Global Economy on the Verge of another Crisis (FREEPOM)

Economics, FREEPOM

Canada Crashes, the Asian Monetary Fund, and the SDR2

By JC Collins

The world is only about four weeks away from the first Federal Reserve interest rate increase in ten years.  While many have proclaimed that increasing rates in the current debt ridden world is impossible, the increasing odds of such an increase (now over 70%) would suggest that the majority of economists and investors feel differently.  It wasn’t that long ago that so many said the Fed could never end Quantitative Easing.  The fact that QE ended has passed without much fanfare or notice by those promoting such conclusions.

The same will happen with the “Fed can never raise interest rates” crowd.  Fortunately the focus will shift from whether rate increases are possible, to the effects which a rate increase, and subsequent rate increases, will have on the global economy.  The negative effects of increases will put strain on the emerging economies and create additional exchange rate volatility.  The dollar may initially strengthen, but will likely begin to depreciate in the weeks and months after the first rate increase.

The increased cost of borrowing will also create havoc with many banks, institutions, funds, derivatives, existing debt, and corporations with crashing EBITDA.  The argument which has been made as to why interest rates cannot be increased revolve around this negative and at times, catastrophic response.  What isn’t considered is that an unwinding and cleansing of the existing system could very well be exactly what is intended.  The insolvent companies and banks will fail and new and existing ones will purchase up the assets at reduced values.

Global liquidity is somewhat of a different issue, though tied to the draining of the US denominated tank.

The admission of the Chinese renminbi into the exclusive Special Drawing Right basket of the International Monetary Fund is the hot button issue which will determine the path forward on many of these issues.  It is expected that the IMF will announce on November 30th what its decision will be.  Though it is speculated that the inclusion of the Chinese currency is all but certain.

The one factor which isn’t considered when discussing the SDR and RMB probabilities is the IMF Quota and Governance Reforms which were agreed upon by the G20 back in 2010.  The idea was to give the emerging economies a larger piece of the funds quota system which would help provide liquidity in the event of another financial crisis.

More on those reforms below.

The financial crisis of a few years back was sparked above and beyond all other things by the deficit and surplus imbalances in the global economy.  The large accumulation of foreign exchange reserves will need to be reversed in order to prevent the coming contagion from collapsing the whole system.

But to think that a strategy has not been devised and rolled out in incremental steps over the last 7 years would be both foolish and illogical.  The process of reserve diversification has already begun as the People’s Bank of China has established bi-lateral swap lines with many central banks around the world.  When the RMB is admitted into the SDR it is expected that over half a trillion dollars’ worth of renminbi will be created overnight.  Overtime a decrease in USD denominated reserves of equal amount take place, and will be offset by the accumulation of RMB reserves.  But this will still not address the issue of reserve accumulation and the potential for further imbalances down the road.

The shift between reserves could further destabilize exchange markets and have unforeseen consequences.  Such cause and effect could be used as a justification for replacing reserve currencies with SDR.  There are multiple methods which could be used with the most probable solution revolving around the substitution account process where existing reserves are exchanged for SDR.

The IMF will take the financial burden under such an arrangement and would suffer the losses from exchange rate changes.  The expectation that the Fund’s members would share in the costs associated with those losses is what prevented the substitution account process from being implemented in the past.

Currently SDR are only created through allocation.  This means that any reserve substitution will be self-limiting.  If the International Monetary Fund was given the ability to sell SDR directly to central banks, some of those self-limiting challenges can be reduced.  Not to mention that losses on existing reserves could be offset by gains realized on SDR loans, which would eliminate the need for one country or institution to take the losses when exchange rates adjust.

See the post The Case for Increasing Interest Rates and Depreciating the Dollar for further details on the use of substitution accounts and how a substitution account reserve fund could be used by the IMF to offset dollar denominated losses.

The IMF could use the newly created SDR to purchase the Treasury bonds, and other government obligations, from those countries whose currency is held at reserve status within the SDR itself.  This is the most important reason for the renminbi to be added to the basket.  The liquidity that could be created through such a process would be beneficial during the next financial crisis.  A crisis which could very well start when the Fed begins to raise interest rates.

