China, the RMB and the $US

For a long while I have been discussing the economic shift of power to the East, in particular the rise of China as the potential major economic power. I have been fairly confident of my analysis, and have posted several pieces on the subject, all of which have been pointing to a major shift in the shape of the world, and a commensurate shift in world power. The following are some posts that I have written on the subject of the shift of power towards China (both economic power and power in a very broad sense):

1. April 2009, China as the World Economic Power?
2. April 2009, The RMB as the Reserve Currency
3. March 2009, Economics and Power, the Loss of US Power
4. March 2009, China, Gold and the $US
5. February 2009, China's Pivotal Role in the Next Step for the World Economy
6. January 2009, The Myth of the Eternal Status of the $US as 'the' Reserve Currency
   

The last of these is a post which does not discuss the shift in economic power, but rather the underlying weakness of the $US as a reserve currency. The remainder directly discuss the shift in economic power to China, which is belatedly being recognised by the mainstream media and analysts. If you have time to review the articles, you will find a progressive argument that amounts to a simple conclusion; that China is positioning itself as the world economic power, and is seeking to displace the US from that position.

Even before these more recent articles, I have been reviewing China and the Chinese economy. In particular, I have highlighted the risks and the potential upside for China of the quasi-mercantilist strategy that has been pursued by the country.

1. January 2009, Free Trade 'Yes' - Mercantilism 'No' - Why China Should be Shut Out
2. August 2008, China Propping up the $US
3. July 2008, China - What Future?
   

The second set of articles only hint at the potential rise of China as a superpower, as can be found in this excerpt from the second article (emphasis added):

Each of the stories above, taken in isolation, would not cause undue alarm. However, when considering them all together, then there is a worrying pattern emerging. It should also be remembered that all of the above are just examples. What is very clear is that China, and the Chinese government, are actively pursuing a policy of unfair trade at home and abroad. Quite simply, they are using economics as a tool of power rather than just enrichment.

I have suggested in a previous post that the world trading system needs to get tough with China. I did not have the time to dig up the articles that I had read, which caused me so much concern, so have previously not outlined this point of view. However, on reading the latest attempt by the Chinese government to manipulate trade, it seemed a good point in time to outline this problem. I am at heart a free trade advocate, but I also believe that trade should be free and use reciprocal rules should be binding and enforced. It is very clear that China intends to rise economically by any means, fair or foul. The crazy part is that the foul is unnecessary, and one then becomes very suspicious of the underlying motives for such methods.

The point in linking to, and asking readers to review these articles, is to highlight the progressive nature of my argument, as well as giving readers an opportunity to review the considerable evidence for a deliberate bid for economic power by China. However, there is much else on the subject of China included in more general posts and too many to detail here.

As it is, it appears that the mainstream analysts are starting to understand what is actually taking place.

One example article can be found in the Business Spectator (I first saw the article in the FT). The thesis proposed in the article is that London and New York have a serious new competitor in the emergence of 'ShangKong', a concatenation of the names Shanghai and Hong Kong. The author points to the simple financial system in China as a virtue, before suggesting Shangkong as the new world financial centre:

How could China make a big, dramatic leap? It could begin by strengthening the links between Hong Kong and Shanghai, and transferring financial know-how from the former colony. The two cities are 750 miles apart, not an insurmountable distance in this age of rapid transit and internet communications. The connections are already being made: Beijing has just declared that Shanghai will be a major global financial centre in the next decade and co-operation between Hong Kong and Shanghai is growing, as shown by recent agreements to work together between key exchanges in both cities. Beijing could declare that Shanghai and Hong Kong will have a common set of regulations and recruit some of the world’s best financiers to bolster its regulatory structures – perhaps luring them with an advantageous tax regime no longer possible in the west.

Besides that, if China continues to raise questions about the dominance of the US dollar and the need for an alternative monetary system, other countries may have no choice but to listen – and gradually act. An eclipse of the dollar would be mirrored by a rise in the use of the renminbi. That would guarantee Shangkong’s prominence.

The author, Jeffrey Garton, is from the Yale School of management, which means that this is a perspective from an academic. As many readers will be aware, the academic community has had a very poor record in understanding the current crisis, with many acting as cheer leaders in the preceding boom. However, whilst not knowing much of Garton's record, another academic has been more successful in calling the real economic situation, and that is Nouriel Roubini. As for Garton, he sees a major shift occurring, and he is offering an analysis in which he confirms my views that the RMB will replace the $US as the reserve currency.

It is noteworthy that the Telegraph is alone among UK newspapers in picking up Roubini's thoughts, reflecting the Telegraph's role as the most intelligent (UK) paper on the subject of the economy. The original article was published in the New York Times and can be found here. Roubini points to the history of previous reserve currency shifts, for example from the £GB to the $US, pointing out that reserve currencies are held by creditors, not borrowers and that excessive borrowing by a reserve issuer undermines reserve status. His argument is quite persuasive, and I therefore recommend reading the complete article.

