• Fed Governor Sandra Pianalto speech on Internationalization of national currencies. Quote:

“The evidence suggests that the share of euros held in countries’ reserve portfolios has increased. This appears to be consistent with the widening of the European Union and the prospective growth of the euro area. The euro now accounts for slightly less than 30 percent of developing countries’ portfolios, and it is the second-most widely used international reserve currency. The British pound and Japanese yen remain well behind.

We have only limited information on the currency composition of those reserves, but the data and anecdotal evidence indicate that developing countries are adding euros to their portfolios faster than they are adding dollars. At the end of 2001, developing countries held 70 percent of their foreign-exchange reserves in dollar-denominated assets, but by 2006, this share had fallen to 60 percent. Valuation adjustments stemming from the dollar’s depreciation since 2001 account for some of the decline in the dollar share, but not all of it.”


“The willingness of individuals and governments to hold a particular international currency depends on how they view the stability of that currency’s long-run purchasing power. A potential loss of purchasing power can erode the economic benefits associated with using any particular currency for international trade. When viable alternatives exist, individuals and governments will gravitate toward the currency with the most stable purchasing power.”

  • Business Week article by Steven Green on China reserves. Quote:

” China is buying oil! China is buying Korean equities! China is buying corn! China is buying Ford (F)! China is buying Angola! Expect to hear a lot of this kind of thing in the coming months. And expect global currency, commodity, and debt markets to get a little bit crazier as a result. China is allocating some $200 billion worth of its massive foreign currency reserves to a new fund that may well start investing in sexier things than U.S. Treasuries. The problem is that while we know that this is probably a huge event, we do not have even the most basic idea as to how the fund will operate.”


“Rivalry between the finance ministry and the central bank spreads over other areas, too. But to keep a long story short, in the lead-up to the government’s big Financial Work Meeting earlier this year, various working groups were established to consider the big issues. The one most in dispute, reportedly, was the panel looking at the FX reserves.

MoF folk argued that China had best look to Japan, where the FX reserves are managed by the MoF. That, plus the ill-defined sense that the FX reserves could be used differently, resulted in the creation of a new entity. The new fund will not be operated under PBoC/SAFE nor the MoF. But Lou Jiwei, a deputy minister of the MoF, has been appointed to run it.

As to scale, we understand that an initial framework document prepared by MoF and PBoC stated that $200 billion would be a reasonable size (apparently because leaving some $900 billion in the reserves sounded just about right).”


“One person I spoke to said that he had heard that the allocation of the new China fund would put $100 billion into physical commodities, $60 billion into Asian equities, and $40 billion into debt. Another had heard China was already buying equities in Hong Kong, Singapore, Korea, and Japan. Another could see no evidence of this. Another thought that buying up Asian debt made much more sense in terms of nurturing influence in the region. And yet another serious fund manager believed that the fund could only continue with the SAFE’s old investment strategy, given the negative impact on the U.S. dollar if they did anything else.”


If the markets ever caught wind of China diversifying its holdings, dollar-selling pressure would be immense—and Washington would have something to say, too. But this raises the question why start a new fund if you don’t want to do anything differently? That creates incentives to be extremely conservative, diversifying quietly and gradually.

Second, consider the possible impact on the region. How would people react if Beijing bought large quantities of the equities and debt traded in Taipei? Or of those traded in Tokyo? If the fund does indeed turn out to be active in Asian equities, China’s relationship with the region will get a lot more complicated. How would other investors feel if China FX Fund owned 5% of their company? Would they be assured that China was only holding a position for financial reasons?

There are also big operational questions. If the new fund went into buying control of ventures overseas—an Indonesian gas field, a failing U.S. corporate, a high-end German engineering venture—how would that entity be operated? Would it be handed over to a Chinese corporate with some experience in that area or would managers and/or directors be sent from the fund?”

  • Celeveland Fed note on subprime derivatives.
  • Bloomberg quotes Bank of America suggesting a possibility of a correlation crisis. Quote:

“The ratings cuts to the automakers triggered losses for banks and hedge funds holding the riskiest parts of collateralized debt obligations, securities that package bonds, loans and credit-default swaps and use the income to pay investors.

An increase in the perceived risk of default by homebuilders such as Dallas-based Centex Corp. and Lennar Corp. in Miami could cause similar losses this year, Bank of America analysts Glen Taksler and Jeffrey Rosenberg wrote in a report today. Construction company profits have plunged since the five- year U.S. housing boom ended a year ago. Rising inventories of unsold homes and reluctance by potential buyers wary of falling prices has stifled sales.

“We see increasing risk signals that remind us of the run- up to the 2005 correlation meltdown,” the analysts wrote in the report titled “The Correlation Crisis of 2007?”

CDOs are divided into portions of varying levels of risk and return. The riskiest piece, known as the equity tranche, pays the highest yield and is the first to absorb losses when credit quality deteriorates.

Investors may demand a higher premium for holding the equity tranche related to the benchmark investment-grade credit- default swap index, should the cost of contracts on homebuilders in the index rise, the analysts said.

“We would not be surprised to see a potential dramatic increase in the premiums required by equity tranche holders to hold first-loss risk,” the analysts wrote. “A reversal in the current demand for equity tranche protection could send investment-grade index spreads significantly wider.”

