I decided that, for the moment, a greater priority would be to try to find out what China is buying with its amassed foreign currency reserves, as this is possibly the most important single factor at this moment in time in the future of the world economy. In particular, China has the potential to make or break the $US. In several posts I have speculated that China will seek to offload $US assets, and will divest as many as possible before markets take fright. China's main holding of $US is in treasuries, and any significant sale of treasuries from China (or possibly stopping purchase of treasuries) will see the $US fall dramatically - or even collapse.
I believe that the $US is looking extremely vulnerable at the moment, and it would not take much for a collapse in confidence. Of particular note is that Warren Buffet appears to have come to the same conclusion, with his discussion of treasuries (and therefore the $US) as a bubble. The recent collapse in the prices of stocks has seen a new surge into treasuries, as investors seek safety, so a prediction of a collapse in this market at this time might seem unusual. However, the action of frightened rabbits caught in the headlights of an oncoming truck might not be considered as an indication of what will happen when there is time for thought.
The steep falls in the stock market are simply another indication of the fundamental weakness in the US economy, and that weakness suggests that the $US must eventually fall. China meanwhile has a delicate balancing act if they are to exit the US treasury market. Any hint of a mass sell-off would lead to a collapse in the $US, and would destroy the value of a large swathe of their reserves.
Within this scenario there is a major question that needs to be answered. If China does start to dump US treasuries, where will they hold their reserves?
The two most obvious contenders are the Euro and the Yen, but both are problematic. With regards to the Euro, this is looking increasingly unstable, though with some potential to buy into the government bonds of countries like Germany. Japan, as ever, I find difficult to fathom, but the speed and depth of the collapse of their export machine does not encourage much confidence. If China does exit the US treasury market, it is not immediately obvious where they might want to put their money. I have had several readers of the blog ask me where they should put their money, and China is in the same position as those investors but on a different scale.
The key difference that arises from such scale is that China has the potential to massively impact upon any market with which it is involved. The sheer size of their reserves means that they can swing any market up or down according to their actions. Aside from this difference, which requires a circumspect approach from China, I would probably find myself having made the same recommendation that I made to individuals nearly a year ago. This was that gold was the best prospect and an asset that might survive the turmoil (though I offered many caveats to this advice, as I am not an investment advisor).
The position of China as a potential maker or breaker of a particular market means that China will act in a way that is as opaque as possible. Even a hint that it is planning to exit treasuries would possibly see a rout, and any hint of entering a market likely to see asset prices rise. However, it is possible to pull some pieces of news/information together, and try to work out what China might do.
This is no easy task as we have the mixed messages coming out of China. For example, back in February, we have the now famous statement from the Chinese authorities on US treasuries, expressed in the following colourful language:
Even at the elite level, the sense of frustration occasionally bubbles over. "We hate you guys," Luo Ping, a director-general at the China Banking Regulatory Commission (CBRC), complained last week on a visit to New York. "Once you start issuing $1-$2 trillion . . . we know the dollar is going to depreciate, so we hate you guys, but there is nothing much we can do."
The same article goes on to say:
As China's economy slows sharply, the debate on how to manage its reserves is intensifying. Some propose spending the money at home; others want more diversification of investments. But the consensus behind recycling foreign currency into US government securities is coming under attack.Essentially, China has expressed awareness of the delicacy of the position of the $US, but has still suggested a commitment to $US assets. The US government is clearly nervous of the situation, as can be seen in Hilary Clinton's begging bowl mission to China, which took place with unseemly urgency. Whilst China is making reassuring noises, this does not necessarily indicate China's actual intentions. As I have mentioned in previous posts, it would be likely that, even if selling treasuries, China would still make reassuring noises to prop up the value whilst they were undertaking the sales.
