressively in face of large contractionary disturbances.5 This insight influenced the historically large cuts in the federal funds rate during 2008.

One prerequisite for this type of aggressive policy response is a credible commitment to long-term price stability--an important implication of both standard models and experience. The public's understanding of the central bank's commitment to price stability helps to anchor inflation expectations, thereby contributing to stability in both prices and economic activity. The Federal Reserve has acted to enhance that understanding in the current environment by lengthening the horizon of the economic projections of Federal Open Market Committee (FOMC) participants and by providing additional information about their objectives for inflation. The stability of long-run inflation expectations during the current crisis has facilitated the policy response and should contribute to the recovery.6

Our efforts to inform the public better about our expectations for inflation illustrate another strand of research that has informed recent policy actions. This research has focused on the central role of communication in guiding private-sector expectations in a manner that contributes to stability in economic activity and inflation. Effective communication not only about inflation but also about the possible path of the policy rate may be particularly important at the zero lower bound, when the scope to influence expectations through changes in the policy rate is obviously limited.7 And, in a historically unusual period, the economic developments motivating central bank actions may be more difficult to interpret and predict than in typical periods, making such communication especially important.8 Notably, in FOMC statements since our policy interest rate was lowered to about zero, the Committee has provided some guidance about the future path of the federal funds rate.

Debt monetization

What is debt monetization and how does it work? How can constant interest rate rules make debt monetization automatic? Why is this a worry and how does it relate to the choice of a new Fed chair?

What it is and how it works

  1. Suppose the government runs a deficit. As an example, let government spending on goods and services be $10,000. For simplicity, all transactions are in cash. Let net taxes from all sources be $9,000 so there is a $1,000 deficit.
  2. The government has $9,000 in cash from taxes, but needs to spend $10,000. Somehow (print money, borrow money, raise taxes, or lower spending) it must get $1,000 more.
  3. Suppose it decides to borrow – issue new debt. Then the Treasury sells a government bond to someone in the private sector for $1,000. The person gives $1,000 in cash to the government and in return gets an IOU (perhaps for, say, $1,100 in one year).
  4. The government now has $9,000 in cash from taxes and $1,000 it has borrowed from the public so it can now purchase $10,000 in goods and services.
  5. Now let’s do the monetization step. This can happen automatically, as explained below, but for now let’s have the Fed conduct a $1,000 open market operation to increase the money supply. To do this, it cranks up the press, loads in some paper and green ink, and prints a brand new $1,000 bill. It takes the $1,000 bill and purchases a bond from the public, for simplicity make it the same bond the Treasury just issued. Then the money supply goes up by $1,000 (and may go up more through multiple deposit expansion) and government debt in the hands of the public goes down by $1,000 since the Fed now holds the bond. The increase in the money supply is inflationary.
  6. What has happened? When all paper has ceased changing hands, the $10,000 in goods and services is paid for by the collection $9,000 in taxes and by printing $1,000 in new currency. The government debt simply moves from the Treasury to the Fed (in the U.S., the Fed pays for its operations from its earnings on these bonds and remits the remainder to the Treasury; I believe the remittance is weekly, but I’m not positive on that).

How can constant interest rate rules potentially cause debt monetization to occur automatically?

Suppose the Fed follows a constant interest rate rule. Further suppose an increase in government spending increases the interest rate (see here for a paper on this by Benjamin Friedman posted at the NBER site today). That is, when the government issues new debt, the supply of bonds increases lowering the price and raising the interest rate. Under these assumptions what will happen when there is deficit spending?

  1. Deficit spending financed by borrowing from the private sector causes the interest rate to go up. Thus, initially two things happen, bonds held by the public (debt) increase and interest rate increases as well.
  2. But the Fed is following a constant interest rate rule. Seeing the interest rate rising, what should it do? It should increase the money supply and to do so it prints money, as above, and uses it to buy bonds from the public. In order to return the interest rate to where it started, all of the debt issued in step one must be purchased with newly printed money (can you smell the fresh ink?).
  3. In the end, what happens? It’s just as above, the entire deficit is financed by printing money and the debt issued by the Treasury ends up in the hands of the Fed.

