Thursday, May 14, 2009

China, the RMB and the $US

For a long while I have been discussing the economic shift of power to the East, in particular the rise of China as the potential major economic power. I have been fairly confident of my analysis, and have posted several pieces on the subject, all of which have been pointing to a major shift in the shape of the world, and a commensurate shift in world power. The following are some posts that I have written on the subject of the shift of power towards China (both economic power and power in a very broad sense):
  1. April 2009, China as the World Economic Power?
  2. April 2009, The RMB as the Reserve Currency
  3. March 2009, Economics and Power, the Loss of US Power
  4. March 2009, China, Gold and the $US
  5. February 2009, China's Pivotal Role in the Next Step for the World Economy
  6. January 2009, The Myth of the Eternal Status of the $US as 'the' Reserve Currency
The last of these is a post which does not discuss the shift in economic power, but rather the underlying weakness of the $US as a reserve currency. The remainder directly discuss the shift in economic power to China, which is belatedly being recognised by the mainstream media and analysts. If you have time to review the articles, you will find a progressive argument that amounts to a simple conclusion; that China is positioning itself as the world economic power, and is seeking to displace the US from that position.

Even before these more recent articles, I have been reviewing China and the Chinese economy. In particular, I have highlighted the risks and the potential upside for China of the quasi-mercantilist strategy that has been pursued by the country.
  1. January 2009, Free Trade 'Yes' - Mercantilism 'No' - Why China Should be Shut Out
  2. August 2008, China Propping up the $US
  3. July 2008, China - What Future?
The second set of articles only hint at the potential rise of China as a superpower, as can be found in this excerpt from the second article (emphasis added):
Each of the stories above, taken in isolation, would not cause undue alarm. However, when considering them all together, then there is a worrying pattern emerging. It should also be remembered that all of the above are just examples. What is very clear is that China, and the Chinese government, are actively pursuing a policy of unfair trade at home and abroad. Quite simply, they are using economics as a tool of power rather than just enrichment.

I have suggested in a previous post that the world trading system needs to get tough with China. I did not have the time to dig up the articles that I had read, which caused me so much concern, so have previously not outlined this point of view. However, on reading the latest attempt by the Chinese government to manipulate trade, it seemed a good point in time to outline this problem. I am at heart a free trade advocate, but I also believe that trade should be free and use reciprocal rules should be binding and enforced. It is very clear that China intends to rise economically by any means, fair or foul. The crazy part is that the foul is unnecessary, and one then becomes very suspicious of the underlying motives for such methods.
The point in linking to, and asking readers to review these articles, is to highlight the progressive nature of my argument, as well as giving readers an opportunity to review the considerable evidence for a deliberate bid for economic power by China. However, there is much else on the subject of China included in more general posts and too many to detail here.

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

One example article can be found in the Business Spectator (I first saw the article in the FT). The thesis proposed in the article is that London and New York have a serious new competitor in the emergence of 'ShangKong', a concatenation of the names Shanghai and Hong Kong. The author points to the simple financial system in China as a virtue, before suggesting Shangkong as the new world financial centre:
How could China make a big, dramatic leap? It could begin by strengthening the links between Hong Kong and Shanghai, and transferring financial know-how from the former colony. The two cities are 750 miles apart, not an insurmountable distance in this age of rapid transit and internet communications. The connections are already being made: Beijing has just declared that Shanghai will be a major global financial centre in the next decade and co-operation between Hong Kong and Shanghai is growing, as shown by recent agreements to work together between key exchanges in both cities. Beijing could declare that Shanghai and Hong Kong will have a common set of regulations and recruit some of the world’s best financiers to bolster its regulatory structures – perhaps luring them with an advantageous tax regime no longer possible in the west.

Besides that, if China continues to raise questions about the dominance of the US dollar and the need for an alternative monetary system, other countries may have no choice but to listen – and gradually act. An eclipse of the dollar would be mirrored by a rise in the use of the renminbi. That would guarantee Shangkong’s prominence.
The author, Jeffrey Garton, is from the Yale School of management, which means that this is a perspective from an academic. As many readers will be aware, the academic community has had a very poor record in understanding the current crisis, with many acting as cheer leaders in the preceding boom. However, whilst not knowing much of Garton's record, another academic has been more successful in calling the real economic situation, and that is Nouriel Roubini. As for Garton, he sees a major shift occurring, and he is offering an analysis in which he confirms my views that the RMB will replace the $US as the reserve currency.

