Markets Insight

Last updated: March 27, 2013 4:52 pm
Markets Insight: Fed must revert to tested reserves policy
Raising reserve requirements is a win-win for banks and economy
Fed Chair Ben Bernanke Holds News Conference©Getty

The financial markets shook with fear last month when the minutes of the US Federal Reserve’s meeting suggested the central bank may reconsider the costs of pumping nearly $1.7tn of excess reserves into the banking system. Of particular concern to Federal Open Market Committee members is the inflationary potential of these reserves if the banks turn them into loans and deposits.

Before the financial crisis, banks held few reserves in excess of their requirements. This allowed the Fed to closely control the level of deposits that are extended when banks create loans. But today’s huge supply of excess reserves means financial institutions can create trillions of dollars of loans and deposits, which will be highly inflationary.

To eliminate these excess reserves, the Fed would have to sell more than half of its nearly $3tn portfolio of Treasury bonds and mortgage-backed securities. Since the Fed has indicated that reversing its quantitative easing would only be done in a rapidly improving economic environment, which normally puts pressure on bond prices, further bond sales from the central bank could be destabilising to the financial markets.

Fortunately, there is a solution to the Fed’s exit problem that does not involve selling securities. It employs one of the Fed’s oldest policy tools: raising reserve requirements.

All textbooks on money and banking highlight the three principal policy options open to central banks: discount lending, open market operations, and reserve requirements. Since the financial crisis broke, the Fed has vigorously used the first two.

Massive discount lending to banks following the Lehman collapse prevented a devastating run on banks. Then huge open market purchases of Treasury and mortgage-backed securities provided the financial system with much-needed liquidity. But the Fed has not altered reserve requirements in more than 20 years and has not raised any reserve ratio on any deposit in almost four decades.

The decline in the use of reserve requirements is startling. Under pressure from the banks to keep costs down, required reserves at the Fed had withered to only $40bn before the financial crisis broke, equal to less than 0.5 per cent of the banks’ liabilities, far below the ceilings set by the Monetary Control Act of 1980.

This legislation allowed the Fed to set a reserve ratio up to 18 per cent on transactions balances and 9 per cent on time deposits. Additionally, the MCA allows the Fed to impose any reserve ratio it wishes on any liability of the banking industry for a period of up to one year.

The Fed’s Flow of Funds Account indicates that total deposits in financial institutions were $10.6tn at the end of 2012. This implies that a 15 per cent reserve requirement on deposits would absorb almost all the excess reserves now in the banks. To prevent banks from evading reserve requirements by issuing other, non-reserved liabilities, the Monetary Control Act also gave the Fed powers to impose reserves on any non-deposit funding source.

A reserve ratio as high as 15 per cent may appear to be extraordinarily burdensome to banks. But in 2008 Congress allowed the Fed to mitigate this cost by paying interest on reserves. As the Fed exits from quantitative easing, one feasible policy for the central bank to pursue is to set the interest rate on reserves at one half of the level of the Fed funds target.

Data from the Fed show that most FOMC members expect the long-run Fed Funds target to be about 4 per cent, which would imply that the Fed would pay a 2 per cent rate on reserves under this policy. Given $1.7tn dollars of reserves, these payments would amount to a $34bn cost to the Fed, which is less than half of the $77bn that the central bank earned in 2012. This means that after paying interest on bank reserves, Fed profits, which are remitted to the US Treasury, would still exceed profit levels that prevailed before the financial crisis.

Another attractive feature of higher reserve ratios is that it allows the government to modify and in some cases eliminate the liquidity and capital ratios dictated by new Basel III banking regulations. Reserves are deposits at the Fed that can be turned into currency on demand and as such are the world’s most liquid asset. The higher reserve levels achieved by this policy will satisfy many of the liquidity requirements in the Basel Agreement.

The bottom line is that by increasing required reserves and bringing the Fed’s third policy tool out from hibernation, the Fed’s exit strategy can be made far easier. And since these reserves satisfy many of the Basel III provisions, this policy can be a win-win for the Fed, the banking industry and the US economy.

Jeremy J. Siegel is the Russell E. Palmer Professor of Finance at the Wharton School of the University of Pennsylvania

Copyright The Financial Times Limited 2013.

