China, Brazil, Nightmare Swaps, And More About December (And What It May Mean)

Central bankers will often tell you exactly what you want to know, at least when it comes to their intentions. You can first begin by reading Milton Friedman and Anna Schwartz’s 1963 monetary bible A Monetary History. It’s all in there. From it, central banks all over the world have devised technical schemes intended to hold fast to the old theories.

I mentioned last September that before Brazil embarked on its suicidal course in the summer of 2013 the country’s central bank had published a paper on the issue of reserves and swaps. The timing wasn’t a coincidence given how Banco do Brasil was in the middle of managing reserves via swaps.

A well known advantage of issuing such contingent liabilities as currency swaps is that authorities become able to intervene in the exchange market indirectly, without affecting the money supply or varying the stock of foreign exchange reserves.

There are a couple reasons why any foreign central bank might be reluctant to mobilize its foreign reserves. The first is a stigma, something like a bank going to the Discount Window at the height of panic. If Brazil during the currency crisis of 2013 had begun “selling UST’s” then there was the nontrivial chance this could make it worse. Something about encouraging speculators (of the “evil” kind).

The bigger problem is internal money supply. The loss of reserves has a direct effect on the central bank’s balance sheet. Withdrawing foreign reserves means shrinking central bank assets – an actual QT. Without some offsetting internal maneuver, itself fraught with difficulties, domestic currency and bank liquidity must suffer.

Swaps, therefore, propose something like the perfect solution. A central bank can deal with “outflows” (eurodollars) without having to pay for its intervention immediately. In Brazil, they subsidize local banks into borrowing eurodollars on their behalf without disturbing the reserve stockpile nor the domestic monetary condition.

Like a magic trick, the evil speculators are left stunned and bewildered, retreating from their dastardly antics as central bankers successfully protect their national interests.

That’s not quite how it works, though. To start with, “speculators”, evil or otherwise, aren’t that stupid because they aren’t really speculators. They are global eurodollar banks who to a central bank might seem like speculators but in reality are the basis for global reserve money. Information asymmetry is working against the 21st-century use of a 1963 monetary handbook.

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Disclosure: This material has been distributed for informational purposes only. It is the opinion of the author and should not be considered as investment advice or a recommendation of any ...

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