Tuesday, September 29, 2009

Bank of England Bills and Printing Money

Regular readers may remember that, some time ago, I sent some questions to the Bank of England regarding quantitative easing (QE - printing money), following an offer by the deputy governor to answer QE questions. I sent an email on July 16th, and now have a response. Before looking at the reply, these were my questions:
1. Reuters has reported on the 9th July that, following no announcement of an extension of the policy of QE by the Bank of England, bond yields rose sharply. Bearing in mind that just the possibility of an end to the policy caused this reaction, does this not suggest to you that QE is propping up the Bond Market?

2. The CPI has finally dipped below the 2% target that the Bank of England uses in setting monetary policy, but is still not far enough off target to require a letter of explanation. I believe that the Governor of the Bank of England has identified QE as an untried unconventional policy with uncertain outcomes. Bearing in mind that during all but the last week, CPI has not fallen below target, how can such an untested policy be justified? In particular, with monetary stability as a key aim, how can such an unconventional policy be justified?

3. With regards to exit strategies for QE, the Bank of England Quarterly Bulletin for 2009 Q2 states that 'Alternatively, the supply of reserves could be reduced without asset sales, through the issuance of short-term Bank of England bills.' Is this policy? If so, can you confirm exactly when and under what circumstances you will finally sell the gilts that have been purchased?

4. A secondary question as a follow on to question 3. If the purpose of QE is not to monetize government debt, then why would you not sell gilts at the end of QE policy? Do you have concerns that the existing expansion of gilt issuance would preclude the sale as the sale might destabilise the gilt market? Is this not a recognition that the gilt market can not support the level of issuance?
The BoE took the trouble to write to me with some answers in an email but, they also referred me to other general answer to questions on their website, pointing me to answers 1, 6, 11 and 13 in particular. I will use the answers from the email and some of the general answers in this post, but you may wish to see the originals general answers in full.

The first point to note is that there was no direct answer to my question (1) in any of the answers that were provided. It appears that the Bank of England does not want to comment on whether they might be propping up the bond market. It might be argued that, in purchasing bonds, the intention is to hold down yields, but I think the implication of a spike in yields on a mere sniff of an end to QE goes beyond this. The question is, of course, an indirect way of asking whether the BoE is monetising government debt. This they have answered, and this is from the email they sent:
Quantitative easing has not been carried out to help the government meet its financing needs, and asset purchases by the Bank have not been made to keep gilt yields at a particular level. Other things being equal, yields can be expected to fall in response to the Bank’s gilt purchases.
In the general answers, they add that monetization of government debt would infringe upon article 101 of the Maastricht treaty, and that they are not being forced to make up a shortfall between government debt and expenditure:
The key point is that the Bank is not being forced to create money in order to cover the gap between the government’s tax income and its spending commitments. If it were carried out to finance the budget deficit, it would be a violation of Article 101 of the Maastricht Treaty (which the United Kingdom must abide by, even though it is not a member of the euro zone). [...]

Central banks routinely buy and sell government debt in the secondary market as part of their normal operations in the money markets and such operations are not deemed to amount to monetary financing under the Maastricht Treaty.
The interesting word in this answer is forced, as it is not apparent where this word has come from. This is the original article 101:
1. Overdraft facilities or any other type of credit facility with the ECB or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments.

2. Paragraph 1 shall not apply to publicly owned credit institutions which, in the context of the supply of reserves by central banks, shall be given the same treatment by national central banks and the ECB as private credit institutions.
The interesting point in this article is that the direct purchase of government debt is actually prohibited, but there is nothing to prevent indirect purchases (as they point out). At the same time, it is not apparent where this idea of 'forced' has appeared from. The implication of this is that, if the BoE were to monetize debt without being forced, this would all be right and proper. It is a most puzzling answer...

