The RMB as a Reserve Currency: Breaking Habits of Thought

The economic power and influence of China continues to grow. In September, 2009, I wrote the following:

The last line of reasoning I considered appears to be the most probable. It is simply that China's wealth is indeed denominated in the $US, and they are just doing enough to hold the $US from free fall. The reason is that this allows them time to use the $US, which they are still accumulating in large quantities, to prepare themselves for the post-$US world. Returning to the speculative post in which I imagined what I might do if I were China, I suggested that they would also diversify their holdings into commodities (in particular gold), other currencies, and would continue and accelerate their purchase and control of commodity/resource companies.

Some quotes from a recent article from AFP:

Chinese firms have become more active in mergers and acquisitions since the global financial crisis that began in 2008, as economic distress has thrown up bargains around the world.

[and]

Between 2005 and 2011, the number of China's overseas acquisitions tripled to 177 and jumped five-fold by value to $63 billion, according to law firm Squire Sanders and intelligence service Mergermarket.

[and]

But academics said more was at work than commerce, as China seeks growing stature and competes with other countries for resources.

If you can cast your mind back to 2007, how did you think of China? The AFP reports on the unease being felt by China's growing influence. If jumping back in time to 2007, if somebody had suggested that China would be this influential, would you have taken them seriously? Whilst China was seen as important, the idea that China would be causing this kind of unease would have been dismissed as fanciful. Another point that I long ago made, at about the same time as discussing China's potential shopping spree, was that China would seek to displace the $US as a reserve currency, and develop the RMB as a potential replacement. This from April 2009:

I have a very curious sense at the moment of the world moving in slow motion. I had thought that the economic crisis would create dramatic moments, but in some respects it appears to be moving through a gradual shift.

One of the predictions that I have made, on two occasions, is the collapse of the $US and the end of the reserve status of the $US. However, it appears that the end of reserve status is being achieved with little drama, as it is apparent that the RMB is slowly but surely being positioned as a replacement of the $US as the reserve currency. We have this latest news from the China Daily:

Five major trading cities have got the nod from the central government to use the yuan in overseas trade settlement - seen as one more step in China's recent moves to expand the use of its currency globally.

From these modest beginnings, the process of moving the RMB to reserve status has continued, and I have occasionally given examples in my posts. This is recent development:

Cracks are beginning to appear; the latest sign is that China and South Korea have come to an agreement in which banks from either country are able to borrow funds from a swap line that makes loans available to companies for deals in local currencies. (Source: “China, South Korea to Boost use of Local Currencies in Trade,” Bloomberg, December 4, 2012.)

This is analysis from Reuters:

Fed up with what it sees as Washington's malign neglect of the dollar, China is busily promoting the cross-border use of its own currency, the yuan, also known as the renminbi, in trade and investment.
The aim is both narrowly commercial - to reduce transaction costs for Chinese exporters and importers - and sweepingly strategic.

Displacing the dollar, Beijing says, will reduce volatility in oil and commodity prices and belatedly erode the ‘exorbitant privilege' the United States enjoys as the issuer of the reserve currency at the heart of a post-war international financial architecture it now sees as hopelessly outmoded.

Zha Xiaogang, a researcher at the Shanghai Institutes for International Studies, said Beijing wants to see a better-balanced international monetary system consisting of at least the dollar, euro and yuan and perhaps other currencies such as the yen and the Indian rupee.

However, I would not want to give a false impression that everyone thinks that the RMB as a reserve currency is likely. For example, this rather curious article from Forbes gives a consideration of the many ways in which the RMB's status is accelerating before then oddly concluding:

Does all this mean China is about to overtake the dollar as the world’s reserve currency? Not anytime soon. A reserve currency, in our view, requires deep and credible government bond markets, an open capital account and critical mass in global financial systems. China’s central bank has laid out a 10-year plan for “internationalization” of its currency. China’s FX bands are widening, but in an incredibly cautious way. Dollar holders need not panic.

Indeed, most articles, including the Reuters one quoted earlier, give caveats, express doubts etc. It is all rather odd, as the expansion of the international role of the RMB is an actuality. Indeed, as long as I have been tracking this steady expansion, the same things are said with each new step, and always that reserve status is something for the distant future. There is a growing conflict between what is taking place, and the analysis of what is taking place. This is a habit of thought and I made the point in an article for Trade and Forfaiting Review in November 2009:

Imagine a world in which there was no international reserve currency, but that an organisation was proposing that the US dollar ought to be the future reserve currency. Would you take such a proposal seriously?

Your response might be that the US dollar sits atop mountains of debt, a shrinking economy and you would point out that the US monetary authorities are printing money to fund record government borrowing. You might actually laugh at such a prospect.

On the other hand, how would you view the Chinese renminbi? You might point out that China holds large reserves of other currencies, the renminbi rests on top of a massive current-account surplus, China’s economy is growing and that the prospects for future growth are all positive. Furthermore, China is a country of savers, with a small fiscal deficit and is an export machine selling goods around the world, ensuring an ongoing utility for the currency in trade.

I do not have a copy of the full article to hand, but recall that I argued something along the lines of the $US as a reserve currency was a habit of thought, rather than a rational assessment. Time has moved along since I wrote the TFR article, and time has supported my case, and still there is a sense that it just isn't possible, even though the step-by-step expansion of the RMB into a reserve currency progresses forwards.

However, at this stage, I am not so certain that the RMB will be the major reserve currency, but not for the reasons that are generally given (e.g. deep bond markets). As regular readers will be aware, I am increasingly cautious about the overall position of the Chinese economy. I am not entirely convinced that China can sustain its economic miracle and, as ever, see political risk in any major slowdown in the growth of the Chinese economy.

Nevertheless, if China does manage to continue its growth, then the indications are that it will continue to chip away at the reserve status of the $US. Returning to the start of the post, the influence of China continues to expand, as the Chinese state encourages firms to seek out and purchase access to resources, and also expand internationally. It is but one example of the astonishing growth in China's economic heft. That influence is being felt throughout the world, and the influence just further enhances China's credibility as a 'major player', and that, in turn, enhances the credibility of the RMB as a reserve currency. Set against this, the economic policy of the US can only continue to erode the influence of the $US. The following is a commentary on the $US and the challenge of the RMB:

Rome in its day held the reserve currency of the world, and how the mighty have fallen. Unless real changes are made, we might be witnessing the beginning of such a shift here. The rising U.S. debt levels are raising questions by many countries around the world as to the legitimacy and viability of the U.S. dollar as the reserve currency.

Politicians in Washington must wake up to the realization that the U.S. dollar’s status as a reserve currency is not written in stone. The financial markets are currently more dynamic and fluid than ever before. It takes only the click of a mouse to move money around the world.

Unless America gets its fiscal house in order, I believe we will see more agreements, such as this one with China and South Korea, which will avoid the U.S. dollar and increase the continuing questions about the viability of its reserve currency status.

The author has a point. After all, if the $US was not already the reserve currency, would you pick it out as a new reserve currency? I think that this unlikely, but perhaps you would disagree?

The Great 'Shift' - China and the West

We are living through one of the times in history when a major and irrevocable shift is taking place. It will be a time that will be the subject of controversy amongst historians and, no doubt, there will be arguments about causation, about what set off a chain reaction of change. They will perhaps ponder and wonder that so many people were so blind to what was actually taking place before their eyes.

The shift that we are witnessing is the move of economic power from the West to the East. It is a well worn theme on Cynicus Economicus, that we are seeing the rise of China, and the fall of the US, and the process is now accelerating. Alongside the fall of the US, we are also seeing further declines in countries like the UK.

When I first arrived to work in China in 1997, I could see the emergence of an economic juggernaut. Sure, there were huge problems, and I encountered the legacy of communism in a generation of senior managers who were next to hopeless. Despite that, when I finally left China, I could see that the future was going to be Chinese. I could see a generation of hard nosed business people emerging.

