ICangles Investment Post…

The balance sheets of the major central banks of the world are in a dangerous state. In the United States, the European Union and Japan they have basically printed money to buy debt, counting the debt securities purchased as an asset and the money paid for them in the liability column. Despite many mistakenly believing China’s central bank must be in good shape with all the U.S. government debt held in its asset column, this overlooks its liability column. Reviewing the magnitude of central bank liabilities, the implications on future policy and potential economic challenges, arguments can be made that central bankers are either wisely learning from history or the equivalent of fools playing with matches in pools of gasoline of their own pouring. Unfortunately their lackluster track record argues more for the latter than the former.

To understand the magnitude of the problem a close look at the numbers is warranted. I’ve previously blogged on the Fed’s heavily leveraged balance sheet. It holds over $2 trillion in U.S. government and private market debt purchased by printing money out of thin air. With only $60 billion in capital that makes for a more than 50-1 leverage ratio—well over what Fannie May held during the real estate bubble. That’s worrisome for a lot of reasons, including that at the heart of all market bubbles is leverage. The Fed has in effect placed a large bet on debt instruments paying very low interest rates and were rates to rise the market value of the low-interest-rate-yielding assets they hold would fall without a commensurate decline in liabilities.

Despite the aggressiveness  of America’s Federal Reserve, the balance sheets of both Japan and China remain larger in proportion to their respective economies. Of the major central banks it was the Bank of Japan that was the first to inject massive liquidity by basically printing money into its private banking system. It has been largely in maintenance mode for the past few years with a mostly unchanged, but bloated balance sheet. However, the Japanese central bank has of late, like America’s Fed, become the biggest buyer of its government’s debt. In fact central banks printing money is enabling government budget deficits in the U.S., Japan and Europe, including both the European Union and the United Kingdom.

The European Central Bank has gone from boringly conservative to aggressively interventionist over the past few years.  By the end of 2012 its balance sheet soared to a record $3.5 trillion. Along with government debt from countries, including Greece, private banks have also borrowed money, including over 500 banks that took advantage of relaxed lending rules in December. On one side the ECB is not making large scale bond purchases like the Fed, but is lending money collateralized by securities of sometimes questionable credit quality, including some non-investment grade bonds. The distinction isn’t even that clear, however, since many of those private banks use the money to purchase government bonds in a profitable carry trade, thereby functioning as an intermediary for Europe’s own quantitative easing program. And because the ECB is tapping cheap credit from the U.S. Fed it all might be best characterized as a global quantitative easing program.

The balance sheet of China’s central bank (PBOC) is also in bad shape, holding over $3 trillion in foreign reserves, mostly dollars.  This does not represent just savings. When China maintains a simple currency peg to the U.S. dollar it means that when companies sell goods overseas, earning foreign reserves, China’s central bank keeps the foreign reserves and issues local currency to companies. But it’s not actually that simple. Although there is disagreement about how much China’s currency is undervalued, there is agreement it is undervalued. As a result China’s central bank is holding over $3 trillion in over-valued foreign currencies on the asset side of its balance sheet and has created a corresponding amount denominated in under-valued Chinese currency.

The very nature of China’s trade imbalance creates an imbalance in the currencies with significant Chinese money creation. Rather than getting American goods in return for trade the Chinese central bank takes debt and issues new money into China’s economy. In this paradigm of unbalanced currencies, movements to fair value in foreign versus Chinese currency decreases the value in the asset column and increases the liabilities. With the current currency peg China is importing additional inflation, as the Fed debases the dollar and increases the money supply, while any move to create more Chinese money simply adds to inflation.

All this debt at the very least means that borrowers (governments) are debasing currencies and providing lenders with negative returns on their savings. Assuming governments aren’t efficient users of capital it also means lower long-term economic growth. The developed world appears to have ridden asset bubbles for short-term gains as long as possible, while in China the game still has a bit longer to run. But while the situation in China is complicated enough to warrant a future post, one aside worth mentioning is that it is largely through the buying of U.S. government debt that the Chinese are able to keep their currency artificially low. Therefore the next time a U.S. politician complains about China manipulating its currency to steal U.S. jobs he or she might want to give some thought to the fact that the co-conspirators in that manipulation are the U.S. politicians running budget deficits and creating the only debt market large and liquid enough to support all that Chinese lending at the core of the manipulation.

The state of central bank balance sheets in the developed world has serious implications on the global economy. In an ideal world central bankers are averting credit market crisis by using drastic action to supply badly needed liquidity and will be able to sell off the debt securities purchased as the economy strengthens in a low inflation environment thereby withdrawing excess liquidity before a rising velocity of money leads to inflation. Of course this assumes growth without high inflation and the absence of stagflation, either of which would erode the value of the debt held in the asset columns, leading to bankruptcy if central banks sold their debt holdings. In that scenario they either would need to be recapitalized by taxpayers or not sell those securities and mark them at the value they were purchased at to still avoid technical bankruptcy. If this happens excess liquidity is not withdrawn from the market, allowing inflation to go unchecked. Which scenario transpires will determine whether central bankers were engaging in what they term quantitative easing or what others deem money printing.

Thus, the current generation of central bankers are either truly wise men or well-credentialed fools who have set the world awash in trillions of dollars in liquidity, and with expansionary policies are in danger of eventually igniting inflation, which the poor state of their balance sheets will preclude them from containing if it combusts rather than builds very gradually. The evidence of history unfortunately points to them being very smart fools trying to ignite economic growth by striking matches (increasing the velocity of money) in a pool of gasoline (monetary liquidity) they have poured. Their policies have led to a boom bust cycle, including the East Asian crisis in the late nineties and global real estate bubble of the prior decade. Current policies have failed to alleviate unemployment or return the global economy to healthy growth. So, the question is probably not whether central bankers are right in their actions, but rather how long will a period of subpar growth with low inflation last and when will high inflation return.