This is one reason why the Fed has made so much noise lately about letting interest rates rise in the face of budget deficits. The Fed is sending a signal to fiscal authorities that it would rather let interest rates rise than monetize the debt and suffer the inflation that debt monetization brings about. So far we have been lucky in this regard. Long-term interest rates have remained low while budget deficits have increased. But if your read what Janet Yellen said yesterday, echoing remarks by other Fed officials, she is clearly concerned that this may not persist and that interest rates could rise quickly. The Fed is signaling that if the increase in interest rates is caused by budget deficits, the Fed is unlikely to intervene due to the inflationary consequences of monetization. It will allow interest rates to rise.

Is this a risk?

For me, this is one of the important considerations for the new Fed chair. I will be interested to hear the commitment of the new chair to fighting inflation even if it’s not a direct commitment to an explicit inflation target. There is every incentive for both parties to choose someone who will allow the debt to be at least partially monetized by allowing inflation to increase because this relieves congress of the responsibility for raising taxes or cutting programs. With debt monetization, government debt disappears and inflation takes its place. While the public moans at the Fed over high inflation, fiscal authorities, because the debt is monetized, are absolved of responsibility. The Fed is signaling it does not intend to monetize the deficit and I hope the choice for a new chair will maintain that commitment."

The US dollar shortage in global banking

Among the policy responses to the global financial crisis, the international provision of US dollars via central bank swap lines stands out.

This paper studies the build-up of stresses on banks’ balance sheets that led to this coordinated policy response.

Using the BIS international banking statistics, we reconstruct the worldwide consolidated balance sheets of the major national banking systems. This allows us to investigate the structure of banks’ global operations across their offices in various countries, shedding light on how their international asset positions are funded across currencies and counterparties.

The analysis first highlights why a country’s “national balance sheet”, a residency-based measure, can be a misleading guide to where the vulnerabilities faced by that country’s national banking system (or residents) lie.

It then focuses on banking systems’ consolidated balance sheets, and shows how the growth (since 2000) in European and Japanese banks’ US dollar assets produced structural US dollar funding requirements, setting the stage for the dollar shortage when interbank and swap markets became impaired.


  1. While dollarization is a rational response of economic agents to political or economic uncertainties, its adverse effects often motivate countries to reduce its level.2 Dollarization is also a rational reaction to interest rate arbitrage opportunities. It may have some benefits, and in extreme cases may be the only viable option available to a country. In the latter case, dollarization can be the choice of the authorities or a result of private agents’ decision to stop using the local currency. However, most countries seek to limit the extent of dollarization, owing to its potential adverse effects on macroeconomic policies and financial stability. These include a reduction or loss of control of monetary and exchange rate policy, a loss of seigniorage, and increased foreign exchange risk in the financial system and other sectors.
  2. A successful dedollarization policy makes the local currency more attractive to residents than foreign currency. Dedollarization entails a mix of macroeconomic and microeconomic policies to enhance the attractiveness of the local currency in economic transactions and to raise awareness of the exchange-risk related costs of dollarization, thus providing incentives to economic agents to dedollarize voluntarily. It may also include measures to force the use of the domestic currency in tandem with macroeconomic stabilization policies.
  3. Experience shows that, even in successful cases, dedollarization is protracted. Dollarization remains persistent even when macroeconomic stability and the credibility of government policies have been (re)established, i.e., when the original causes of dollarization have been eliminated.3 Once dollarization takes hold, economic agents are reluctant to switch back to using the local currency, because they lack confidence and the cost of redenominating transactions is high until consensus is reached among market participants on the use of the local currency. Indexation or a fixed exchange rate facilitates switching from foreign currency to local currency, but indexation may become persistent and the implicit guarantee of a fixed exchange rate can reinforce dollarization.
  4. This paper provides a summary of the key policies that encourage dedollarization. Few studies of dedollarization have been undertaken, even though it is an important policy issue in many emerging and developing economies. This paper draws on the experiences of countries that successfully dedollarized and of those that have had less success. While acknowledging that economic agents target a mix of foreign and domestic assets and liabilities to minimize the volatility of their portfolio, it does not address the optimal level of dollarization or policies to reduce the risks related to a given dollarization level. 4
  5. The paper concludes that dedollarization requires credible macroeconomic stabilization complemented by microeconomic measures. In addition to macroeconomic stabilization, two─–way exchange rate volatility and stable and low inflation are key ingredients of dedollarization. Additional policies and measures are often necessary to break persistent dollarization and encourage the use of the local currency.
  6. The paper is organized as follows. Following a brief overview of the causes and effects of dollarization in Section II, Section III discusses the macroeconomic and microeconomic policies and measures that contribute to dedollarization. Section IV analyzes the effect of dedollarization policies, in particular exchange rate volatility and prudential measures. An extensive review of the financial and prudential measures that can facilitate dedollarization are provided in Appendix I, Tables I─V.