The experience in China shaped my thinking on economics. On the ground in China I could see the massive investment from the West shaping a new and dynamic China. The Chinese welcomed us with open arms and, when I first arrived, were still somewhat in awe of the success of Western business. However, as time progressed, I also saw that Westerners were seen as a soft touch, who would overpay on everything.

The establishment of joint ventures was just one example of the many ways in which the Chinese would extract great deals. When I first arrived in China, all of the consultants were urging investments in joint ventures, and would prattle about notions such as 'guanxi', without any real knowledge of what they were talking about. The Western companies would send out a senior executive with orders to arrange a joint venture. When they arrived in China, they would be presented with four or five prospective joint venture partners, all of whom would have opaque business operations.

In the end, with all of the partners similarly opaque, the Western executive would settle on the least ugly partner. The documentation would then be drawn up, and the business would commence. It was at that point that the Western company would find out that they were supporting a whole raft of pensioners and other commitments in the joint venture. As part of the deal, the Western company would introduce new technology and process, train the management and the workforce. The trouble is that they were training the people ready for a new company to be established by their joint venture partner, and the new company would take all the technology, process and training, and open a competitor company. The competitor would be free of all of the social commitments and other costs.

Then there were the deals where, in order to win a contract, China would insist on technology transfers. I remember a GE power station turbine deal with technology strings attached, or the opening of an assembly plant by Airbus in order to secure deals in China. In so many cases, the price of doing business in China was risking the very thing that made the Western companies such a success; transfer of technology and process.

Then there is 'outsourcing', the rush to China to cut costs at the price of de-skilling the Western work force. It is not just the factory workers, but the designers and engineers who end up de-skilling. A good designer or engineer will understand the process of manufacture. Whilst there may be a legacy of good designers, as time goes by, the great design will emerge in the location of the manufacturer, and that will mean China. It will take time, but it will happen. The other trouble with outsourcing is that, as the manufacturers undertake the work, they will gain scale and experience, and will one day seek to move up the value chain. They will be in a position where all they need know is how to market and distribute their products. Outsourcing may make profit in the short term, but often at the cost of the future of the company doing the outsourcing.

Alongside this, there has been the artificial manipulation of currency by China, and no respect for intellectual property rights. The countries of the West have allowed this to take place, and now appear powerless to stop such practices.

There is a reason why I have returned to the subject of China. I have long argued that the ascent of China will progress far faster than most analysts and commentators suggest. I have long argued that China will emerge as the winner from this crisis, and have argued that their currency will be the new reserve currency in the future. Over many, many posts, I have tracked their steady process of internationalisation of the RMB, and consistently argued that the $US is so weak that it must collapse. I have returned to the subject as the mainstream media are finally really starting to understand what is taking place. Amongst the many articles, it is this article from Ambrose Evans-Pritchard that inspired me to return to the subject:

Beijing does not need to raise money abroad since it has $2 trillion (£1.26 trillion) in reserves. The sole purpose is to prepare the way for the emergence of the yuan as a full-fledged global currency.

"It's the tolling of the bell," said Michael Power from Investec Asset Management. "We are only beginning to grasp the enormity and historical significance of what has happened."

[and]

"Everybody in the world is massively overweight the US dollar," said David Bloom, currency chief at HSBC. "As they invest a little here and little there in other currencies, or gold, it slowly erodes the dollar. It is like sterling after World War One. Everybody can see it's happening."

"In the US they have near zero rates, external deficits, and public debt sky-rocketing to 100pc of GDP, and on top of that they are printing money. It is the perfect storm for the dollar," he said.

"The dollar rallied last year because we had a global liquidity crisis, but we think the rules have changed and that it will be very different this time [if there is another market sell-off]" he said.

The self-correcting mechanism in the global currency system has been jammed until now because China and other Asian powers have been holding down their currencies to promote exports. The Gulf oil states are mostly pegged to the dollar, for different reasons.

This strategy has become untenable. It is causing them to import a US monetary policy that is too loose for their economies and likely to fuel unstable bubbles as the global economy recovers.

The article was a response to news (since denied) that China, France, Japan, Russia, and the Gulf states were planning to abandon the $US for pricing of commodities. Ambrose Evans-Pritchard argues that the currency of pricing commodities is of no importance, but this is something with which I disagree. This is what I had to say on the subject of the emergence of the RMB as a reserve currency in April:

However, the real key to reserve status is when trade is more broadly conducted in the RMB, such as move to trading oil in RMB. Perhaps Venezuela will offer such an opportunity? An article here suggests that Venezuela may need to turn to China for financial support, and this may well present an opportunity for China to start this process:

In Latin America, the external funding situation remains relatively stable but in the case of further deterioration of capital flows, the solid economies would be able to tap the IMF or the Inter-American Development Bank (IADB) for non-conditional lines of credit, while the economies with less sound macroeconomic frameworks such as Ecuador, Argentina and Venezuela would most likely only be able to obtain funds through more formal conditionality or by turning to lenders like China.

Returning to the question of whether it is possible, I see no reason to prevent the RMB from taking on this role. There has been talk about the RMB not being 'liquid' enough, the lack of depth of their financial markets. However, I take a fairly simplistic view, which is to ask whether a currency has the underlying strength of being able to be used to purchase goods and services. The answer to this question is, of course, 'yes'.

It appears that ambitions for pricing of oil in RMB are far more ambitious than I first thought. Whilst the story has been denied, there is an underlying logic to the story that belies the later denials. It is only a matter of time before we see commodities priced in RMB.

In order for the RMB to succeed the $US as the reserve currency, it was always going to be necessary for the $US to collapse. The US has undertaken policy that will ensure such a collapse, and it is simply for the reason that the US is fiscally incontinent, printing money, and pouring the wealth of the future into zombie banks. When the $US falls, the US will finally see the forces of inflation unleashed, as the massive imports of commodities, goods and services surge in price. It is at this point that the underlying reality of where real economic power lies will finally become clearly visible. It is at this point that the real wealth generating capacity of the world will emerge into the light.

When the US is no longer able to borrow, when it is reliant upon what it actually produces, rather than borrows, it will be apparent how bad the situation has become. The same will be true of several other economies, such as the UK. For many years, these economies have been subsidised by the economies to the East and, without any further subsidy, they will find life is far harsher than they have ever imagined.

The rise of China is no mystery but, no doubt, the historians will manage to find controversy, manage to bury all of this under complexity. The economists will meanwhile suggest that the transfer of economic power emerged out of the banking crisis. The reality is far simpler.

The Western world was complacent, arrogant, and bloated. Collectively, the West allowed the emergence of a new competitor who used mercantilist policies to accumulate the modern equivalent of bullion, they allowed the export of all that had made their economies such a success and, when confronted with reality buried their heads in the collective sand of borrowing and money printing. Whatever happened, once China opened to the world, a new economic challenge was inevitable. However, the way that the West met the challenge has ensured that China will emerge as the great economic power.

As we move towards the end of 2009, we are entering into a new world, a new economic structure. We are witnessing a change in the world that will be viewed in hindsight as one of the defining moments of the 21st century.