With regards to the question about why the policy is being enacted whilst CPI has barely moved below target, this is the answer in the email:
The objective of the MPC remains to hit the Chancellor’s 2% CPI inflation target. Therefore the MPC continues to focus on the medium term prospects for inflation when setting monetary policy. The MPC judged in March that in the absence of a further monetary policy stimulus, the growing margin of spare capacity created by the recession would push inflation significantly below the target in the medium term. With Bank Rate already almost as low as it could go, the MPC decided that a substantial stimulus through quantitative easing was warranted. That was the reason for embarking on unconventional monetary policy. Central banks routinely buy and sell government debt in the secondary market as part of their normal operations in the money markets. What distinguishes quantitative easing from normal operations is their scale and the length of time for which the assets are likely to be held.
There is nothing new in this answer. The BoE been wrong in their inflation forecasts up to now, such that the expected fall in the CPI has not taken place ....it is not clear therefore why QE is still being enacted, as it is freely admitted that it is 'unconventional' and therefore carries with it risks that are unknown? Under their own considerations, it will take at least 6 months for the impact of the policy to be felt, so it is not the policy that has prevented deflation. Deflation has simply not happened.

Questions (3) and (4) generated some interesting answers, with this from the general answers:
When it comes to tightening policy, the MPC will have two instruments available: raising Bank Rate; and selling back assets. Removing money from circulation can be achieved by selling the assets back to the private sector. The MPC will be likely to use a combination of raising Bank Rate and selling back assets, although the precise sequencing and the relative importance of the two instruments will be considered month by month at each MPC meeting. The Bank will seek to sell the assets it owns in an orderly fashion in order not to disrupt the market for government debt.
And this is the answer sent in the email:
The market for UK government debt is one of the deepest and most liquid financial markets in the world. Nevertheless, buying and selling large quantities of assets quickly is likely to influence prices.If the MPC decides that it wants to reduce the quantity of reserve balances held by the banks, it could issue Bank of England bills in exchange for the reserves, rather than selling the Bank’s holdings of government debt back to the non-bank private sector. The assets could then be sold back in an orderly fashion over a longer time period. Whether the Bank issues extra bills in exchange for the reserves or not will ultimately be a technical decision that will be taken with a view to market conditions at the time [emphasis added].
It is notable that they do not mention the sale of Bank of England bills in the general answers, but instead simply say they will sell 'assets'. It is apparent that I was correct in thinking that the BoE is not planning to sell the government debt back into the market for a long time, but is rather planning on tightening monetary policy through issuance of Bank of England bills. This is still not public knowledge, and I am uncertain that the distinction would be understood.

The BoE are right to assert that any quick sale of the bonds would influence prices, but this bumps up against a fundamental concern. How might the BoE sell the bonds into the market at any time during which there is already such massive issuance of new debt? How long will the BoE have to hang onto the government debt, and what market conditions might be considered opportune for selling the bonds?

The bottom line is that the BoE will not be reversing the QE policy in what might be seen as a conventional way (e.g. selling the original assets back). It might be argued that there is no conventional way in an unconventional policy, but I do not believe that open market operations, the nearest equivalent, would allow for assets to be purchased and held in this way. With such a radical policy, it would be expected that the BoE would have clear criteria for a return of the bonds to the market in an orderly way, and under what circumstances they might sell them.

The logic of QE is that, should an upturn in the money supply or inflation become apparent, they will need to reverse the policy. However, this would not mean an immediate tightening of the money supply, but would likely be a progressive tightening. Just as interest rates are not normally altered by large increments, or the policy of QE undertaken in one large 'dollop', there is no reason why the end of QE should be undertaken as a 'dollop'.

There is no discussion of any detail, because the Bank of England will certainly know that, with government issuance of debt flooding the market, there is absolutely no time in the foreseeable future at which they might offload the bonds without causing a crisis. The BoE's holding of government debt is simply too large...The only reason that any other method might be used for monetary tightening is that the amount of debt being issued by the government can simply not be digested by the markets. There is more debt being issued than demand. The BoE is simply filling the hole in demand.

