Page 3 of 4 CHINA'S DOLLAR MILLSTONE, Part 1 Breaking free from dollar hegemony
By Henry C K Liu
necessary. But the SHIBOR, as a market benchmark, will be set by the market and
all market participants. Yi asserts that all parties concerned including
financial institutions the National Inter-bank Funding Center and National
Association of Financial Market Institutional Investors should have a full
understanding of this, and actively play a role in the operations of SHIBOR as
"stakeholders", the new buzzword in Chinese policy circle, thanks to Robert
Zoellick.
Yi said that "under the command economy, the central bank is the leader while
commercial banks are followers. But from the current [market economy]
perspective of the central bank's functions, the bipartite relationship varies
on different occasions. In terms of monetary policies, the central bank, as the
monetary
authority, is the policy maker and regulator, while commercial banks are market
participants and players. But in terms of market building, the relationship is
not simply that of leader and followers, but of central bank and commercial
banks in a market environment. This broad positioning and premise will have a
direct bearing on how we behave. On the one hand, it requires the central bank
to work as a service provider, a general designer and supervisor of the market.
On the other hand, it requires market participants and various associations to
cultivate SHIBOR as stakeholders and players on a leveling playground."
The fact of the matter is that in the US, the central bank, in addition to
being a lender of last resort, has become a key market participant in the repo
market (in which, effectively, stock is borrowed or lent for cash, with the
stock serving as collateral) to keep short-term interest rates aligned with the
Fed funds rate target set by the Fed Open Market Committee. Until proposed
reforms are adopted by Congress, the Fed is not the regulator of non-bank
financial institutions, be they investment banks and brokerage houses, hedge
funds, private equity firms, or the recently active foreign funds.
The role of regulating the issuing of securities in the US belongs to the
Security Exchange Commission (SEC), created by the Securities Act of 1933 to
protect investors by maintaining fair, orderly and efficient markets while
facilitating capital formation. Securities offered to the general public must
be registered with the SEC, requiring extensive public disclosure, including
issuing a prospectus on the offering. It is a time-consuming and expensive
process.
Most commercial paper, the market that precipitated the credit crisis in August
2007, is issued under Section 3(a)(3) of the 1933 Act, which exempts from
registration requirements short-term securities with certain characteristics.
The exemption requirements have been a factor shaping the characteristics of
the commercial paper market. Private equity firms with fewer than 15 investors
and hedge funds, even though they may control billions of equity and multi
billions of credit, are not regulated by the SEC.
When the Federal Reserve and other central banks have taken crisis-induced
actions since August 2007 to calm markets to get market participants to believe
that the financial system will continue to operating normally, market
indicators, such as London InterBank Offered Rate (LIBOR), on which SHIBOR is
modeled, suggest that the Fed's message has not been accepted by market
participants. The LIBOR, a global benchmark, normally trades predictably at
only a few basis points (hundreds of a percentage point) above the federal
funds rate. It is a "traded version of the fed funds rate". As such, it's an
important benchmark for determining lending rates on big corporate deals,
mortgages and other lending markets.
LIBOR has been out of normal alignment with the Fed funds rate since the credit
crisis began in August 2007. The Fed and the European Central Bank have already
been greasing the markets by adding liquidity through reserve operations. When
the credit crisis broke, one-month LIBOR was traded at an abnormally high 5.82%
when the Fed funds rate target was 5.25%, a 57 basis points spread, and the Fed
discount rate was cut 50 basis points to 5.75%. The Fed has since cut the fed
funds rate target from 5.25% to its current 2% and the discount rate from 6.24%
to 2.25%, but the spread between the Fed funds rate and LIBOR has not narrowed.
Three-month dollar LIBOR was trading at 2.75% as of July 11, 2008, 75 basis
points above the Fed funds rate. It means banks are not willing to lend
short-term money to each other for fear of counterparty default. Also, as part
of general tightening in the current credit crisis, banks have been hoarding
cash to respond to the frozen asset-backed commercial paper market. Many
European banks have committed to credit lines to big issuers of this paper, and
because nobody wants to take on more of that paper, those paper-issuing
companies are forced to borrow from banks using their bank credit lines -
making banks need more cash to build up required reserves. With more than $1
trillion of commercial paper set to come due every six weeks since August 2007
and more than $700 billion as of June 2008, banks are reluctant to tie up their
reserves lending to other banks even at rates that would normally seem
extremely attractive.
