Reaching for the Heavens


By Monish Chhabra ǀ 28th February 2015

In 2014, the world made 97 new skyscrapers (buildings that are 200 meters or taller). China made 58 of them.

This year in 2015, China alone will construct more than 100.

All this is happening when the property prices are falling. New home prices in 69 of the 70 big Chinese cities fell by 5.1% in January, from the year ago.

The regulators are in a bind. On one hand, they cut the Required Reserve Ratio of the Chinese banks to boost lending. On the other, they clamped down on the margin lending by 3 major brokers.

Liquidity, it seems, has its own mind. Bank loans are struggling in China however, the entrusted loans, trust loans and margin trading are growing at record pace.

At least, someone is borrowing. Europe is jealous.

European Central Bank (ECB) announced a trillion dollar quantitative easing program, to boost lending in Europe. They are hoping a 10% increase in monetary base would create at least 2% inflation.

The Swiss National Bank (SNB) saw it coming and front ran. They abandoned the cap on their currency against the euro, days before the ECB announcement.

What the Swiss tried to do for 3 years, before giving up now, was to preserve their competitiveness against a weakening currency. That is no different from what the Germans want.

The difference is in the implementation. Germany officially adopted the euro, permanently fixing its currency to the rest of the Eurozone. A German euro is equal to an Italian euro. Nobody questions it.

However, the Swiss fixed their franc at 1.20 euros. This deal bears more speculative pressure.

Swiss pegged it. Germans welded it.

So why give up now?

Usually the peg breaks down when the country runs out of the foreign reserves to defend its own currency. However, this time it broke because SNB accumulated too much foreign reserve.

That sounds like a happy problem. Not really so, if what you accumulate is becoming worth less.

SNB bought so much in the last 3 years that its euro holdings rose to the equivalent of $250 billion – almost 40% of the country’s GDP.

With the euro weakening against dollar at a rapid pace, and another quantitative easing in sight, SNB became nervous about its euro holdings. It could technically become insolvent if it kept buying more euros and they kept weakening. They de-pegged.

Ironically, the cure hastened the curse.

Within minutes of the SNB announcement, the euro crashed by 30% against the Swiss franc. Quite likely, SNB is now insolvent.

Can a central bank go bust?

Let’s start with the balance sheet of a country’s central bank.

On the asset side, a central bank may hold these –

    • Public-sector debt (all government linked debt)

    • Private-sector securities (mostly debt, sometimes equity)

    • Loans to commercial banks (through discount window)

    • Foreign-exchange reserves (what freaked out SNB)

    • Gold reserves.

The liabilities of the central bank may consist of these–

    • Currency (all the banknotes and coins in circulation)

    • Reserves (held by commercial banks at the central bank)

    • Debt securities (issued by the central bank).

Usually, most central banks have slightly higher assets than liabilities. That creates a sliver of equity or net worth.

However, if there is a shortfall in assets, a central bank can create more currency or reserves to cover any liability needs.

If printing continues, it may create concerns of inflation or undesired political perception. But as long as the liabilities are in its own currency, the central bank can satisfy them.

Any negative equity can be dealt with. The central bank’s assets generate some interest or return, while its local currency liabilities are usually interest-free. This free spread will make the bank solvent, over a period long enough.

Sometimes they even get paid on their liabilities, by setting a negative rate on reserves, as with both ECB & SNB currently. Imagine – you borrow money and you get interest on your loan!

The problem arises when the central bank liabilities are denominated in foreign currencies.

In such situations, a central bank can go bust if it cannot pay back its foreign-currency debt. It then becomes a mortal soul – like the rest of us – who can’t print what they borrow.

Such a bank needs to be re-capitalized by the government or shut down. Such instances have happened in the past. However, SNB is not in that situation. It is safe.

So, was anyone really hurt by the crash of euro vs. franc?

Citigroup lost $150 million on its currency desk. FXCM – a currency broker in the US - suffered losses of $225 million on client accounts. Another currency broker – Alpari in the UK – became insolvent. Global Brokers in New Zealand is bust too.

The biggest scalp so far was the $830 million hedge fund called Everest Global Macro fund. This 24-year old fund lost almost everything on that single day. It is now shut.

The likely cause of the fund’s demise is excessive leverage. Sometimes, prices gap and stop losses don’t work.

Leverage lifts all - a 20-year old fund or a 200-meter tall building. High up in the clouds, the ground becomes invisible.

But playing God has one mortal problem – the mortality. Come the tremors, the same leverage turns a crack into a ravine.

This write-up is for informational purpose only. It may contain inputs from other sources, but represents only the author’s views and opinions. It is not an offer or solicitation for any service or product. It should not be relied upon, used or construed as recommendation or advice. This report has been prepared in good faith. No representation is made as to the accuracy of the information it contains, nor any commitment to update it.