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

However, in a couple of respects I believe that Roubini is completely wrong. For example, he says the following:
We have reaped significant financial benefits from having the dollar as the reserve currency. In particular, the strong market for the dollar allows Americans to borrow at better rates. We have thus been able to finance larger deficits for longer and at lower interest rates, as foreign demand has kept Treasury yields low. We have been able to issue debt in our own currency rather than a foreign one, thus shifting the losses of a fall in the value of the dollar to our creditors. Having commodities priced in dollars has also meant that a fall in the dollar’s value doesn’t lead to a rise in the price of imports.
This is exactly the kind of wrong headed thinking that has led to the current situation. The ability to borrow huge sums of money is not a good thing, but a risk associated with being a reserve currency. The ability to raise more debt than can be repaid is a problem - not a benefit. It allows a government to act beyond the usual constraints of debt markets, allows large current account deficits, and mutes what would otherwise be powerful market signals. In other words, without the reserve status the $US would have slid long ago, and the US would have needed to have reformed before reaching the current crisis situation.

Another problem I have with Roubini's analysis is the question of timing. He has the following to say:
At the moment, though, the renminbi is far from ready to achieve reserve currency status. China would first have to ease restrictions on money entering and leaving the country, make its currency fully convertible for such transactions, continue its domestic financial reforms and make its bond markets more liquid. It would take a long time for the renminbi to become a reserve currency, but it could happen. China has already flexed its muscle by setting up currency swaps with several countries (including Argentina, Belarus and Indonesia) and by letting institutions in Hong Kong issue bonds denominated in renminbi, a first step toward creating a deep domestic and international market for its currency.
He goes on to suggest that it will take ten years for the shift to take place. This seems to contradict the rest of his argument, which highlights the underlying weakness in the $US and the underlying strength of the RMB. As he identifies at the start of the article, reserve currency status is linked to creditor status. In the case of the $US, there is a massive and expanding deficit, no prospect of a return to surplus, and a deliberate policy of massive currency issuance through quantitative easing policy (printing money). Why would it take ten years for the shift to take place?

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

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

As it is, as I have pointed out in previous posts, China is slowly but surely maneuvering the RMB into a position where it does indeed become the reserve currency. In a recent post, several commentators have added to the evidence of this progressive process by linking to an article from a blogger here. A later commentator then linked to the possible source of the blogger's article (thanks for the link, Gina), which was an article in The China Post:
HONG KONG -- About 50 percent of Hong Kong's trade with China may be settled in yuan as exporters reduce their exposure to a weakening dollar, Industrial & Commercial Bank of China (Asia) Ltd. said.

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

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

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

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

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

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

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

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

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

Note 1:

Another interesting point that Roubini makes is in his discussion, which is on a different subject to the main article is as follows:
But what could replace it [the $US]? The British pound, the Japanese yen and the Swiss franc remain minor reserve currencies, as those countries are not major powers. Gold is still a barbaric relic whose value rises only when inflation is high. The euro is hobbled by concerns about the long-term viability of the European Monetary Union. That leaves the renminbi.
Regular readers will know that I have flirted with the idea of a gold standard in currencies, but eventually came to the idea of a currency of fixed issuance (the link is to a long article that approaches the subject is a fairly roundabout way). I am somewhat surprised to see an economist using emotive terms such as 'barbaric relic' in reference to a gold based currency. This is not an explanation of why gold is not a viable alternative, but an emotive argument. The reality is that, in the current situation, it is possible to see how easily governments and central banks can debase a fiat currency when there is no restraint on the issuance. Whilst no longer subscribing to a gold standard, I believe that some form of restraint on issuance of currency is better than the current situation of no restraint.

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

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

Note 2:

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

Note 3:

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

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

Note 4:

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

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

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

Note 5:

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

Note 6:

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


  1. Minor point:

    the academic community has had a very poor record in understanding the current crisis Compared to which other communities? Academic economists (f.eksThoma/Roubini/Schiller) first brought the then impending crisis to my attention. I would say that a few accurate prognostications have made the academic community marginally less terrible that those of governments / Wall Street economists / financial journalists / investors etc etc etc.