As another concern, this is a quote from the general answers, on reselling of BoE holdings of bonds:
It is possible that gilt prices will fall, thus raising the corresponding interest rates, when the Bank starts to sell its holdings. Subject to achieving the 2% inflation target in the medium term, any sales will be co-ordinated with the Debt Management Office so as to limit any adverse impact on the functioning of the gilt market.
This should be a matter of some concern. The BoE will be co-ordinating the sale with the DMO, which is the arm of government that raises finance. There should be no direct linkage between the activity of monetary policy and the issuance of government debt. The BoE has no business in ensuring that the government might be able to finance their debts or at what rate, and is now admitting that their operations are now (at least partly) being controlled by the central government through the DMO.

This is the basic problem; if the government were not issuing too much debt, then there would be no need for the co-ordination, as a steady offloading of the debt would not unduly interfere with the market. Also, if a private institutions were to co-ordinate with the DMO there would be outrage. The BoE and the DMO acting together is, quite literally, rigging the market.

What we have is a situation where the BoE is preparing to find reasons to hang on to government debt, and to not return the debt to the market (where it belongs) without the permission of (sorry, co-ordination with) the DMO. All the while, they continue to purchase more debt, despite the fact that CPI is still at a level at which there is no need even for a letter of explanation.

Over and above the answers to my questions, there were some interesting points in the general answers. For example, they go to some lengths to distance themselves from the idea that what they are doing is a variant of the Zimbabwe problem. This is the disingenuous explanation:
In the Weimar Republic and Zimbabwe, the central bank printed money to finance government expenditure. This vastly increased the money supply, and hence prices rose rapidly. This is not happening in the United Kingdom. Here, the Bank is buying assets from the private sector to stimulate the wider economy, because otherwise we risk undershooting, rather than overshooting, the inflation target. Quantitative easing is not carried out to help the government meet its financing needs. When the economy recovers, most of the purchased assets will be sold back to investors, reducing the money supply.
Note the misdirection in suggesting that they are buying 'assets' from the public sector. Whether directly or indirectly, they are buying government debt, and therefore they are supporting the purchase of government debt. Note also, that they are talking of when the economy recovers, and also implying that they will sell the government debt back. However, the prospect of sales of Bank of England bills in place of reselling the bonds directly contradicts this.

The last quote is one which is not of great importance in the big picture, but is indicative of the way in which the BoE is trying to bury the simple fact that they are printing money.
What is the difference between reserve balances and printing money?
Reserve balances are, in effect, electronic money held only by commercial banks and can only be used to settle transactions between them and with the Bank of England. The Bank issues paper currency in response to the demand for banknotes from the public. But reserves and notes both represent claims on the Bank of England (‘central bank money’) and the banks can exchange the reserves for notes, although as they receive Bank Rate on their reserves they will only do this if the notes are needed to meet, for instance, withdrawals of deposits. When the Bank buys assets under its quantitative easing programme, the bank account of the seller goes up by the value of the sale and their bank simultaneously acquires an equal quantity of reserves.
How this might differ from running money off a physical printing press and depositing the money in the vault of the recipient bank completely eludes me. In both cases, the recipient bank has the money available to them to do with as they wish, including converting reserve balances into bank notes. The implication here is that a reserve balance is not printing money, and whilst technically correct (there is no physical printing press) the outcome is identical.

In amongst such obfuscation, I would just like to highlight the one useful new piece of information that has emerged. It is apparent that the BoE holding of government debt is not going to be returned to the market for a long, long time. Whilst they have not said this directly, I believe that their direction is pretty clear. Their explanation for why they might not sell back the bonds in a rush is plausible, but there is nothing that would stop them from steadily selling - if the market were not already flooded.

This is the key point. The BoE have been stepping in to support issuance of government debt which would otherwise almost certainly not find sufficient buyers. The issuance of debt from the government is ongoing, and there is therefore no opportunity to sell the bonds in the foreseeable future. The Bank of England is therefore engaging on a policy of purchasing government debt which it will hold over a long period, and it is doing it with printed money.

