Friday, February 13, 2009

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

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as I have recently managed to get around to reading my print edition of the Economist, which is already over a week out of date.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

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

A good starting point in considering the article is a part with which I can agree, which is as follows:
'Of course China manipulates its exchange rate—in the sense that the level of the yuan is not set by the market, but influenced by foreign-exchange intervention.'
Whilst I agree with this statement (obviously) and have previously highlighted some examples of intervention / manipulation to support the $US, this is not the whole story. On top of the active interventions in the market China has a raft of capital controls in place, which prevent the free movement of capital in and out of China (the article linked to is about some loosening of the controls). The point about such controls is that the utility of the currency is severely limited i.e. for uses such as purchasing for import of goods and foreign direct investment into China. Quite simply, if China removed the controls, then the RMB would emerge as a major world currency, and quite possibly as a reserve currency. The article in the Economist conveniently forgets this small detail.

As for the main thrust of the article, and this sort of argument is common, the rest of the article is a discussion of what the RMB exchange rate should be. I will not repeat all of the detail of the argument, but will quote their conclusion as follows:
The evidence that the yuan is significantly undervalued is hardly rock-solid. It probably is still a bit too cheap, and it would certainly be a mistake for Beijing to allow it to fall, not least because this would risk a protectionist backlash from abroad. In the longer term, the yuan needs to keep rising against a basket of currencies. But for now, some of the accusations being thrown at China are wide of the mark.
The problem is that, all of these arguments are completely irrelevant. Having lots of economists contemplating what the RMB should be is entirely beside the point. If the RMB is not significantly undervalued, then why does China intervene, and why the capital controls? A million and one economists can produce a million and one justifications for the RMB being 'about right', but then why does China not just let the currency loose? As it is, the arguments for the RMB not being undervalued are very poor, but that is beside the point.

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

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

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

I will quote sections from the article, and I think you will see why this is so odd:
China will continue to buy US Treasury bonds even though it knows the dollar will depreciate because such investments remain its “only option” in a perilous world, a senior Chinese banking regulator said on Wednesday.

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

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

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

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

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

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

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

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

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

With regards to the situation as it stands, as I pointed out in a recent post the Telegraph reported the following:
Where is the money to come from? China, the Pacific tigers and the commodity powers are no longer amassing foreign reserves ($7.6 trillion). Their exports have collapsed. Instead of buying a trillion dollars of extra bonds each year, they have become net sellers. In aggregate, they dumped $190bn over the last fifteen weeks.
I have tried to find out who these sellers are, but have been unable to find the information (any comments/links on this appreciated). On the other hand, the US is still managing to sell bonds, albeit that the 'The Treasury had to pay a little more than expected'. I have read other similar stories recently. It is also apparent that there is contradictory information, with another article suggesting that foreign central banks are buying US bonds, and another article reporting 'Long Bond Crumples Amid Selloff'.' I will confess that the aggregate real position eludes me at the moment, as there are wide variations across different types of bonds (the Lehman aggregate index shown in the link includes other bonds such as mortgage backed). I will freely confess here that my knowledge of the technicalities of the bond market is insufficient to make sense of the data directly, and I am therefore relying on reports on the data.

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

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

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

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

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

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

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

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

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

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

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

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

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


  1. Its not about under or over valued. That condition is in a state of flux. Above or below only matters at the time of transition.

    What matters is who has money in the bank. Not hologram money.

  2. CE, thanks (again) for an eloquent and intelligent blog.

    In addition to the 'non-arguements' you referred to in the Economist article, I was suprised to read (in the article) passages such as;-

    Some argue that China’s large current-account surplus is incontrovertible proof that the yuan is too cheap. Morris Goldstein and Nicholas Lardy, at the Peterson Institute for International Economics in Washington, DC, estimate that the yuan’s real trade-weighted value needs to rise by another 10-20% to eliminate the surplus.

    I guess i am naive, but it still suprises me that peope are paid well to come up with, and attempt to defend, tosh such as this.
    Gentlemen at the Peterson Institute...the Chinese work hard, save hard! Its that simple.
    There is no rule that says that just because the US/UK et al have squandered the last 20 years of Easy Oil, the Chinese (leaders or citisens) have to do likewise.