In one respect, China has been relatively open. It has made it clear that it expects that the US will follow a sound monetary/fiscal policy, if it is to continue as a buyer of treasuries:
The U.S. “should make the Chinese feel confident that the value of the assets at least will not be eroded in a significant way,” Yu, who now heads the World Economics and Politics Institute at the Chinese Academy of Social Sciences, said in response to e-mailed questions yesterday from Beijing. He declined to elaborate on the assurances needed by China, the biggest foreign holder of U.S. government debt.It is here that we encounter the current policy of the US government. We have now had the first Obama budget. This budget was notable for considerable rhetoric on responsibility by Obama, but was lacking in any credible plan on how to reduce the budget or current account deficits. The actual substance of the budget was a massive expansion in deficits, and the budget therefore simply adds a new driver to the massive increases in US indebtedness that has resulted from the various bailouts, stimuli (monetary and fiscal), and the other many drivers of ever mounting borrowing. In total, the current US policy might be summarised as an expansionary spending binge, with no clear plan on how to pay back the borrowing . This will hardly conform with Chinese expectations of protecting their investments, and the Chinese government will surely not be taken in by Obama's rhetoric.
As such, if the Chinese were not simply trying to influence US policy with idle threats, it seems unlikely that they will be willing to continue to support the US economy with further lending.
Note: I was just set to publish the post and came across yet another article saying that the bail out in the US is expanding yet again, with Bernanke proposing more money to 'save' the banking system. At what point will anyone think 'enough!' Whatever the severity of the problem, the answer just keeps coming back - just pump in more money, at whatever cost....
With regards to actual Chinese activity, it is apparent that Chinese treasury purchases were already slowing in January, with some analysts suggesting that the mix of assets held have been altered in preparation for a fast exit from treasuries:
The U.S. Treasury’s international capital statistics showed that in November, China’s net holdings of long-term U.S. Treasury securities fell by more than $9 billion. However, the country’s short-term holdings rose by $38.2 billion. Determining the motivation here is difficult — it could simply be that China followed the rest of the crowd in jumping headlong into the safest securities possible, or more worrisome factors could be at stake.
“When any creditor shortens the term structure of its holdings, the borrower should probably be cognizant of that, because the creditor is giving up yield to give itself the option of exiting quickly,” says Brad Setser, fellow at the Council on Foreign Relations. “That’s one way to interpret the shortening of the structure of China’s holdings.”
A you would expect, I have tried to get some hard figures on what China is actually doing at the moment with treasuries, but have been unable to find any sources of this information (links/comments welcome). As such, I am unable to provide any firm information on the actual situation, which is rather frustrating. The same can be said for the Chinese position on European and Japanese bonds. However, with regards to European bonds, it seems unlikely that China has been moving out of treasuries into European bonds, as there have been problems in the sales of bonds in many auctions in Europe, even including German bonds. Had China been shifting holdings into these markets in any significant way, then such outcomes would be unlikely.
On the other hand, it has become apparent that China has been dabbling in the US stock market, and has therefore seen significant losses with the plunge in US stocks:
This outcome might signal a return to treasuries, but just as likely might be a warning to China about the risks inherent in remaining in the US. Either outcome is possible, but I believe that the latter outcome will certainly be a consideration in the thinking in China.
Provisional figures from the US Treasury department showed that Beijing was holding $99.5bn of shares in June 2008, up from $29bn in 2007. Two years ago, China only held $4bn in US equities, preferring to concentrate on Treasury bills.
However, economists said the latest figures suggested that China may have bought as much as $150bn of equities worldwide, or 7pc of its vast foreign exchange reserves.
Brad Setser, an economist with the Council on Foreign Relations, a US think tank, said the State Administration of Foreign Exchange (SAFE), a branch of the Chinese central bank charged with looking after the foreign reserves, was responsible for the buying spree.
Finally, we come to gold, the other possible asset that China might consider as a safe haven for their reserves. As I dug around, it became apparent that China has been beefing up gold investments for quite a while, as well as having a booming gold mining industry. Overall Chinese demand for gold is now the second highest in the world, with tantalising hints (unsubstantiated - see original article) that China is actively beefing up official reserves as well. However, before we get too excited that China will dump treasuries for gold, one analyst points out the following:
I mentioned at the start of the post that gold represented a good opportunity for China, but there are limits to how far China might take such a policy. The same might be said for other precious metals. However, it does seem quite likely that precious metals will play a larger part in China's overall mix of assets. This still leaves the central problem of what else China might move into, if it moved out (is moving out of?) of US treasuries? The same analyst who points out that China can not shift into gold, also argues more broadly that there are no credible alternatives to US treasuries.
What about gold? That one’s easy: it’s estimated that all the physical gold in the world that’s ever been produced amounts to roughly 140,000 tons (worth about $4.5 trillion dollars using $1,000 an ounce). About 75% of that is either in coins or jewelry… not available to China, or to any other government.
