China's Currency

PART III: Futures Imperfect for China


Henry C K Liu

Part II: Tequila Trap Beckons China

This article appeared in AToL on November 13, 2004

Liquidity, a fundamental concept in finance, can be defined as the ability to buy or sell large quantities of an asset quickly and at low cost. A liquidity crunch is the main cause of financial cycles of boom and bust. Financial cycles are different from business cycles in that they are predominantly driven by liquidity and illiquidity. Financial cycles are the dominant force in finance capitalism, replacing the business cycles in industrial capitalism.

In a bubble economy, asset values are inflated beyond the level supported by the money supply. The abrupt monetization of assets in a crisis requires large amounts of ready cash in the financial system. But cash is among the lowest-yield financial instruments that are expensive to hold. Thus the main source of cash in times of crisis is always the central bank, which can issue money at will and at no monetary cost, at least for the US. Other central banks cannot issue dollars, the currency of choice in international finance. They cannot issue money even in their own currencies without the penalty of exposing their currencies to speculative attacks because of dollar hegemony. The vast majority of equilibrium asset pricing models do not consider trading and thus ignore the time and cost of transforming financial assets into cash or vice versa. The history of recent financial crises suggests that at times market conditions can be so severe that liquidity can decline or even disappear temporarily. Such liquidity shocks are a potential channel through which asset prices are influenced by liquidity.

Bond of bother

The current yield environment more closely resembles 1994 than 1987. In 1994, the bond market was caught on the wrong side of economic fundamentals by the Fed's low-interest policy and crashed with Fed policy reversal toward higher rates. But unlike 1987, the stock market was spared in 1994 because money merely left bonds for stocks. Yet stock prices eventually need to be supported by corporate earnings, which will be the Achilles' heel of any equity bubble because rising interest rates tend to dampen corporate earnings. In a situation when both bonds and stocks face price collapse, market participants may simply hold on to cash in an attempt to preserve capital. In that case, central banks face what Keynes calls a liquidity trap and become impotent in curing a financial crisis with added liquidity. The last victim of a liquidity trap was Japan in the late 1990s when banks could not find creditworthy borrowers, even with negative interest rates.

For 2004, many traders view the rout in bond prices as merely the unwinding of an overbought unbalance caused by interest rates staying too low for too long. Bond portfolios are mostly still above water for the year, although they lost much of their earlier gains. By historical standards, the rise in interest rates since June 13 can be considered extreme, at least in percentage terms.

The policy of using interest rate cuts to pump up demand incurs economic costs, as evidenced first in Japan and then recently in the US. The costs include the danger of structural damage to long-cycle finance institutions such as those in the insurance sector. The soundness of these finance institutions can be threatened by abnormal spreads between short and long-term interest rates as well as by the adverse effect of new debts on the value of outstanding debts. There is also the question of sustainability and subsequently re-igniting inflationary pressures. In other words, the Fed's low interest strategy between 2000 and 2003 might have led to a bond bubble similar to the equity bubble of the 1990s, and its subsequent reversal on interest strategy creating conditions that ensure the bond bubble will burst.

Long-term yields have fallen to a level that requires a prolonged period of price stability or deflation to justify. Five-year yields slightly above 2% require zero inflation in the US economy over the next five years, a clearly unlikely scenario, particularly so with commodities and oil. US bonds have risen further and faster than at any stage in the past 40 years, a phenomenon that looks jarringly like the Nasdaq run-up of the late 1990s which hit its all-time high on March 10, 2000 at 5132.52. The heavily tech-dependent index would fall more than 77.8% in the three years after the bottom dropped out of the so-called Internet bubble. It now hovers around 1900. Since February 2000, the decline in five-year yields is down from 6.76% to 2.08%, which was greater in percentage terms (68%) than the 59% drop from September 1981 to August 1986 that set the scene for the 1987 crash.

Before 1994, short-term rates fell from 8% to 5% only to climb back to 8% again. Today, 10-year yields have risen from below 3.5% to over 4% and can rise above 5% over an 18-month period. Yet volatility seems built into the market. Ten-year yields again fell below 4%, hitting 3.984% on October 22, 2004. Unsophisticated investors traditionally are lured into bonds as a safe investment when in fact the potential for capital loss in bonds is just as great as in equities in the new economy. Bonds tend to produce a lower return because they are perceived to be less risky than equities. Yet on a three- or five-year view ahead, this perception will be wrong due to the Fed's interest rate vicissitudes. There is at least a possibility of 10-year bonds falling by 25% over the next 18 months as there is of shares falling by the same amount. The threat to bonds even if there is no resurgence of inflation will be that other investments will outperform them in a neutral interest rate environment, putting downward pressure of bond prices. Yet most investors in bonds do not have that same awareness of risk as equity investors.

The consequences of a bond market crash are complex and generally not well understood. That it hurts pension funds and forces governments to borrow at higher rates is obvious. Less obvious is that it also distorts bank balance sheets and is lethal to the financial sector. US Fed chairman Alan Greenspan has expressed the view that markets are now more sophisticated and better hedged than in 1994. But the US now depends more on foreign savings. The market for mortgage-backed securities has tripled in a decade to $4.7 trillion. Participants in that market hedge their bets in the bond market, amplifying bond market moves. Even slight interest rate moves by the Fed may have a bigger and less predictable impact as a result.

Swap to power

The US twin deficits are showing no signs of abating with Greenspan reassuring the market that the US economy is in "reasonably good shape". Derivatives such as total return swaps (TRS) can make short-term dollar loans (liabilities) appear as portfolio investments (assets). Also, the requirement to meet margin or collateral calls on derivatives may generate sudden, large foreign exchange flows that would not be indicated by the amount of foreign debt and securities in a nation's balance of payments accounts. As a result, the balance of payments accounts no longer serve well for assessing country risks. As China liberalizes it credit markets, or pushes the yuan into the global credit markets, its $450 billion-plus foreign exchange reserves will appear less significant as a hedge against speculative attacks on the yuan.

In the event of currency devaluation or sharp downturns in securities prices, derivatives such as foreign exchange forwards and interest rate swaps and TRS function to quicken the pace and deepen the impact of the crisis. Derivative transactions with emerging market financial institutions generally involve strict collateral or margin requirements. The rate of collateralization is estimated at around 20% of the notional principal of the swap. If the market value of the swap position were to decline, the East Asian firm would have to add to its collateral in order to bring it up to the required maintenance level.

Thus a sudden sharp fall in the price of the underlying security would occur at the beginning of a devaluation or a broader financial crisis would require the Asian firm to immediately add dollar assets to its collateral in proportion to the loss in the present value of the swap positions. This would trigger an immediate outflow of dollar reserves as local currency and other assets are exchanged into dollars in order to meet the collateral requirements. This would not only quicken the pace of the crisis, it would also deepen the impact of the crisis by putting further downward pressure on the exchange rate and asset prices, thus increasing losses to the financial sector. An upward revaluation of the yuan may well produce such instability all over Asia.