Bondholder Protection

Credit-default swaps are designed to protect bondholders against defaults. Buyers of the contracts receive the face value of defaulted debt in return for handing over the bonds or the cash equivalent.

The CDX Series 8 Index of investment-grade credit-default swaps includes homebuilders Centex, Lennar, Toll Brothers Inc. and Pulte Homes Inc. It also includes mortgage-lender Countrywide Home Loans Inc. and mortgage insurer and financial guarantor Radian Group Inc.

Equity Plummets

In May 2005 equity tranches plummeted after Standard & Poor’s cut the credit ratings of GM and Ford to junk, driving up the perceived risk of holding their debt and forcing investors to exit the riskiest portions. At the time, the CDX index included four auto-related companies.

The fall in equity value also forced investors to buy more protection on the investment-grade bond index to hedge their positions. That pushed up the cost of protecting against default by roughly 20 basis points, according to Bank of America. A basis point is 0.01 percentage point.

Credit-default swaps based on homebuilder bonds fell yesterday after surging this week to the highest levels since at least October 2004, the earliest date for which prices are available. Contracts tied to the debt of Miami-based Lennar, the nation’s largest homebuilder by revenue, fell $7,000 per $10 million to $113,500, according to CMA Datavision.”

  • Morgan Stanley note on asset shortages. Quote:

“Sovereign debt issuance by the AXJ countries has declined sharply as a percentage of GDP since the Asian Financial Crisis a decade ago. In absolute dollar terms, total AXJ sovereign bonds outstanding currently stand at only US$830 billion, compared to US$8.4 trillion for the US, US$9.7 trillion for the EU and US$8.2 trillion for Japan. The annual total C/A surplus of AXJ is equivalent to around 40% of its own stock of sovereign bonds outstanding. “


Since most of the net new equity issuance in the past two years has taken place in Hong Kong, it would be reasonable, for our purposes, to consider the US and AXJ as a de facto dollar bloc. Capital flows into HK to acquire these new shares have to be ‘converted back’ into US dollars by the HKMA. This means that, from the perspective of the available size of net new equity supplies, the dollar bloc offers by far the greatest opportunity for global investors.

Therefore, looking at the lack of supply of financial assets by AXJ and the opposite for the US and the dollar bloc, we are not surprised that the US has had a relatively easy time financing its C/A deficit. “


“Thinking about exchange rates from the perspective of the quantity of supply of financial assets can also help explain the up-trend in EUR/USD in the past five years. The value of all traded debt (sovereign, corporate and others), compiled by the BIS, issued in dollars and euros shows that the total stock of all types of debt issued in EUR exceeded that in USD back in December 2003. At present, all EUR-denominated bond instruments total US$8.3 trillion, compared to US$6.4 trillion for all USD-denominated debt. “


“The surge in credit derivatives was, in our opinion, a direct result of financial innovation and the originators’ desire to manufacture supply to meet the demand for these instruments. In other words, investors’ appetite for these securities created its own supply of this class of risky assets. The growth of credit derivatives raises the issue of ‘indebtedness’ in the US, that much of this type of debt does not really constitute genuine ‘indebtedness’ but rather exactly the opposite: flush liquidity. “

  • Fed Governor J.Lacker speech , a primer on Philips curve.
  • Washington Post article on Asian Union. Quote:

What has happened in Europe over the last 50 years since the Treaty of Rome is truly remarkable. It has shown that nations with different ambitions and dreams can be molded into a single matrix of unity in diversity. It is a triumph of reason over vanity. The common legacy of a thousand years of wars and misery, with Christianity and Hellenistic culture binding them all, have cemented a New Europe committed to the pursuit of peace and prosperity. Europe’s momentum of integration has hardly slowed; it is expected to keep expanding to the east until it reaches the Ural Mountains.

What implications does the European Union model have for Asia? Should Asia follow this path, build a single market and a borderless region? The answer, I believe, is unequivocally yes. Already, Japan and South Korea, despite their political differences and never-ending squabbles over a history of conquest and apology, are quietly talking about waving visa requirements for each other’s citizens. Their steel and automobile industries are closely linked through mutual investment and exchanges of technology. China and India, with a combined population of 2.3 billion, have become a major market for Korean goods. East Asians, at least, are building these increasingly peaceful interactions upon a common heritage of Buddhism and Confucian culture.

But is Asia politically ready for such a big leap? Not yet, but it is clearly becoming more aware of the possibility, thanks to the pace of economic empowerment. What Asia needs today are an Asian Jean Monnet and Robert Schuman to launch the debate over future regional integration. Asia has not had a towering visionary leader since the departure of Gandhi.

Two things are vital for this process to begin: the speedy achievement of regional economic integration, spreading the desire for further development and prosperity within a borderless Asia. Development also helps end war and focus efforts on conflict resolution; after all, the parties have more to lose. At the same time, regional powers like Japan and China must take the lead in starting an Asian version of the Helsinki Process by launching an Organization for Security and Cooperation in Asia, to promote dialogue and detente. Promotion of human rights and exchanges of science, technology and culture within the region should be facilitated by this multilateral channel.

Arrival of the age of development in China and India, Asia’s two largest nations, has made it possible to start dreaming about an Asian Union based on economic benefits and common political aspirations. The success of the European Union has shown the way. Asia can, and should, follow its path. It is the way of the future.”