The Temptation of China’s Capital Account

Yu Yongding

27 March 2013

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BEIJINGDespite fluctuations, China’s overall economic growth has been stable over the last three decades, owing not only to the economy’s strong fundamentals, but also to the government’s successful management of cross-border capital flows. 
Capital controls enabled China to emerge from the Asian financial crisis of 1997-1998 largely unscathed, even though its financial system was at least as fragile as those of the affected countries. The Asian financial crisis persuaded China’s leaders to shelve plans, launched in 1994, to liberalize the capital account. 
In 2002, China reinitiated liberalization efforts, lifting restrictions on Chinese enterprises’ ability to open foreign-currency bank accounts, and allowing residents both to open foreign-currency accounts and to convert the renminbi equivalent of $50,000 annually into foreign currencies. The authorities also introduced the “qualified domestic institutional investors” (QDII) program to enable residents to invest in foreign assets one of many initiatives aimed at easing upward pressure on the renminbi’s exchange rate by encouraging capital outflows. At the same time, the “qualified foreign institutional investors” (QFII) scheme allowed licensed foreign entities to invest in domestic capital markets. 
In early 2012, the People’s Bank of China (PBOC) released a report calling for policymakers to take advantage of a “strategic opportunity” to accelerate capital-account liberalization. Shortly after the release, QFII quotas were relaxed significantly. 
In fact, such an acceleration has been underway since the government initiated renminbi internationalization in 2009. Although currency internationalization is not tantamount to capital-account liberalization, progress on the former presupposes progress on the latter. By allowing enterprises to choose currencies for trade settlement, and creating renminbirecycling mechanisms,” the government effectively eased the restrictions on short-term cross-border capital flows.
Most economists in China seem to support the PBOC’s stance, citing the potential benefits of capital-account liberalization. But Chinese policymakers should also recognize the significant risks inherent in relaxing capital controls. 
First, China needs capital controls to retain monetary-policy independence until it is ready to adopt a floating exchange-rate regime. As Barry Eichengreen has pointed out in the context of the post-WWII Bretton Woods system, capital controls weaken “the link between domestic and foreign economic policies, providing governments room to pursue other objectives.” Because capital controls capped “the resources that the markets could bring to bear against an exchange-rate peg,” they “limited the steps that governments had to take in its defense.” With current- and capital-account surpluses, the renminbi’s exchange rate is still under upward pressure. Without adequate controls on short-term cross-border capital inflows, the PBOC will find it difficult to maintain monetary-policy independence and exchange-rate stability at the same time. 
Second, China’s financial system is fragile, and its economic structure rigid. Hence, the Chinese economy is highly vulnerable to capital flight. In recent years, China’s financial vulnerability has been rising, with enterprise debt estimated to exceed 120% of GDP, and broad money supply (M2) amounting to more than 180% of GDP. At the beginning of 2012, China’s concerns centered on local-government debt, underground credit networks, and real-estate bubbles. Now, growth in shadow-banking activities has been added to the list. Without capital controls, an unforeseen shock could trigger large-scale capital flight, leading to significant currency devaluation, skyrocketing interest rates, bursting asset bubbles, bankruptcy and default for financial and non-financial enterprises, and, ultimately, the collapse of China’s financial system. 
A third reason to go slow on easing capital controls is that China’s economic reforms remain incomplete, with property rights not yet clearly defined. Amid ambiguity over ownership and pervasive corruption, the free flow of capital across borders would encourage money laundering and asset-stripping, which would incite social tension. 
Finally, with more than $3.3 trillion in foreign-exchange reserves, China is a particularly attractive target for international speculators. Owing to its underdeveloped financial system and inefficient capital markets, China would be unable to withstand an attack akin to those that triggered the Asian financial crisis without the protection of capital controls. Already, even without a major speculative attack, the exchange-rate and interest-rate arbitrage facilitated by renminbi internationalization have imposed significant losses on China. 
To be sure, a cautious approach should not be allowed to impede incremental progress toward capital-account liberalization. But a broad framework for determining the timing of each policy step, based on rigorous cost-benefit analysis, is essential. While some measures that the PBOC has taken under the banner of capital-account liberalization have turned out to be both necessary and appropriately moderate, others may need to be reassessed and rescinded. 
Today, as all major developed economies resort to expansionary monetary policy, the global economy is being flooded with excess liquidity, and a “currency war” is looming large. As a result, short-term capital inflows, whether seeking a safe haven or conducting carry trades, are bound to become larger and more volatile. 
In these circumstances, with China’s financial system too fragile to withstand external shocks, and the global economy mired in turmoil, the PBOC would be unwise to gamble on the ability of rapid capital-account liberalization to generate a healthier and more robust financial system. On the contrary, policymakers should tread carefully in their pursuit of financial liberalization. Given China’s extensive reform agenda, further opening of the capital account can wait; and, in view of liberalization’s ambiguous benefits and significant risks, it should.
Yu Yongding was President of the China Society of World Economics and Director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences. He has also served as a member of the Monetary Policy Committee of the People's Bank of China, and as a member of the National Advisory Committee of China’s 11th Five-Year Plan.


March 27, 2013, 8:21 p.m. ET

Regime Change Comes to Euro Policy

The banking crisis in Cyprus prompted an overdue financial reckoning that, with luck, will spell the end of 'too big to fail.'