Congress must increase the debt limit

"The Senate must soon increase the national debt limit to above $13 trillion — and Democrats are looking for political cover.

Knowing they will face unyielding GOP attacks for voting to increase the eye-popping debt, Democrats are considering attaching a debt increase provision to a must-pass bill, possibly the Defense Department spending bill, according to Democratic and Republican sources.

Adding it to the defense bill would allow Democrats to argue that they voted for the measure to help troops in harm’s way — and downplay that their vote also expanded the limit for how much money the country can borrow.

The strategy has not yet been finalized, aides and senators said. The House already approved a debt limit increase of $925 billion — above the $12.1 trillion ceiling Congress approved as part of the economic stimulus package last February — but Democrats may seek to increase the limit further so they don’t have to revisit the politically treacherous issue until after the 2010 midterm elections.

As of Tuesday, the debt stood at $11.95 trillion, staring at senators amid a roiling health care debate in which critics have seized on the potential costs of the overhaul. Unlike those of the House, the Senate’s rules do not allow it to automatically increase the debt with its adoption of the annual budget resolution. That puts senators in a tough position politically. And if the Senate balks at the increase, Treasury Secretary Timothy Geithner has warned that the slow economic recovery could collapse, as investors around the world would sharply lose confidence in America’s abilities to meet its credit obligations.

“This president inherited, in some ways, an economic fiasco,” said conservative Democratic Sen. Mary Landrieu of Louisiana. “It’s not going to be a pleasant vote, but it may be necessary until we can get back on track.”

Indeed, Democrats are quick to point out that President George W. Bush left President Barack Obama with a $10.6 trillion debt — and that the debt limit was increased seven times in the Republican’s eight years in the White House. But now Democrats are in charge of Congress and the White House; and the Treasury Department reported last week that the annual deficit for the fiscal year that ended Sept. 30 stood at a record $1.4 trillion, with that number likely to balloon under Obama’s policies.

Setting monetary policy - Australian approach

  • Monetary Policy and the Regions Glenn Stevens, Governor, Reserve Bank of Australia, Address to Foodbowl Unlimited Forum Business Luncheon, Shepparton, 20 September 2010

  • Source: The Conduct of Monetary Policy in Crisis and Recovery Glenn Stevens, Governor, Reserve Bank of Australia, Address to The John Curtin Institute of Public Policy and the Financial Services Institute of Australasia Public Policy Breakfast Forum, Perth - 15 October 2009

The Policy Framework

"...The centrepiece of the framework for monetary policy is a medium-term target for inflation. This framework combines two important principles that both theory and practical experience about monetary matters have taught us.

The first is that, in the long run, monetary policy is about the value of money – that is, prices. Over long horizons, the size of the economy and its average rate of growth will be driven by developments on the supply side – such as the availability of land and labour, the extent of accumulation of real capital, technology, and the efficiency with which we use all those factors. Monetary policy can’t make those factors grow faster.

The second is that, in the short term, monetary policy changes do affect the real economy, because they affect aggregate demand. If trend inflation has risen, for example, getting it down again usually requires a period of slower growth in demand. But we don’t want that period of slower growth to be any longer or more pronounced than necessary. By the same token, if as a result of some shock demand falls below potential supply capacity, the resulting downward pressure on inflation may provide scope for monetary policy to be easier for a time, which will help to limit the cyclical weakness in economic activity

Our objective of keeping consumer price inflation to 2–3 per cent, on average over time, strikes a good balance between these short-term and long-term considerations.

The ‘on average’ specification allows deviations from the target in the short term, which are often unavoidable anyway, but still embodies a commitment that those deviations will be reversed in a reasonable period of time. It allows the economy’s growth potential, determined by productivity, labour force growth and so on, to be realised. At the same time, the explicit numerical goal for inflation helps to anchor expectations of inflation and works to preserve the value of money.

As such, it is in our view fully consistent with, and gives practical expression to, the objectives given to the Bank in legislation: the stability of the currency (that is, its purchasing power); full employment; and the economic prosperity and welfare of the people of Australia. It has bi-partisan support in the Parliament. It has also been, in practice, over the 15 years we have been using it, the most effective framework for monetary policy Australia has had so far.

