Currency Swaps and Rum: Let's Get Wasted on Our Way to Bottom

Wednesday, September 02, 2009 , , , , 0 Comments

The history of the US feeding the UK goes way back, despite what you may have been taught in primary school.

LA Times:

With little fanfare, a deal is moving forward to direct billions in U.S. tax dollars to an unlikely beneficiary -- the giant British liquor producer that makes Captain Morgan rum.

Under the agreement, London-based Diageo PLC will receive tax credits and other benefits worth $2.7 billion over 30 years, including the entire $165-million cost of building a state-of-the-art distillery on the island of St. Croix in the Virgin Islands, a U.S. territory.

Treasury Secretary Timothy Geithner has said he does not have authority to block or investigate the project. Criticism on the Hill has been confined to a small group that includes Republican Congressmen Dan Burton of Indiana and Darrel Issa of California, plus a handful of Democrats with large Puerto Rican constituencies.

The key to the deal is a special tax collected on every bottle of rum sold in the United States -- some $470 million a year. The tax was first imposed in 1917 ,and most of the money is funneled back to the governments of rum-producing U.S. territories in the Caribbean to help create jobs, pay for local government services, and promote consumption of rum.

Puerto Rico, which requires that 90% of its rum tax money be used for the public welfare on the island, says it has had as many as 300 workers making Captain Morgan and many if not all those jobs will disappear if Diageo moves its operations to the Virgin Islands.

"It's insulting that the money we give is essentially paying for a foreign corporation to move from one U.S. location to another, while cutting jobs," Ellis complains.

Insulting, yes. All that strange, no. Before we move on, let me just say that I'm glad I never liked rum that much in the first place. British rum? Are you serious?

Now, about that reacharound...

Market Oracle:

Through the treasury’s Exchange Stabilization Fund and the Federal Reserve's System Open Market Account, the United States has twice used swap agreements in failed attempts to prop up the dollar. On both those occasions, the treasury was subsequently forced to issue foreign currency-denominated debt (Roosa bonds and Carter bonds) to repay swap drawings. Evidence of this repeated misuse of currency swaps can be seen on The United States Treasury Department’s website.

Intervention Operations

Treasury policy during 1961-71 period focused on deterring capital outflows from the United States and giving major foreign central banks an incentive to hold dollar reserves rather than demand gold from the U.S. gold stock. The ESF resumed intervention operations in the foreign exchange market in March of 1961 (for the first time since the mid-1930s), but it soon became apparent that the resources of the ESF alone were too small to sustain transactions of the magnitude necessary. At the invitation of the Treasury, the Federal Reserve joined in foreign exchange operations in February 1962. The Federal Reserve entered into a network of swap agreements with other central banks in order to obtain foreign currencies for short-term periods for use in absorbing forward sales of dollars by foreign central banks hedging exchange risk on their dollar holdings. To provide foreign currency to repay the Fed's swap drawings, the Treasury during the 1960s issued non-marketable foreign currency-denominated medium-term securities (Roosa bonds) and sold the proceeds to the Fed.

Later in the 1970s, the US monetary authorities built up foreign currency reserves substantially. For this purpose, the ESF entered in a $1 billion swap agreement with the Bundesbank in January 1978 (which has since been allowed to expire). In connection with the dollar support program announced in November 1978, the Treasury issued foreign currency-denominated securities (Carter bonds) in the Swiss and German capital markets to acquire additional foreign currencies needed for sale in the market through the ESF. The United States also drew its reserve position in the IMF.

Given the US’s repeated abuse of currency swaps, it is very disturbing that the fed is once again engaging in an enormous amounts of such agreements.

I know what you're thinking, what could currency swaps possibly have to do with rum? Well we're making a point here; with these, you never know which currency needs the swap (unless, like in the example above, the country who initiated the swap can't repay). As we have also learned, though the US started this whole mess, we've been following the UK for months - quantitative easing, anyone?

The Market Oracle piece goes on to explain the implications of new Fed swap lines, of which pounds are included:

1) There would be no need to secure these new agreements if the fed hadn’t already used most of its existing $308.8 billion in central bank liquidity swaps.

2) This implies that unwinding the Federal Reserves existing swaps would leave the US with close to 300 billion in foreign denominated debt.

3) This development also implies that much of the dollar’s recent rally has been artificially created by the Federal Reserve’s 300 billion currency swap intervention.

4) To date, the fed’s currency swaps have been presented as motivated by shortfalls in USD funding in foreign institutions. While this might have been true initially, it is now obviously false.

5) Considering that the fed is planning 15-fold increase in us monetary base, 300 billion in foreign debt could quickly turn into 3 trillion or more.

So who needs the loot this time? The Bank of England or the boys back home? Is there a precedent for a central bank currency swap in which both parties face default?

Reacharound, kids, reacharound, scratch my back and I'll scratch yours. What's to say there isn't a buy our debt we'll buy yours at work here? It's a race to the bottom, and everyone is just trying to loot what they can from the corpse. What's worse, we're letting them.

Jr Deputy Accountant

Some say he’s half man half fish, others say he’s more of a seventy/thirty split. Either way he’s a fishy bastard.