Note 1: I have not referenced as many points as usual. However, many of the points made are consolidating the points made in previous posts, and these provide support for the case that I am making. I have listed some previous articles on China and the $US, if you are interested in seeing my case in greater detail, and the evolution of my thoughts on China's rise:

1. July 2008, China - What Future?
2. August 2008, China Propping up the $US
3. January 2009, Free Trade 'Yes' - Mercantilism 'No' - Why China Should be Shut Out
4. January 2009, The Myth of the Eternal Status of the $US as 'the' Reserve Currency
5. February 2009, China's Pivotal Role in the Next Step for the World Economy
6. Fenruary 2009, China and the US - Fighting on the Edge of a Cliff
   
7. March 2009, Economics and Power, the Loss of US Power
8. March 2009, China, Gold and the $US
9. April 2009, China as the World Economic Power?
10. April 2009, The RMB as the Reserve Currency
11. May 2009, China, the RMB and the $US
    
12. July 2009, The RMB as the Reserve Currency - an Update
13. September 2009, The Rise and Rise of China
    

Note 2: Am I repeating myself here, or does this post add to past posts? Comments welcomed. If readers feel I should move off this subject for a while, I will do so.

China and Treasuries - A Puzzle

Perhaps some readers may think that I am obsessed with China as, once again, China is the central subject of this post. A long while back I speculated on what China might do as the current economic crisis unfolds (yes, it is still in full swing). The basis of my speculation was quite simple; I simply thought about what actions I would take if I were in the position of China.

My first thought was that it would be vital to move reserves out of the $US, which would mean offloading treasury positions. I was unsure at the time about how this might be achieved without spooking the entire market, and destroying the value of the remaining holdings. As it was, the exit method is relatively simple and involves shifting holdings from long term debt into short term, and simply not rolling over the existing debt. It turns out that China has been making this shift for some time, but remains a net buyer of treasuries:

For instance, the report showed huge central banks such as Japan and China remained buyers of U.S. assets. China's holdings of U.S. Treasuries rose to $800.5 billion in July from $776.4 billion in June.

The same report showed a net outflow of capital from the US, and this makes the ongoing purchase of treasuries by China ever more curious. Of particular note is a recent article in the Shanghai Daily, which will reflect the official government 'line'.

AS the global economy appears headed toward recovery, concerns are growing that the United States' addiction to massive fiscal stimulus as an economic panacea could eventually lead to an even bigger crisis - a loss of confidence in the US dollar.

Nobel Prize-winning economist Paul A. Samuelson raised the specter of a "truly global financial panic" if countries funding the US deficit, particularly China, decide their investments in US Treasury securities are no longer safe.

Warren Buffett warned in The New York Times that side-effects of the current fiscal intervention could be as dangerous as the financial crisis recently averted - in the form of inflation eroding the dollar's purchasing power.

Preserving the dollar's strength has importance far beyond protecting American tourists from the shock of paying the equivalent of US$25 for a hamburger in London or Tokyo.

Economic experts are concerned about the dollar's health for a number of reasons. Most importantly, the scale of current trade and spending imbalances puts heavy downward pressure on the dollar's value over the long term.

The US imports far more goods and services than it exports, flooding international markets with dollars and undermining their value.

The Chinese 'line' on the $US and the actions of China contradict one another. The standard explanation for this is that China simply can not afford the destruction of the $US, as the two economies are tied inextricably together. Such an assertion would suggest that China sees a future in which it just continues to fund US consumption forever. When the switch into short term debt is considered, this is simply unbelievable. One way or another, China knows that it must move off the treasury treadmill. Why they have not already done so remains a puzzle, but they must begin a retreat soon. In particular, the $US slide seems to be gaining momentum, with Geithner's remarks on the future status of the SDRs as a reserve asset pushing the decline further:

The Dollar Index, which the ICE uses to track the dollar against the currencies of six major U.S. trading partners, dropped to as low as 75.915, the weakest since Sept. 22, 2008, before trading 0.2 percent down at 75.944.

One explanation for the weakness of the $US is that economic recovery is providing an incentive to move into higher yielding assets. This from Bloomberg:

The dollar fell to a one-year low against the euro and weakened versus the yen on speculation the global economic recovery is gathering strength, encouraging investors to buy higher-yielding assets.

A contrast to this explanation was issued a few hours before this post, and comes from China's Xinhua news:

The Fed began its two-day monetary policy meeting on Tuesday and would announce rate decisions on Wednesday. The central bank is widely expected to leave key rates unchanged at historic low level, and its statement after the meeting would be fundamentally same with previous statements.

If the statement is in line with expectations, it means that the Fed would keep its ultra-loose monetary policy for a while, increasing pressures upon the dollar. Any unexpected signal could spark big fluctuations in currency market.

It was reported that U.S. is proposing a broad new economic framework to tackle global economic imbalances on the Group of 20 financial summit due later this week. The framework may lead to weakness in the dollar, analysts said. It prompted investors to take profit from the greenback's gains in previous sessions.

It is very clear that the line in China is that it is US profligacy putting pressure on the $US (a view shared by myself). It is very clear that, if Chinese news sources are following the official government line (the normal practice), the Chinese government has concluded that a $US fall must take place. This makes the ongoing purchase of treasuries ever more puzzling.

I did speculate that perhaps, just perhaps, China is hoping that the US will reverse the current policies (in particular in the face of Chinese complaints). However, the more I thought about this, the less probable it appeared to be as a credible explanation. There has been absolutely no indication from any arm of the US government of any indication of any reversal of current policy. Unless there have been some substantive assurances given behind closed doors, it appears highly improbable that China might hold any hopes for change.

Another line of reasoning I followed was that China simply does not want to be seen as the country that 'pulls the trigger' on a $US collapse. Once the crisis takes hold, they will be able to stand back and suggest that they did all they could to support the world financial system - despite US profligacy. Once again, however, I am not entirely convinced with this argument. Compared with the diplomatic gains, the potential economic losses make this appear to be a very poor trade off. I am also not convinced that China would be that concerned with such niceties, as they will in all cases be able to point to their requests for responsibility from the US and their patience when the US continued to devalue their assets.

The last line of reasoning I considered appears to be the most probable. It is simply that China's wealth is indeed denominated in the $US, and they are just doing enough to hold the $US from free fall. The reason is that this allows them time to use the $US, which they are still accumulating in large quantities, to prepare themselves for the post-$US world. Returning to the speculative post in which I imagined what I might do if I were China, I suggested that they would also diversify their holdings into commodities (in particular gold), other currencies, and would continue and accelerate their purchase and control of commodity/resource companies.

With regards to gold, it is now no secret that China has been purchasing gold (600 tons - though are now planning to buy domestic production of gold), and also other commodities (though there are some suggestions that this is easing back). There are also hints that China is going to restrict supply of some of their own key commodities, which will support a growth in high tech industry. Also, with regards to securing access to resources, China appears to be accelerating a process that had already started at the time I made the speculative post. A friend kindly pointed me to a recent article in the FT on this subject:

China’s sovereign wealth fund is deepening its holdings in commodities by investing about $850m in Noble Group, a Singapore-listed commodity shipping and trading company with deep roots in China.

In the past two years, CIC has shifted its emphasis from dollar investments in financial firms, including Blackstone and Morgan Stanley, to investments in commodities groups and hard assets including real estate.

With regards to currency, the $US 50 billion purchase of SDRs is one form of diversification, and perhaps ties in with the ambition for the RMB to displace the $US as the reserve currency. My aim here though, is not to restate my arguments for why the RMB might succeed, though yet further signs can be found of the ambition in action:

[regarding the purchase of $50 billion of IMF SDRs] But the agreement stated that China will pay the IMF up to 341.2 billion yuan ($50 billion), also known as renminbi, for the SDR bonds, based on the Aug. 25 exchange rate [...]

But Zhang also noted several other, more intriguing possibilities about how the IMF could harness the yuan soon to end up in its hands.

It could use yuan to buy assets from other financial institutions or for issuing loans, hence spreading the Chinese currency more widely.

"This would signify that the renminbi, to a certain degree, would replace the dollar as a global reserve currency. It would be an important impetus for renminbi internationalisation and it would have a negative influence on international demand for the dollar," Zhang wrote in a research note.