The EU's GDP is now greater than the US's. Yet the euro economy is still much smaller than the dollar economy due to dollar hegemony. The pool of euro-dollars (off-shore dollars) in circulation is now larger that of dollar circulation within the US. The introduction of the euro led to a surge in euro-denominated bond issues, and this in turn boosted arbitrage and hedging activity by issuers, dealers and investors. Participants in European markets began to use interest rate swaps to hedge their holdings of non-government bonds in the early 1990s, several years before participants in the dollar and other markets began to do so. At that time, financial institutions were the dominant non-government issuers in European markets, and as a result quality conditions in the non-government bond market were similar to those in the swap market. Participants in European markets thus became accustomed to hedging credit products with swaps.

The growth of the euro swap market was driven by hedging and positioning activity. Following monetary union, swaps quickly gained benchmark status in euro financial markets, displacing some of the benchmarks in the legacy currencies as the locus for price discovery about future short-term interest rates.

The fragmented nature of European government securities markets strengthened the incentive to switch to swaps for speculating on and hedging against interest rate movements. The market for unsecured inter-bank deposits was among the first euro financial markets to become integrated and, given that swap rates embody expectations of future inter-bank rates, this contributed to the rapid integration of swap markets in the euro legacy currencies. In fact, a single euro swap curve emerged almost overnight. Therefore, short positions - those taken in expectation of an increase in interest rates - can be created with relative ease in the swap market by choosing the "pay fixed" side of a swap.

In contrast, the secured market, specifically the general collateral repo market, was slower to break out of the segmentation that characterized it prior to monetary union. Differences in governments' credit ratings, settlement systems, tax regimes and market conventions remain obstacles to the complete integration of euro government securities markets. As a result, a single market for general collateral repos does not yet exist; market participants must still specify the nationality of government debt used as collateral before they conclude a repo transaction. This complicates the use of government securities to hedge or speculate on interest rate movements.

The switch to swaps was reinforced by a series of traumatic market events in the late 1990s. Events surrounding the near collapse of Long-Term Capital Management in September 1998 highlighted the risks inherent in the use of government bonds and related derivatives to hedge positions in non-government securities. This had been a routine strategy among dealers up until that time, albeit more so in the dollar market than in the euro market.

Squeezes in German government bond futures contracts over 1998-2002 had a similar effect. Temporary increases in the scarcity premium on euro government securities during auctions of third-generation mobile telephone licenses in 2000 also made government securities less attractive for hedging and position-taking purposes.

Overnight index swaps (OISs) have become especially popular hedging and positioning vehicles in euro financial markets. An OIS is a fixed-for-floating interest rate swap with a floating rate leg tied to an index of daily inter-bank rates. In the euro market, OISs are overwhelmingly referenced to the euro overnight index average (EONIA) rate - a weighted average of interest rates contracted on unsecured overnight loans in the euro area inter-bank market. Trading in EONIA swaps is highly concentrated in maturities of three months or less, and EONIA swap rates are widely considered to be the preeminent benchmark at the short end of the euro yield curve. Banks, pension funds, insurance companies, money market mutual funds and hedge funds all make extensive use of EONIA swaps to hedge and speculate on short-term interest rate movements. OISs are also traded in US dollars and other major currencies, but they have not gained benchmark status in these markets.

The benchmark status of the euro swap curve is reflected in quoting practices for corporate bonds. These practices often depend on the credit quality of the issuer and the nationality of the investor. Euro-denominated bonds issued by investment grade borrowers are usually quoted in terms of a spread over the swap curve. For non-investment grade corporate bonds, prices are quoted in the form of outright yields. Interest rate swaps are becoming more widely used as benchmark instruments in the US dollar market too. However, the shift is less advanced than in the euro market. For example, many US investors still prefer to price dollar-denominated corporate bonds against the treasury yield curve rather than the swap curve.

Notwithstanding the growth of the euro swap market, futures contracts continue to be heavily used as hedging and positioning vehicles. Indeed, trading in euro-denominated money and bond market futures soared in the run-up to and years immediately following the introduction of the single currency. Contracts based on three-month Euribor - a trimmed average of interest rates quoted for term deposits in the euro area inter-bank market - and traded on the London International Financial Futures and Options Exchange (LIFFE) are by far the most actively traded short-term interest rate futures in the euro market. Contracts based on German government securities and traded on Eurex dominate activity in longer-term euro futures.

The growth of the euro swap market has been accompanied by greater diversity in the range of players using interest rate swaps. In the run-up to European monetary union, the inter-dealer segment drove the growth of the euro swap market. At end-1998, positions vis-ŕ-vis other dealers accounted for 52% of the outstanding notional amount of euro interest rate swaps and forwards. Since 1999, the dealer-customer segment has become increasingly important. By end-June 2002, positions vis-a-vis financial customers accounted for 42% of the outstanding notional amount of euro interest rate swaps and forwards, and positions vis-a-vis non-financial customers a further 7%. By comparison, in the dollar swap market, positions vis-a-vis financial customers accounted for 41% of outstanding contracts, and positions vis-a-vis non-financial customers 15%. The smaller share of the dollar swap market accounted for by inter-dealer positions - 45%, compared to 51% in the euro market - is explained in part by greater concentration in the dollar market, which results in dealers offsetting more of their transactions internally rather than with other dealers.

Even European governments have begun to use interest rate swaps to manage their risk exposures. The French government has since October 2001 employed swaps to shorten the average maturity of its debt. As of end-July 2002, it had written swaps totaling 61 billion euro in notional principal, equivalent to approximately 8% of the outstanding French government debt. The German government uses swaps to lower its interest costs. At present, it is authorized to swap up to 20 billion euro, equivalent to about 3% of its outstanding debt. The Dutch, Italian and Spanish governments are also active in the euro swap market. The entry of governments into the interest rate swap market has tended to put a ceiling on euro swap spreads.

Although the range of players using swaps is increasing, the number of intermediaries is declining. Swaps are overwhelmingly traded over the counter (OTC), and so dealers are critical to the functioning of the swap market. Given customers' traditional preference for dealing with high-quality counterparties, trading in OTC markets has long been dominated by a handful of better-rated dealers. In particular, the major dealers have tended to be commercial banks with credit ratings of at least double-A.

In recent years, intermediation in OTC markets has become even more concentrated owing to mergers and acquisitions. For example, following the merger of Chase Manhattan and JP Morgan in 2000, the combined entity's share of the global OTC interest rate derivatives market equaled approximately 25%. In the EONIA swap market, the five largest dealers accounted for 48% of all trading activity during the second quarter of 2001 and the 20 largest dealers 88%. Other segments of the euro interest rate swap market were more concentrated, with the five largest dealers accounting for 60% of turnover. The euro swap market, however, is less concentrated than the dollar market. Two banks hold nearly three quarters of all interest rate derivative contracts booked by US banks, and the five largest banks hold over 90% of outstanding contracts.

Banks headquartered in the euro area are the most active dealers in the euro swap market, writing 46% of notional contracts outstanding in end-June 2002. Among euro area banks, German banks are the largest dealers, with a 21% market share, followed by French banks at 15%. US banks' share of the euro swap market was 35% at end-June 2002. In comparison, US banks' share of the dollar swap market was 54%. Japanese banks play only a marginal role in the euro and dollar swap markets but have a 33% share of the yen market.

