Monthly Archives: June 2012

The Accommodating Item In The Swiss Balance Of Payments

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Michael Sankowski has a post titled Swiss Franc: Trade Of The Year in which – as the title suggests – he points to getting the timing right of the depreciation of the Swiss Franc against the Euro as one trade which can have a huge payoff. His argument  is: assuming that the Euro will survive and financial markets gain confidence in the Euro, change in investor portfolio preference into Euro-denominated assets will depreciate the Franc.

Which is fine – as this New York Times article Necessity, Not Inclination, Nudges Europeans Closer Fiscally And Politically argues, it seems Germany is being forced to cede some control to the European Parliament which may act as a central government of the Euro Area (hopefully democratically elected!).

In September 2011, after the SNB found it frustrating that in spite of its intervention in the foreign exchange markets, it could not prevent an appreciation of the Franc. So it decided to say this:

Notice that it is not really a peg but a floor on EURCHF. Here’s a chart of EURCHF (via FT)

Daniel Neilson wrote a post about this on INET but his scenario is slightly different on what may actually happen to the Euro Area.

At any rate, he has an nice study of the effects of the flows on the balance sheets of the SNB and Swiss banks.

… the SNB is facilitating the world’s portfolio reallocation out of EUR and into CHF. Even fixed at 1.20 francs per euro, funds have been fleeing the euro area as the crisis heats up again. The SNB’s policy means that any net flow results not in price adjustment, but in fluctuations in the size of its own balance sheet.

Neilson also makes an interesting observation that there is a similarity of this to TARGET2 in which Bundesbank acquires claims on foreign central banks as funds flow into Germany. He points out however that the SNB has a choice of which asset it can purchase!

Since I am more a balance of payments kind of person, I tend to see this in that language. When a financial institution or a household – either a resident or a nonresident – liquidates Euro denominated assets for its purpose, it will purchase Francs for Euros. The dealer – a bank – which makes this conversion will credit the seller’s bank account and and will try to get rid of the excess Euro denominated deposits at its correspondent bank (which it obtained). If the SNB does not intervene, this sale of EUR by Swiss banks will appreciate the Franc and hence the SNB has to accommodate this and buy EUR. It can then purchase high-quality Euro denominated assets such as German government bills (?). The Swiss bank who made the conversion will have both its assets and liabilities denominated in Franc increase (assets: SNB settlement balances, liabilities: deposits). With the short term Franc interest rate at zero – the SNB needn’t do a “sterilization” operation.

How does this look in the financial account of the balance of payments? If the initial inflow was 100, then:

We can say that the item reserve assets of the SNB is the accommodating item in the balance of payments.

Peter Garber From 1998 On TARGET

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In exchange rate agreements and arrangements such as the ERM I and II, central banks would risk running out of foreign reserves in case of a speculative attack on the currency. They may commit to each other on defending the exchange rate but in extreme cases, the agreements may lose their significance.

When I saw first this guideline on the ECB Website on TARGET (on NCBs and the ECB providing unlimited and uncollateralized credit facility to each other) – a couple of years back – I was a bit shocked but later seemed to make sense:

In return, the Euro Area member nations had to irrevocably lock in exchange rates as per this nice article on TARGET by Peter Garber in 1998: Notes On The Role Of TARGET In A Stage III Crisis (h/t Tom Hickey). Garber also has another interesting article (a special report from Deutsche Bank) The Mechanics Of Intra Euro Capital Flight, December 2010.

According to Garber in the previously existing Very Short Term Financing Facility (VSTFF), central bank of the nation seeing private inflows theoretically has to provide unlimited credit to the central bank of the nation seeing private outflows.

The VSTFF is a facility to be used if serious intervention is necessary to preserve official bilateral bands in the Exchange Rate Mechanism. Under the Basle-Nyborg agreement, the weak currency central bank is to intervene in the exchange markets to prevent the exchange rate from breaching the band. The strong currency central bank is responsible for providing credit to the weak currency central bank through the VSTFF, theoretically in unlimited amounts but in fact limited by the effect on the strong currency central bank’s monetary policy.

More in the paper. Of course, Garber is incorrect in assuming that the central bank providing credit loses control of its monetary policy. (Expect a future post on Sterilization). Anyway interesting paper – especially on how capital flight from the “periphery” before a breakup can lead to huge losses for the creditor Euro Area nations.

Toward A Higher European Integration?

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In an article today Europe Mulls Major Step Towards “Fiscal Union”, Reuters reports that Angela Merkel is pushing for a “giant leap forward”:

After falling short with her “fiscal compact” on budget discipline, German Chancellor Angela Merkel is pressing for much more ambitious measures, including a central authority to manage euro area finances, and major new powers for the European Commission, European Parliament and European Court of Justice.

She is also seeking a coordinated European approach to reforming labor markets, social security systems and tax policies, German officials say.

Until states agree to these steps and the unprecedented loss of sovereignty they involve, the officials say Berlin will refuse to consider other initiatives like joint euro zone bonds or a “banking union” with cross-border deposit guarantees – steps Berlin says could only come in a second wave.