    On a slightly different note, if one concedes that the purchase by China of huge quantities of US Treasuries / $ reserves has had the effect of keeping the USD this such a big deal?
    I mean why does Washington get so exercised by it?

    If you want to run the Worlds Default Currency, surely this sort of activity goes with the territory?
    This is analagous to an ignorant Mon blaming the sweet shop for her spoilt child becoming obese! MOM, you doled out excessive pocket money and watched with pride as your little moppet gorged on candy, you idiot.

    Washington (and london) fudged growth and inflation stats, set inappropriate interest rates as a consequence... and now want to blame china for saving??


  3. America has already started selling USD, isn't that what they're really doing when they introduce more USD onto the market? adding more to the supply?

    What is the difference between America doing it and China? if you separate America from the USD then America is in the same position that china is, massive reserves of dollars (unlimited in fact) and in need of the financial stimulus for its economy.

  4. Many thanks for yet another stimulating and clear-thinking post.

    I don’t think the two possibilities you mention (China and the USA coming to an arrangement, and China concealing its US bond sell-off) are in any way incompatible, as perhaps you imply. On 3 February, you posted about the UK’s recognition of Tibet in November, and suggested that the Brown administration might have bought itself some time as a result - a very plausible supposition. Is it not probable that the Chinese are now using their dollar holdings as a bargaining chip over some other political goal? While the bonds retain value they would be more use for blackmail.

    There are numerous things I can think of that the Chinese might value above the bonds - Taiwan being the most obvious, but there are many others to choose from - especially as the bond holdings have been built up over a relatively short period and the Chinese tend to take a very long term view politically. We keep buying bonds, you give us our other goal, would be an easy trade.

    If this is right, and if I was the Chinese premier, I would not have tried to use my power with an outgoing lame-duck President. I would wait for the new one, let him settle in and absorb the position, and then show my strength in some way. I imagine a month would be sufficient time for a novice to learn the ropes before real pressure could be applied - given the bonds are a wasting asset, and the situation is unstable, it would be foolish to wait any longer.

    President Obama was sworn in on 20 January - and the month is nearly up...

  5. Your puzzlement about the anomaly of Chinese thinking in buying an asset it knows is going to depreciate can perhaps be explained if you consider politics as part of the equation.

    Should the US contemplate action in various parts of the world - Middle East, Iran, North Korea, Sudan etc which China perceives as being against its interests then having huge amounts of US$ the sale (or even just the threat of sale) of which would destabilise the US and its allies is a potent threat

    I understand that President Eisenhower used a similar threat to bring about the end of the Anglo/French intervention in Suez in 1956.

    Congrats on your blog - very informative

  6. Alfred:

    All very fair points. I have to admit that there is an unhappy logic in what you say. I have to admit the possibility that you may be correct. As you mentioned, the UK deal on Tibet may just be one example of how China can now flex its economic muscle.

    It is quite possible that such back room deals are taking place. My only concern with the idea in principle is that I can not see the US government bowing to such demands, but that is a guess at the psychology of the actors, and nothing more than that.

    As such, I will keep your insightful comments in mind. You could be right - there are many concessions that China might want to extract in return for support of the $US. When the US gave up power over the $US to overseas investors, there can be little doubt that they also gave away a substantial amount of their power.

    I am a firm believer that power overall is rooted in economic power. As such you have reminded me of an underlying principle in my thinking. Maybe I need to keep this in mind in my considerations!

    Thanks for a useful comment.

  7. Coshbrew:

    I had not seen your post when I added my last comment. Yes, Suez is a potent example of economic power in action. I read/saw something making this point recently, and it is hard to argue with the principle. I would link to where I read/saw this but it was one of those situations of browsing, so I forget where I saw it.

    Again, a perfectly fair point. In both Alfred and your post, it is a situation in which politics can influence economics. In these circumstances, we can only guess at what deals might be taking place.

