Monday, March 30, 2009

FX Briefing : ECB Security Purchases - the Genie is out of the Bottle


  • China is striving to influence the global financial system
  • ECB vice-president Papademos describes additional measures ECB could take
  • ECB is set to cut the refi rate by 50 basis points to 1%
This week, forex markets were driven primarily by the sustained recovery in equity markets and the subsequent increase in risk appetite. The US private-public purchasing programme for toxic assets and loans could also have played a part. This development boosted emerging market currencies as well as “commodity” currencies such as the Canadian and the Australian dollar. But currencies such as the Korean won and the Swedish krona, which had previously been considered particularly at risk, also benefited. After last week's rebound, EUR-USD remained relatively flat. Mid-week, rates had tumbled from around 1.36/37 at the beginning of the week to below 1.35, but recovered again to about 1.3550 towards the end of the week. The yen, which had also firmed against the dollar the previous week, relinquished its gains. USD-JPY rose from about 95 to 98. The yen has now depreciated significantly again versus the euro. In January, EURJPY was about 115, but it is now back to around 133 again.

China wants global monetary system reform The Chinese central bank's call for a new international monetary system caused quite a stir this week. Zhou Xiaochuan, governor of the People's Bank of China, suggested increasing the use of International Monetary Fund Special Drawing Rights (a unit of account created by the IMF based on a basket of key international currencies) as a new global reserve currency.

China's main argument is that a reserve currency country (not specifically named, but obviously the US) is constantly confronted with the dilemma of trying to achieve its domestic monetary policy goals while at the same time ensuring the stability of the reserve currency. China's suggestion is more food for thought rather than the complete draft of a new system. It is by no means certain whether a currency based on a basket of currencies like the Special Drawing Rights could in fact take over the role of an international reserve currency. And it would be even harder to create an autonomous supranational currency.

China is probably aiming at achieving two immediate objectives: first, in the run-up to the G20 summit at the beginning of April, it probably wants to assert its right to have a say in international monetary questions. The International Monetary Fund is to be given additional responsibilities, and requires fresh capital. China is willing to pay additional capital into the Fund in return for having a say. An increase and reform of IMF quota on the basis of economic performance would lead to a massive shift in the distribution of power in the Fund to the benefit of the big emerging market nations like China, India, Russia and Brazil, and to the detriment of the major industrialized countries, particularly the US.

Second, China's proposal is a warning to the US not to jeopardize the value of other countries' currency reserves. A few weeks ago, Chinese Premier Wen Jiabao had already asked the US government to guarantee the safety of Chinese investments in the US. China is in a dilemma, however: its monetary authorities' dollar holdings are now so vast, that it could not move out of dollar assets without suffering a loss.

ECB's monetary policy options

Another notable event was a speech given by ECB vice-president Lucas Papademos on Thursday in Brussels. It is striking that the assessment of macroeconomic risks has worsened again compared, for example, to that in the governing council's statement at the beginning of March. As far as we know, Mr Papademos is the first ECB representative to admit to downward risks to price stability, credit supply constraints, and the danger of an adverse feedback loop between the real economy and the financial sector. Most importantly, however, Mr Papademos hints that the ECB is intending to implement further measures in addition to interest rate cuts. According to his remarks, the ECB could, firstly, extend the maturity of refinancing operations. Up to now, this was a maximum of 6 months. Secondly, Mr Papademos sees a possibility of purchasing private debt securities in the secondary market to improve liquidity in this market segment and reduce the cost of funding of the real economy.

The ECB governing council is not likely to present a hard and fast plan to purchase private securities next Thursday. However, the fact that the vice-president of the ECB, who tends to be rather tight-lipped as regards monetary policy, starts talking about possible quantitative measures shortly before a council meeting, must be more than a coincidence. Now that this genie is out of the bottle, it will be difficult to get it back in again. We therefore consider it feasible that the governing council will next Thursday at least admit that it is considering such measures. Furthermore, we expect the ECB to lower the refinancing rate by a further 50 basis points to 1.0%. This measure would be most effective if the deposit rate, which is currently serving as a basis for the overnight rate, were to be cut from 0.50% to zero at the same time. In our view, this is possible and would make sense. However, market participants' expectations diverge on this point.


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