In the closed door offices of central bankers from Brazil to Moscow, there is a growing concern that the currency wars of QE I, II and III will eventually take a turn for the worst. And there is not much they can do about it.
While it might not be a surprising turn, the problem is no one really knows what to do when inflation hits the U.S. and elsewhere.
"In the not-so-distant future the world’s central bankers will have to find alternative global reserve currencies to replace the developed world incumbents," says Jan Dehn, an economist with the Ashmore Group in London, a wealth management firm with $71 billion under management. "China has seen the light, but other emerging market countries are still to fully grasp the risks and opportunities associated with the demise of the global reserve currencies in the years ahead," says Dehn.
For the layman, what Russian and Brazilian central bankers do is of no concern. But in the big bad world of dollars, euros and yens, those bankers are holding the gold. Some 80% of all foreign currency reserves are sitting in a bank somewhere in the emerging markets. China alone has over $4 trillion in reserves. Russia, Brazil and India have a little over a trillion combined.
It's not that China has seen the light, per se. It's the only large economy that stands a chance at becoming a reserve currency. And to some degree, it already is. More than 50 central banks are holding the Chinese renmimbi (RMB) in reserves and more are considering doing so.
China's RMB is not fully convertible like other reserve currencies and is therefore not liquid enough for massive trades. That is expected to change. Wheels are in motion. China is really the only possible addition to the current reserve class. It makes most sense that the RMB eventually become a hold in those funds. After all, this is the world's No. 2 economy.
More than 95% of global foreign exchange reserves are today held in dollars, euros, pounds and yen. Central banks in those countries have been tasked with fixing problems that go beyond what central bankers normally do. Since the days of Ben Bernanke at the U.S. Federal Reserve, portfolio managers have been following the whims of central bankers from Tokyo to Washington, betting on toxic asset purchases like the mortgage backed securities repurchases that guaranteed a price for those old subprime assets, and bonds in general. They have, in effect, helped drive up equity prices even when growth in countries like Japan was zero. Who knew that a 1% yielding bond would be priced at a premium of 50%. Or, that countries in northern Europe would actually be able to force banks and insurers to buy negative yielding debt. Crazy things have happened in core economies governed by central banks on QE.
Over the last five years, those central banks have helped push Japanese equities up 38%, U.S. equities up 94% and European equities (
Yes, China has high debts. But the core economies have even higher total debt burdens.
QE saved the world from a Great Depression 2.0, but it is not without its consequences, says Dehn. The problem is, the consequences will mainly be felt in those cash-heavy emerging markets. It's by design.
"It is obvious that (the U.S.) will only be able to meet some of the objectives they have set. At best, they will succeed in converting their debt problems into inflation problems. But when they do so, the world is likely to wake up to a new and difficult problem – how to find new, healthy currencies to replace the current global reserve currencies," he says.
What's So Great About Being A Reserve Currency?
Being a world reserve currency comes with benefits. For one, the U.S. does not have any problem financing its deficits. There is a sovereign wealth fund in Qatar that will fund federal budgets, as there is surely the Bank of Japan and People's Bank of China, the top two foreign buyers of American debt.
Demand for American debt keeps interest rates low, which helps spur both lending and borrowing. Acquiring things -- whether it's a new car or a Cosco container full of shoes -- is easily funded in the U.S. That reality is simply not the case in Latin America, Africa and mostly all of Eurasia, including Russia.
A country with global reserve currency status does not need to hold cash reserves. The U.S. has $121 billion. Brazil has $371.2 billion.
Emerging market nations were required to keep cash reserves in order to save free-floating currencies from speculative attacks. Lenders also demanded governments to hold enough cash to pay interest on foreign debts. Reserves are security.
Still, a country like Brazil could probably put that money to better use. Instead, the money is being used to fund the U.S., while Brazil's government receives low yield for doing so. When interest rates rise, the Treasury debt sitting in Brazil will be worth less than it was when they bought it.
Of all the big emerging market central banks, China is the only one truly capable of obtaining reserve status. The IMF is meeting later this year to discuss whether to include the RMB in its basket of Special Drawing Rights, which is the IMF's currency. If so, China could be in a position to quickly increase its percentage of world central bank currency holdings.
Such a move depends as much on the IMF decision makers, however, as it does on Beijing policy makers.
When the rest of the world discovers that the global reserve currencies are not worth the paper they are written on, China will look like a nice paper alternative. Indeed, this is why investment banks like Ashmore, HSBC and others are betting on the renmimbi to become a truly convertible, liquid fixed income investment. Monetary policy in the core is playing a role in that.
"One can hope that the rise of the renminbi will provide a wake-up call for other central bankers from the inertia induced by a temporarily strong dollar," Dehn says.
Technocrats in the emerging market central banks say that once inflation takes hold in the dollar and euro, then the purchasing power of their reserves will decline rapidly. How does one sell $10 million in debt yielding 2% when you can get $10 million in debt from the same Treasury department yielding 3%? You sell it at a capital loss, buy the 3% and then do it again when it goes to 4%. That's the future these bank's are looking at now in their crystal balls.
Perhaps, says Dehn, this is exactly what the U.S., European Union and Japan want. By debasing their currencies again, they will be passing the cost of adjustment to foreigners instead of inflicting politically costly austerity on voters at home.
For those nations, even if they were holding a few billion more renmimbi, that reality would not change. Until China's currency is as free-floating as the reserve currencies of today, the RMB can only take up so much space in a central bankers bank account.