It is, quite literally, monetization of government debt and, even if it was started as inflation policy (unlikely), it is now the only thing that is preventing government bankruptcy. That the BoE must hold on to the debt is an indictment of the government, and their fiscal incontinence. I have long argued that this is a policy of debt monetization, and the use of BoE bills to reverse QE is just further confirmation.

Note 1: Despite my cynical view of the BoE policy, I am always impressed with their polite approach in their answers. As a strong critic of the BoE, this is to their credit.

Note 2: Please accept my apologies for the lack of replies to many comments. My 'real life' is very busy at the moment, such that I am very pressed for time. I have even been forced to rush this post, even though it is one of the subjects of particular interest to me, and would have preferred a better researched post (finding article 101 in EU documentation exacerbated the problem, as it was not very easy to find). I hope that the rush does not show.

Tuesday, September 22, 2009

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?

Wednesday, September 16, 2009

When will the Money Printing Stop?

Having already posted today, this is more of a note than a full post. I have noted recently that the UK inflation figures yet again defied Bank of England expectations of deflation. Whilst their recent inflation report was full of caveats on inflation vs. deflation, the original justification for quantitative easing (QE-Money Printing) was a deflation scare. As I have pointed out in many posts, the target inflation rate has barely been missed throughout the entire period of QE, and the predictions of deflation have never come to pass. The requirement for the Bank of England to write a letter of explanation to the chancellor is if the Bank of England misses the inflation target by 1%.

Yet again, inflation is still sitting stubbornly close to the target, such that no letter is required. This from the Telegraph:
The Consumer Prices Index (CPI), which is the Government's preferred measure of inflation, dropped to 1.6pc from 1.8pc in July - the lowest level since January 2005 according to data from the Office for National Statistics (ONS). It was the third month in a row that CPI was below the 2pc target.
As it is, the main cause of the fall in the rate of inflation is lower gas and electricity prices, which have fallen by considerable amounts. If we turn our minds back, it is apparent that the high prices with which these price falls are compared were extremely high prices resultant from the spike in prices of oil, which I predicted would fall back.

It is also noteworthy that the reason for continuing inflation is the higher prices of imports, which was my suggested reason for continued inflation when considering inflation versus deflation. The weakness of the £GB was always going to have a counterveiling impact to the shrinking of the economy. This point is of particular note for the US, now that the $US is sliding. In the case of the UK, I pointed out that currency weakness would take a while to show up in import inflation, as prices and contracts will take a while to adjust (e.g. when a contract is signed, it takes often takes a long while before the contracted goods are actually delivered at the pre-inflation price). The same will apply for the US, with time lags in inflationary pressures.

Returning to QE, it is interesting to see that the media have been distracted from the original purpose of QE, now that the predicted deflation has not taken place. This is from the FT:

Although six months is a comparatively short time to judge QE, Mr King can already point to some signs of success, but these are balanced against other more negative indicators.

On the positive side, government and corporate bond yields have fallen, boosting company borrowing in the capital markets. Indeed, sterling corporate bond issuance has surged to an annual record, with three months still remaining of the year.

Ten-year gilt yields are only 3 basis points lower, at 3.61 per cent, than the day before QE - but Charles Bean, the Bank's deputy governor, insists that they would have been 50bp higher without QE.

Investment grade sterling bond yields are 2 percentage points lower, at 6 per cent, than in early March, although euro-denominated corporate bond yields have fallen just as sharply with the help of the European Central Bank's injections of liquidity into the money markets.

QE has also boosted the equity markets, although it is difficult to quantify how much money investors have switched into shares from their gilt sales. The FTSE 100 has risen 38 per cent since the launch of QE, but a lot of the gains were due to an improving world economy and resilient corporate profits.

Like so many commentators, the deflation scare that was the justification for QE is quietly being forgotten. It is not clear why the memory of so many journalists and commentators are so short. With the notable exception of Liam Halligan in the Telegraph, it seems that the origins of QE are of no importance.