The target is expressed in terms of the Consumer Price Index (CPI). This is, of course, only one of a number of price indexes. But the CPI was chosen because: it is the best known and accepted published price index; it is pretty reliable; and it presents fewer analytical problems for this purpose than other measures of prices.

Statement on the Conduct of Monetary Policy

This statement records the common understanding of the Governor, as Chairman of the Reserve Bank Board, and the Government on key aspects of Australia’s monetary and central banking policy framework.

Since the early 1990s, inflation targeting has formed the basis of Australia’s monetary policy framework. Since 1996, this framework has been formalised in a Statement on the Conduct of Monetary Policy. The inflation targeting framework has served Australia well and is reaffirmed in the current statement.

This statement should continue to foster a better understanding, both in Australia and overseas, of the nature of the relationship between the Reserve Bank and the Government, the objectives of monetary policy, the mechanisms for ensuring transparency and accountability in the way policy is conducted, and the independence of the Reserve Bank.

This statement also records our common understanding of the Reserve Bank’s longstanding responsibility for financial system stability.

RBA actions in the North Atlantic crisis

"...Let me now turn to the actions of the RBA during the crisis, outside of the policy rate decisions. One summary way to compare the actions of the RBA with that of other central banks is to look at movements in their balance sheets. Graph 9 shows that the Reserve Bank provided a sizeable degree of liquidity support to the market following Lehman, but that our balance sheet has since declined as this liquidity support has been unwound. The graph also shows the substantial increase in the balance sheets of the Fed, ECB and Bank of England, which have all yet to decline.

One marked difference between the increase in our balance sheet and that of the Bank of England and the Fed, is that here, the increase resulted predominantly through our regular market operations (although the foreign exchange swap facility with the Fed accounts for a sizeable portion of the rise in our balance sheet, see below). In contrast, the bulk of the increase in the UK and US is from direct purchases of government securities (and mortgage securities in the US) associated with their policy of quantitative easing. The actions we undertook to provide liquidity to the domestic money market were conducted almost entirely within our pre-existing framework for market operations. We have always dealt with a wide range of counterparties (which are not just banks as is often mistakenly thought), and we have always had the capacity to adjust the term of our operations very quickly. Because we operate in the market every day, it is relatively straightforward for us to assess the degree of tension in the market and respond accordingly. Our operating system is flexible and we availed ourselves of that flexibility through the crisis period. Obviously our life was made easier by the fact that the difficulties we faced were markedly less than those in other countries, but the framework we had established over a number of years did make our task easier.

The extent of liquidity we provided can be gauged by looking at the evolution of exchange settlement (ES) balances which are the balances in the accounts that financial institutions hold with us. As counterparty risk rose, banks were more inclined to hold larger precautionary balances with us. To allow us to provide assistance to the debt markets by undertaking more repos without putting undue pressure on the overnight cash market, in late October, we introduced a term deposit facility This was effectively an ES balance held for a week or two, rather than overnight.

Graph 10 shows that balances held at the RBA peaked in late 2008 at the height of global risk aversion. But notwithstanding a recent seasonal increase around the end of the year, ES balances are back to around $1½ billion and banks no longer have any term deposits with us. So that aspect of our liquidity support has been fully unwound.

To provide some certainty to longer term funding, we offered 6 month and 1 year terms for our repos on a daily basis from October 2008. But as demand for these longer terms diminished, we ceased offering these daily, although we are still willing to deal at these longer terms if it is consistent with our liquidity management objectives and the pricing is appropriate.

Another action we took during the crisis was to expand the sphere of collateral eligible for our market operations. We now accept all AAA-rated paper (except highly structured paper). As I have said before, we intend to maintain that wider collateral pool. Another significant change to our collateral policy we made was to accept so-called self-securitised RMBS from the issuing institution. Our counterparties made extensive use of this, particularly as collateral for our longer-term repos. By the end of December 2008, self-securitised RMBS accounted for just under half of our repo collateral. But as those repos have matured, their share of our collateral has declined to under a quarter.

Finally, in October 2008, we, along with a number of other central banks, established a foreign exchange swap facility with the Fed. This facility was introduced to address the global shortage of US dollars (outside the US) which was causing a substantial dislocation in swap markets.5 Under this facility, we auctioned US dollars, obtained under swap from the Fed for Australian dollars, to our domestic counterparties in exchange for domestic collateral. (We took a larger than normal margin on that collateral to protect us from the exchange rate risk). Usage of this facility peaked at the end of December 2008 and it was last accessed here in April 2009. The facility was formally terminated, along with those of other central banks, on 1 February.