The pricing of interest rate swaps in general depends on the interest rate used for the floating rate leg of the contract. The yield used for the fixed rate leg is supposed to embody expectations about the future path of the floating rate for the life of the contract and the risk associated with the volatility of that rate. For euro swaps, the choice of the floating rate tends to depend on the contract's maturity. For short-dated swaps, EONIA is the most common basis for the floating rate leg. Euribor was commonly referenced following monetary union but by 2000, had been superseded by EONIA at the short end of the swap curve. For longer-dated swaps, Euribor remains the key reference rate. The underlying instruments for both EONIA and Euribor are unsecured interbank deposits and therefore these rates reflect a degree of credit risk. Indeed, most banks in the EONIA and Euribor contributor panels are rated double-A.

The pricing convention for euro swaps is to provide quotes in terms of the yields that specify the fixed payments for the contracts. This is unlike the convention for US dollar swaps, which are typically quoted in terms of spreads over US treasury yields. Hence, the price of a five-year euro swap might be quoted as 4%, without any reference to a government bond yield, while that of a five-year US dollar swap might be quoted as 50 basis points over the five year US treasury yield. To be more precise, quoting in spreads for dollar swaps is conventional for dealers in New York, while quoting in yields for this contract would be more typical for dealers in London. EONIA and Euribor are the most common reference rates. Swap rates include a premium for counterparty risk

In spite of the benchmark status of euro swaps, their yields still tend to hover above the yields for the most liquid triple-A rated government bonds in a given maturity, just as dollar swap yields tend to be higher than US treasury yields. At the 10-year maturity, for example, the fixed rate on euro swaps at end-January 2003 was about 20 basis points above the yield on the German bund. Swap rates are typically higher than rates on triple-A rated securities because they contain a premium for counterparty credit risk, which is often associated with the major dealers in the market.

Alternatively, deterioration in the perceived creditworthiness of the government could result in a narrowing of the spread. For example, fiscal difficulties in Germany appeared to contribute to a narrowing of the spread between euro swaps and German government bonds in 2001 and 2002. In the past, a customer could mitigate counterparty risk by spreading positions across several dealers. As consolidation in the financial industry reduced the number of active swap dealers and credit ratings of the remaining dealers were downgraded, daily settlement and especially collateralization became increasingly common. The widespread use of such mechanisms for mitigating counterparty risk resulted in narrower and more stable swap spreads.

Nevertheless, counterparty risk can still at times unsettle the swap market. For example, credit concerns about several large US banks - including major derivatives dealers - caused dollar and, to a lesser extent, euro swap spreads to widen in July 2002. Other possible influences on swap spreads include the general level of interest rates and the slope of the yield curve. However, the economic rationale behind these factors is difficult to explain, and their relationship with spreads tends to be unstable over time. Liquidity was a concern in the past but liquidity in the euro swap market is now such that yields tend not to be driven by imbalances in supply and demand.

Rising Europe

European swap markets were already quite liquid prior to monetary union, and they gained liquidity following the introduction of the single currency. The use of interest rate swaps by some market participants as hedging and positioning vehicles increased the willingness of other participants to do likewise, resulting in a self-reinforcing process whereby liquid markets become more liquid.

A liquid market is one where participants can rapidly execute large-volume transactions with a small impact on prices. There are at least three dimensions to market liquidity: tightness, depth and resiliency. Tightness refers to the difference between buying and selling prices. Depth relates to the size of trades possible without moving market prices. Resiliency denotes the speed with which prices return to normal following temporary order imbalances. Collateralization is increasingly common.

Euro swaps are one of the most liquid instruments available in euro financial markets. Indeed, EONIA swaps are the most liquid segment of the euro money market. EONIA swaps of 2 billion euro are regularly traded in the inter-dealer market for maturities up to three months, and significantly larger trades are not uncommon. Bid-ask spreads are typically 1 basis point. The Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity shows that the average daily turnover of euro-denominated OTC interest rate contracts almost doubled between April 1998 and April 2001, to 231 billion euro. Compared to the $56 trillion in notion value of dollar derivative in 2002, the euro derivative market is still miniscule.

By 2001, the turnover of euro swaps and forwards exceeded that of all interest rate products other than money market futures, US treasuries and German government securities. Trading in EONIA swaps appears to account for much of this growth. Beyond two years, however, the euro swap market is neither as tight nor as deep as the larger European government securities markets. Anecdotal evidence suggests that bid-ask spreads for euro swaps are wider than those for government securities: one basis point for inter-dealer swaps, compared to less than half a basis point for the most recently issued German government securities. Quote sizes are also smaller: approximately 100 million euro for five and 10-year swaps, compared to at least 150 million euro for the most recently issued German bobls (or Bundesobligationen) and bunds. Trading activity in longer-dated swaps is a fraction of that in futures contracts on German government bonds.

Moreover, liquidity in the euro swap market appears more likely to evaporate during periods of extreme volatility than liquidity in the larger government securities markets. In particular, interest rate swaps remain less liquid than they would be if they were traded on an organized exchange, where a central clearing house could act as the counterparty to all trades. Counterparty credit risk becomes of paramount concern during periods of market volatility, when uncertainty about the health of financial institutions often increases. Consequently, arrangements for dealing with counterparty risk play a major role in determining market liquidity under stress.

Assuming that the soundness of the clearing house is ensured, the liquidity of instruments traded on organized exchanges tends to be more robust to stress than that of instruments traded over the counter. Steps have been taken to encourage greater centralization in the swap market. In the early part of 2001, the London Clearing House, supported by several of the largest swap dealers, began clearing and settling interest rate swaps in all of the major currencies. At about the same time, LIFFE introduced futures contracts on two-, five- and 10-year euro swaps. However, trading of swap futures accounts for an insignificant proportion of global swap activity. In contrast, trading of futures contracts on German government bonds accounts for the larger part of activity in the German government securities market. EONIA swaps are the most liquid segment of the euro money market, but government securities markets are more liquid at longer maturities.

It remains unclear whether swaps will continue to erode the benchmark status of government securities and consolidate their position as the dominant positioning and hedging vehicles in euro fixed-income markets. In addition to the previously mentioned concern about counterparty risk, another concern is that the participation of large, one-sided players such as governments could increase the risk of idiosyncratic movements in swap yields - ie it could increase basis risk - and so make swaps less effective hedges.

Repos could eventually compete with EONIA swaps for benchmark status at the short end of the euro yield curve, as they do in the US dollar market. European repo markets are growing rapidly and steadily becoming more integrated, boosted in large part by market participants' efforts to limit counterparty credit exposures. The development of a tri-party repo market - in which settlement and management of the collateral is delegated to a central clearing house - is especially noteworthy because it allows a basket of securities to back a transaction, including lower-quality, less liquid securities. At the longer end of the yield curve, government securities remain attractive benchmark instruments, not least because of the tremendous liquidity of German government futures contracts.