  2. You wrote....

    "It is noteworthy that the Telegraph is alone among UK newspapers in picking up Roubini's thoughts, reflecting the Telegraph's role as the most intelligent (UK) paper on the subject of the economy."

    ...which is true insofar as The Telegraph will say anything if it thinks it will help get a Conservative government elected. When, as seems inevitable, Cameron and Osborne take over the mess in a year's time we shall see if The Telegraph changes its tune.

    In the meantime the best UK writer on economic affairs is probably Will Hutton of The Guardian. He seems to have some understanding of the scale of the disaster even if he is still clinging on to the hope that things will get better.

  3. The other side of this coin (or should I say facet of the Rubik’s cube) is that China also seems spending a lot of its smelly USD reserves on stockpiling commodities. Apologies if this has been linked before, but see Ambrose Evans-Pritchard from a month ago (especially the thought-provoking comments):

    And has anybody else noticed that silver is massively outperforming gold at the moment? Curiouser and curiouser.

    China also appears to be beefing up its ability to stockpile oil, both as crude and refined products:

    Sale shopping, store of value, normal development or goodnight Taiwan? Or shades of all four? Hmmm.

  4. Great Article - Even if they do not succeed, the picture you paint, and the news that keeps trickling out is defiantly pointing to a power play from China.

    The western powers do indeed seem to be acting in a way that is playing in to their hands though I wonder if this was anticipated when it was decided to increase their economic clout, or if some of the Chinese measures are purely reactionary and chance and western idiocy has dealt China a better hand than they deserve.

    I note that the article in your note #4 seems to have been removed from the Telegraph's website.

    Another blogger had copied it in entirety, so readers should go there or try archive sites, as its a fantastic read. The whole thing seemed a farce to me, and the confession seems to validate my view to some measure.

    Also from the same blog, he prints an email from a Spread betting company banning short sales in several large companies including Citigroup, Morgan Stanley, GM and Ford

    "Due to significant increases in the cost of borrowing stock in the underlying market, along with a lack of available shares to borrow, we have been forced to restrict short selling on the following US Shares:"

    I wonder if you could explain what that could indicate is happening to those stocks, and why there seems to be such a dearth of stocks to borrow all of a sudden.

    Lefty Feep

  5. Cynicus,

    As usual a fantastic post.

    Between the 18 and 20 May, the Brazilian president Lula da Silva is due for a trip to China and apparently he is going to invite currency swaps with China equivalent to some 3.2bn.

    It appears that this is, amongst other things, the result of China becoming the largest trading partner with Brazil from April 09.

    In the words of Mr Silva:
    “The current economic crisis shows that in time it will be necessary to replace the USD as the reserve currency... At present the USD is the universal currency, which means that money flows from emerging countries to American Treasuries. This is absurd...We need to establish new mechanisms as to avoid dependency of the USD..”

    The USA were until April the largest Brazilian trading partners, with exchanges valued at some USD 2.8bn. They now trail behind the Chinese with which trades are worth up to USD 3.2 Bn.

    Some academics and business people believe that the proposed currency swap will be welcomed in China, however they also mention that the risks will be greater than dealing in Euros or USD as the risks of these currencies are transparent, whilst the Yuan (RMB) can easily be manipulated by the PRC.

    I apologise for the link which is of a major Portuguese newspaper. This means that the article was written in Portuguese.
    Notwithstanding, I trust that this confirms the source:

    On a different subject and following the recent episodes in QE, would there be any chance of having your thoughts on the recent increases in treasuries yields?


    ps. It is not being mad that is a problem. A problem is driving yourself mad :)

  6. I found the following passage from one of the referenced articles quite disturbing (in the sense that I like a nice quiet life):


    "Importer #1 is the European Union; importer #2 is the United States. Some of these countries may soon find themselves hard-pressed to earn enough Yuan to continue importing Chinese-made products."

    It seems to imply an acceptance of quite considerable economic disruption that would damage Chinese industry first and foremost. Or maybe the shape of world trade is set to shift in some way?

    Not too sure about Nigel's comment on the BTL landlord Will Hutton, though. Do you mean Larry Elliott?

  7. CE,

    Thanks again for your excellent blog. It serves as my center of gravity as I learn as much as I can from various sources about what's going on and why.