What all of these points are driving to is that China might be just providing enough support for the $US through bonds to prevent a free fall of the $US. The motive might be that they are using the time of instability to prepare for a post $US world, and are seeking to position themselves to ride out the storm that would follow a major fall in the $US. It is no more than speculation, but they may simply be preparing for the troubles ahead, whilst their $US have some use and value.

So far, so interesting, as they do appear to be following the most logical strategy for a country in their current position. However, I also speculated previously about the next step in the strategy over and above the points I have already mentioned. In particular, if the $US falls dramatically, and there is plenty of speculation on this end emerging in the mainstream media recently, what would China do in this situation?

My argument was that China would, as soon as a $US rout looked realistic, sell hard and fast into the market, and seek to recover as much value from the $US holdings before hitting the bottom. I speculated that they would likely have a contingency plan in place, including a floor at which they would stop selling and hold. In the event that this kind of scenario took place, the US economy would go into severe shock, along with the institutions of government. No doubt, just as China has prepared for this contingency, I am guessing that the US is likewise prepared. My guess is that they will have a plan to stem the tide, but also that they will be playing the role of King Canute.

In the economic aftershock, China will still be left with significant holdings of US assets. In some respects, these will be of little value. However, my speculation is that this would provide a vital element in China's bid for economic ascendancy. In particular, they could use their new found economic strength to go on a shopping trip in which they would seek to purchase leading US companies, and in particular companies with leading edge technologies. The economic position of the US government will be so dire that they will seek any form of an infusion of capital and overseas currency into the country, and will not be in a position to block any Chinese moves on US companies, with the sole exception of industries that are directly related to the defence sector.

In this scenario, China might be able to jump up the technology ladder at a rate that would otherwise be impossible. It would facilitate the step up the value chain that is necessary for China to achieve economic super power status. This from a recent Xinhau news article, in which they report on the Chinese Premier, Wen Jia Bao, as suggesting that the economic crisis presents risks and opportunities:

China has the capabilities of taking over the commanding heights in the fields of economy and science and technology, said the premier.

He highlighted the importance of choosing the correct new and strategic industries that can play a supportive role for the country's current economic and social development. China must master key technologies, otherwise, the country might be controlled by others, he stressed.

Wen said that China needs industries that have broad prospects, consume less energy, have a larger impact on other sectors, offer more jobs and make more money. "We must select and develop new and strategic industries with an international view and strategic thinking," he added.

A total of 47 academicians, professors, experts, entrepreneurs and industry leaders attended the meeting and gave their views on the issues of these new industries.

It is very clear where China's ambitions are directed and they simply reflect the ambitions of most countries. The difference is that China is increasingly moving into a position where those ambitions might be achieved.

As with my original post, the one in which I speculated on China's actions, I can only speculate here, and would emphasise that it is no more than speculation. There are a few problems in the argument, such as why China might undermine the $US with negative statements, if they seek to prepare for a post $US world, and need the $US for preparation. This appears to contradict the argument, and can not be explained. Many elements of my previous speculation have been enacted by China, but they are nevertheless still net purchasers of treasuries, against my expectations. It may be that I am missing something, but I have yet to find any explanation other than the one that I have suggested here.

As ever, and in particular with such a speculative post, comments and thoughts are welcomed. Perhaps there is a more mundane explanation?

The Rise and Rise of China

From the early point in this blog, I have emphasised the importance of China in the world economy, and this view is now shared by the mainstream. China has rapidly moved from being an important element of the world economy into becoming one of the central actors. On a bookshelf crowded with books about China, I have a copy of James Kynge's 'China Shakes the World', a book with a title which many would have taken as poetic fancy at the time of writing. For those of us who actually witnessed the growth of China, it was simply a statement of reality. China was already shaking the world at the time that the book was written, but most of the West had simply not noticed. We are all now paying attention.

In July 2008, I had the following to say for the prospects for the Chinese economy in the economic crisis:

The Chinese economy may, or may not be, at a point where internal growth within China has the potential to take up the slack. Has it yet reached that point? It is very difficult to say. It is a finely balanced point, but the economic growth of the coastal areas is now being replicated in the interior. Can the growth in the interior maintain the momentum of the coastal cities? The Chinese government has huge reserves to draw upon should the economy falter, and may seek to use those funds to further develop the interior of the country. There is also an ongoing and dramatic process of infrastructure investment which may help carry China through the bad times.

Furthermore, China has being making ever stronger inroads into markets such as Africa, and South America. Whilst these can not replace the US and European markets, they may serve to ameliorate the effects of a downturn.

Much as I expected, there was a massive 'stimulus' for the Chinese economy, much of which is directed at the interior. A summary of the stimulus is given by the China Daily:

The Chinese government announced its 4-trillion-yuan ($585-billion) stimulus package in November last year to boost domestic demand and economic growth amid the global downturn. The money will be mainly spent on new highways, railways, housing, schools, hospitals and environmental protection projects.

I have discussed in many posts the change in the balance of the world economy, always with China in mind. For example, in an article in TFR magazine, I used the example of the SUV and Tata Nano to illustrate the changes in the distribution of consumption that would flow from the crisis. However, I had not guessed that China would actively encourage such changes. Just one aspect of the stimulus has been the subsidy of car purchases, and the result of the policy has been widely reported:

Sales of cars, sport-utility vehicles and multipurpose vehicles, rose to 858,300, the China Association of Automobile Manufacturers said in a statement today. Sales fell 6.2 percent in August 2008 as the Olympic Games damped demand.

This year, a 4 trillion yuan ($586 billion) stimulus plan has shielded China from the global recession, helping car sales jump at least 45 percent for four months in a row. Full-year sales of cars, trucks and buses may hit 12 million, the government said last week. Surging demand helped Geely Automobile Holdings Ltd., China’s biggest privately owned carmaker, to double profit in the first half.

Alongside the stimulus measures, there has been a massive surge in bank lending in China, underpinned by government policy. However, the massive growth in lending is widely believed to have fuelled a stock market and property bubble within China, such that the Chinese government is now seeking to reign in the expansion:

China will study the use of “regulatory tools” to adjust bank lending after the nation had a record 7.37 trillion yuan ($1.1 trillion) of new loans in the first half, a deputy central bank governor said today.

The People’s Bank of China will “study use of regulatory tools to adjust banks’ lending activity,” Deputy Governor Su Ning said at a forum in Shanghai, without elaborating. China’s central bank will also “emphasize” monitoring of asset price changes and watch international capital flows, he said.

China’s record credit expansion, which helped economic growth rebound to 7.9 percent in the second quarter, also raised concerns that bank loans have been diverted and used to buy shares and real estate, fueling gains in stock and property markets. Benchmark shares, which gained 57 percent this year, are in “deep bubble territory,” according to former Morgan Stanley Asia economist Andy Xie.

The China Banking Regulatory Commission will take “effective” steps to prevent bank loans from being diverted to the stock and property markets, the China Securities Journal reported today, citing Wang Huaqing, the regulator’s discipline chief. Banks that fake loans and earnings reports will also face harsher punishments, the report cited Wang as saying.

What we are seeing is that the Chinese appear to have learnt the lessons of the economic crisis, and are seeking to avoid lending being diverted into asset price bubbles, though it is quite possible that the action is too late. I was in China in 2007, at the time of another surge in the Chinese stock market, and witnessed the mentality of investors first hand. Many people I met were playing the stock market, and were being amazed at how much money they could make. They congratulated themselves on how smart they were, without realising that a monkey could have picked stocks and still seen them rise.

Likewise, with property, it was possible to see huge numbers of brand new apartment buildings, but at night there would be no lights on in the building. What was happening was that individuals were investing in property, and leaving the apartments empty in the expectation of sale at a later profit (in China, once an apartment has been lived in, the value falls). Large numbers of shopping malls were being built, but whether there was sufficient demand for the expansion was questionable.