However, in a couple of respects I believe that Roubini is completely wrong. For example, he says the following:

We have reaped significant financial benefits from having the dollar as the reserve currency. In particular, the strong market for the dollar allows Americans to borrow at better rates. We have thus been able to finance larger deficits for longer and at lower interest rates, as foreign demand has kept Treasury yields low. We have been able to issue debt in our own currency rather than a foreign one, thus shifting the losses of a fall in the value of the dollar to our creditors. Having commodities priced in dollars has also meant that a fall in the dollar’s value doesn’t lead to a rise in the price of imports.

This is exactly the kind of wrong headed thinking that has led to the current situation. The ability to borrow huge sums of money is not a good thing, but a risk associated with being a reserve currency. The ability to raise more debt than can be repaid is a problem - not a benefit. It allows a government to act beyond the usual constraints of debt markets, allows large current account deficits, and mutes what would otherwise be powerful market signals. In other words, without the reserve status the $US would have slid long ago, and the US would have needed to have reformed before reaching the current crisis situation.

Another problem I have with Roubini's analysis is the question of timing. He has the following to say:

At the moment, though, the renminbi is far from ready to achieve reserve currency status. China would first have to ease restrictions on money entering and leaving the country, make its currency fully convertible for such transactions, continue its domestic financial reforms and make its bond markets more liquid. It would take a long time for the renminbi to become a reserve currency, but it could happen. China has already flexed its muscle by setting up currency swaps with several countries (including Argentina, Belarus and Indonesia) and by letting institutions in Hong Kong issue bonds denominated in renminbi, a first step toward creating a deep domestic and international market for its currency.

He goes on to suggest that it will take ten years for the shift to take place. This seems to contradict the rest of his argument, which highlights the underlying weakness in the $US and the underlying strength of the RMB. As he identifies at the start of the article, reserve currency status is linked to creditor status. In the case of the $US, there is a massive and expanding deficit, no prospect of a return to surplus, and a deliberate policy of massive currency issuance through quantitative easing policy (printing money). Why would it take ten years for the shift to take place?

Another point is that he is suggesting that China make its bond market 'more liquid'. I am not sure, in this context, what he means, but he may be implying that this might mean issuance of greater numbers of bonds. If China were to do so, this would simply replicate the problems that the US eventually suffered. Issuance of debt is not a requirement for reserve currencies, and it is the lack of debt that is one of the reasons for the inherent strength of the RMB. However, maybe I am misunderstanding his intended meaning. The point is that a reserve currency simply needs to have sufficient issuance to cover internal needs for a unit of exchange and sufficient to allow for the currency to be used for external trade.

The trick is to issue sufficient for these needs to prevent appreciation/depreciation of the currency. After all, a currency is a unit of exchange....and reserve status means that it is possible to issue greater quantity without implying that there is a full immediate redemption of the unit in goods or services (I discuss the underlying value of currency here, and the nature of reserve status here).

As it is, as I have pointed out in previous posts, China is slowly but surely maneuvering the RMB into a position where it does indeed become the reserve currency. In a recent post, several commentators have added to the evidence of this progressive process by linking to an article from a blogger here. A later commentator then linked to the possible source of the blogger's article (thanks for the link, Gina), which was an article in The China Post:

HONG KONG -- About 50 percent of Hong Kong's trade with China may be settled in yuan as exporters reduce their exposure to a weakening dollar, Industrial & Commercial Bank of China (Asia) Ltd. said.

The first settlements of international trade using China's currency will start with about 400 Chinese companies in five pilot cities, Stanley Wong, deputy general manager at the unit of China's biggest bank, said in an interview today in Hong Kong. The payments may expand to half of all trade when authorities extend the program nationwide as soon as 2010, he said.

“There has been a perception that the U.S. dollar will continue to weaken,” said Wong. “Definitely on an annual basis, the yuan will probably appreciate against the U.S. dollar around 3 percent to 5 percent. It makes sense for companies to avoid foreign-exchange risk.”

This is just a further addition to the many small moves (see the links to my earlier posts) that have been made by China to initiate the RMB as a currency for trade settlement. Whilst each move in isolation might not be meaningful, the overall pattern is clear. The only element lacking is any official acknowledgement of the process in China, which has instead been to focus attention on the weakness of the $US, and to create a red-herring of IMF SDR's as an alternative reserve. As I have pointed out previously, the Chinese government will rarely take an open position on such a subject, and instead use proxies and indirect methods to lay out their position. However, ignoring the official position and looking instead at actions, there is every reason to think that China is now on the way to an official policy of RMB reserve status.

In many of my early posts, I pointed to a fundamental shift in the underlying shape of the world economy (summarised here), and have explained that this is the underlying reason for the current economic crisis. The more I have looked at the part that China has played in this change, the more apparent that it has become that China has moved to the centre stage of the world economy. Having said this, I have often issued caveats to my analysis, in particular emphasising the risks that are inherent in the Chinese policies. I still hold to those caveats, but I am increasingly of the view that the actions of China are both farsighted and likely to prove effective in shifting economic power into their hands.