It seems the one thing that emerges from a discussion on the relationship of interest rate to inflation is that clear definitions of economic condition are necessary to fully understand or describe such relationship. Although it is not a derivative instrument until it is structured as a swap, interest is a derivative whose value is derived from the amount of the loan principal and the interest rate. The interest rate determines the amount of interest to be paid over time on a principal sum that in turn determines the size of the cash flow. The total cash flow in a financial system reflects its liquidity. Thus interest rate has a direct effect on liquidity.

In a debt-free economy, interest rate is irrelevant because with zero principal, the interest payment is also zero, regardless of the interest rate. In a saturated debt market, as in Japan now, the interest rate is also relatively irrelevant because all outstanding loans are mostly likely fully hedged and new loans are not being written for lack of demand or creditworthiness common in a liquidity trap. The zero interest rate in Japan has little impact on the economy because qualified borrowers cannot be found even at negative rate. In other words, outstanding bad loans have already absorbed all available collateral.

Thus it follows that the impact of interest rate on inflation is a function of the size of the aggregate debt in an economy in relation to the market value of the collateral. Aggregate demand for new debt is a function of surplus collateral which is in turn a function of market value. A sudden and drastic fall in market value increases the loan to asset ratio and depletes surplus loan to asset ratio. Therein lies the detonator for implosion of a debt economy in a bear market.

What is a bear market? Price is no doubt the intended intersection of supply and demand, provided supply and demand are defined broadly without excluding externalities. But price does not always lead to transactions. And only transactions make a market, not price. There is sometime a price with no market when the asking price is stubbornly too high to attract buyers. In an open market, technical analysts will tell you that when an item is put up for sale, the price is not set by the seller or the potential buyer. Price is the result of open bids, adjusted according to the degree of market friction. What produces a bear market is the absence of bids, the seller in a non-monopoly then lowers the asking price out of fear that another seller may steal the sale. Potential buyers hold back in hope for a more desperate seller. Thus a bear market emerges. Sellers do not compete with buyers, but with other sellers, the same being true with buyers.

A bull market is created by reverse dynamics. Buyers pay asking price or offer above asking price out of fear of losing the deal. Sellers hold back for better offers from competing buyers. If the upward price pressure is greater than interest cost, potential sellers will borrow against the asset rather than sell. This tends to increase the market value of the asset, qualifying it for additional loans, which in turn pushes prices up further. This is what is known as the wealth effect on debt. This spiral could go on forever if it were not for the little problem of interest payment. Loans are not allowed to postpone interest payments. When that happens it is called a default, the worst word in the credit business. Just as the concept of forgetfulness depends on the concept of memory, the notion of debt is dependent on its service and repayment. A debt without the support of regular or pre-arranged interest payment or the prospect of principal amortization turns into a loss. Thus loans rely not just on collateral, but also on the cash flow that the collateral or other assets can generate for servicing the loan by paying interest periodically or at an agreed time. This little convention prevents the existence of perpetual bubbles.

There will come a point when the cash flow capacity of assets will fail to support the interest payments on a ballooning loan perfectly secured by the underlying assets' rising market value. When that happens, the borrower must sell to reduce his debt and the upward price pressure peaks and starts reversing itself as downward price pressure. The bull market then abdicates and the bear market takes over. The nature of the credit market is such that the downward slide is much more forceful and speedy than the upward climb. The rapid downward slide is called a burst of the debt bubble or a debt collapse.

Now, history has shown that two related developments could under normal conditions prevent or soften a debt collapse. They are, first, a sufficient and timely increase of the money supply by the central bank and subsequently reflation that is brought about by increased money supply in a no-growth or negative-growth economy, or inflation which is caused by a money supply growth rate ahead of economic growth rate.

Anatomy of money supply

The money supply then is of critical importance to monetary policy considerations. To monitor the money supply, the Fed tracks three monetary aggregates, M1, M2, and M3, each of increasing scope but decreasing rate of turnover. M1 comprises the traditional definition of money as a means of payment. It includes currency in circulation plus the checkable deposits in depository institutions (banks and thrifts). Currency in bank vaults and bank deposits at the Fed are not a part of M1, although they are part of the monetary base, sometimes designated M0. M2 includes M1 plus retail non-transaction time deposits. M3 includes M2 and wholesale deposits. Each of these money aggregates serves a different purpose for Fed deliberations. At the end of August 2004, M1 measured $1.34 trillion; M2 measured $6.3 trillion and M3 $9.28 trillion, which increased by $390 billion over the $8.89 trillion measured at the end of August 2003. Yet the latest available data on notional values of dollar derivative is $56 trillion for 2002, up from $45 trillion in 2001. The figure could reach $65 trillion for 2003 that would be more than seven times the M3.

Too much money in relation to the output of goods and services leaves money idle and tends to push interest rates down and push prices and inflation up. Inflationary growth in turn requires more money to sustain growth. Too little money tends to push interest rates up, lowers prices and output and causes unemployment and idle plant capacity, which in turn further reduces demand for money. There was a time when the money in deposits with commercial and saving banks roughly equaled to loans outstanding in the economy. The Fed, through setting the cost of funds (interest rate), partial reserves and capital requirements for banks, could manage the rise and fall of the money supply.

The Fed still attempts to manage the money supply by setting bank reserves and the discount rate at which banks borrow to meet their reserves needs, as well as Open Market Operations to achieve Fed funds rate (ffr) targets by trading government securities to inject or drain money in the banking system. The Fed also participates in the repo market to keep the repo rate in line with the ffr. Repos allow banks to skirt the reserves requirement when expanding their loan portfolios. Banks often do not even own the government securities they use to execute repos, the proceeds of which yield banks such interest rate spread from bank loans that the cost of borrowing the government securities are more than covered.

With deregulation, all money except cash has become interest bearing. And with Automatic Teller Machines (ATM) and credit card use, the amount of cash needed in the economy has shrunk dramatically. Everyone is operating with just-in-time cash management. M2 is overnight repos, overnight eurodollars, savings accounts under $100K and money market mutual fund shares. M3 is M2 plus time deposits over $100K and term repos. Finally, L (Long-term liquid funds) is M3 plus T-bills, savings bonds, commercial papers, bankers acceptances and eurodollar holding of US residents (non-bank). Derivatives are not included in money supply data.

With the growth of securitization, banks pass off their loan portfolios to investors in the credit markets. In this process, banks act as reverse intermediaries from their traditional retail role in both deposit and loans and become retail marketers of loans to feed a wholesale credit market. This credit market is totally outside the control and jurisdiction of the Fed. Tax deductibility of interest on home mortgages, interest on margin accounts, interest on loans for corporate mergers and acquisitions affects significantly the impact of interest rates on inflation.

Risk business

Risk arbitrage is a risky play to profit from the simultaneous purchase of stock in a company being acquired and sale of stock in its proposed acquirer. It is also known as takeover arbitrage, a play that profits by cashing in on the expected rise in the price of the target's shares and drop in the price of the acquirer's price. The risk is if the takeover falls through for any number of reasons, the arbitrageur may be left with huge losses. Risk arbitrage differs from risk-less arbitrage, which entails locking into profit from differences in the prices of two securities or commodities trading on different exchanges. Risk arbitrage is done through credit, using the current market value of the shares as collateral.