At present, lending and deposit interest rates are regulated in China with a
floor lending rate and a ceiling deposit rate. Central banker Yi said that
"[W]hen clients complain about high interest rate, commercial banks can pass
the buck to the central bank because the central bank sets the interest floor.
When SHIBOR matures, SHIBOR will become the culprit. Such a change bears
important legitimacy, authoritativeness, and persuasiveness, and can make
SHIBOR a recognized and authoritative benchmark."
Yi sees market-based interest rates coming from deregulation. But if the
central bank deregulates deposit rate ceiling and lending rate floor when there
is no other reliable benchmark to substitute them, the result could be worse.
When is the right timing for deregulation? The answer is when a new benchmark
matures. SHIBOR is an important benchmark in the process of making interest
rates more market-based. An interest rate floor and ceiling are likely to exist
for some period. Can the market-based interest rate transformation process
start with discount rate linking with SHIBOR? In fact, discount facilities are
loans. A breakthrough with the discount rate will have a far-reaching impact on
market-based interest rate transformation, and provide experience for future
interest rate reform, according to Yi.
Yi touched on the relationship between SHIBOR and internationalization of the
yuan. In the past, the central bank looked only at the domestic market, but now
it must adopt a global perspective. Many currencies in the world have their
benchmark interest rates, including LIBOR, EURIBOR, Japan's TIBOR and so forth.
The launch of SHIBOR shored up transaction volume in the Chinese money market.
Comparatively speaking, Shanghai's money market capacity now is much smaller
than that of London and New York. But the yuan will soon become an important
currency in the world, so China will steadily push ahead with yuan
convertibility under the capital account.
At present, great appreciation pressure on the yuan driven by large amounts of
capital influx is to a large extent due to a positive speculative outlook of
China's economy and purchase of yuan-denominated assets by foreign companies
and individuals. The money market is part of the financial infrastructure that
will establish the role of the yuan in world markets, according to Yi.
Many existing financial products are linked to interest rates set by the PBoC.
So when the PBoC adjusts interest rates, multiple factors have to be taken into
account so as to balance the interests of various parties. Any move to balance
interests involves different interest groups and complex situations. So a
widely accepted and objective benchmark is needed, and SHIBOR can serve that
need. More products, from company provident funds, public welfare funds,
company trust funds to wealth management products, housing provident funds and
broker depository funds can be linked to SHIBOR.
Chinese equity markets have been taking a beating in recent months. The
Shanghai Composite Index fell from a peak of 6,124 in mid-October 2007 to 2,566
in early July 2008, a fall of 58%, largely due to the rising exchange value of
the yuan and market pressure on yuan interest rates to rise to keep lenders
from cutting off loans at negative interest rates. If the yuan becomes freely
convertible and tradable, China would be receiving 3% interest on its sizable
dollar reserves currently at $1.8 trillion while paying 6% interest on much
larger yuan deposits.
By seeking growth through exports for dollars, China has trapped itself in an
incurable mismatch between necessary domestic macroeconomic policies to assure
sustainable growth and its central bank's monetary policy dictated by dollar
hegemony. This mismatch is counterproductive, crisis-prone and unsustainable.
And as China liberalizes its interest rate regime and currency convertibility
as advised by neo-liberal economists whose credibility has been bankrupted by
unfolding events, the Chinese economy will face another financial crisis that
will wipe out a good part of the export-led financial and economic gains in the
last decade. All exporting economies that have abandoned capital controls since
the emergence of deregulated globalization of financial markets have been
regularly devastated by recurring financial crises that have imploded every
decade, the last three being the 1987 market crash, the 1997 Asian Financial
Crisis and the 2007 credit crisis. This latest crisis has yet to fully play out
its destructiveness and there are no signs so far that US policymakers trapped
in dysfunctional supply-side ideology have the economic wisdom and the
political dexterity to prevent it from turning into a global depression.
China was relatively spared in the 1997 Asian Financial Crisis largely due to
its then cautious pace of opening up its financial sector to global market
forces reacting to dollar hegemony. This time around, China can only insulate
itself from this pattern of global financial crises by making a concerted
effort to shift its exports to the domestic market and to reduce substantially
its trade dependency from the current near 70% to below 30% in a planned manner
and on an orderly schedule. Exports should be returned by policy to an
augmentation role in the economy,
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