The clear theme here is that the RBA did provide assistance to contribute to the smoother functioning of financial markets through the turbulence, but the assistance we were required to provide was considerably less than in other countries, and importantly, we have been able to unwind it as market conditions have improved..."

Euro and the Greek bailout

"Derivative traders are signaling that the euro’s slump to a nine-month low will continue even if European Union leaders bail out Greece.

Short-term rates for borrowing in euros in the forwards market are the cheapest relative to loans in dollars since September. The 50 percent collapse in that spread this month signals investors are betting the European Central Bank will keep its target interest rate at a record low, sacrificing euro strength to prevent deficit cutting by debt-laden economies in the region from stymieing growth.

“Investors have already started to think about the next likely phase of the present crisis, and it appears that all they are finding are new reasons to sell the euro,” said David Woo, global head of foreign-exchange strategy at Barclays Plc in London. “Aggressive fiscal tightening by Greece, Spain and Portugal are likely to plunge their economies back into recession. All else being equal, this calls for a looser monetary policy.”

The shift underscores a turnabout in the two most-traded currencies. In the last three quarters of 2009, the euro outperformed the dollar relative to 15 major currencies tracked by Bloomberg, with Deutsche Bank AG’s euro index gaining 1 percent and the IntercontinentalExchange Inc.’s Dollar Index down 9 percent..."

The effects of exchange rate policies

US Treasury Semi-Annual Report to Congress

"The U.S. Department of the Treasury today released the Semi-Annual Report to Congress on International Economic and Exchange Rate Policies, as required under Sections 3004 and 3005 of the Omnibus Trade and Competitiveness Act of 1988. The report covers the period from January 2009 through June 2009, but where available and appropriate, information through early October 2009 is included. The report, along with past reports, can be found at

The report describes U.S. economic developments as well as international economic, financial, and exchange rate developments during the first half of 2009. In particular, it focuses on the policy actions that major U.S. trading partners – representing more than 80 percent of U.S. international trade – have taken to lay the foundation for economic recovery.

During the period under consideration, virtually every country and economic area described in the report put in place additional monetary and fiscal measures to bolster demand. These forceful actions worked, and the report shows that financial conditions in the United States and around the world have improved dramatically and signs of an economic recovery have begun to emerge. Global current account imbalances have fallen sharply during the crisis from a peak of 5.9 percent of world GDP to an IMF-estimated 3.6 percent in 2009. The U.S. current account deficit has fallen from a peak of 6.5 percent of GDP in the fourth quarter of 2005 to 2.9 percent of GDP in the second quarter of 2009.

As noted in the report, Treasury has concluded that no major trading partner of the United States met the standards identified in Section 3004 of the Act during the most recent reporting period.

Low inflation = lower volatility of imports

This paper explores the effect of terms of trade volatility on macroeconomic volatility using a panel of 71 countries from 1971–2005. It finds that terms of trade volatility has a statistically significant and positive impact on the volatility of output growth and inflation, although the magnitudes of these effects depend on the policy framework and the structure of markets.

Specifically, adopting a more flexible exchange rate tends to ameliorate the effect of terms of trade shocks on macroeconomic volatility. The paper also finds some evidence that a monetary policy regime that focuses on low inflation helps to moderate the volatility of output and inflation in the face of a volatile terms of trade.

The same is true of financial market development in the case of output volatility. Using data on the expenditure components of GDP, the channels through which terms of trade shocks affect output are examined. The results suggest that terms of trade volatility has its largest effect on the volatility of consumption, exports and imports. There is evidence to suggest that greater financial market development helps to mitigate the effect of terms of trade volatility on consumption volatility, while monetary policy that focuses on low inflation is associated with lower volatility of imports.

International monetary systems

"Mark Carney, Governor of the Bank of Canada talks on international monetary system (IMS) in his recent speech.

The international monetary system consists of

  • (i) exchange rate arrangements;
  • (ii) capital flows; and
  • (iii) a collection of institutions, rules, and conventions that govern its operation.

Domestic monetary policy frameworks dovetail, and are essential to, the global system. A well-functioning system promotes economic growth and prosperity through the efficient allocation of resources, increased specialization in production based on comparative advantage, and the diversification of risk. It also encourages macroeconomic and financial stability by adjusting real exchange rates to shifts in trade and capital flows.