Risk aversion is not just an attitude, it is a calculable premium. Given the same return with different risk alternatives, a rational investor will seek the security offering least risk, or conversely, the higher the risk, the higher the demanded return. In the credit market, instruments are all priced precisely and with uniform standards to reflect risk aversion. Risk-based capital ratio is a minimum ratio of estimated total capital to estimated risk-weighted assets, required by FIRREA (Financial Institution Reform and Recovery Act). The benchmark for risk-free return is the three-month treasury bill. The CAPM (capital asset pricing model) used in modern portfolio theory has the premise that the return on a security is equal to the risk-free return plus a risk premium.

The ideal of a transaction is to be risk-less. A risk-less transaction guarantees a profit to the trader that initiates it. An arbitrageur may lock in a profit by trading on the difference in prices for the same security or commodity in different markets due to market inefficiency. For instance, if gold is selling for $450 at NY and $449.86 in London briefly due to market inefficiency, a trader who acts with electronic speed may buy a contract in London while simultaneously selling a contract in NY, yielding a risk-less profit. These transactions serve a function in eliminating market inefficiency. Risk-less transaction is also a concept used in evaluating whether dealer mark-ups and mark-downs on OTC (over the counter) transactions with customers are reasonable or excessive. Nasdaq uses the 5% rule, meaning mark-ups (when customer buys) and mark-downs (when customer sells) should not exceed 5%.

Uncertainty is not measurable, but risk is a measurable possibility of losing or not gaining value. The most common risks in finance are inflation risk, interest rate risk and exchange rate risk. These risks are interlinked in complex relationships. Other business risks are inventory risk, liquidity risk, actuarial risk, regulatory risk, political risk, credit risk, risk of principal and underwriting, and guarantor risks. Risk-adjusted discount rate in portfolio theory and capital budget analysis is the rate necessary to determine the present value of an uncertain or risky stream of income. In the so-called New Economy of the 1990s, this discount has been thrown out the window and replaced by fantastic premiums. It is useful to remember that interest rate is the cost of money at an annual rate, interest itself is the cost of using money (debt) over time. The cost of availability of money is a standby fee. Money not used is interest-free, regardless of interest rate.

Interest rate risk exists when changes in interest rate will adversely affect the value of an investor's securities portfolio. For example, holders of long term bonds or utility stocks assume a significant interest rate risk because the value of those bonds or utility stocks will fall if interest rates rise. Interest rate risks can be hedged by buying interest rate futures or interest rate options contracts. It is useful to understand that futures and option contracts are not market prediction, but market implications that are precisely calculable. Interest-sensitive stocks are those of firms whose earnings change when interest rates change, such as banks, insurance companies, financial companies or utilities.

Bank participation in derivative markets has risen sharply in recent years. Average daily global turnover in OTC derivatives markets increased to $1.2 trillion in April 2004, a rise of 112% at current exchange rates and 77% at constant exchange rates as compared to April 2001. OTC derivatives are traded outside exchanges between private counterparties. The notional value of derivative contracts held by all insured commercial banks in the US increased from $6.8 trillion in 1990 to $11.9 trillion in 1993, an increase of 75%, to $45.1 trillion at the end of 2001 and $56 trillion at the end of 2002, and continues to grow dramatically. Nearly 81% of the $56 trillion notional value of derivatives represents interest rate derivative contracts at just 5 dealer banks.

The top five derivatives dealers hold 93% of total notional values. More than 86% of these dealers' holdings are interest rate contracts. Therefore, in terms of the derivatives risk matrix, a vast majority of commercial bank derivative activity is in interest rate contracts at a few dealer banks. These dealers conduct derivative activities as part of their total trading operations, which makes analyzing derivative risk difficult to isolate from total trading risk. Furthermore, if a bank is speculating in derivatives, it occurs within these trading portfolios and is not reported separately. A major concern facing policymakers and bank regulators today is the possibility that the rising use of derivatives has increased the risk profile of individual banks and of the banking system as a whole. The global nature of derivative markets and firms' participation in them suggests that a disruption in these markets could have wide-ranging effects that would be transmitted across national boundaries.

While the number of banks reporting derivative securities use declined from 587 to 369 during by 2001, the dollar volume of assets of the banks utilizing derivatives increased from $2.3 trillion to $5 trillion. This represents about 77% of all commercial bank assets. In 2001, the 25 largest banks in the US accounted for 99% of bank-held derivative securities. Bank mergers have since reduced the number to five. The smaller banks that used derivative securities utilize them for purposes of hedging 75% of the time.

On the other hand, the top 25 banks held most of their derivatives for trading; at the end of 2001, only 0.6% of the derivatives held by these giant banks were held as hedges. The remaining 344 banks utilizing derivative securities held close to 60% of the notional value of derivatives for hedging purposes; compared with 70% in 1999. The biggest banks not only participate in the derivatives market as end-users but also act as dealers by providing OTC derivatives for non-financial companies. Thirteen US-based bank holding companies are primary dealer firms in the derivative market. Derivatives held for trading purposes are accounted for on the balance sheet at fair value, with gains and losses reflected on the income statement.

Risk management techniques that reduce return volatility can be called hedging, but if these same techniques are used to increase return volatility it is generally called speculating. Derivatives not held for trading are being used for purposes of hedging. Most derivative contracts are not traded on organized exchanges, but are traded in the OTC market between counterparties.

Risk management is about the creation and preservation of value rather than the elimination or reduction of risk. Risk-based capital requirements have been associated with a shift of assets from loans to securities or into securitized residential mortgages, and into off-balance-sheet activities at some banks. Less capital is required for holding securities rather than loans and for holding residential mortgage loans rather than commercial or consumer loans. There is evidence that regulation had a greater impact on bank capital decisions than did market discipline.

One of the primary methods banks use to address risk management concerns is the implementation of value-at-risk (VaR) models. Banks make the choice of VaR models based on the response to regulatory penalties for violations. Banks began to use VaR models in the late 1980s to measure the risks of their trading portfolios. Both the Bank of International Settlement Basel I Accord of 1988 and the 1996 Amendment discuss the use of VaR models. VaR is a method of assessing financial market risk by measuring the worst expected loss over a specified time horizon with a given level of confidence.

The Basel Committee on Banking Supervision's paper titled "International Convergence of Capital Measurement and Capital Standards: A Revised Framework" deals with the new capital adequacy framework commonly known as Basel II to secure international convergence on revisions to supervisory regulations governing the capital adequacy of internationally active banks. The committee intended the framework to be available for implementation by the end of 2006, but postponed it to 2007. The fundamental objective of the committee's work to revise the 1988 accord has been to develop a framework that would further strengthen the soundness and stability of the international banking system while maintaining sufficient consistency that capital adequacy regulation will not be a significant source of competitive inequality among internationally active banks with the concept and rationale of the three pillars (minimum capital requirements, supervisory review, and market discipline) approach. In developing the revised framework, the committee has sought to arrive at significantly more risk-sensitive capital requirements that are conceptually sound and at the same time pay due regard to particular features of the present supervisory and accounting systems in individual member countries.