In this case, I am reporting what was taking place in 2007, and it is not clear that the situation is the same this time. However, I suspect that the situation is very similar, and that there are problems on the horizon, in particular now that China is taking its foot off the credit accelerator. Recent volatility in the Chinese stock market may only be the start, as the degree of irrationality of Chinese investors makes even Western investors appear rational. This, in conjunction with the opacity of information, makes the Chinese stock market a genuine casino.

Despite the surge in interest in China, problems remain in having a clear understanding of China, such as the opacity of the information of what is actually happening in the country. Figures are massaged and manipulated, governance is hidden behind a wall. Even when there is an announcement of import, it is often made by a proxy for the government, such that the government can float an idea whilst still being able to deny it as policy. It is hard to be certain of what is, and is not, happening in the Chinese economy.

A good starting point for consideration of the underlying Chinese economy is the level of activity within the economy. The official figures for this are widely viewed with suspicion, such that it has now become commonplace for electricity usage figures to be used as a proxy for the level of activity. This is a report from August by AFP:

Power consumption in China rose for a second successive month in July, official data showed Friday, giving more hope that the world's third biggest economy is recovering from the global slump.

The six percent year on year increase, released by the National Development and Reform Commission, followed a 3.8 percent lift the previous month.

Before June demand had been falling continuously since October, according to previous media reports citing government data.

Despite the rise, electricity use in the first seven months was down 0.9 percent from the same period a year earlier, the commission, the nation's top economic planning agency, said in a statement.

The commission gave no reason for the recent increase but it came at the same time as a rebound in the industrial sector, which consumes more than 70 percent of the power in China.

Industrial output -- a main gauge of activity in plants across China -- rose 10.8 percent in July from a year earlier, the National Bureau of Statistics said this week, on top of a 10.7-percent hike in June.

Such figures do suggest a major perking up of activity within the Chinese economy. The question is how much of the activity is built upon the government's stimulus to the economy, and high risk credit expansion?

In the meantime, Chinese exports, the driver of Chinese growth are starting to stabilise after the major contraction that followed the commencement of the economic crisis:

Chinese exports fell less sharply in August from year-earlier levels than the 23 percent drop seen in July, as the overall outlook for overseas shipments improved, a top customs official said on Monday.

Li Kenong, vice head of the General Administration of Customs, also told Reuters that exports grew in August on a month-on-month basis. He declined to give specific figures.

"From the recent months' figures we can say that China's exports will definitely become better and better over time, but it is still difficult to judge when it will turn to positive growth," Li said on the sidelines of a news conference.

The comments underpin optimism that, even though net exports will probably exert a negative pull on gross domestic product growth this year, the extent of the decline is easing as demand stabilises in Western countries.

So where does all of this leave the underlying state of the Chinese economy? The first point is that, unlike countries like the UK and US, China can afford the fiscal stimulus, and there are projects that can actually be funded with some purpose. China does still need more infrastructure, and the country has the savings and resource to fund this. With regards to property and the stock market, these do present risks on the horizon. However, having said this, if China can stabilise and recommence growth in exports, this would limit the problems that might arise.

As many readers will be aware, China now has somewhere in the region of $US 2 trillion of reserves, with a third of the reserves held in US treasuries. What we are now seeing is that China has the power to make or break markets. It was apparent that this would be the case some time ago, and I wrote the following in a post a long while ago:

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).

We are now seeing that effect actually playing out in the gold market. This consideration from a report in the Telegraph, from a Chinese individual who is described as a roving Chinese economic ambassador:

“Gold is definitely an alternative, but when we buy, the price goes up. We have to do it carefully so as not stimulate the market,” he said.

In other words, China is buying the dips, and will continue to do so as a systematic policy. His comment captures exactly what observation of gold price action suggests is happening. Every time it looks as if the bullion market is going to buckle, some big force steps in from the unknown.

The massive holdings of treasuries have been a topic that I have discussed at some length in many posts in the blog. In one post, I speculated that China would seek to quietly offload its store of treasuries, doing so whilst not alarming the market and destroying the value of all of their $US holdings. In order to do so, I suggested that they would shift their holdings into other assets, and seek to embark on a shopping spree:

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.

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.

If you have time, I might suggest that you read the post in full. Since writing the post, much of what was then speculation has become reality. The only missing element is the collapse of the $US and, as I have detailed in previous articles, the $US is looking ever more unstable. My expectation is that, as the $US collapses, China will go on a shopping spree in which, in the economic chaos, they will seek to purchase key companies at bargain basement prices. In doing so they will leap frog up the technology hierarchy.

Another element of the consideration of China's economic ambitions has been an ongoing subject of the blog. This is the ambition of China to replace the $US as the world's reserve currency, a suggestion that was widely considered to be impossible at the time that I started writing about it. In a series of articles, I have followed the tentative moves towards this goal. In July of this year, I pulled together many of the points made in previous posts, and provided an update on the progress of China towards their reserve currency goal. Once again, you may wish to read the post in full, as I will just quote a couple of sections here:

I have long argued that China is using the idea of an SDR reserve currency as a stalking horse. In positioning the SDR as the replacement for the $US, China can engage the support of other countries like Russia, India and Brazil, who might blanch at the prospect of the RMB as the reserve currency (e.g. see here for discussion of support for the SDR in relation to India and Russia).

The underlying reality behind the challenge for reserve supremacy is that China is increasingly the linchpin in the global financial system. Whatever China does with its massive reserves quite literally shapes the world financial system. China quite literally has the power to make or break any asset or any market, as can be seen in the attention paid to every utterance from China regarding the $US. When a country has such economic firepower, it is puzzling that anyone might suggest that it is not ready to take on the role of a reserve currency. I can only assume that many analysts are taking the SDR stalking horse seriously, and are not considering the vacuum that will be left when the $US finally collapses under the weight of quantitative easing and fiscal profligacy.

[and]

The only question marks that remains over the RMB as a reserve currency are largely to do with whether China can continue the present economic momentum, and the timing and nature of the collapse of the $US. When I first wrote about China for the blog in July 2008, I highlighted the risks for China, but concluded that on balance I favoured the view that China would emerge in the ascendant in the economic crisis. Whilst still issuing a note of caution, the developments since that time are even more favourable for China. With regards to the collapse of the $US, it is quite astounding that it has defied gravity this long.

As the current situation stands, the RMB is looking very much like the new reserve currency, and it is not going to become the reserve currency in ten or twenty years time, but in the near future. It may be that SDRs will be implemented as a reserve on a temporary basis during the transition, for long enough for China to satisfy the aspirations of the other supporters of the SDR. However, unless China's ascent is halted (e.g. through civil unrest), it is almost certainly going to succeed in the ambitions for the RMB.

The latest news appears to confirm China's ambitions. This is a recent report from the New York Times:

The Chinese Ministry of Finance said Tuesday that it would issue 6 billion yuan worth of government bonds in Hong Kong, a major step to internationalize its currency at a time of concern about the dollar.

The yuan bond issue, the equivalent of $879 million, will “promote the yuan in neighboring countries and improve the yuan’s international status,” the ministry said on its Web site.

“The first step toward internationalization is regionalization,” Shi Lei, a currency analyst at Bank of China in Beijing, said during an interview. “China wants to develop the offshore market in Hong Kong.”

What appeared to many analysts as an impossibility, the replacement of the $US by the RMB, is fast moving towards a real possibility. One interesting speculation is that the move by China to accumulate gold might be the first steps towards a gold standard RMB, but I would reemphaise that this is nothing more than wild speculation at this stage. However, in the coming currency chaos, such a move would absolutely secure the status of the RMB.