    However, the underlying economic drivers are the essential element. If the US is bowing to such demands, then it is finished as a world power. As I have said many times in past posts, the US must face down the threat of currency collapse instigated by China. If it does not do so....

    Again, a useful point to bring to the overall picture. Thanks.

    You can

  8. “Propaganda is to a democracy what the bludgeon is to a totalitarian state.” Chomsky

    Dont underestimate our establishments power to kill a story if its in the national interest and if necessary changing the facts to appease, signal, and hide their intentions. The article is a Joke.

    And No I don't do conspiracy theories, and I don't like Chomskys views either, but he is right in the quote.

    A couple of interesting links came to mind that ran across my mind while reading your post.

    China as lender of last resort

    Transcript of phone conversation between Paul Volker (“BIG PAULIE’) and Tim Geithner (“TIMMY”)

    Did you not notice that the Chinese PM (chinas no2) was on a surprise state visit last week?

    China PM

    Sept 18 was China saying, dont f**k with us, we can kill you and we dont like you letting your banks go bankrupt, so think of another plan, thus Tarp.

  9. Well, for my tuppenceworth, I think China is doomed. Quite simply, I think the engine of the global economy, and globalism per se, has been the insane profligacy of the U.S. consumer. That engine is now (probably irreparably) broken.

    All the Chinese have essentially done is create a production bubble to match the American (or Western) credit bubble. That bubble has to deflate.

    I don't really see how the attempt by the Chinese to stimulate domestic consumption can replace the lost American markets, as I can't see the Chinese morphing, in the space of 6-12 months, into 20-stone, Hummer-driving, house-accessorising turbo-consumers. In fact I can't see them doing that ever. And even if you could convince the Chinese to spend rather than save, they simply don't have the living space to put the stuff.

    I even read a recent article that suggested that the Chinese are in fact pulling in their horns and spending less. Certainly the Japanese government has had no success in turning Japan into a nation of consumers after several decades as a stable, developed country.

    I think the Chinese government, like every goverment, has to stop thinking it can hold back the tide of contraction. It has to instead focus on how the contraction can be best managed to preserve social stability.

    Once the race to the bottom has ended, China may indeed end up, by default, as the world's most powerful nation. However, I think that will be a kind of booby prize, as the Chinese will have very little ability to project that power.

  10. China is in no way doomed. Chairman Mao once said something to the effect of 'a cultural revolution here a cultural revolution there". That still applies.

  11. I've been following this blog for sometime now. This morning I found (yet another) one of Mark's long standing predictions seems to be coming to pass. It's increasingly likely Ireland will default on its debt..

    It's interesting that when Mark first predicted this it would have been laughed out of the mainstream media.

  12. Re "China and the US are locked together in an unseemly economic embrace"

    You might find this picture appropriate

  13. Ireland is the least of the EU's problems:

    It looks like Europe is far deeper in the mire than even the USA.

  14. Passerby, thanks for linking.

    The chap who sent me that isn't even a banking expert, he just ploughed his way through the facts and figures and said what everybody else is now saying.

  15. Just take a look at the whole picture for a change. World economy is just a fine tuned ponzi scheme. It can work for ever as long as you have constant growth. And that is it's flaw. You can stick to it and go on for ever. IN PAPER.

    Planet earth is a closed system. It doesn't have infinite resources. No matter what you do with math, you only have a set amount of oil, iron, gold. Sooner or later you are going to hit a wall, as you have said already. We just hit our first wall and the whole scheme is in near collapse. You may patch it and continue, but only for a while. You are going to hit that wall again.

    You know, the only way to prolong it for a long time (before it hits a wall again), is space. Make the solar system, our closed system. It is not infinite, but it can handle us for a couple of centuries. Too bad that space exploration, is not cost effective.