Fed governor Ben S Bernanke in a speech before the Institute of International Bankers in Washington DC on October 4, 2004 highlighted two areas important for internationally active banks: (1) home-host supervisory cooperation, and (2) the proposed bifurcated application of Basel II in the US and the special issues it creates for cross-border banking. Banks with significant cross-border operations have concerns about the prospect of each national supervisor implementing Basel II in ways inconsistent with the principle of consolidated supervision. Bernanke observed that Basel II capital accord is not a treaty, but a consensus that the authorities in each national jurisdiction will inevitably apply in their own specific ways, reflecting their preferred approaches to bank supervision and regulation.

The large number of banks with cross-border operations will continue to fall under the consolidated supervision of their home-country supervisors. But at the same time, each host-country supervisor is entrusted by its own government with ensuring that legal entities operating within its jurisdiction are operating in a sound manner with adequate capital. The combination of global banking and sovereign states has produced "tensions". Three aspects of Basel II may raise the level of tension experienced by internationally active banks still further: (1) Basel II is more complex, (2) it includes requirements for capital to cover operational risk in addition to credit risk, and (3) it has all the uncertainties of the new and the untested.

These issues cannot be fully avoided in a world order of sovereign states. In contrast to the treatment for credit risk, Basel II allows both the consolidated and the individual legal entities to benefit fully from operational risk reduction associated with group-wide diversification. However, host countries entrusted with ensuring the strength of the legal entities operating in their jurisdictions will not be inclined to recognize an allocation of group-wide diversification benefits, given that capital among legal entities is simply not freely transferable, especially in times of stress. US authorities do not see implementation of the Advanced Internal Ratings Based method for credit risk and the Advanced Management Approach for operational risk in the US before 2008.

Theories on financial intermediation suggest that banks can minimize the cost of monitoring information by diversifying their assets. Banks can also use financial derivatives for hedging, which can be an effective mechanism for controlling risks. However, there are potential dangers if banks utilize derivatives for speculative purposes. Banks have capital "charges" on banks that use derivative instruments, but these capital costs are independent of whether these instruments are used for hedging or speculative purposes. Interest is the cost of debt and debt is part of the money supply, and in modern finance, the biggest part. Not all debts are interest-bearing and some debts carries negative interest either nominally or de facto due to inflation. The acceptability of the cost of debt is generally measured against the opportunity cost of not taking debt.

Interest rate swaps and currency swaps have seen explosive growth in the last two decades. Interest swaps are used to reduce risk by synthetically matching the duration of assets and liabilities of financial institutions as interest rates get higher and more volatile. In currency swaps, two parties sell each other a currency with a commitment to re-exchange the principal amount at the maturity of the deal. Originally done to get around exchange control, currency swaps are now widely used to tap new capital markets.

The World Bank has been an active participant in currency swaps with US corporations. An interest rate swap is an arrangement whereby counterparties enter into an agreement to exchange periodic interest payments based on a specified notional principal amount. Swap options give either the payer or receiver the right but not the obligation to enter into an interest rate at a pre-set rate within a specific period, or the receiver the right to receive fixed payments. Often, the swaps are further hedged with other instruments. Debts can be taken in a number of currencies, other financial instruments and company shares.

A weak dollar policy is one that forces or allows, by government policy, the dollar to fall in value against foreign currencies. That means holders of dollars and dollar assets will get fewer units of another currency in exchange for their dollars as on outcome of government policy. A weak dollar helps US exports because it enhances the purchasing power of holders of foreign currencies who may or may not be foreigners. The conventional factors behind a weak dollar are: loose US monetary policy, deteriorating confidence in the US government, trade and/or budget deficits, relatively low interest rate on dollar-denominated debt and/or returns on dollar assets, from both dividends and market capitalization value.

Structured finance exerts fundament impact on the relationship between interest rate and inflation rate. The key instrument in structured finance is the derivative, which is a contract whose value is based on the performance of an underlying financial asset, index or other investment. For example, a structured note issued by a corporate may pay interest to note holders based on the rise and fall of oil prices. This gives the investor the opportunity to earn interest and profit from the change in price of a commodity at the same time. In this case, it is obvious that market price of a commodity drives interest rate and not the reverse.

The world of derivatives

Other derivatives are complex debt instruments. It can be a medium-term note, in which the

issuer enters into one or more swap arrangements to change the cash flows it is required to make. A simple form utilizing interest rate swaps might be a three-year floating rate note paying LIBOR (London Interbank Offer Rate) plus a premium semi-annually. The issuer arranges a swap transaction whereby it agrees to pay a fixed semi-annual rate for three years in exchange for LIBOR. Since the floating rate payments (cash flows) offset each other, the issuer has synthetically created a fixed-rate note. The risk of interest rate fluctuation is passed on to the counterparties of both ends of the swap. Thus interest rate risk is exchanged for counterparty risk which theoretically is less - but not necessarily - risky.

Structured settlements are agreements to pay a designated party a specific sum in periodic payments over an extended period, sometimes for a lifetime without definitive end, instead of a lump sum. The risk on the uncertain aggregate payout amount is assumed by the structure. An ordinary option is a derivative whose value changes in relation to the performance of the underlying stock. In their 1973 paper, "The Pricing of Options and Corporate Liabilities", Fischer Black and Myron Scholes published an option valuation formula that today is known as the Black-Scholes model. It has become the standard method of pricing options. Black and Scholes derived a stochastic partial differential equation governing the price of an asset on which an option is based, and then solved it to obtain their formula for the price of the option.

Black and Scholes made indispensable contribution to the growth of the option market by providing a mathematical calculation for precise pricing of an option, changing it from mysterious prediction to rational implication. A more complex example of an option would be a futures contract, where the option value varies with the value of the futures contract, which in turn varies with the value of an underlying commodity or security. Derivatives on the performance of assets, interest rates, currency exchange rates and various domestic and foreign indices are common. A key characteristic of derivatives is its ability to exploit leverage, which when used knowledgeably, can enhance returns for investors and be useful in hedging portfolios. In the 1980s, abuses in program trading became notorious and in the 1990s, when the protective strategy of portfolio insurance was distorted to mask systemic risk, leading to huge losses for hedge funds, mutual funds, municipalities, corporations, banks, financial institutions and investment banking houses. These astronomical losses resulted from unexpected movements in interest rates, caused by central bank fiats and exchange rate tumults, adversely affecting the value of derivatives when unwound.

Bear markets are prolonged periods of falling prices. Theories aside, a bear market in stocks is usually brought on by the anticipation of declining economic activity and deflation expectation; and a bear market in bonds is caused by rising interest rates brought on by inflation expectation. But there is also a market convention that a bear market in equity pushes a bull market in bonds, caused by a flight to quality and safety. Thus the relationships between bond prices and equity prices are often indeterminate and complex.