    Regarding your 'divisional currency model' from the dinner table conversation post:

    "The way around this is not to increase the units of currency, but to sub-divide the currency into smaller units. Just as today there are pounds and pence, as the value of a currency increases, it would need to be divided into pounds, pence and 'x'."

    This could easily happen. I refer to GoldMoney's goldgrams as a gold-backed digital currency and their new iPhone application for cash-like convenience:

    (I hope that doesn't sound like a sales message! I'm not afflicated with Goldmoney.)

    What do you think about the idea of simply further sub-dividing goldgrams (milligram, microgram, etc) to adjust for the price deflation resulting from a gold standard?

  8. If China achieve their goal and power moves to them... what would the consequences be? Do we actually *know* they would be bad? We don't really. It might be the sort of change that would have a silver lining.

    Everybody in the UK now seems to understand that we need to start 'making things' again. That's a change in the mood of the nation.

    Once we try, and find we can't compete, what then? People will ask why and circumstances will force deregulation or business and employment and public spending restraint once more. At least, that's how I *hope* we'd respond.

  9. Mark,

    i believe you have an Achilles heel; your 'mistrust' of China.
    China simply acts in its best interests.
    Despite ALL the advantages we in the West have had over China (et al), we have BLOWN IT.
    China did not engineer our downfall. We have managed it all by ourselves.

    China is not perfect, but by God sir, nor are we.

    We cannot afford another Cold War, and nor should we want one.
    China, for all its foreign reserves, is still a poor country in terms of assets per capita.

    We are bankrupt but have masssive social security, pensions, healthcare etc etc.

    'We' have the inherited wealth of 200 or more years of vanguard technology, allied with having already used most of the worlds stock of key natural resources.
    China is paying top dollar for its share of whats left.

    What would the chinese Average Joe make of your collection of paranoia above? Anger? Bewilderment? Bemusement?

    Have we lost all hope, self-confidence, and respect?

    'We' have the inherited wealth of 200 or more years of vanguard technology, allied with having already used most of the worlds stock of key natural resources.
    China is paying top dollar for its share of whats left.

    Maybe its just me, and i love your blog, but i cannot agree with with the tone of this entry.
    You are whinging like the primary school bully who runs to teacher when unexpectedly thumped hard by someone they under-estinmated.

    We blew it!
    Get over it!

    Farmer John

  10. Farmer John wrote:
    "Despite ALL the advantages we in the West have had over China (et al), we have BLOWN IT.

    China did not engineer our downfall. We have managed it all by ourselves."
    I thought it was our "globalist" politicians who engineered our downfall... on purpose.

    See ya in the gulags.

  11. I'm still interested in this idea of whether China can 'go it alone' when it comes to world economic dominance.

    In years gone by there was the slogan "British know-how", and a Google search uncovers the phrase being used even now.

    e.g. "Chinese government eyes British know-how"

    Is it just a slogan, or was there ever really a critical mass of British 'know-how' that meant something? Where did it come from?

    Can a country like China really go from developing nation status to world economic dominance within a few years?

    Can western 'know-how' (if it ever existed) simply be bought in like any other commodity? What will the source of 'know-how' be in the future if the West's economies decline under a massive burden of debt? Or can a country like China simply make a conscious decision to educate its population and hey-presto there's all the 'know-how' they need?

    I am suspicious that the Adam Smith-ites think that the markets can achieve anything, whereas I believe that there was something very special in the combination of circumstances that led to the Industrial Revolution in the West which cannot be replicated by performing a few corporate takeovers and training students extremely rigorously to pass exams.

  12. Careful Lemming.

    Asking those questions will lead you down the path of what role evolution and genetics play in the 'economy'.

    You don't want to be called a 'waaysist' do you?

    Never forget... 'we are all equal'.

  13. VoteThemOut

    I wasn't suggesting any role for genetics or evolution in the economy, merely that something very special happened in the UK when the Industrial Revolution occurred and it still resonates in our culture today.

    Could this be replicated from scratch 'by design' by another country in a matter of a few years? I am not yet convinced.

  14. Just another thought on China's economy.

    Is China, at the moment, actually instigating wealth creation or merely running a service economy? Isn't the distinction quite important, because a service economy, no matter how successful, can never become 'top dog' for long..?


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