The new gold available each year is miniscule: about 2,600 tons (almost $83 billion dollars worth) of new gold is being mined and refined annually, increasing the total supply by 2% per year.
You can see that China’s problem - if it wants to invest in gold as a diversification strategy - is that there isn’t enough available for sale. 30,000 tons are held in various government central bank vaults. Privately held bullion amount to about 20,000 tons.
Any major purchase of gold on the open market - which is where China would have to buy it - would drive up its price. To put this in perspective: China buys enough U.S. treasuries in one month to pay for all the gold mined in a year everywhere in the world.
However, the analyst makes a basic error in thinking that China would have to take an all or nothing approach. He does not consider that China might spread their reserves over a wide range of assets, and this is my best guess for the direction of China's policy. If they follow this strategy, and implement it with care, China has the potential to rapidly jump towards becoming the world's most powerful economy.
The first step is to manage the sale of US treasuries with the greatest of care, such that they gain as much value of the sales as possible before the $US collapses. As they move out of $US they would likely buy as many precious metals as possible without driving the price too high, as well as buying into emerging market, European and Japanese bonds. In doing so, they will be taking risks but with the benefit that they will be positioning the RMB as the next reserve currency. Furthermore, it is no secret that China has been trying to buy into various commodity companies (or natural resource companies), such as the ongoing saga of the Chinalco purchase of Rio Tinto or their wider expansion of investments in this sector.
When the markets finally do spook, and the $US falls, China would need to keep selling hard into the market until the $US reaches a planned point at which China will halt further sales. I have no idea where that halt might be against what, but would guess that at the very least (whether I am right or wrong about the overall picture) China will have made contingency plans. With such large holdings of $US and the abysmal state of the US economy, it is hard to imagine that there is not an exit strategy for China.
Assuming that I am correct (a big assumption) at this point the US and OECD economies will probably go into a state of crisis, with stock markets collapsing and a wider state of panic amongst governments. Whilst the OECD governments will (I guess) have contingency plans for such an eventuality, there will be nothing that can be done to halt the slide when it happens. It is quite possible that there will be plans in place to support the $US in the event of a slide, in both Europe and Japan. However, I do not think anything will halt the slide once it starts.
With the US in shock, China can then use the remaining holdings of $US to go on a shopping spree into the US. In particular, China can offer to enter the markets with an offer of salvation - but at the cost of unopposed access to purchase the companies that might provide a leap into the high added value industries with technology or specialist skills. They will not put it this way but, in a climate of economic panic, they will be in a position of calling the shots, as the only significant player able to halt the slide. As a result of the panic, they will be able to buy even good companies at fire sale prices. As such, they will be able to use whatever $US assets they still hold to take a major leap up into added value industries.
Inevitably, such a large fall/collapse in the $US will see the undermining of the status of the $US as a reserve currency. The Euro is now in a position of such instability that it will not have the potential to act as a replacement. The Japanese Yen might have some potential as a replacement, but the RMB will be better positioned as the strongest contender. In particular, the Japanese will likely act to rescue the $US during the crisis, but will fail to stem the tide, and undermine the credibility of/weaken the Yen in the process.
If China was to follow such a course, it would put itself in the position of being the major world economic power, or would do so at least in principle.
So far, so gloomy and so apocalyptic......Astute readers may realise that this is all very highly speculative, and misses the underlying flaw in the whole strategy.
The flaw is that, if China were to follow such a course, it would also risk self-destruction. I have discussed this problem in many previous posts. The problem for China is that it has built its economy to service Western economies through high levels of exports. As such, if there is an economic collapse in the US and Europe, China will also destroy the markets for its goods. In doing so, it will see a massive contraction in the export sector of its economy, with a commensurate explosion in unemployment. The Chinese government is almost certainly aware of the fact that their legitimacy rests upon economic growth and nationalism, and that any dramatic fall in the economy might cause significant social unrest, including the possibility of major revolt.
