FED watchers usually strain to find pearls of wisdom hidden within the carefully worded minutes of Federal Open Market Committee meetings. The summary of the March meeting, however, suggests that Fed Chairman Alan Greenspan is sharply at odds with several FOMC members over the central bank's foreign-currency operations.
Dissident FOMC members object to how the Fed conducts foreign-exchange operations on behalf of the Treasury, and, further, question the legal authority under which the Treasury has vastly expanded its currency-market intervention. This dispute provides a rare insight into the Fed's role as agent for the U.S. And it raises troubling questions about how the central bank manages currency risk as well as how it executes U.S. monetary policy.
When the Fed buys or sells dollars in the foreign-exchange market, it does so under authority from the Treasury, but executes transactions both for its own account and for the Treasury's Exchange Stabilization Fund, or ESF. Currency bought is credited to the appropriate accounts, and any risk borne by the Fed has in the past been limited to its own modest long position in various foreign currencies.
Since the dollar peaked in 1985, however, this situation has changed as the size and frequency of dollar sales authorized by the Treasury have grown enormously. Because the Treasury has reached its statutory limit for foreign-currency holdings, the Fed has steadily accumulated on its own books huge foreign-currency balances, which it "warehouses" on behalf of the Treasury, effectively avoiding legal limits on ESF currency holdings.
Now when the Fed buys German marks or Japanese yen for the Treasury's account, it places the foreign currency on its own books and remits the equivalent amount of dollars to the Treasury. In effect, the Fed "creates" dollars backed by foreign currency bought at the behest of the Treasury, thereby providing Secretary Nicholas Brady with interest-free credit outside the congressional appropriations process.
The Federal Reserve Bank of New York currently holds $9 billion worth of foreign currency on behalf of the ESF, but has "warehoused" at least $21 billion more because of recent foreign-exchange operations; the latter amount is essentially a loan to the Treasury.
"Very large purchases of foreign currencies had raised {Federal Reserve} System holdings to historically high levels," according to FOMC minutes released May 18. "Some members expressed concern that the increased system holdings carried the risk of sizable losses if the dollar were to strengthen substantially." Those in Washington who are close to the story say the bland description of "concern" disguised a heated debate.
The Fed is exposed to currency risk first and foremost because the value of its foreign currency holdings falls if the dollar strengthens. Since the Fed has only modest dealing and investment management capabilities compared with an average money-center bank, it does not hedge the price risk on its portfolio through the use of futures or options, but instead is simply "naked long" a variety of foreign currencies, which are invested in government debt instruments issued by the subject foreign nation.
The Fed is also exposed to currency risk because it accepts as collateral on "currency swaps" -- a.k.a. loans -- currency from heavily indebted countries, many of which cannot even use their funds to settle claims in private financial markets. A quirk in Fed policy accords equal credit treatment to the central banks of Poland, Japan, Yugoslavia, Argentina, Mexico and West Germany -- simply because they are all central banks. This is like equating the credit and payment risk associated with Morgan Guaranty Trust in New York with the Medellin, Colombia, branch of BCCI, the notorious Luxembourg bank that has been implicated in laundering drug money for Gen. Noriega.
Multimillion -- or even billion -- dollar loans are made by the Fed, interest free, with no "haircut," or discount, assessed against the currency provided as "collateral." Even where no substantial private market exists for the currency in question, the Fed extends credit based on the official exchange rate on a dollar-for-dollar basis. When Fed officials lecture domestic U.S. banks about credit standards for domestic real-estate loans, while they daily violate the most fundamental concepts of credit policy and risk control, the agency's credibility suffers.
Mexico, for example, is a regular customer of both the New York Fed and the ESF, using pesos as security at the officially supported exchange rate. At the end of January 1990 (latest figures available), Mexico owed the Fed $700 million on an essentially unsecured loan that most banks and investment firms (except possibly Citibank) would never touch. But Mexico's credit is good at the Fed because Nick Brady has authorized the loan.
Since nationalized Mexican banks, which are de facto "affiliates" of the central bank, are the sole market-makers of pesos, the Fed is entirely dependent on the Mexican government's willingness and ability to repay this facility at the original exchange rate, a prospect one senior Fed official familiar with that country's deteriorating balance of payments calls "frightening" because "a default has never happened before." History buffs, stay tuned.
Both the Fed's warehousing operations for the Treasury and its extensions of credit to indebted countries expose the central bank -- and ultimately the United States -- to enormous financial liability without any explicit legal authority from Congress. Indeed, having expanded currency warehousing authority to $21 billion only last December, the FOMC agreed just three months later to expand it another 20% to $25 billion. This latest action, however, was too much for some FOMC members.
Two Fed governors, Wayne D. Angell and John P. LaWare, as well as Cleveland Fed President W. Lee Hoskins, who joined the FOMC in January as part of the regular rotation of regional bank presidents, voted against the increase. Angell and Hoskins expressed concern that the Fed's authority to hold foreign currency for the Treasury was "inappropriate in the absence of a definitive indication of congressional intent in this area. The transactions in question, which are repurchase agreements that have the characteristics of a loan to the Treasury, could be viewed as avoiding the congressional appropriations process called for under the Constitution."
Angell and Hoskins also criticized foreign-exchange market intervention to hold down the dollar in world markets, saying that "the intervention carried out over the past year had undermined the credibility of the system's monetary policy." Hoskins went even further, saying that "intervention was ineffective unless accompanied by changes in the monetary policy that would be inconsistent with price-stability objectives."
What the Cleveland Fed president is really saying between the lines is that if for political reasons Treasury really wants a lower dollar, it first should win policy changes from Congress that will persuade the Fed to lower interest rates, then authorize Fed dollar sales to gently push markets lower. Or put another way, if the Fed is forced by profligate spending in Washington to fight domestic inflation with high real interest rates, selling dollars in the foreign exchange market is at best spitting in the wind, and at worst inflationary (and perhaps even illegal).
In a perverse parody of politics fighting monetary prudence, the Fed keeps interest-rate policy tight while the Treasury, with the Fed acting as agent, orders sales of dollars into the foreign-exchange market. The arrangement whereby the Fed controls interest rates, but the Treasury rules foreign-exchange policy, is shown to be unworkable when the two are in basic disagreement over policy.
The most troubling aspect of this is that the Treasury is funding currency-market intervention and Secretary Brady's illusory "debt reduction" strategy on the central bank's books, and then compounding the danger by borrowing dollars against the foreign currency while the Fed bears the market risk. The congressional framers of the Federal Reserve Act, who acting from populist conviction sought to insulate the central bank from political manipulation, are doubtless rolling in their graves.
The Treasury might argue that the only impact on the Fed of a valuation loss when foreign currency is sold would be reduced remittances to the Treasury (most Fed income comes from interest paid on Treasury debt held for liquidity purposes), yet the fact remains that the central bank's balance sheet is being used as an overdraft facility by Nicholas Brady (and his predecessor, Secretary of State James Baker) in order to pursue political objectives in the currency market or bail out mismanaged debtor countries. If money is to be spent pursuing such goals, it should be legally authorized and appropriated by the Congress, and subjected to regular oversight by the General Accounting Office.
Ironically, Chairman Greenspan, who unlike his taller predecessor is not a career Fed insider, inherited a complex legal and bureaucratic mess in the Fed's foreign-currency operations. The intramural dispute within the FOMC may help nudge the central bank in the direction of supporting a more straightforward U.S. exchange-rate strategy, but only an awakened Congress can make this possible by ending the Treasury's abuse of Fed financial resources. Sounds like a task for an old-fashioned populist named Henry Gonzalez, chairman of the House Banking Committee.
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