USD, Too Hot to Handle

Jeffrey Snider from Alhambra Partners recently gave an excellent interview on the economic effects of Eurodollars with Eric Townsend from MacroVoices. Eurodollars are USD that are held by banks outside of America.

The Eurodollar market began in the 1960’s. For various reasons such as international trade, sovereign USD depositors fearful of the US government confiscating their assets, and or American banks looking to escape domestic interest rate controls, the Eurodollar market grew. The interest that banks paid each other to borrow USD abroad is the foundation of the London Interbank Offered Rate (LIBOR). In 1971, Nixon was forced to violate the Bretton Wood’s agreement and suspend the USD’s gold convertibility. The Eurodollar thus became the global reserve currency.

Buttressing its supremacy was the need for oil-exporting countries to recycle their USD into the banking system. The Petrodollar and Eurodollar are one in the same, and the interplay between the two has a significant impact in today’s economic regime.

As the financialisation of the global economy intensified from 1990 to 2008, banks heaped on greater and greater amounts of derivatives exposure and in effect created larger Eurodollar balances. The Global Financial Crisis in 2008 marked the turning point where Eurodollar balances began declining. Jeffrey argues that 2008 was not about US subprime mortgages, but a banking crisis predicated on declining Eurodollar balances.

The Fed’s medicine of quantitative easing is a useless tool when aimed at the Eurodollar market. Apart from USD FX swap lines to other central banks, it is questionable which tools the Fed can legally use to alleviate the USD shortage. To properly address the situation, the Fed would need to become an even larger hedge fund than it currently is today. They would thus need to be active in all manner of FX and interest rate derivatives (e.g. cross currency basis swaps).

Jeffrey concludes with a sober assessment that due to an inability or unwillingness of the Fed and other central banks to address the actual problem, we could be left with a stagnant global economy for decades much like Japan. However unlike Japan, most nations’ subjects won’t sit by and calmly watch hentai porn while their economic situation progressively worsens.


What is of interest to Bitcoin traders is how this Eurodollar shortage affects China. Jeffrey spells it out succinctly:

Currency exchange rates don’t tell the price of any currency, rather they show us a measurement of eurodollar flow and flexibility. As CNY appreciated before and after 2008, not during the crisis, it was as ‘dollars’ flowed in such that they had to be locked up in higher bank reserve requirements. Conversely, since 2013, as CNY ‘devalues’ as ‘dollars’ disappear leaving the PBOC to either supply them itself or allow banks greater RMB flexibility through lower RRR.

I experienced a Eureka moment after reading and rereading this passage. Using the two charts below, he puts all the pieces together.

The PBOC’s balance sheet peaked in 2013 alongside the value of the Yuan. State owned enterprises (SOE) effectively arb’d the PBOC. They borrowed dollars cheaply offshore, and then imported them into China to take advantage of the higher domestic interest rates. This caused the CNY to appreciate.

Large Eurodollar inflows masked as CNY would have been bigly inflationary. Therefore the PBOC raised rates through the Reserve Ratio Requirement. However, as rates rose further it became even more profitable to attempt to bring Eurodollars onshore.

Currency appreciation was part of the government’s plans, but too severe an upward movement would be detrimental to exporters. A smooth appreciation required the PBOC to sell Yuan and purchase dollars. These dollars were then converted into US Treasuries. That is why their balance sheet rose as the currency appreciated.

Far from a monolithic Party that cooperates harmoniously for the mutual benefit of all comrades, factions of the Chinese government (SOEs) were undermining the financial health of the Middle Kingdom.

The dollar and rates began rising in 2013, dollars began flowing out of China. The short position needed to be covered. As the hot money flowed the other direction, the PBOC had to sell down reserves and decrease interest rates to help the Banks replace the lost deposits. The PBOC in the face of rising domestic inflation continues to lower the RRR; the banks are toast otherwise.

The faster and larger the US rate normalisation and currency appreciation, the larger the short squeeze.

March Is Green Lit

Grandma Yellen during various interviews and communiques proclaimed that a March rate hike is on the table. A hike so soon after December would prove the Fed is deadly serious about normalising rates. It would also spoil the PBOC’s plans for a calm period before the October National Congress.

After a period of currency appreciation, the PBOC reactivated its favourite rate hike dissuasion tool. USDCNY after hitting a low of 6.83, has risen above 6.88 in the last month. Unless the PBOC can push the S&P 500 lower through aggressive devaluations, the Fed could hike in their face, exacerbating the Eurodollar short squeeze.

The Perception Battle

Onshore, the PBOC faces a perception battle. Bitcoin hitting an all time high in January is perceived by many as a vote of no-confidence by disloyal comrades. While the PBOC can reliably control large SOE’s if need be, if a hoard of retail punters decide that they want to convert a small amount of CNY into USD, the jig is up.

The likelihood that Bitcoin withdrawals are re-enabled in China by the large exchanges is miniscule. Those will remain in place until at least October, or when the PBOC feels it has spooked Yellen away from raising rates.

Interview Transcript

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