Throughout the policy of QE the Bank of England has sought to generate confusion over the role of deflation and inflation as their justification for QE. This is an excerpt from a previous post, where I highlight the kind of methods being used:
If we remember, the bank targets CPI, not RPI. However, in the Bank of England inflation report from February, it might be noted that the RPI is discussed in the report, even though the CPI is the target for inflation. You will note how the measures are blurred in this passage.
Deflation is sometimes used to describe any fall in the general level of prices (as measured in the United Kingdom by the CPI, RPI or the GDP deflator), however short-lived. A more economically significant phenomenon, however, would be a sustained period of negative inflation.

The RPI is likely to fall temporarily over the coming months (Section 4.1). This period of negative retail price inflation would be unusual (Chart A) and predominantly reflects the much lower contribution from mortgage interest payments, following the recent large falls in Bank Rate. The MPC’s central projection is for its target measure, annual CPI inflation, to remain above zero throughout the forecast horizon. (p33)
Whilst there is no direct statement of targeting of RPI, the way in which the whole passage is put is somewhat grey. The same section of the report then goes on to warn of the dangers of deflation......it appears that the Bank of England is subtly conflating the two measures, and they even use a chart which is designated as the 'ONS composite index'. (p33) One of the interesting points is that an argument for printing money directly follows this discussion of RPI and deflation:
Periods of low inflation, associated with weak demand, may limit a central bank’s ability to use conventional monetary policy to stabilise the economy. But if reductions in official interest rates do not prove sufficient to meet the inflation target, policymakers still have other options available to them to stimulate the economy, if necessary (see the box on pages 44–45 in this Report). (p33)
In a previous post, I have explained exactly why there is no element of QE that might justify the policy. This is beyond either a summary or quote, so I would recommend those that have not already read the post, to read it now.

Yet again, despite no indication of serious deflation, there is no indications of any halt to quantitative easing. Why is this? More to the point, why is it that so many in the media are sitting back and watching the monetization of government debt continue with so little concern? At this point, the press should be filled with outrage. Instead, they appear to accept this policy as if it were perfectly normal. Have they not noticed that the policy justification has failed to materialise?

Exactly how or when QE might stop, and under what circumstances, continues to be opaque. It seems that nobody seems willing to give the answers, and the press does not appear to be concerned. In the interim, the government continues to spend money still wet from the printing press.....to say that this is a bad situation is an understatement.....

Special Drawing Rights - What are they?

I have had a very interesting contribution to the blog regarding IMF Special Drawing Rights (SDRs) in a comment, with the commentator also sending some additional information by email. The point made by the commentator is that it appears that there is the development of quantitative easing (printing money) at the world level through the issuance of SDRs. As such, I thought I would examine SDRs more closely, which has proved to be a somewhat challenging task.

This is the explanation of SDRs from the IMF website:
The SDR is an international reserve asset, created by the IMF in 1969 to supplement its member countries’ official reserves. Its value is based on a basket of four key international currencies, and SDRs can be exchanged for freely usable currencies. With a general SDR allocation taking effect on August 28 and a special allocation on September 9, 2009, the amount of SDRs will increase from SDR 21.4 billion to SDR 204.1 billion (currently equivalent to about $317 billion).
The SDR is based on a basket of currencies including the £GB, $US, Japanese Yen and Euro, but is also potentially a claim upon the currency of any IMF member. The status as a reserve asset "derives from the commitments of members to hold, accept, and honor obligations denominated in SDR." In other words, it is a form of money. Perhaps the most interesting aspect of the SDR is the following (from the IMF):
"The IMF has the authority under its Articles of Agreement to create unconditional liquidity through "general allocations" of SDRs to participants in its SDR Department (currently, all members of the IMF) in proportion to their quotas in the IMF."
What this means is that the IMF has no limit on the amount of money that it is able to create, and that is the creation of money in addition to the central banks of the basket currencies. The IMF is able to create money at will. To give a sense of the value of the SDRs, the exchange rate for SDRs is $US 0.634, £GB 1.048 as of 10 September (figures will change as the page is updated), and the SDRs also pay interest according to a calculation based upon the bond yields of the currency basket members (currently 0.26%):
SDR allocations provide each member with a costless asset. If a member’s SDR holdings rise above its allocation (for example, if it purchases SDRs from another member), it earns interest on the excess; on the other hand, if it holds fewer SDRs than allocated, it pays interest on the shortfall at the official SDR interest rate.
However, SDRs are unusual in that they can only be held and traded by governments and 'prescribed holders' such as the BIS. What we seem to have here is a currency which can be issued at will, with no restraints, and which can then be used by governments to pay their debts to each other. It is therefore interesting to note that the IMF has just completed a record allocation of SDRs to the tune of $US 250 billion:
The Board of Governors of the International Monetary Fund (IMF) has approved on August 7, 2009 a general allocation of Special Drawing Rights (SDRs) equivalent to US$250 billion to provide liquidity to the global economic system by supplementing Fund’s member countries’ foreign exchange reserves.
In order to support the finance of the IMF and SDRs, the following countries have chipped in:

• As of end-July 2009, three bilateral borrowing agreements, designed to temporarily bolster the Fund's capacity to provide timely and effective balance of payments support to member countries during the current crisis, are effective: Japan ($100 billion), Norway ($4.5 billion), and Canada ($10 billion).

• In addition, European Union members have pledged loans worth €75 billion ($100 billion). Switzerland has pledged about $10 billion. China, Brazil and Russia have indicated their willingness to invest in notes issued by the IMF.

• In sum, substantial progress toward the G-20 goal of $250 billion in immediate resource additions has already been made and the Fund is continuing to work with members to supplement its resources.

In broader terms, this is the IMF description of the source of the organisation's financing:

The IMF's resources come mainly from the quotas that countries deposit when they join the IMF. Quotas broadly reflect the size of each member's economy: the larger a country's economy in terms of output, and the larger and more variable its trade, the larger its quota tends to be. For example, the United States, the world's largest economy, has the largest quota in the IMF. Quotas are reviewed periodically and can be increased when deemed necessary by the Board of Governors.

Countries deposit 25 percent of their quota subscriptions in Special Drawing Rights or major currencies, such as U.S. dollars or Japanese yen. The IMF can call on the remainder, payable in the member's own currency, to be made available for lending as needed.

Perhaps the most interesting point here is that many of the countries that are the major contributors to the IMF are countries with large and growing government debt, with the US as an obvious example. As such, there is a situation in which, for example, the US is funding lending despite having a high level of net debt. The money that they are lending is borrowed money. The creditor is a debtor, and the real creditors are therefore the lender of the money to the US, with China as one of the major lenders. This from Forbes:

He [Liu Guagxi, director general of the Capital Account Management unit of its forex reserve body -- the State Administration of Foreign Exchange (SAFE)] said Beijing was encouraging overseas direct investments and the yuan would be growingly recognized as a global currency.

'Renminbi (yuan) will be more and more widely recognised worldwide and more and more in use in trades and capital transactions. This is irreversible,' he said.

China wants the yuan to be added to the basket of currencies that make up the International Monetary Fund's Special Drawing Right (SDR) virtual currency.

It is apparent that China has recognised that, in reality, a large proportion of the funding of the IMF is actually rooted in Chinese credit. In addition to the US contribution being rooted in borrowed money from China, China is also lending money directly to the IMF with the purchase of SDRs.

An IMF official, speaking on condition they not be named, said the board initially considered limiting the bond sales to $150 billion, based on the level of interest from member states. Board members decided against such a cap because IMF needs will evolve over time, the official said.

China’s government has said it will buy $50 billion in notes. Russia and Brazil last month said they would each buy $10 billion of bonds from the IMF. India has also indicated it would contribute to an IMF bond program. The four nations make up the so-called BRICs.

“This is a victory for the BRICs, particularly China,” said Claudio Loser, the former director of the IMF’s Western Hemisphere department. “Because they will be investing in the fund they will have, directly or indirectly, some say in the governance of the fund that goes beyond their quota.”

The IMF’s “quota” system allocates voting rights to member states based on their financial contributions.

The note sales probably would not reach the $500 billion in new funding that the lender is seeking, Lipsky said.

