Wednesday, 24 September 2008

Selling the family silver

On the road to financial ruin, an oniomaniac may cross a series of boundaries into increasingly desperate, previously unthinkable behaviour in order to carry on spending. Having exhausted their credit, they may raid their children's savings, or pawn their wedding ring. It seems that, in its attempt to stave off bank closures and even a mild recession following perhaps the greatest boom in history, the USA will soon cross such a line by starting to sell off its foreign currency reserves.

Last week's announcement of a government guarantee for money market mutual funds stated that the backing for the guarantee would be provided by the $50bn Exchange Stabilization Fund (ESF). Essentially, this is the fund which the US Treasury would use to fund intervention in the foreign exchange market if required, and includes the Treasury's share of the US foreign currency reserves (the rest being held by the Federal Reserve in its System Open Market Account). According to Michael Bordo, this is the first time in the ESF's history that it has been used for domestic purposes.

To RebelEconomist, this initiative begs the question, how can this foreign currency fund be used for domestic purposes? Well, the ESF does currently hold about $17bn in dollar securities, to provide dollars in case the US government wanted to sell dollars in the foreign exchange market, but the size of the guarantee accounts for the entire ESF, including its euro, yen and SDR assets. The implication is that, if the $3tn+ money market mutual fund industry suffers losses in excess of $17bn, the US Treasury will be forced to sell foreign currency assets to buy dollars. Since the USA has historically tended to disdain holding foreign currency reserves itself, it (ie the Treasury and Fed combined) owns (ie not counting foreign currencies held temporarily through reciprocal currency swap arrangements with other central banks) only about $47bn of euro and yen reserves. Even moderate losses sustained by money market mutual funds arising from bankruptcies such as that of Lehman, which caused the Reserve Primary Fund to become the first money market mutual fund to "break the buck" (in other words, lose some of its investors' capital and not just interest) since 1994, could quickly deplete the USA's foreign currency reserves almost entirely. Moreover, it is not clear that the drawdown of the ESF has not begun already. The US authorities have also undertaken to buy short term agency debt and lend money to money market mutual funds to help them meet redemptions, with the first $2bn of these operations being done yesterday, and reports so far do not make clear that this support for money market mutual funds is not also being funded from the ESF.

For now at least though, no plans have been announced to draw on the much larger, and more iconic, US gold reserves.


Brian said...

Nice article RebelEconomist. And a good question with respect to using the ESF for domestic purposes (and the potential need to sell foreign reserves).

I too noticed the permanent open market operations of last week and this week (purchasing agencies). The total is now $14.5 billion since 9/19. Are you saying (or speculating) that these agency purchases were made to help beef the ESF?


RebelEconomist said...

No, quite the opposite Brian. At the end of August, the ESF was holding $16.8bn of treasuries. If the discount note buying operation is drawing on the ESF, I would expect to see its treasurys being run down first, before its foreign currency assets (note that the Fed also hold some of the US foreign currency reserves). In that case, either the ESF will be run down, or else it will end up full of discos, but certainly not beefed up!