A revolution in science began on the Galápagos Islands in the Pacific, where Charles Darwin conceived his theory of natural selection. Now, on an island halfway around the globe, we're watching Darwin's theory being applied to banks in Cyprus, their bondholders and their large depositors: The unfit are becoming extinct.

This is a revolutionary rejection of the dominant doctrine of "too big to fail," or too interconnected to fail, and moral hazard be damned. Cyprus marks the first full-fledged bank failure permitted in the euro area since the common currency's introduction in 1999. It is also among the very few anywhere since the failure of Lehman Brothers in 2008.

Small depositors at Laiki Bank and the Bank of Cyprus will be protected under European Union rules. But the banks will put into resolution (Laiki) and restructuring (Bank of Cyprus), and larger depositors and bondholders will likely take a big hit.

Since the Lehman failure, the presumption in Europe and around the world has been that enforcing market discipline on bondholders or large depositors would risk contagion throughout the global banking system. That fear has been especially intense within the 17 nations that, like Cyprus, use the euro. The dread has been that if banking stresses cascaded, it could lead to a disorderly break-up of the currency union, creating incalculable risks for the world economy.

Over the past week of negotiations, Cyprus did indeed threaten to leave the euro if the "troika"—the European Commission, the European Central Bank and the International Monetary Funddidn't compromise on its refusal to bail out the banks. At the same time, the ECB threatened to cut off liquidity to Cypriot banks if they didn't agree to restructure the insolvent pairan action that would have effectively kicked Cyprus out of the currency union.

In the end, Cyprus blinked. The ECB's threat was risky, given how relatively small the problem was. Bailing out the Cypriot banks would have cost the troika only about €6 billion ($7.7 billion). That's a pittance compared with euro-area loans to Greece, Portugal, Ireland and Spain, much of which went to bailing out banks. But it seems that drawing a line in the sand at Cyprus was a risk the euro area very much wanted to take.

On Monday, Jeroen Dijsselbloem, who heads the Eurogroup of euro-area finance ministers, bluntly told reporters that if other countries like Cyprus with highly leveraged banking systems get into trouble, "the response will no longer automatically be that we'll come and take away your problem."

If the bank can't solve its own problems, he said, "then we'll talk to the shareholders and the bondholders, we'll ask them to contribute in recapitalizing the bank, and if necessary the uninsured deposit holders."

Why the tough policy now? Cynically, perhaps it is because so much of the immediate burden will fall outside of Europe—specifically, on Russians, whose flight capital makes up the bulk of the Cypriot banks' large deposits.

More fundamentally, even in socialist Europe the authorities realize that bank bailouts lead to an addictive cycle of excessive risk-taking with other people's money. When bondholders and depositors believe they are government-guaranteed, banks can raise capital at risk-free rates and become too big, too complex and too leveraged. Every bailout reinforces the behavior. Why else—except for repeated experience that the ECB and euro-area taxpayers would bail them out—would wealthy Russians have dared to keep their billions in Cyprus, creating a pool of deposits more than four times the tiny island nation's gross domestic product?

Allowing the bank failures to happen represents a serious policy change in the EU, and it will take some getting used to. As soon as Mr. Dijsselbloem's remarks hit the wires Monday, bank shares across Europe fell sharply, prompting him to issue a two-sentence memo clarifying that Cyprus was "a specific case with exceptional challenges."

In reality, views like Mr. Dijsselbloem's have been coming from the European Commission and the ECB for months. Now the policy has been put into practice. In part, that's because Cyprus's bank crisis arose after the euro area had already bailed out banks in Greece, Ireland and Spain. The cost in taxpayer money and moral hazard was high, but those bailouts stabilized the worst banking risks in Europe.

At the same time, the most at-risk nations have done much to save themselves by taking on the difficult work of eliminating the moral hazard baked into their socialist economies. For example Portugal has moved ahead aggressively with privatizations. Spain is on the way to becoming a net exporter by reining in union power and repositioning itself as a low-cost global manufacturing center.

So taking a tougher approach now toward troubled euro-area banks is really not as risky as it seems. As Mr. Dijsselbloem put it on Monday, "the situation is more calm." There's no reason to think that this will be a repeat of the ECB's disastrous decision two years ago to hike interest rates far too soon, just when the euro area was slipping back into recession and so many deep structural problems hadn't yet been addressed.

Regime change is never easy. The tantrum this week in euro-area bank stocks is misleading: Credit spreads in interbank markets—the best indicator of systemic stresshaven't budged. And despite endless media images of Cypriots lined up at ATMs, there has been not the slightest hint of a bank run anywhere else.