The last element in the consideration of China is the mercantilism that is the centre of Chinese economic policy. I have detailed the many mercantilist practices of China, and have railed against the acquiescence of the West to such policies. Their manipulation of the RMB, various trade barriers, and disregard for intellectual property have been common themes. I will not re-state the points made in previous posts, but simply point out that China has been playing to its own rules, and those rules have been mercantilist in approach.

I have covered some considerable ground in this long post. Even so, bearing in mind the complexity of the situation in China and the role of China in the world economy, the post has only brushed over the subject. It has also not considered the ongoing risks for China, which have been detailed in many previous posts. In particular, there is a risk that, if the Chinese economy does at some stage suffer a severe contraction, there are significant risks of major unrest within China. Whilst I have emphasised this in previous discussions, I am now less convinced of the risks. Yes, there are question marks about what might happen with any further collapse in exports, if consumption in the West contracts further. Yes, there are potential problems when the stimulus recedes and lending is tightened.

However, the record of China to date suggests that they have the potential to ride the coming storms.

Having followed the progress of Chinese policy, it has become ever more apparent that they have been playing the 'great game' to win, and that they have played their hand beautifully. It is impossible in one post to convey how they have achieved their current position as the preeminent actor in the world economy. I find myself with a grudging admiration for the way in which they have positioned themselves, and find a measure of contempt for the politicians in the West who have allowed China to play the game so effectively. As the current situation stands, we are witnessing the shift of economic power from the West to the East, with China emerging as the world economic super power.

At this stage, such a rise by China is still not guaranteed, but as each month passes by, the probability of their success appears to be growing. It looks like the 21st century will be the century of China, and that the 'great divergence' described by Pomeranz is coming to an end (note 2). China is returning to its place as the centre of the world.

Note 1: I have listed below links to some previous posts on China. As you follow the posts, it may be apparent why it is that I have become increasingly confident that China will be so central to the world economy in the future. Within the posts it will be apparent why I have so much confidence in the success of China.

1. July 2008, China - What Future?
2. August 2008, China Propping up the $US
3. January 2009, Free Trade 'Yes' - Mercantilism 'No' - Why China Should be Shut Out
4. January 2009, The Myth of the Eternal Status of the $US as 'the' Reserve Currency
5. February 2009, China's Pivotal Role in the Next Step for the World Economy
6. Fenruary 2009, China and the US - Fighting on the Edge of a Cliff
   
7. March 2009, Economics and Power, the Loss of US Power
8. March 2009, China, Gold and the $US
9. April 2009, China as the World Economic Power?
10. April 2009, The RMB as the Reserve Currency
11. May 2009, China, the RMB and the $US
    
12. July 2009, The RMB as the Reserve Currency - an Update

There are many other posts that discuss China, and these can be found here (a search against the word 'China' on the blog). As I have mentioned, I have seen China as being a vital part of the world economy for a long time...

Note 2: I am not convinced in all respects about the arguments put forward by Pomeranz in his book on the 'Great Divergence'. However, he is correct in identifying China as having a consistent history as an economic powerhouse, and that the divergence from this role with the rise of the West was an exceptional event (or series of events).

Note 3: I was provided with many links to assist me with this article, when I proposed writing it. I am very grateful for these, and one of particular interest is the prospect of China defaulting on derivatives contracts. I wanted to use the article, but simply ran out of time/space. I would, however, suggest it as an interesting read. It is rather puzzling.

The RMB as a reserve currency - an update

I have been discussing the steady progress of China in setting up the RMB as the reserve currency for a long while, and have proposed that it is fast moving towards success (though success is not guaranteed). Economists like Nouriel Roubini have suggested that this is going to be a long term process:

This decline of the dollar might take more than a decade, but it could happen even sooner if we do not get our financial house in order. The United States must rein in spending and borrowing, and pursue growth that is not based on asset and credit bubbles. For the last two decades America has been spending more than its income, increasing its foreign liabilities and amassing debts that have become unsustainable. A system where the dollar was the major global currency allowed us to prolong reckless borrowing.

Roubini is seeing a long term decline in the $US, and sees the RMB as being unready to take the place of the $US. In an update to his article, he has this to say:

So the process that will lead - in the medium-long term - to a challenge of the US dollar as the major global reserve currency has started. The US creditors - the BRICs, the Gulf states and others - are becoming increasingly alarmed that the US will deal with its unsustainable fiscal path via inflation and debasement of the value of the dollar via depreciation. So they will not sit idly waiting for this to happen: they are already diversifying into gold, into resources (as China purchases mines and energy, mineral and commodity resources all over the world) and into shorter term maturity US Treasuries that have less market risk than longer term Treasuries. With two-thirds of US Treasuries, being held by non-residents and the average maturity of such government debt down to 4.5 years, the risk of a refinancing crisis and disorderly fall in the dollar will increase over time unless the US presents a credible plan for medium term fiscal consolidation.

Even the Chinese are approaching the issue of the shift in reserve currency with some considerable caution, so Roubini's view is mirrored by the official view of the $US replacement in China:

Yet even Chinese officials pour cold water on the idea that this might happen fast. China Vice Foreign Minister He Yafei, who is traveling with China President Hu Jintao this week to attend the G8 meeting, said Sunday night in Rome that the creation of a supranational reserve currency has been discussed “among academic circles” but that any proposal outlined “is not the position of the Chinese government,” according to China’s state-run Xinhua news agency (in Chinese here). And, at the Global Think Tank Summit in Beijing on Saturday, Li Yang, a former adviser to the PBOC and a prominent academic, said that the transition to a multi-reserve currency system could take 20-30 years or longer.

In some respects I have no argument with Roubini. I have long argued that the US deficits will eventually see the $US decline in value. However, I would argue that his implication of an orderly decline is far too optimistic. The fragility of the $US is becoming increasingly evident as each day passes. Just one example can be found in a recent article from Reuters on 26th June:

NEW YORK (Reuters) - The U.S. dollar fell broadly on Friday after China renewed its call for a super-sovereign reserve currency and as improving appetite for risk dented the greenback's safe-haven allure.

China's central bank on Friday did not mention the dollar by name but said it was a serious defect in the international monetary system that one currency should dominate.

Whilst such negative news dents confidence, it is still not enough to finally pull the rug out from under treasuries, as more recent news reports a rally in the face of poor stock market performance:

Treasuries rose, with the 10-year yield touching the lowest in more than a month, as investors speculated the worst recession in 50 years has further to run, tempering concern record U.S. borrowing may outstrip demand. U.S. debt gained as the U.S. sold $35 billion of three-year notes at the lowest yield since May. The auction is the second of a record four this week totaling $73 billion and stocks fell.

What we are seeing in these two reports is a process that I described in a recent article in the TFR magazine, which is that fear is driving markets, and that there is an oscillation from one place of risk to another place of risk. The problem is that there is no safety in any of the traditional safe havens. As each day passes, the underlying reality of the weakness of the $US is gaining traction, as ever more analysts are coming to realise that the current fiscal policy can no longer be sustained. An interesting example can be found in the Telegraph, which reports the analysis from the Federal Reserve's senior economist:

He added: “Similarly, a percentage point increase in the projected debt-to-GDP ratio raises future interest rates by about 4 to 5 basis points.” Economists are predicting a wide range of ratios but Mr Congdon said it was “not unreasonable” to assume debt doubling to 140pc. At that level, Mr Laubach’s calculations would see long-term rates rise by 3.5 percentage points.

The study is damning because Mr Laubach was the Fed’s economist at the time, going on to become its senior economist between 2005 and 2008, when he stepped down. As a result, the doubling in rates is the US central bank’s own prediction.

