China's Pivotal Role in the Next Step for the World Economy

There are a couple of issues that I would like to cover in this post, and both relate to China. The first arises as I have recently managed to get around to reading my print edition of the Economist, which is already over a week out of date. However, I found an interesting article on the question of Chinese currency manipulation, which you can find online here.

The reason why the article is interesting is that the Economist presents a non-argument that suggests that 'attacks on China's cheap currency are overdone.' The really interesting part is that the argument is a good reflection of these arguments in general. The puzzling thing is that anybody puts these arguments forward with a straight face.

A good starting point in considering the article is a part with which I can agree, which is as follows:

'Of course China manipulates its exchange rate—in the sense that the level of the yuan is not set by the market, but influenced by foreign-exchange intervention.'

Whilst I agree with this statement (obviously) and have previously highlighted some examples of intervention / manipulation to support the $US, this is not the whole story. On top of the active interventions in the market China has a raft of capital controls in place, which prevent the free movement of capital in and out of China (the article linked to is about some loosening of the controls). The point about such controls is that the utility of the currency is severely limited i.e. for uses such as purchasing for import of goods and foreign direct investment into China. Quite simply, if China removed the controls, then the RMB would emerge as a major world currency, and quite possibly as a reserve currency. The article in the Economist conveniently forgets this small detail.

As for the main thrust of the article, and this sort of argument is common, the rest of the article is a discussion of what the RMB exchange rate should be. I will not repeat all of the detail of the argument, but will quote their conclusion as follows:

The evidence that the yuan is significantly undervalued is hardly rock-solid. It probably is still a bit too cheap, and it would certainly be a mistake for Beijing to allow it to fall, not least because this would risk a protectionist backlash from abroad. In the longer term, the yuan needs to keep rising against a basket of currencies. But for now, some of the accusations being thrown at China are wide of the mark.

The problem is that, all of these arguments are completely irrelevant. Having lots of economists contemplating what the RMB should be is entirely beside the point. If the RMB is not significantly undervalued, then why does China intervene, and why the capital controls? A million and one economists can produce a million and one justifications for the RMB being 'about right', but then why does China not just let the currency loose? As it is, the arguments for the RMB not being undervalued are very poor, but that is beside the point.

I really do not understand these arguments as they are quite simply irrelevant and fatuous. What is most worrying about the arguments are that they are (as in the Economist) shoe horned into arguments suggesting that any measures against currency manipulation are 'protectionist'. The fact that an artificial low currency protects your internal market against imports does not seem to figure in these arguments.

There is something odd in these arguments overall. For example, the Economist promotes itself as free trade, free market magazine. However, when it comes to China, it seems that the rules suddenly change. I can see no logical or rational explanation for why this would be the case. It is all rather odd......

At this point, I would also like to highlight another oddity. I was given a link on my last post by Sal, to an FT article. I have been doing occasional searches for new on US bonds, so I had also found the article. My guess is that Sal was more than a little puzzled by the article. The article can be found here (sorry, for some reason the software refuses to allow this link to be connected to the text):

http://www.ft.com/cms/s/0/ba857be6-f88f-11dd-aae8-000077b07658.html?nclick_check=1

I will quote sections from the article, and I think you will see why this is so odd:

China will continue to buy US Treasury bonds even though it knows the dollar will depreciate because such investments remain its “only option” in a perilous world, a senior Chinese banking regulator said on Wednesday.

And:

Mr Luo, speaking at the Global Association of Risk Management’s 10th Annual Risk Management Convention, said: “Except for US Treasuries, what can you hold?” he asked. “Gold? You don’t hold Japanese government bonds or UK bonds. US Treasuries are the safe haven. For everyone, including China, it is the only option.”

Mr Luo, whose English tends toward the colloquial, added: “We hate you guys. Once you start issuing $1 trillion-$2 trillion [$1,000bn-$2,000bn] . . .we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do.”