Maybe the policy revolution begun in Cyprus will spread. Perhaps even in the United States, too big to fail will be stricken from the thousands of pages of stifling new laws and regulations that enshrine "systemically important financial institutions." If natural selection were permitted to operate in bankinganother phrase for the process would be creative destruction—the perverse incentives that have kept capital from flowing toward growth-enabling investment would be erased. That's what it will take to shift the world economy out of the weakest recovery on record, and into a true expansion.

Mr. Luskin is the chief investment officer, and Mr. Roche Kelly is the chief Europe strategist, for TrendMacro.

France’s German Mirror

Dominique Moisi

27 March 2013

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BERLINBerlin’s Tegel Airport, which still greets most of the passengers arriving in the capital of Europe’s leading economic power, is outdated and provincial. The opening of Schönefeld Airport, transformed into an international hub, has been delayed for more than a year for technical reasons (a somewhat reassuring challenge to Germany’s reputation for efficiency). Yet, despite the gray and chill of March in Central Europe, Berlin exudes confidence. More than ever, the city is a work in progressconfused, not very beautiful, and overcharged with history.
Berlin is a construction site that has managed to transform its multiple pasts into positive energy. Diversity destroyed: Berlin 1933-1938” is the unifying theme of a series of exhibits marking the 80th anniversary of Hitler’s coming to power and the 75th of the Pogromnacht. At the Deutsches Historisches Museum on Unter den Linden, entire classes of young pupils and students flock to see the exhibit’s evocation of destruction by a criminal regime whose objects, from loudspeakers to uniforms and weapons, are displayed in an educational manner.
Young Berliners cannot ignore where they come from. Yet, perhaps because the past still rings like a warning – and is still physically visible in the topography and architecture of the city todayBerlin is striking in its simplicity, its radiant modernity (symbolized by the glass dome of the Reichstag, a conception of the British architect Norman Foster), and, above all, its intensity.
That positive energy contrasts starkly with the decadent beauty of Paris, a city that is on a path of “museification.” Of course, if you can afford to live there, Paris remains a great place to be. But Berlin is a better place to work, even if what you do is very poorly paid. The porter who brings my luggage to my hotel room is of Tunisian origin. He is a happy Berliner and a proud new German. And, even on a low salary, he can live and raise his children in the city itself.
Thanks to its moderate housing costs, Berlin has not become, like Paris, a ghetto for the rich. Unlike the French, who are handicapped by the high cost of housing, Germans’ purchasing power is more harmoniously distributed, creating more room for household consumption to contribute to economic growth.
Germany’s positive energy is, of course, the result of success translated into confidence, which Chancellor Angela Merkel incarnates with strength and simplicity.
Merkel has changed profoundly while in office. Five years ago, she did not exude the natural authority that she now possesses. Today, like Pope Francis, she is clearly at ease with herself. Has there been a French president since François Mitterrand who was truly a match for a German chancellor? If France has replaced Germany as “the sick man of Europe,” it is for political reasons, above all: vision, courage, and strength on the northern side of the Rhine, and vacillation, inertia, and weakness on the southern.
Of course, given its excessively low salaries and adverse demographic trends, Germany will continue to face difficulties. But to emphasize only these problems, as some French do, is pure escapism.
German demography cannot be described as the solution to French youth unemployment, as though one could rest on a slogan such as: “They lack young people, our young people lack jobswhat a perfect match!” This widespread sentiment irresponsibly assumes that time is working in favor of France, regardless of whether it implements structural reforms.
France’s current direction is a source of deep concern in Germany, whose evolution should be seen in France as a source of inspiration – an example to be emulated, even if the country must not fall into self-flagellation. Yet today’s debate in France over the German model reminds one eerily of the discussions that followed France’s defeat in the Franco-Prussian War.

In June 1871, just after the war ended, the French statesman Léon Gambetta declaimed: “Our adversaries have won, because they rallied to their side foresight, discipline, and science.” Germany, it seems, can still rally those eternal values.
The major difference now is that the European unification process rules out war – even economic war – between the two countries. On the contrary, in the mirror of Germany, the French must ask themselves fundamental questions. Have they made the right choices in terms of leaders and policies in recent decades?
The places of power in France do not encourage modesty. In his latest book, Days of Power, the former agriculture minister, Bruno Le Maire, writes condescendingly of the building that houses his Danish counterpart in Copenhagen, which he compares to low-income housing. With too much pomp, too many stumbling blocks, and a dearth of dynamism, France today can and should learn from Germany.
 Dominique Moisi is Senior Adviser at IFRI (The French Institute for International Affairs) and a professor at L'Institut d’études politiques de Paris (Sciences Po). He is the author of The Geopolitics of Emotion: How Cultures of Fear, Humiliation, and Hope are Reshaping the World. .

Copyright Project Syndicate -