In the meantime, in the face of increasing uncertainties, one of the few remaining props for the $US is the purchase of treasuries by the Federal Reserve:

TOKYO, June 29 (Reuters) - U.S. Treasuries edged down in Asia on Monday as traders took profits after a rally pushed benchmark yields to their lowest in nearly four weeks, while the prospect of the Federal Reserve buying bonds this week underpinned prices.

It is clear that the process of printing money to purchase bonds can not continue forever. Whilst the process is currently supporting the bond market, the process of itself weakens the bond market, as it generates inflationary expectations. As such, having started the process, the Federal Reserve is now locked into the process. The more bonds that they buy, the less confidence in the $US, and the less confidence in the $US, the more bonds the Fed must buy. They are now locked into a cycle that must eventually end with the destruction of the value of the $US.

Whilst all of this is taking place, the Chinese continue to promote the idea of SDRs as a replacement for the $US:

The Special Drawing Right (SDR), a unit of account used by the International Monetary Fund, presents a viable alternative to the dollar as a global reserve currency, said Li Ruogu, chairman of the Export-Import Bank of China, a major state-run bank.

"It is a feasible plan to reform the present SDR and make it into a real settlement currency, a universally accepted 'currency basket' that would replace the dollar at the heart of the monetary system," Li was cited as saying in Financial News, a newspaper published by the central bank.

I have long argued that China is using the idea of an SDR reserve currency as a stalking horse. I positioning the SDR as the replacement for the $US, China can engage the support of other countries like Russia, India and Brazil, who might blanch at the prospect of the RMB as the reserve currency (e.g. see here for discussion of support for the SDR in relation to India and Russia).

The underlying reality behind the challenge for reserve supremacy is that China is increasingly the linchpin in the global financial system. Whatever China does with its massive reserves quite literally shapes the world financial system. China quite literally has the power to make or break any asset or any market, as can be seen in the attention paid to every utterance from China regarding the $US. When a country has such economic firepower, it is puzzling that anyone might suggest that it is not ready to take on the role of a reserve currency. I can only assume that many analysts are taking the SDR stalking horse seriously, and are not considering the vacuum that will be left when the $US finally collapses under the weight of quantitative easing and fiscal profligacy.

One argument I have read (sorry, I forget where) is that China would not want the RMB to become a reserve currency, as it would mean that the RMB would strengthen. There is some merit to this argument, as the fall of the $US against the RMB would make a serious dent in China's trade. However, the problem that underpins the current fragility is that China is currently subsidising US consumption at the expense of Chinese people.

At present, China is funding the US deficits and consumption in return for treasuries. Those treasuries are a promise of payment in $US, and yet the issuance of $US is massively expanding even as output is falling in the US. With each $US a representation of the output of the US economy, such issuance of $US currency and debt means that each currency unit is representing a smaller amount of output (I explain this in more detail here). As such, one way or another, China must eventually shift its reliance on a large US export market, and start to gain the full value of their economic output. They can not continue to literally give away a proportion of their output to the US, which is what the purchase of treasuries represents.

The only question marks that remains over the RMB as a reserve currency are largely to do with whether China can continue the present economic momentum, and the timing and nature of the collapse of the $US. When I first wrote about China for the blog in July 2008, I highlighted the risks for China, but concluded that on balance I favoured the view that China would emerge in the ascendant in the economic crisis. Whilst still issuing a note of caution, the developments since that time are even more favourable for China. With regards to the collapse of the $US, it is quite astounding that it has defied gravity this long.

As the current situation stands, the RMB is looking very much like the new reserve currency, and it is not going to become the reserve currency in ten or twenty years time, but in the near future. It may be that SDRs will be implemented as a reserve on a temporary basis during the transition, for long enough for China to satisfy the aspirations of the other supporters of the SDR. However, unless China's ascent is halted (e.g. through civil unrest), it is almost certainly going to succeed in the ambitions for the RMB.

Note 1: I have recently seen an article which agrees with my view that the SDR is a stalking horse, though he is using the expression 'smoke screen'.

Note 2: I have had some negative feedback on the new comments system. More feedback would be welcome, as I am starting to think that I need to revert to the old system (which might be a bit tricky to actually do, but I will work it out if necessary).

The Underlying Problems in World Trade

Regular readers will know that I am very cynical about the talk of recovery in the Western economies. I recently posted on the optimism for the US economy, and pointed out the many indicators that suggested that the economy is a long way from recovery. Similar arguments may be made for the UK economy. However, for this post, I thought I would return to the underlying nature of the economic situation, and there are a few factors that I would like to highlight.

The first of these is that the balance of trade, and current account balances of the UK and US are still in negative territory. Rather than detail the situation as it stands, I will try to illustrate the profound problem this represents through a gross simplification. I hope I will be forgiven this method.

If we were to imagine a world in which there were only two trading countries, that their trade was confined to two products, and that their trade was undertaken as barter, we can strip out the complexities of currency, and see the underlying problem. For the example, we will imagine that one country exports packs of pharmaceutical pills, and the other country toys. In country A, they manufacture 100 packs of pills per day, with 100 workers manufacturing 1 packet of pills each per day. In country B, they manufacture 100 toys per day, with 200 workers producing half a toy each per day. The workers in country B are willing to exchange 1 toy for 1 packet of pills in barter exchange. As such, the productivity of country A is twice that of country B, implying that country A is by far the wealthier country.

The problem that then arises is as follows; Country A is consuming 80 packets of pills per day, but also consumes 40 toys per day. Furthermore, Country A is saving nothing, whilst Country B is saving some. In the table below, it is possible to see how, after five years of this arrangement, Country A owes country B a whole years labour per worker. I make no pretense that these are real figures, but they serve to illustrate principles ( I hope the table is clear, as Blogger shrinks the images down, which is very annoying). As a note the exchange value is 1 toy for one pack of pills, such that each represents 1 unit of output.



What we are looking at in this table is a country B with large numbers of workers, with low productivity, but relatively small consumption levels and a high savings rate overall. I have put a separate column for savings in the table, but the debt owed by country A is (of course) representative of savings. The point in having a separate column is just to emphasise that the individual consumers in country B are very thrifty and cautious, and they therefore hold back from committing all of their stored wealth as credit to Country A. In other words they keep a store of toys (money) ready for exchange in the event of emergency. The model only shows the export trading part of the economy, and this store of toys is there for the exchange of goods and services, but still represents stored value.

The purpose of the table is to show what happens when one country over-consumes, and another under-consumes. Despite the high productivity of Country A, they are still in deep, deep trouble. By seeing the trade in terms of barter rather than currency, it is apparent that it is labour that is being exchanged.

Typically, what we see is such ideas hidden under mountains of economic theory, and obscured by many complicating factors. However, if we look at trade in these simple terms, it is possible to see how, in the end, one worker ends up owing another worker a huge amount of their labour. In this scenario, each Country A worker owes country B an entire years worth of labour. When considering this, it is necessary to also factor in to the equation that no individual is able to actually give a year of their labour to repay debt, so this labour must be repaid over time. As such, of course, the labour that is providing the credit in goods would (and does) demand interest for foregoing the consumption that they might achieve now for future consumption.

The table does not therefore fully express the severity of the situation for country A.

If we apply such a principle to the real world, thinking of the US (like Country A) and China (like Country B) as obvious examples, it is possible to see that something, somehow, absolutely has to 'give'. If we remove the complications of currency, it is possible to see that there is huge amount of labour owed by the US to China. It is also possible to see that China has the savings that will allow it to ride through the current downturn. For real current account balance figures, the US can be found here, and China here.

Inevitably, life is not as neat as the illustrative example, but the principles are what really underpin the nature of trade. It is the exchange of labour between two countries, not the exchange of money. Money is just an intermediary that represents the equivalent of toys and packets of pills.