These specially allocated SDR’s would allow the IMF to act as an international lender of last resort, lending which would take place in multiple currencies, namely those in the SDR composition, which will soon include the renminbi.

Another probability if the 2010 reforms are not implemented by the end of this year is to bypass the US veto by creating an SDR2 which would work in conjunction, but separate, with the main SDR.  See the post Introducing the Alternative SDR2 for more information on the possibility and structure of such an arrangement.

Under an SDR2 arrangement, China could lend large amounts of its foreign reserves to both the International Monetary Fund and the Chiang Mai Initiative Multilateral.  As I’ve state before, the CMIM will evolve into the Asian Monetary Fund, a subservient institution under the IMF.  See post Meet the Asian Monetary Fund.  This sort of reserve-pooling would eliminate the need for quota reforms within the IMF and in effect bypass the United States on its delay of implementing the agreed upon 2010 Quota and Governance Reforms.

The American delay on these reforms is not an accident, or a partisan issue.  It would appear that the US Treasury and Democrats are on one side of this diametric, while the Republicans are on the other.  One wants the reforms while the other keeps delaying.  But it is now looking probable to most that all parties involved within the US structure have been working towards an acceptable delay script which will end when interest rates increase and the turmoil begins to rumble through the global economy.

It has always been the POM analysis that a strategy of problem/reaction/solution is being used to corral the economic sovereignty of nations.  The last two years of research and writing has only confirmed this for me further

When we consider that money market rule changes, which are set to take place in the US next October, will push half a trillion dollars’ worth of investment into Treasuries, the path forward becomes even more obvious.

A massive shifting of reserves is set to begin in the coming months as the Fed increases interest rates.  China will be forced to end the managed peg to the dollar so as to allow their currency to appreciate against the dollar.  See the post The Mystery of the October SDR for more information on the changing money market rules, and the post Renminbi SDR Weight and the End of the Dollar Peg for additional insight.

With interest rates increasing, the pressure placed on the emerging economies will be offset by the exchange rate pressures placed upon the US by a shifting of the reserves, whether through substitution or lending.  If the RMB is indeed added to the SDR basket as expected, at a potential weight of 14% to 16%, we could see a more orderly response to the changing dynamics of the international monetary framework.

Time will tell.

But what is certain is that the next crisis is close at hand, and it is a crisis which has been planned for since at least 2009 and 2010.  How effectively the world responds will depend on the factors reviewed above.

It may appear easy to sit here and write words on a computer telling people not to panic, but appearances are deceiving.  The main industry which I work within is being hammered by the collapse in crude and other commodity prices.  Not a week goes by that I don’t hear about more layoffs and project cancellations.

Along with that, Canada is set up for an epic housing market crash and our new Liberal government has just announced that the budget they committed to as a campaign platform is now all but dead in the water.  It will take years for my country to climb back out of the financial hole it has dug for itself during the boom years.

Let’s not forget that if the Fed in fact raises interest rates next month, the Bank of Canada will have to follow in short order, or the CND will depreciate even further against the USD. And when interest rates increase in Canada the housing bubble here will begin to contract with renewed vigor and those holding personal debt (Canadians have the highest personal debt in the world) will be left holding much heavier Visa card  and personal line of credit statements.

At a truck stop the other week I saw the following graffiti written on a bathroom stall.  “Please god, bring another boom.  I promise I will spend less and save more”.  When I reflect on the last eight years I feel like the US may be ahead of the curve.  The rest of the world, including my home Canada, are about to experience the crisis which America experienced in 2008.  In the meantime my friends south of the border will be experiencing massive job creation as the USD depreciates and exports explode.

The boat will rock, of that there is no doubt, but the international strategy is coming more into focus, and perhaps, just perhaps, things may not be as bad as many expect.  At least outside of Canada.  – JC

Interested and optimistic readers may also find value in the post The Coming Commodities Boom.

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