I have said many times that overseas holders of $US assets are going to be fully aware of the impact of US policy on the value of the $US, and here we have confirmation of such awareness. Luo Ping is a very senior person in the Chinese banking system, so what he says carries some weight.

However, what are we to make of this? We actually have a situation in which China will invest its foreign currency in assets in which it knows it is going to lose money. This is a most extraordinary investment strategy - and so I will repeat the same point - China is going to invest in something where they know they will lose money.

The explanation given by Mr. Luo just does not make sense, as he is implying a far more limited choice of investments than are actually out there. As such, there must be an alternative explanation for Mr. Luo's statement. My own view is that there are two possibilities.

The first of these is that China and the US have somehow come to an arrangement behind closed doors. As I have pointed out in previous posts, China and the US are locked together in an unseemly economic embrace, with both sides in deep trouble if the $US should fall, but also with both sides building up ever greater economic imbalances. If you have not read my posts on the subject I discuss this here. My problem with this answer is that I simply can not see how such a behind closed doors conversation might end with China deciding to buy ever more devaluing US paper. In particular, they need to be selling such paper at the moment in order to finance their own stimulus. I can not discount this option, but it does not make sense.

The other option is rather more convoluted. I have mentioned that the likely strategy of China will be to sell $US assets as fast as possible, but to try not to sell them at such a rate that they will 'spook' the market and spark a $US collapse. In other words, they will seek to offload as many of their $US assets as possible whilst they still hold their value. The statement of Mr. Luo appears to be the opposite of this, so how can this be related to this strategy?

The answer is quite simple, but I must emphasise that this is pure supposition. If you are a key player in the market, and want to offload a large part of your holdings at the best price, then you will not want everyone to think that you are a seller. The knowledge that you are about to sell will of itself move the markets. As such, you propose that you are a buyer in the market, and in doing so help support the market during the period in which you are selling. Set against this, why would he say that the $US will depreciate, as this will not support the market? Perhaps this is simply a statement of the obvious, and he makes it to reassure the market that they will buy regardless of the losses?

Of course, eventually the action of China in the market will eventually be visible, but such an approach would extend the period in which they could extract the maximum value from their sales.

With regards to the situation as it stands, as I pointed out in a recent post the Telegraph reported the following:

Where is the money to come from? China, the Pacific tigers and the commodity powers are no longer amassing foreign reserves ($7.6 trillion). Their exports have collapsed. Instead of buying a trillion dollars of extra bonds each year, they have become net sellers. In aggregate, they dumped $190bn over the last fifteen weeks.

I have tried to find out who these sellers are, but have been unable to find the information (any comments/links on this appreciated). On the other hand, the US is still managing to sell bonds, albeit that the 'The Treasury had to pay a little more than expected'. I have read other similar stories recently. It is also apparent that there is contradictory information, with another article suggesting that foreign central banks are buying US bonds, and another article reporting 'Long Bond Crumples Amid Selloff'.' I will confess that the aggregate real position eludes me at the moment, as there are wide variations across different types of bonds (the Lehman aggregate index shown in the link includes other bonds such as mortgage backed). I will freely confess here that my knowledge of the technicalities of the bond market is insufficient to make sense of the data directly, and I am therefore relying on reports on the data.

In amongst all of this contradictory information, where does the truth lie on the key issue of what China is doing? Happily this question can sidestep the technicalities, and it is possible to think of what China might have as an overall strategy, without knowing the technical details of how it might be enacted.

I would argue that my supposition of China announcing buying when it is selling would be the most logical answer. There is no question that China needs to utilise reserves to support their own economy, there is also now no question that China and other overseas investors will know that the $US must fall, and no doubt that they know that $US assets will devalue with the $US. On the other hand, I doubt that the US and China can come to an arrangement which will resolve the imbalances between their economies, as absolutely no arrangement comes to mind which would satisfy both sides. However, perhaps I am wrong?