The more that the idea of SDRs is examined, the more curious the whole scheme becomes. On the one hand there is an organisation which has no economy of its own, issuing a currency that is rooted in the economies of debtor countries. It then disburses created currency over and above its own holdings of assets, including to the countries that are funding the organisation. This is the IMF on access to financing:
Access to financing. The amount of financing a member can obtain from the IMF (its access limit) is based on its quota. Currently, under Stand-By and Extended Arrangements, a member can borrow up to 100 percent of its quota annually and 300 percent cumulatively. However, access may be higher in exceptional circumstances.
....but the financing of the IMF does not actually come from the countries that are providing the quota, but instead coming from countries like China, who are lending the funds to countries like the US to provide the quota.

Quite simply the SDR is a currency, a form of money, that is rooted in the lending of the major creditor economies such as China. As such, the idea that the currency is rooted in a basket of currencies from debtor countries is, to say the least puzzling. It is no wonder that China is seeking to have the basket include the RMB, as the RMB is the real funder of a large proportion of the SDRs.

In effect, what a country like the US can do, is borrow money from China, lend the same money into IMF funding, and as a result can multiply access to even greater credit. Furthermore, the more money the US lends, the greater the control that the US has in the disbursement of money, as voting rights are tied to the amount of funding that is provided. One of my recent posts was published in Seeking Alpha, and the post discussed the rise of the RMB as a world reserve currency. I pointed out at the time that China's support for SDRs was a red herring, and that China was seeking to replace the $US with the RMB as the world reserve currency. There were several comments that were critical of the post, suggesting that the RMB as the next world currency were a fantasy.

When we actually look at the funding of the SDRs and the IMF, it becomes apparent that one of the China is one of (if not the most) important underlying creditor. Despite this, up to now, their influence in the IMF is disproportionately small. The idea that they might genuinely support SDRs as a new international reserve currency under current arrangements is therefore highly improbable. As I have suggested in previous posts, the SDR is simply a stalking horse for the replacement of the $US with the RMB.

China, in purchasing the SDRs is simply making explicit the reality that the RMB is now the most important currency in the world system, as it is the primary currency of international credit. Whilst China will, in the short term, seek to support the SDR system, they will only continue as a creditor in the long term if Chinese influence in the IMF becomes more proportional to their real role as a major creditor. To a lesser extent, the same might be said of the other underlying lenders, but I have concentrated on China as the major creditor to the US, and therefore the major creditor to the IMF.

In the meantime, the IMF is enacting a policy of quantitative easing (money printing) in which they are issuing currency which is based in economies that are already themselves undertaking quantitative easing. This IMF printed money is being issued internationally, and represents further calls on the output of the countries that constitute the basket of currencies. The problem arises is that countries like the UK and US are currently incapable of supporting their own level of consumption with their output, so it is not clear how such issuance might actually be underwritten without a further underwriting by creditor countries. In other words, the SDRs are entirely contingent for their value on the willingness of countries like China to continue to support countries like the UK or US with credit.

What we are actually seeing in the issuance of SDRs is an illusion. There is, in reality, very little that might support them going forward, at least as long as their value resides in currencies that are being debased by their own central banks, as well as by the issuance of the SDRs themselves. Quite simply, they present the same problems as the fiat currencies in which they are based, and simply serve to add to the problems of those currencies. Alongside this, we can see that the whole system remains beholden primarily to the ongoing support of China, both directly and indirectly.

As a conclusion to this post, I will admit that I find the whole issue of SDRs to be inherently confusing (not something I like to admit), and that my analysis of this issue is therefore open to question. My reading for the post included a wide variety of sources, such as an IMF Working Paper (e.g. 'International Liquidity and the Role of SDR in the International Monetary system', 2002, Clark and Polak). Despite such reading, I find myself struggling to see the SDRs as anything but a fantasy whose value is built upon foundations of sand. I therefore welcome other interpretations, analysis, or explanation and critiques.

Tuesday, September 8, 2009

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.


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.