Carney then provides a snapshot of 3 IMS we have had – Gold Standard, Bretton Woods and current hybrid system. On th present system he says:

After the breakdown of the Bretton Woods system, the international monetary system reverted to a more decentralized, market-based model. Major countries floated their exchange rates, made their currencies convertible, and gradually liberalized capital flows. In recent years, several major emerging markets adopted similar policies after experiencing the difficulties of managing pegged exchange rate regimes with increasingly open capital accounts. The move to more market-determined exchange rates has increased control of domestic monetary policy and inflation, accelerated the development of financial sectors, and, ultimately, boosted economic growth.

Unfortunately, this trend has been far from universal. In many respects, the recent crisis represents a classic example of asymmetric adjustment. Some major economies have frustrated real exchange rate adjustments by accumulating enormous foreign reserves and sterilizing the inflows. While their initial objective was to self-insure against future crises, reserve accumulation soon outstripped these requirements. some cases, persistent exchange rate intervention has served primarily to maintain undervalued exchange rates and promote export-led growth. Indeed, given the scale of its economic miracle, it is remarkable that China’s real effective exchange rate has not appreciated since 1990.

In each major global crisis we have had to reform our IMS. We cannot continue with the current IMS as well. Changes need to be made as we would end up in similar problems later on as well.

So what is the way forward? He suggests some options:

The first is to reduce overall demand for reserves. Alternatives include regional reserve pooling mechanisms and enhanced lending and insurance facilities at the IMF. While there is merit in exploring IMF reforms, their effect on those systemic countries that already appear substantially overinsured would likely be marginal. As I will touch on in a moment, the G-20 process may have a greater impact.

He explains these in details.

Corporate borrowers bulk up balance sheets

"Borrowers have sold more than $1 trillion in U.S. corporate bonds in 2009, the fastest pace on record, taking advantage of lower rates and government support to bolster cash holdings after last year’s credit freeze.

Citigroup Inc., the third-largest U.S. bank by assets, and General Electric Co.’s finance unit in Stamford, Connecticut, were the year’s biggest issuers, according to data compiled by Bloomberg. Sales compare with $873.2 billion in all of 2008, and $1.17 trillion for 2007, the biggest year for bond sales.

Issuance soared as companies that couldn’t sell debt following the collapse of Lehman Brothers Holdings Inc. in September 2008 grabbed at opportunities to tap the market. Investors reached for yields near the widest on record relative to benchmark Treasury rates, amid a wave of government intervention to repair financial markets, according to Mark Kiesel, global head of corporate debt portfolios at Pacific Investment Management Co., manager of the world’s largest bond fund.

“Credit markets have the wind at their back, thanks to accommodative fiscal and monetary policy from global central banks,” Kiesel wrote this month on Newport Beach, California- based Pimco’s Web site. “Many investors who swung aggressively into credit were rewarded well for the risk they took.”

Corporate bond spreads tightened 4.59 percentage points this year to 3.45 percentage points as of Oct. 9, according to Merrill Lynch & Co.’s U.S. Corporate & High Yield Master index. Spreads narrowed to 3.43 percentage points on Sept. 24, the tightest this year.

Using that index, corporate bonds, including reinvested interest, have returned 23 percent this year, which is better than any full year since 1997, the Merrill Lynch data show.

The Federal Reserve last year cut its target for overnight loans among banks to a range of zero percent to 0.25 percent as the government created programs to free up credit amid the worst crisis since the Great Depression. Financial companies sold $192 billion of debt in 2009 under the Temporary Liquidity Guarantee Program, which opened a new avenue for funding for banks shut out of debt markets since September.

As the government’s efforts to revive credit markets took hold, corporate-bond issuance surged at the beginning of the year “as if somebody had turned a light switch on,” said Chuck Lieberman, chief investment officer at Advisors Capital Management LLC in Hasbrouck Heights, New Jersey.

“A year ago, we were only buying high-quality credit with short maturities,” Lieberman said in a telephone interview. “By early 2009, we had switched completely and were buying BBB and BB, and only long maturities.” Lieberman said his firm is buying BB- and B-rated credit as returns on the higher-quality debt are no longer attractive.

Central banks increasingly snubbing dollars

Central banks flush with record reserves are increasingly snubbing dollars in favor of euros and yen, further pressuring the greenback after its biggest two- quarter rout in almost two decades.