  16. In the name of continuing the speculation on strategy & outcomes, I'd like to qualify some comments I've made... I've been saying that I don't think the problem of the overvalued West (pound/dollar etc.) would be enough on its own to bring about a major currency collapse. There is no one player big enough (and with nothing to lose) to collapse the West, and too much collaborative impetus to ensure major currencies are propped up.
    However, as I said before there are plenty more flies in the ointment, and as those flies keep causing cracks in the dam wall, the West like the proverbial Dutch boy must eventually run out of fingers to plug the holes (gotta love a mixed metaphor). So the complexity of the endless bailouts must come at some price, and so must the social problems that result from problems with the 'real' economy etc... All flies in the ointment, and all allude to the type of precipice scenario's CE and others are alluding to.

    I believe that if it was just one big crack in the dam, there is enough collaborative impetus internationally for the financial system not to collapse - even over time, as deals could arguably be worked between creditors and debtors, no matter how impossible they may seem now.

    I think it will be a fly in the ointment - one of the many complex problems accruing that will cause the eventual collapse, not someone causing a run on the dollar/pound out of thin air - although these things will probably happen soon after, as collaborative impetus fails.

  17. Red:
    I completely agree. A confluence of factors is likely to collapse Western economies.
    But if you trace all those flies back you may find they all stem from CE's fundamental arguments (not saying your argument's stink of course Mark).
    In other words they could be the knock on effects of the East-West trade imbalance and the doubling of the global workforce without a corresponding increase in commodities.
    I haven't tried tracing them back - its merely a suggestion.

  18. Mark,

    You're drifting from economics into geopolitics here, which is fair enough given that when you go down to the root of things, economics is not an independent sphere of human activity, but ultimately about power (the little theories it comes up with are simply rationalizations of power relations, and people with guns provide the necessary backdrop).

    Wealth and power are in the final reckoning "real" things, and although you can bluff your way for a time (as Britain has), in the end, the "truth" wins out. What I like about your approach is that you are ultimately a "seeker", and do not subscribe to received wisdom. I don't think your approach is "cynical", just rational. Btw. dump your subscription to "The Economist". I say this as a recovering market fundamentalist, and long time enthusiast of said publication (I still admire it for its intellectual sophistication and command of English, but in the end it is just a dishonest, ideological rag, peddling a manifestly false view of reality, just like "Pravda" did in its day). Continue thinking for yourself... There are many people like you, and I'm happy to see more and more of them are attracted to your blog.

    I have little to contribute re. the general discussion of China/USA/EU etc. relations. I don't have enough raw data or understanding of the dynamics to speculate about what will happen in the near future. I can only monitor the little things happening on the ground. Hanging out in Shanghai bars with my (equally) cynical friends, we've coined a new term PAOW (punching above own weight). This term applies every time we see a middle-aged, overweight, middle-manager type (obviously working for some US or UK bank), with a movie-star grade Chinese girl, half his age on his arm. Sustainable????? I think not, but fun while it lasts...

    All the best

  19. Hello Mark, I urge you to take a look at this article in the Telegraph

    It's about the weak pound being good for Britain.
    Go to the last paragraph, and you will find that it is almost a direct quote from the film "Being there". In the film the lines are spoken by Peter Sellers, a mentally subnormal gardener who is mistaken for an economic genius by the American heirachy. (Ring any bells mr Brown ?).
    "Right now, we may look to be in for a long and hard economic winter. But, just as the chills of winter each year give way to the promise of spring, you can be equally sure that the current recession will eventually come to an end and economic spring will arrive."
    Please, tell me I'm dreaming....

  20. Hello Mark,here you will find the VERY similar idea from the film "Being there". (Sorry I forgot to put this in with my main post)

  21. I'm not the usual anonymous

    Post link for interest. Sorry missed the posts on FRB/fiat currency

    This guy suggests its all acedemic and we are all screwed anyway

    Seems a bit extreme but..........

  22. cynicus

    firsly thanks for great blog, keep it up, also do you write for newspapers? and if so do provide links to we can consume more of this wisdom :)

    anyways to get to the point

    take a look at this channel4 video

    i read all your posts on china so you might find this interesting


  23. On cue we see Hilary Clinton grovelling in China. As I have said in another blog: who needs bombs when you can conquer economically? We feared China getting nuclear weapons. As usual we were looking the wrong way.


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