If we think of the world in terms of this underlying exchange of labour, then it becomes clear that the previous current account deficits of the US has put the economy very, very deep in debt. If we then view the ongoing current account deficits, then we can see that the problem is just getting worse, albeit at a slower rate. The US is confronted with choices, none of which are very palatable. The first choice is to accept the reality of the debts, and therefore do what is absolutely necessary. This is to live in a frugal way until the labour owed to China is repaid. This means, in practical terms, a significant decline in living standards, with a massive decline in consumption, as more of the value of labour is switched to exports. For China, this means that they would not have to work so hard to achieve the same living standard, or they might still work as hard and have a far higher living standard.

After all, if the US starts to use its labour to repay debts, then the value of that labour will flow into China in the form of goods and services.

It is at this point, that life gets somewhat more complicated. It is the question of how this might be achieved.

The simplified model ignored currency in order to illustrate the underlying principles of what has taken place in the world economy. However, the reality of the world is that it does have a currency system. The underlying problem that the US must confront is that, at current valuation of the $US (albeit it has fallen back recently), it can not compete with Chinese labour in many sectors (thus the ongoing deficits). This is a very curious situation.

What we currently have is a belief that the ongoing deficits and the existing debt of owed labour do not matter when considering the value of the $US. It is the only explanation of why the $US might be valued in the way that it is. In part, this is a result of a false confidence in the productive capacity of US workers and the US economy as a whole. Another part of the problem is that China has a nasty choice. The only way that they might be repaid for the labour owed by the US is to accept that part of the existing debt of labour owed be wiped off the slate. I will try to explain this difficult concept...

When Chinese labour was exchanged for promissory notes from the US, there was a belief that the US would eventually exchange the labour for the full value of the notes. The problem arises that, if the US were to make this exchange on the original terms, then US labour would be unable to exchange their labour for the products of Chinese labour. Quite simply, they owe too much of their labour, and repayment would mean that they are living in relative poverty. In short, their consumption would fall back to a degree where they would by buying very, very few goods and services. The Chinese economy is largely centred around provision of their labour to provide goods and services to the US economy, and the halting of the consumption in the US would leave many companies without a market.

Now if we return to the table example, it is apparent that the Chinese are very productive, but consume very little. They are cautious consumers. In order for the situation to be rectified, they need to consume more of their own output. In other words they need to live more wealthy lives. The trouble is that, for cultural and systemic reasons, they are cautious, and would rather not use their acquired wealth for immediate consumption. If they were to consume more of their output, then they would be in a position of living relatively wealthy lives, and this would be further bolstered by the repayment of the labour owed to China by the US.

The problem then arises as to what will happen to all the factories that have, in effect, been lending the labour to the US? If the US economy collapses, then there is no market for their goods. If they demand that the US repays the debt of labour owed (on the original terms) the US will be very poor, and will be unable to afford to buy any of the products of Chinese labour.

The Chinese are now in an uncomfortable position. It is apparent that the US would struggle to have its workers repay debt, and this would be a political nightmare to enact. Nobody likes to move from apparent wealth to actual relative poverty. As such, instead of accepting the underlying reality that is represented in the current account deficits, both the US and China are doing the equivalent of sticking their fingers in their ears and singing 'la, la, la, la!' at the top of their voices.

The real problem, however, is what the US is doing to try to rectify the problem. It is apparent that US labour has been doing the same as the country A workers in the table. They have been consuming more than they produce, and now owe significant amounts of their labour to China. Now that they are confronted with repayment of their debts, they simply do not want to pay. Furthermore, they are demanding that their ability to consume more than their output is continued.

The US government, rather than telling them the hard reality that it is repayment time, is telling them that they can, in fact, continue to consume more than they produce. In order to allow this to happen, they are using several rather dishonest measures. The first of these is that they are attempting (and currently succeeding) in persuading many countries, organisations and people, that the US is in a position to one day repay the debt of labour owed, and that the US has sufficient future output to repay even more debt to the labour of others in the future. The curious part of this is that, up to this point in time, they have offered no explanation of how the US might actually achieve such (increasingly massive) debt repayments.

The second measure that they are enacting is the policy of printing money, and the eventual devaluation of the $US. This is a measure to allow the US to default on the debts of the past. In the table, the barter exchange rate is 1 toy = 1 packet of pills. However, in the real world currency is an intermediary, and devaluation of the currency is a way of post hoc arranging that 1 toy = something like 0.6 packets of pills. In other words, they are reneging on their debt, and breaking their promise to pay.

Whilst this may resolve past debts through dishonest means, it still leaves the US with an underlying problem. The apparent wealth that they have enjoyed is, in part, due to living on the labour of others. However, if they do not repay their past debts, that labour will be withdrawn (e.g. if they devalue their currency, China will no longer lend their labour). At the time that the labour is withdrawn, the US will find that it is reliant upon the output of its own labour, and that labour is insufficient to support the standard of living that was possible with the labour input of countries like China. They will find that they are very much poorer than they imagined, and that is a painful situation to confront.

Perhaps this is too simplistic. I would welcome comments on the situation, and how the underlying premise might be wrong.

Having said all of this, it might appear that I am painting China as an innocent party in the current problems. However, as I have emphasised in the past, China has manipulated its currency in a policy of mercantilism. In so doing they have systemically under priced the value of their labour, and used this to ensure positive trade balances. The cost of this has been borne by Chinese workers, whose purchasing power of imported goods has been diminished, and whose earnings have not properly reflected the market value of their labour. For example, by holding the value of the RMB at an artificially low level, the cost of imported goods has been held high, meaning that each worker is relatively poorer than they might otherwise be. This has also had the effect of overpricing US labour, such that it is not competitive.

The result of such a policy is that China has protected its domestic manufacturers in the home market, and subsidised their exports through underpricing their labour. In so doing, they are making an investment in the future of China, as the result of the underpricing is that they are able to compete unfairly, by undercutting US companies and putting them out of business. I remember reading an article in the Economist a long while ago that suggested that a country in receipt of subsidised goods should be grateful that they are able to consume the products at a discounted rate. However, the result of such subsidy is to destroy businesses that might otherwise compete with such products.

What we can now see in the relationship between China and the US is a very messy situation. The US owes a huge amount of labour to China, and is unable to pay this debt without a massive retrenchment in consumption. That the US is not facing up to debt, and is increasing debt, is a problem that will simply not go away. Whilst US consumers are now starting the painful process of debt repayment, the government is increasing its debt to attempt to maintain living standards in the US. However, in doing so, the overall debt in labour owed to other countries is still increasing. This despite the fact that the US is both unwilling and unable to service existing debts as their economy is currently structured.

Meanwhile, China continues to under price its labour, and therefore continues to undercut the labour of the US, such that it continues the process of hollowing out US capacity to ever repay the debt. In doing so, it drives the US ever further into a ditch.

Quite simply, when we remove the complications of currency, and think of the debts owed by one country to another in terms of labour owed, the madness of the current situation becomes apparent. It is also possible to see that the actions of governments are quite simply making a very bad situation worse, and that the final outcome - or denouement of the situation - will be ever more extreme.

Note 1: I hope that all of this makes sense. I showed the post to another person before publication to see whether there were any errors in my thinking, and the response was very positive. I am aware that many readers of this blog are very astute, so I will also look to you to identify any problems in my thinking. My concern is that, when expressed this way, the gravity of the situation becomes so profoundly obvious, that I simply must be missing something. I look forward to the comments.

Note 2: I have had some interesting links that are pointing to increasingly negative sentiment for the $US. The link provided by Don Keyes is a good summary of the situation. Is this the start of the $US collapse? Quite possibly...but I have predicted the collapse before and been wrong. Like any sane person, I do not want to see a $US collapse. However, set against this, better sooner than later....the longer the US government and Federal Reserve follow their mad policy, the greater the long term damage to the US and world economy.