Policy makers boosted foreign currency holdings by $413 billion last quarter, the most since at least 2003, to $7.3 trillion, according to data compiled by Bloomberg. Nations reporting currency breakdowns put 63 percent of the new cash into euros and yen in April, May and June, the latest Barclays Capital data show. That’s the highest percentage in any quarter with more than an $80 billion increase.

World leaders are acting on threats to dump the dollar while the Obama administration shows a willingness to tolerate a weaker currency in an effort to boost exports and the economy as long as it doesn’t drive away the nation’s creditors. The diversification signals that the currency won’t rebound anytime soon after losing 10.3 percent on a trade-weighted basis the past six months, the biggest drop since 1991.

“Global central banks are getting more serious about diversification, whereas in the past they used to just talk about it,” said Steven Englander, a former Federal Reserve researcher who is now the chief U.S. currency strategist at Barclays in New York. “It looks like they are really backing away from the dollar.”

The dollar’s 37 percent share of new reserves fell from about a 63 percent average since 1999. Englander concluded in a report that the trend “accelerated” in the third quarter. He said in an interview that “for the next couple of months, the forces are still in place” for continued diversification.

America’s currency has been under siege as the Treasury sells a record amount of debt to finance a budget deficit that totaled $1.4 trillion in fiscal 2009 ended Sept. 30.

Intercontinental Exchange Inc.’s Dollar Index, which tracks the currency’s performance against the euro, yen, pound, Canadian dollar, Swiss franc and Swedish krona, fell to 75.77 last week, the lowest level since August 2008 and down from the high this year of 89.624 on March 4. The index, at 76.104 today, is within six points of its record low reached in March 2008.

Foreign companies and officials are starting to say their economies are getting hurt because of the dollar’s weakness.

Bribery and currency paper maker Securency

Securency is an Australian joint venture company which is 50% owned by the Reserve Bank of Australia (“RBA”) with the remaining 50% being owned by Innovia Films (“Innovia”).

The Company is governed by the Board of Directors of which four members are appointed by each of the joint venture partners. The Chair of the Board, appointed by the RBA, is presently Dr Bob Rankin (since 2008). From 1998 to 2008 the Chair was Mr Graeme Thompson.

The Company’s core business is the manufacture and supply of polymer substrate (“product”) to central banks and other government authorities which is used in the production of banknotes and other security documents. The base material used for polymer banknotes is produced by Innovia. To date 29 countries from around the globe have issued polymer banknotes.

The Company has grown very rapidly in recent years. In 2003 the Company had one production line and sales volume of approximately 50,000 reams. It now has three production lines across two plants in two countries and an annual production of approximately 200,000 reams.

At the request of Securency, the Australian Federal Police (“AFP”) is investigating the possible commission of criminal offences related to allegations of bribery of foreign government officials.

In addition, the Board of Securency Directors (“the Board”) is also seeking to determine:

  • Whether the law or the Company’s processes or procedures have been contravened;
  • If it can continue to feel confident in the information being provided by management; and
  • Where improvements can be made to the Company’s procedures and processes.

We make the following findings in relation to payments to Agents:

  • Management received advice from the Company’s legal advisors that Securency should keep a register of all payments to Agents, which documents all relevant information relating to payments, including the payment dates, payee, monetary amount, reason for the payment and the reasons for all payments to Agents in countries in which they are not domiciled. It is not clear whether this advice suggests that the Company should maintain a single, centrally managed register or some other similar system in which to record this information. Despite this, we have are not aware of a register, file or any other system that records and documents all of the information contemplated by the legal advice.
  • A number of payments have been made to certain Agents’ bank accounts located in jurisdictions outside of their country of residence. Management did seek advice from its legal advisors in relation to the appropriateness or otherwise of making payments in this manner to particular jurisdictions. That advice recommends that Securency subject Agents who requested to be paid in a bank account located outside their country of residence to a higher level of due diligence prior to agreeing to payment into such an account. However, we found no evidence that management complied with this advice and the reasons for approving payments to these bank accounts in these jurisdictions have not been recorded.
  • Management has, contrary to the Company’s Agent remuneration model, made a number of non-commission related payments to some of its Agents. There is nothing inherently improper with this; however, the reasons for these non-commission payments are not readily ascertainable in the absence of the documentation of these payments in a central payments register. Upon our review of the relevant supporting documentation, many of these payments are classified as reimbursements and in most cases the payments were not disclosed to the Board as payments to Agents.


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