A bear spread is a strategy in the options market designed to take advantage of a fall in the price of a security or commodity. A bear spread execution buys a combination of calls and puts on the same security at different strike prices in order to profit as the security's price falls. An alternative execution buys a put of short maturity and a put of long maturity in order to profit from the differences between the two puts as prices fall. A bear trap situation confronts short sellers when a bear market reverses itself and turns bullish. Anticipating further decline, the bears continue to sell and then are forced to buy at higher prices to cover at expiration date, especially on triple witching Fridays, third Fridays in March, June, September, and December, in what the market calls a short squeeze. A bear raid attempts to manipulate the price of a stock by selling large numbers of shares shot to pocket the difference between the initial price and the new, lower price after the maneuver. Bear raids are illegal under SEC rules which stipulate that every short sale be executed on an uptick (the last price higher than the price before it) or a zero plus tick (the last price was unchanged but higher than the last preceding different price). There are, however, enforcement problems of this rule due to the complexity and speed of transactions and the fact that foreign markets that trade US shares have different rules.

Bull spreads can be executed in three varieties: Vertical spread (simultaneous purchase and sale of the same class at different strike prices but with the same expiration date); calendar spread (same price but different expiration date); diagonal spread (combination of vertical and calendar spreads). An investor who believes a stock will rise, even if only moderately, can buy a 30 call for 1+1/2 and sell a 35 call; both options are "out of the money". The net cost of the spread, or the difference between the premium and the based price, is $1. If the stock rises to 35 just prior to expiration, the 35 call becomes worthless and the 30 call is worth $5 with an investment of $1. If the price goes down, the investor loses $1.

Defeasance in corporate finance is a technique whereby a corporation discharges old, lower-rate debt without repaying it prior to maturity. The corporation uses newly purchased securities with a lower face value but paying higher interest or with a higher market value. The objective is a cleaner, more debt-free balance sheet and increased earnings in the amount by which the face value of the old debt exceeds the cost of the new securities. The first time defeasance was used was in 1982 when Exxon bought and put in an irrevocable trust $312 million of US government securities yielding 14% to provide for the repayment of principal and interest on $515 million of old debt paying 5.8-6.7% and maturing in 2009. Exxon removed the defeased debt from its balance sheet and added $131 million after tax earnings to that quarter. In that case, high interest rates actually yielded a profit for a company with low-rate old debts. Defeasance is now routinely used by every corporation, confusing the impact of interest rates on short-term profit.

Collateralized Bond Obligations (CBO) are investment grade bonds backed by a pool of junk bonds. CBOs differ from CMOs (Collateralized Mortgage Obligations) in that CBOs represent different degrees of credit quality rather than different maturities. CBO underwriters package a large and diversified pool of high-risk, high-yield junk bonds, which is then separated into tiers. A top tier represents a higher-quality collateral and pays the lowest interest rate; a middle-tier is backed by riskier bonds and pays a higher rate; the bottom tier represents the lowest credit quality and instead of receiving a fixed interest rate, receives the residual interest payments - money that is left over after the higher tiers have been paid.

Then there is the Z tier that is below all three upper tiers. CBOs, like CMOs, are substantially over-collateralized and this fact, plus the diversification of the pool backing them, earns them investment grade bond ratings. Holders of third-tier CBOs stand to earn high yields if the default rate in the collateral pool falls in good times or falling rates, or lose money when the default rate rises in bad time or rising rates. CBOs provide a way for big holders of junk bonds to reduce their portfolio and for securities firms to tap new sources of buyers in the junk bond market. CMOs separate their mortgage pools into different maturity classes called tranches by applying income (payments and prepayments of principal and interest). Tranches pay different rates of interest and can mature in a few months or 20 years. CMOs are usually backed by government guaranteed or other top-grade mortgages with AAA ratings. If mortgage rates drop sharply, causing a flood of refinancing, prepayment rates will soar and CMO tranches will be repaid before their expected maturity.

Convertible bonds are off-balance-sheet obligations that give its holder the privilege, but not the obligation, to exchange for securities of the issuing company at some future date under prescribed conditions, usually when market share value reaches a certain point. Also, convertible bonds require the issuer to repay some or all of the obligation if the share value of the issuer falls below a specified level. Bond mutual funds are designed to produce current income for shareholders. Bond funds also produce capital gain or loss when interest rates fluctuate. Unlike the bonds they hold, these funds never mature. Bond swap simultaneously sells one bond and purchase another, with the motive to swap longer maturity to produce a profit; or to swap improved yield for higher risk, or lower yield for higher quality, or to create tax-deductible loss through the sale while purchasing a substitute bond to preserve the investment.

It is obvious that derivatives inject elasticity if not outright distortion in the relationship between interest rate and inflation rate. And since the notional value of the derivative market is many times the market value of the credit and equity markets, this distortion now dominates markets behavior. This is one reason why the traditional business cycle has been lengthened. It is not because of Greenspan's magic touch. But the business cycle has not disappeared, merely extended at a cost. The cost is a much more violent and sudden release of built-up pressures when counterparty risks move against the system.

The dated archives of economic literature can yield little light on the current impact of interest rates on inflation. Anything written more than 5 years ago must be describing conditions that bear little resemblance to the current financial architecture and credit markets and thus drawing theoretical conclusions that may not be relevant except in a historical context. The debate on whether high interest rate is inflationary or deflationary seems to be a puzzling controversy in economics. Within the current international financial architecture, interest rates cannot be fully understood without taking into account their impact on exchange rates and credit markets. In a globalized financial market, if the exchange rate is artificially sustained by high interest rate, there is little doubt that the impact would be deflationary on the local economy. This logic is also supported by empirical data in recent years.

Yet, many astute economists insist that high interest rate causes inflation, at least in the long run. Perhaps it is true that high rates can cause inflation in closed economies, but it is no longer necessarily true in open economies in a globalized financial market. Interest rates are the prices for the use of money over time. These prices do not always track the purchasing power of money, which is the monetized expression of the market value of commodities (the transaction price) at a specific time. The purchasing power of money fluctuates over time, expressed by the prices of futures and options which are functions of the uncertain elasticity between interest rates and inflation rates.

As the price for the use of money over time rises, the general effect will be deflationary if money is viewed as a constant store of value. Otherwise, money will forfeit its function as a constant store of value. On the other hand, if money is viewed as a medium of exchange, the ultimate liquidity agent, then rising price for its use over time is inflationary as a cost.

In any economy, money tends to play both roles, though not equally and not consistently over time. For market participants, depending on their positions (borrower or lender) at specific points of the economic cycle (expanding or contracting liquidity), they will find different views of money (exchange medium or value storer) to be to their financial advantage. Thus borrowers generally consider high interest rate as leading to cost inflation (bad), and lenders consider high interest rate as slowing inflation (good up to a point). Asset deflation offers good buying opportunities for those who have money or have access to credit, but bad for those who hold assets but need money, and the pain is proportional to asset illiquidity. Since most holders of ready cash also hold assets, deflation has only limited and short-term advantage for them. For inflation to be advantageous, continued expansion of credit is required to keep asset appreciation ahead of cost inflation.

Defining inflation

The problem is further complicated by the fact that inflation is defined mostly by mainstream economics only as rising price of wages and commodities, and not by asset appreciation. When it costs 10% more to buy the same share of a company as yesterday, it is considered growth - good economic news. When wages rise 5% a year, it is viewed as inflation - bad economic news, despite the fact that the aggregate purchasing power is increased by 5%. Therein lies the fundamental cause of a bubble economy - growth and profit are generated by asset inflation rather than by increased aggregate demand stimulating aggregate supply.