Whilst this might suggest that China must continue to support the $US, in order to keep their export machine turning, it is not clear that this provides a solution for China. It is becoming increasingly clear that, whatever China itself does, the US is rapidly sinking into a quagmire. Under such circumstances it looks increasingly likely that the US is in any case collapsing as an export market and that, even without any action on the part of China, the $US must eventually sink. Whilst China can continue to prop up the US economy in return for increasingly worthless bits of paper (in exchange for the labour of their population), the US economy must in all cases eventually see a considerable contraction.
China is therefore faced with a choice of an all or nothing approach - or letting the US rapidly decline whilst they pursue a futile policy of trying to prop up the unsupportable. In one case they have an opportunity to extract the maximum remaining value from their reserves, and in the other they will simply pour more of their resource into a black hole.
I must emphasise that this is all speculation, as I do not know what the Chinese are planning, and what they might do in the current situation. China being China, it is hard to ever discern what their actual plans might be, as they lack any form of transparency whatsoever. However, it does seem that they have some hard choices on the best way for them to deal with the economic crisis. Whatever they do, they risk social instability, and even the possibility of major social unrest. Whichever direction they take, they will be entering into a high stakes game, with the potential for chaos should they make the wrong choices.
In all of this speculation, I am also making an assumption. The assumption is that the current US policy must mean that the $US will eventually collapse. I simply do not believe that a massively indebted country with very little in the way of savings, a massive current account deficit, can get out of trouble through an explosion in new borrowing and massive increases in deficits. It might be argued that this is simplistic, but I make no apologies for taking such a straightforward approach. However, with every new bailout or stimulus, the economic situation of the US just seems to deteriorate further. I think that China will be observing this and will take note of the fact that nothing seems to work in stopping the US economy from collapsing.
I can imagine that, within the closed world of Chinese policy making, there will be some heated debates on the best course of action. If, and it is a big 'if', I am correct, then it appears that the world economy is on a knife edge. If China is debating the position of the $US, they will be aware of the risks in waiting compared with the risks of acting to preempt the slide. Whilst I admit to being speculative in much of the post, I can not believe that China is not discussing this subject and, if there is a discussion about the risks, there will certainly be contingency plans. The big question is - which way will they jump?
(alternative scenarios welcomed in the comments section)
Note 1: For regular readers, they will be aware that I have long been expressing my concern both at the policy of QE (Printing Money), and the opacity of the policy with which it is being undertaken. I have recently written to the Bank of England (BoE), requesting some details on the policy, and have encouraged readers to write to their MPs asking for more information (see note 2, I have copied a suggested letter).
My concern has been that the most radical policy ever undertaken by the BoE, with potential for profound effects on the UK economy, has seen no detail of how the policy will be undertaken, without even any discussion of how much money will be created. Furthermore, in the information provided, it is clear that there is no formal mechanism for reporting what is taking place.
The bottom line is this. At present there is absolutely nothing provided by the government or BoE to distinguish what is going on from what happened in Zimbabwe.
A short while ago I received a letter from a BoE Press Officer requesting a 'chat'. I have now had that 'chat'. The summary of the conversation is that no further detail on the policy will be provided until the publication of the letters between the Chancellor and the BoE which discuss the policy. Whilst the BoE press officer was inevitably polite, he cast no light upon the policy. A long conversation amounted to 'wait for the letters to be published'. The only point of substance was a suggestion of a possible means of reporting the QE activity, but this was not an official statement of intent.
The worrying part of this is that this means that the first we will know anything about the policy is when it is actually implemented. As such, we will be seeing one of the most radical economic policies ever undertaken implemented without any discussion of the details of the policy prior to implementation. The idea that a policy with such magnitude of potential consequence for the wider economy should be undertaken in circumstances of such opacity is quite extraordinary.
The BoE letters are apparently going to be published very shortly, so I will await the publication. If they fail to clearly answer the questions that I have asked, then I will continue to pursue this matter as far as I can, including putting as much pressure on the BoE as possible. Whilst this blog now has a large readership (which is gratifying) I would also urge you to write to your MP requesting greater transparency.
To date I have expressed the view that QE is a method of financing government operations through the printing press. I have argued that the UK government is aware that it will have problems raising the money to finance operations of the government. As you will have noted in the above post, raising money through bond sales is becoming increasingly difficult. It seems more than a coincidence that, at such a time, the printing presses are about to start running. The opacity of the policy just serves to confirm my worst fears.
