Posted by: Dirk | November 11, 2008

Payback time

Goldseek reports that international reserves (excluding gold) are falling, using somewhat obscure sources, but anyway:

The WSJ reports:

To combat these sharp moves, Brazil, Mexico, Russia, and India collectively have drawn down their reserves by more than $75 billion since the end of September, selling dollars to protect their currencies, according to Win Thin of Brown Brothers Harriman.

This is related. As long as there are big imbalances in international trade, there must be capital flows, too. If, for instance, Germany exports more than it imports, it must accept foreign assets (mostly foreign cash) as payment. If trade is balanced, however, foreign buyers could pay with euros acquired by exporting to Germany (or other eurozone members), but since we assume that Germany exports more than it imports, there must be trade partners which import more than they export. The foreign assets accepted for payment can end up on the balance sheet of the central bank, if exporters exchange the money for euros through the banking system. This is very likely, since one must keep in mind that most foreign exchange reserves are held by China and oil-exporting countries. In these countries, the central bank is an important player in the banking system.

Now, if countries with trade deficits find it hard to finance those by capital inflows from the global capital market, then they will have to accept a balance of trade equal to zero: imports and exports have the same value. Since capital is hard to get and very expensive for countries like Iceland, Romania and the like, these countries might be forced to curb their imports. This would of course result in lower exports of countries with positive trade balances, like China and Germany.

Germany’s export sector is very productive, and falling demand (through falling exports) would lead to a decline in GDP, since the workers could not be put to work in equally productive industries. This is the worst case scenario. We will see whether the decline in central bank’s reserves is only a temporary effect (see 1988 in the graph above), or whether we see a big turn around. Maybe foreign exchanges has just shifted from central banks to the private sector. Or maybe the fall of some currencies in dollar terms is behind the decline, or the effort to stabillize some currencies (like seen above). However, a reversal in the accumulation of reserves by the world’s central banks would come at a bad moment for the world economy. Demand is already faltering, and a decline in exports (demand from abroad) is the least thing our economies need at this moment. It would probably trigger calls for new international economic order. If somebody still remembers this old concept.

On a more optimistic note, if central banks had to spend their reserves (‘The most recent data shows about 64 percent of the $3.81 trillion of world currency reserves are held in dollars and 20 percent in euros.’, Chinn and Frankel in 2005), the threat of inflation would surely be gone. Also, demand in the US would be stimulated: either directly by buying from the US, or indirectly by exchanging dollars into other currencies and thereby leading to a depreciation of the US dollar.

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