In the meantime, US policies appear to be perfectly formulated to encourage and support the shift in power. Their profligacy, and outright rejection of reform, are catalysts for the process, and will make the shift occur more quickly, and with greater effect.

If the US continues on the current path, it is quite possible to imagine the arguments of future historians. They will view the Bush and Obama years as the critical years in the loss of US power, and the decline of the US economy. They will point to the debt accumulation, government profligacy, populist policy, the irresponsibility of the Federal Reserve, and the failure to confront the mercantilist policies of China - the argument will be over which was the nail in the coffin of US power. From my point of view, the argument is that it is impossible to view any of these factors in isolation, but rather to view them as part of a single process.

The single process that unifies all of these elements is self-delusion. It is the belief that power is an inherent right, that wealth is an inherent right, and that underlying economic realities might be wished away. In short, the leaders, the analysts, and the people of the US forgot that power and success are rooted in real wealth creation, not the ersatz wealth of borrowing and printing money.

As yet, there is no guarantee of the shift in power towards China. There are many risks, and China is operating in a dynamic system, in which outcomes will always be uncertain. Having said this, their overall strategy appears to be bearing fruit and, with the help of US policy, they are now firmly on track for success.

Quite simply, I believe that they are winning, and others are starting to share this view.

Note 1:

Another interesting point that Roubini makes is in his discussion, which is on a different subject to the main article is as follows:

But what could replace it [the $US]? The British pound, the Japanese yen and the Swiss franc remain minor reserve currencies, as those countries are not major powers. Gold is still a barbaric relic whose value rises only when inflation is high. The euro is hobbled by concerns about the long-term viability of the European Monetary Union. That leaves the renminbi.

Regular readers will know that I have flirted with the idea of a gold standard in currencies, but eventually came to the idea of a currency of fixed issuance (the link is to a long article that approaches the subject is a fairly roundabout way). I am somewhat surprised to see an economist using emotive terms such as 'barbaric relic' in reference to a gold based currency. This is not an explanation of why gold is not a viable alternative, but an emotive argument. The reality is that, in the current situation, it is possible to see how easily governments and central banks can debase a fiat currency when there is no restraint on the issuance. Whilst no longer subscribing to a gold standard, I believe that some form of restraint on issuance of currency is better than the current situation of no restraint.

The very essence of Roubini's argument is that the unrestrained issuance of currency has created the current problems, and it is difficult to see how such issuance might be restrained without some kind of commodity backing. A 'barbaric' gold standard currency would have prevented this mess, as gold would have flowed out of the US with the massive deficits, and therefore the currency issuance would have been constrained.

If that is barbaric, then I am all in favour of barbaric.

Note 2:

I found a fascinating clip that illustrates how shockingly opaque the Federal Reserve actually is. This is, of itself, a subject of a post. The clip can be found here. You may be shocked.....

Note 3:

So much for the 'Green Shoots'. The US consumer has apparently been (as expected by anyone grounded in reality) pulling in their horns. Taylor, of the famous Taylor rule, is suggesting that US interest rates will need to rise in the near term, in an analysis that slams down much of the recent optimism and analysis of the situation. Meanwhile Freddie Mac is drawing on another $6 billion due to ongoing losses - but apparently the crisis is now over....??? and foreclosures continue at shocking levels...

More depressing, from the UK there is news of a lift in the numbers of first time house buyers. I feel sorry for these individuals, who are no doubt reading of recovery, and optimism, and are thinking to climb onto the housing ladder whilst there is still time....no doubt they will hear this story in the press, and from the mouths of the estate agents. They are, of course, buying long before the bottom has been reached. For example, the buy to let market looks dire, and signals more properties coming onto the market at discounted prices. As for the economy overall, the BoE has come in with a pretty gloomy picture in the latest inflation report, which can be found here....(the GDP projections might be seen as good material for black humour).

Note 4:

The idiocy of the US bailout schemes is highlighted in an article here, which also serves to confirm the 'clubiness' that I detailed in a recent article:

“The taxpayers ought to know that we are in effect receiving a subsidy. They put in 40pc of the money but get little of the equity upside,” said Mark Patterson, chairman of MatlinPatterson Advisers.

The comments are likely to infuriate Tim Geithner, the US Treasury Secretary, because MatlinPatterson took advantage of the TARP’s matching funds to buy Flagstar Bancorp in Michigan. His confession appears to validate concerns that the bail-out strategy is geared towards Wall Street.

Note 5:

Thanks, as ever for the comments. There was a little tension between two commentators, and I was glad to see the tension resolved in such a reasonable way. As ever, the standard of the comments and intelligence of the commentators is a pleasure to see.

Note 6:

Apologies for linking to so many old articles, but this appears the best way to highlight the overall picture of China. I hope that readers have the time to view these, as they do together paint (I believe) a compelling picture.