As I have discussed before, at this moment in time, China sits as a pivotal mover in the world economy. The position of the RMB, and China's huge reserves are central to what will happen next. As such, when someone such as Mr. Luo speaks out, it is worthwhile paying attention. In this case, the problem arises that what he is saying makes no sense. I have given my best guess at what is going on, but remain unsure of whether my answer to this is correct. In this case, only time will tell...

....as always, comments are welcomed.

Note 1: The types of bonds in the US vary with different maturities, and different methods of providing returns. If you want to see the variations, Wikipedia offers a useful introduction. As I have mentioned, I have insufficient knowledge to understand the technicalities of the bond markets. In terms of the big picture, I am not sure that this is a problem, but rather it is a problem for understanding the implications of individual data, and day to day news. If I have time, I will give myself a crash course in the subject, as I prefer not to use the interpretations of others as a guide to what is happening. In the interim, please note that I am relying on the interpretations provided in reports, and this is not ideal.

Note 2: Steve Tierney comments that the UK has legislated away the inherent strengths of the UK and I have to agree with this, and also the related comment of Ishmon. Perhaps the UK's decline is best expressed in the recent news that the new trains for the UK rail system will be Japanese. The government describes the winning bid as a UK led consortium, on the basis that the finance is coming from UK institutions....need any more be said...

Note 3: Chris comments on the sacking of the person who flagged that HBOS was taking crazy risks. The interesting point here is that the bank defends the sacking by saying that there were personal differences. This is exactly the point - nobody likes the party pooper, and this is more than likely the source of the personal differences. Don Keyes links to an article in a comment, and if you read this article, you may see a linkage between the HBOS party pooper and the article. A similar mechanism at work perhaps....

Note 4: David Larkin asks what would make the news - celebrity tittle tattle or a world economic collapse, as does ChaSh. Sadly, I share their cynicism that it would be the former (on that subject, thanks for the link from Josiah Stamp's Ghost to a more nuanced view of the media).

Note 5: A commentator called 'Thoughts' points out that the first bank bailout is about equivalent to the bonuses awarded by the bankers, linking to an article here. This is interesting as an idea, but is now being dwarfed by the ongoing support for the banks which, for me at least, is a bigger worry. However, there are certainly some big issues with the rights and wrongs of the way that the bailout money has been used that are highlighted.

Note 6: A comment from 'Passer by' expresses puzzlement at events of the moment. I think he is right to think that, in the background governments are seeking resolution to the problems in the world economy, but I would disagree that they can find any resolution to the problems. I can see no answer to the underlying problems except for painful readjustment.

Note 7: Red has asked for a post on strategies and outcomes. This is something that I would like to do as soon as I have time, but it is a very demanding subject. I am hoping to have more time in the future, and will be able to address this then. In the meantime, I can sympathise with the views that Red has expressed. The whole world economy is tied to the health of the $US, and everybody knows this. A similar point is made by shtove. My problem is simply that it just takes one major $US holding country to break ranks, and the whole edifice collapses....

Red's comment turned into a healthy debate on possible strategies, with Jonny suggesting that underhand methods will be one course of action. I will not comment on the detail of the debate, and suggest you read it an make up your own minds. However, that countries might resort to dirty tricks is quite possible in principle, as we know from history that this has been done before. The question then arises as to how power is distributed, and how it is utilised. This is a question that goes beyond the scope of this blog, except to say that economic crises such as this one encourage unpleasant actions on the part of governments. However, that does not imply that governments will always act in this way, just that it is possible.

Note 8 : Concerned Citizen makes the comment that the current actions of governments are a "shit or bust" approach. I actually think this is a neat summary of the situation. They must (I hope) realise that their actions are a last desperate throw of the dice. They are like the gambler who borrows another $100 in the hope that the last roll will save them from their previous losses.

Note 9: I am sorry that I am posting on an irregular basis, but am very short of time at the moment. I as somewhat frustrated as I have a growing list of subjects I would like to cover...and hope to get on to these as soon as possible.