As such, when I review the BoE letters when they are published, my aim will be to closely analyse exactly what they commit to, and whether they leave any 'wriggle room' for either the BoE or government on the issue of full disclosure of exactly what they are doing with the policy.
Quite simply, this policy has the potential to wreck the UK economy, and I have seen nothing to date, and heard nothing to date, that offers any reassurance.
You can find the email address for your local MP here (click on the map for your constituency).
This is is my suggested letter which you can copy and paste, or alternatively write your own version:
I am writing as I have very increasing concerns over the recent Bank of England policy to implement quantitative easing. In particular, I am worried about the following:
- There is no policy document that clearly outlines how this policy will operate, what quantity of money will be created, what assets the money will be used to purchase, and what method will be used for the purchases.
- In addition to this Mervyn King has suggested that the method of reporting for Quantitative Easing will be through the MPC minutes. This is not the purpose of the MPC minutes, and there is no requirement for full disclosure of activity in such a method of reporting.
I am very concerned at such opacity in consideration of the fact that the Bank of England will be using money creation to purchase gilts. In this situation the Bank of England will therefore be creating ('printing') money to purchase government debt. This might be seen as government operations being funded by printing money.
Under such circumstances, it would be reasonable to expect the Bank of England to offer a transparent and detailed discussion of the policy as a formal policy document, as well as a formal, full and transparent procedure for reporting their activity.
I would therefore be most grateful if you could, on my behalf, seek to clarify why this process is being undertaken in such an opaque manner, and clarify exactly what the policy will be. I would also be grateful if you could press for a proper method of reporting on the policy of quantitative easing.
Additions, suggestions for improvement will be welcomed. Just leave a comment below.
I predicted a while ago that the £GB or $US would collapse within three months, and that after the collapse of one, the other would follow shortly after. I am still convinced of the extreme fragility of the economic situation for both countries, and still think that I may yet be right. I have not checked the exact date I made this prediction, but I think I still have about 2-3 weeks to run before I am wrong.
I have been wrong about the $US before, and hope that I am wrong again this time. However, it seems that others such as Warren Buffet are also expressing concerns about the sustainability of the $US (if treasuries go, the $US will follow). I still think it will need an external shock to kick the $US down, but am becoming less certain of this. If I am right about China (a big 'if') then it might be that China will precipitate the fall...
Note 4: An interesting reply to one reader's request to his/her MP on the subject of QE (I assume using my standard letter). I will quote it in full, as it is more than a little disturbing:
'Have sent a copy of the letter to my local MP (Labour, Scotland). His reply:That an MP can send such a reply sends shivers down my spine. If we take even a modest interpretation, we are getting a response that says that this is a desperate gamble.....
Thank you for your email and I do appreciate your concerns at the current economic crisis. I am quite unsure as to the alternative that you believe may help steer our financial institutions out of the current mess?!'
Note 5: There have been lots of comments on my post on the underlying cause of the economic crisis. I have has a further request from Josiah Stamp's Ghost and Jonny for some kind of forum, and will try to look into this at some point in the future. I am not sure that there is sufficient critical mass of readers (yet) to support the forum, but probably not far off. However, finding the time is not easy...
ChasH makes an interesting point, suggesting that offshoring might mean that there will be continued decline in strong companies in the OECD. I think that, once the balance of labour costs adjusts, this process might come to a halt as the cost versus benefits will alter. However, we will see...
Some interesting points of view from Lord Keynes, which I would like to address at some stage, time allowing. Lord Keynes appears to the devil's advocate amongst the commentators, which is useful to have on the blog. It is good to have challenging views.
Also, thanks in general for some interesting and stimulating links, which I nearly always follow up (I do occasionally miss one or two). One stood out as I already think highly of the author, which is as follows:
Niall Ferguson is very astute, though I do not agree with everything he proposes. I am currently awaiting the arrival of his recent book on the history of finance, which may be an interesting read. If it is as good as I think it might be, I will let you know....
Sorry, yet again a quick review on the comments. I have taken a part random sample on this occasion, and will try to continue to address as many comments/questions as possible. I hope I will be forgiven, but I have had to devote quite a bit of time to posts recently.
Note 6: It occurs to me that this post is very speculative. I hope that it is seen in this light, and other scenarios/views on what might happen next are welcomed, as well as any critiques of my scenario.