Thus the relationship of interest rate to inflation is dependent on the definition of money. But that is not the end of the story. Under finance capitalism, inflation is not merely too much money chasing too few goods as under industrial capitalism. Under financial capitalism, two elements: Credit availability and credit markets have overshadowed the traditional goods and equity markets of industrial capitalism. This makes it necessary to re-examine the traditional relationship of interest rate and inflation.

In a bull market, the buyer has the advantage because the buyer has the final upside. In a bear market, the seller has the advantage because the buyer is left holding the downside bag. Of course one must avoid buying at the peak and selling at the bottom. And such strategies have self-fulfilling effects, as technical analysts can readily testify. These effects are magnified in long-run bull or bear markets that are represented by a rising or falling sine curve. However, the buyer's advantage in a bull market may be neutralized by the inflation that usually accompanies bull markets. Thus a true bull market must yield net capital gain after inflation and real interest cost, ie interest cost after inflation. And in a deflationary bear market, the seller's advantage is reinforced by deflation for he can repurchase at a later date with only a fraction of his realized cash from what he sold previously. Not only would the seller avoid additional loss of holding the unsold asset in a falling market, the cash from the sale appreciates in purchasing power with every passing day.

Thus money plays a passive role as a medium of exchange and an active role as a store of value on the movement of prices. The conventional view that inflation is caused by, or is a result of (the two are not identical) too much money chasing too few goods then is not always operative. This is because the availability of credit and the operational rules of credit markets can distort the traditional relationship. Credit markets, which have expanded way beyond traditional credit intermediated by the banking system, operate on the theory that money generally must earn interest, whether it is actually put to use or not. There are of course abnormal times when money actually earns negative interest because of government policy or foreign exchange constraints, as in Hong Kong in the early 1990s and Japan in 2000.

When idle money earns no interest, credit reserves dry up, because it creates greater incentive to put money to work, ie investing it in productive enterprises. For money to remain idly waiting for better opportunity, interest rate must equal or exceed opportunity cost of idle cash. Interest then acts as a penalty for idle money. When idle money earns interest, the interest payment comes ultimately from the central bank, which alone can create more money with no penalty to itself, though the economy it lords over is not immune. Since late 1999, the Japanese monetary authorities have repeatedly reaffirmed their commitment to maintaining their zero interest rate policy until deflationary forces are dispelled. The result is a great deal of idle money in Japanese banks with no creditworthy borrowers. Japanese savers are foregoing interest income for increasing purchasing power of their idle money in an unending deflationary spiral. With dollar hegemony, the Fed can create dollars by fiat with immunity to the dollar economy, at the expense of the non-dollar economies of the world.

Efficiency in the credit markets pushes money toward the highest use and willingness to pay the highest interest. Thus when the central bank tightens money supply, the market will drive up interest rate and vice versa. Thus interest rate is a credit market index. When a central bank, like the Fed, uses interest rate policy to manage the money supply, it is in essence using a narrow market index to manipulate the broader market. It is no different than the Fed fixing the Dow by buying or selling bluechip shares to influence the broad S&P. Central banking is incompatible with truly free financial markets.

When prices fall, one reason may be that consumers do not have money to buy, as in most recessions with high unemployment. Or it may be the result of potential consumers withholding their money for still lower prices as in Japan now, and in some degree in China in 1998-2000. So deflation is caused by too many goods trying to attract too little money entering the market, but not necessarily too little money in the economy. But if every seller can realize a cash surplus in a subsequent repurchase in a bear market, where does all the surplus money go? Obviously it goes to pay interest on the idle money waiting for a cheaper price, reducing the central bank's need to issue more money to carry the interest cost on idle money. The net effect is a removal of money from the market and increase the amount of idle money in the economy.

So deflation actually pushes up interest rates without necessarily altering the aggregate money supply. The effect is that until prices fall at a slower rate than the interest rate on idle money, there is no incentive to buy. Thus deflation-driven rising interest rate creates more deflationary pressure in a bear market. High interest rates move more wealth from borrowers to lenders and from bottom to top in the wealth pyramid. Moreover, the impact of high interest rate modifies economic behavior differently in different income groups and even on different activities within the same individual. When the prime rate for some banks reached over 20% in 1980, credit continued to expand explosively. The opposite happened when the Bank of Japan reduced interest rate to zero. High rates only work to slow credit expansion if the rates are ahead of inflation. And zero rate only works to accelerate credit expansion if there is no deflation. So raising interest rate to combat inflation or lowering rates to combat deflation can be self-defeating under certain market conditions.

The availability of financial derivatives further complicates the picture, because both interest rates and foreign exchange rates can be hedged, obscuring and distorting the fundamental relations between interest rates, exchange rates and inflation. The recurring global financial crises in recent years were manifestations of this distortion.

The theory of market equilibrium asserts that market tends to reach "natural" equilibrium as it approaches efficiency, which is defined as the speed and ease with which equilibrium is reached. Yet the market is complex not only because the relationship of market elements is poorly defined or even undefinable, but also the very instruments designed to enhance market efficiency tend to create wide volatility and instability. Thus a "natural" equilibrium state can, in fact, be defined as the actual state of the fluctuating market at any moment in time. With 24-hour trading, the notion of a milestone moment of equilibrium is problematic. Further, the very financial instruments created to enhance market efficiency toward its "natural" equilibrium state make the equilibrium elusive. Such instruments are mainly designed to manage risk generated by both broad market movements and momentary disequilibrium.

Structured finance mainly involves unbundling financial risks in global markets for buyers who will pay the highest price for specific protection. Because users of these instruments look for special payoffs through unbundling of risk, the cost of managing such risk is maximized. This unbundling renders the notion of market equilibrium inoperative. The unbundled risks are marketed to those with the biggest appetite for such risks, in return for compensatory returns. Thus market equilibrium is not any more merely a large pool of turbulent transactions with a level surface. It is in fact a pool of transactions with many different levels of interconnected surfaces, each serving highly disaggregated specialty markets. Equilibrium in this case becomes a highly complex notion making the impact and prospect of externalities highly uncertain and unpredictable. This uncertainty and unpredictability caused the demise of Long Term Capital Management - the mother of high-flying hedge funds - on account of failed hedges in a matter of days.

Interest swaps, for example, are not single purpose transactions for managing interest risks. They can be structured as hedges against inflation risks, or foreign exchange risks, or any number of other financial risks to satisfy needs or provide protection. And the impact is not limited to the two contracting parties, since each party usually hedge again with a third counterparty. That is what makes hedging systemic. A further irony is that the very objective to insure against unit volatility risk by covering the market broadly increases risks of systemic illiquidity. While each individual contract is structured with immaculate logic and clarity, the aggregate systemic effect is totally opaque and incomprehensible. No one really understands the magnitude of the destructive force that can result in a chain reaction triggered by the tiniest rupture. Under such circumstances, it's a puzzle why China is so keen to join a system that is bent on self-destruction.

Next: China Steady on the Peg