“Kaldorians” jumped to highlight the serious defects in the European plan for integration when officials were working on the Maastricht Treaty. One of the implicit assumption on which the dogma of “free trade” is pushed is that current account deficits do not matter. The government’s task is to only make markets free in this view. The Euro Area was formed with the highly incorrect notion (among various others) that nations can simply solve their “balance of payments problem” by getting rid of it altogether.

I was reading this article by Ken Coutts and Wynne Godley from 1990 [1] where the authors point to different kinds of arguments put forward by others to defend this position (“current account deficits do not matter” provided markets are made free).

There appear to be six different lines of argument to the effect that the current account deficit can be ignored …

… (v) A different kind of argument makes a comparison between a nation with an external deficit and a relatively poor region within a nation. It is pointed out that there is no balance of payments problem for Scotland or for Northern Ireland and from this it is concluded that as soon as Britain joins a European monetary union its balance of payments ‘problem’ will disappear permanently …

… The argument (v) that a region within a country cannot have a balance of payments ‘problem’ ignores the fact that if a region imports more than it exports its trade deficit is automatically paid for by fiscal transfers.[footnote: Strictly speaking, the fiscal transfers will always exactly compensate for any trade deficit only after allowing for the acquisition of financial assets by the private sector as implied by the ‘New Cambridge’ identity (exports less imports equals net government outlays plus the ‘trade’ deficit). The identity says, of course, nothing whatever about the level of real income and output which trading performance will have generated]. The point may be illustrated by considering an extreme case where a region consumes tradables but cannot produce them at all. In this case there will be a trade deficit exactly equal to imports of tradables, but the flow of government expenditure and net transfers will provide a minimum level of income support and keep life of a kind going without any borrowing at all taking place. If an uncompetitive region were not in receipt of fiscal inflows, its inhabitants would have no alternative but to emigrate or starve. This example illustrates that merely by sharing a common currency with another area, a region or country does not automatically dispose of its balance of payments problems since its prosperity still depends on how successfully it can compete in trade with other areas. The Delors Report itself correctly observes that a monetary union transforms a weakness in the ability to compete successfully from being a balance of payments problem into a regional problem to which there is only likely to be a solution by using the instruments of regional policy.

The movement toward more integration by giving higher powers to the European Parliament was also suggested by Wynne Godley and Marc Lavoie in 2007 [2]:

… Alternatively, the present structure of the European Union would need to be modified, giving far more spending and taxing power to the European Union Parliament, transforming it into a bona fide federal government that would be able to engage into substantial equalisation payments which would automatically transfer fiscal resources from the more successful to the less successful members of the euro zone. In this manner, the eurozone would be provided with a mechanism that would reduce the present bias towards downward fiscal adjustments of the deficit countries.

References

  1. Prosperity and Foreign Trade in the 1990s: Britain’s Strategic Problem, Oxf Rev Econ Policy (1990) 6 (3):82-92. Link
  2. A Simple Model Of Three Economies With Two Currencies, Camb. J. Econ. (2007) 31 (1): 1-23. Link

Cyprus Seeking Bailout

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According to a Wall Street Journal article from yesterday Cyprus Seen Close to a Request for Bailout, Cyprus (2011 GDP: €18bn approximately) is set to become the fourth Euro Area nation to seek a bailout after Greece, Ireland and Portugal. According to the WSJ:

Late last year, the country negotiated a €2.5 billion ($3.1 billion) bilateral loan from Russia. Now, Cyprus is in talks with China for another bilateral loan, of an undisclosed amount, that looks unlikely to materialize in time.

Had to go into trouble considering that economists have been realizing that the Euro Area problems is an internal balance of payments crisis.

The closest proxy for a nation’s net indebtedness is the net international investment position (as opposed to “external debt” which excludes equity held by nonresidents). Here’s the chart as of 2011: the NIIP is at the end of 2011 and the GDP is the gross domestic product for the whole year.

(click to enlarge)

Note: Greece’s NIIP improved in 2011 (from minus 100% of gdp) due to large revaluation losses suffered by foreigners as Greece financial markets fell in 2011.

The financial markets is now nervous about Spain and Slovakia’s next in the line if the graph is to be believed and it’s external position is in dangerous territory also – at minus 64%.

According to Wynne Godley, anything between 20-40% of net foreign indebtedness can be highly dangerous. Of course his models also show that there is nothing intrinsically stopping such imbalances from continuing and can go on as long as foreigners do not mind but something has to give in – such as slower growth to prevent the imbalances from continuing before foreigners start minding or a crash.

At this point, Slovakia doesn’t seem to be in trouble with its generic 10-year government bond yield at 3.645% – with its public debt at 43.3% of gdp at the end of 2011 according to Eurostat. This of course means that the domestic private sector is a net debtor (i.e., its financial assets is lesser than its liabilities). A more detailed analysis is required on how internal imbalances will play out and spill over to the external sector. Here’s from Statistical Appendix of the “Alert Mechanism Report”.

(click to enlarge)

Moving on to something different:

Heteredox Economics In Playboy!

Via Twitter:

click to view the tweet on Twitter

John Cochrane of Chicago calls heteredox economists “kooks” and claims he and his colleagues use rigorous models!