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WAS FOREIGN RESERVE BUILDING THE FIRST QE?
Many of the big changes in markets over the last 20 years make more sense if we think about foreign reserve building as a form of QE.
Most investors think about foreign reserves and QE as two distinct aspects of financial markets. Foreign reserves tend to be build in foreign assets (by definition), and are largely used to “protect” the value of the domestic currency. QE are largely asset purchases of domestic assets, often with the implied or explicit aim of devaluing the currency. However, it seems to me that in the early 1990s Japan began to build foreign reserves aggressively with the aim of keeping the Yen weak. That is Japan’s foreign reserve building was more like QE. Japan’s share of foreign reserves move from 10% share of world reserves to a peak of 35% in the early 2000s
Two things changed in 2000s that led to the supercharged growth in foreign reserves. East Asian nations that had suffered currency crises began to build substantial foreign reserves. China in particular over took Japan in mid 2000s.
If we think about foreign reserve building as a form of QE, then central bank activism began well before the global financial crisis. Markets began to change structurally with the beginning of the build out of Japanese foreign reserves in 1990. This structural change would have accelerated post the Asian Financial Crisis as other Asian nations built reserves. There is evidence to support such a line of thinking. Using Federal Reserve estimates of households net worth, US net worth to GDP has been higher than highs seen in 1950s since the mid 1990s, well before central bank activism became entrenched in financial markets.
Asset flows to the US, which includes both assets held as foreign reserves, as well as private assets have exploded higher, and as net international investment position (NIIP) data suggests, very one sided. Again it shows the US NIIP began to expand dramatically during the 1990s as Japan and East Asian nations began to build foreign reserves.
If this analysis is correct, then monetary policy in capital providers to the US becomes more important than monetary policy in the US. It is notable, for me at least, that Japan has tried to tighten monetary policy three times since the bubble economy burst. Briefly in 1997 before the Asian Financial Crisis, briefly before the dot com bubble burst, and again in 2006 before the Global Financial Crisis. It is also noticeable that the long US bull market since 2008 has coincided with no attempts by the Japanese to raise interest rates.
I thought that one reason the Japanese public tolerated such extreme monetary policy was due to very low food inflation. Conversely rising food prices would then create the political environment to reverse current monetary policy. That may still be the case, but Japanese food inflation has been ongoing since 2015 for some time with no noticeable change in monetary policy.
In many ways, the US dollar has become too big to fail for exporters like Japan, who are almost forced to buy US assets to prop up the dollar. The system seems self sustaining, but as mentioned in my previous note, China may be making a play as a new reserve currency. Any success for China in this would likely have very negative consequences for US assets.