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.

China, the RMB and the $US

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Note 1:

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

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

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

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

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

Note 2:

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

Note 3:

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

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

Note 4:

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

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

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

Note 5:

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

Note 6:

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

Fighting on the Edge of a Cliff - The US and China

There has been some lively debate in the comments section following my posts on Fractional Reserve Banking, and it has been very encouraging to see so much response. Whilst the subject might appear to be abstract at first glance, when I come to some future posts it will become increasingly apparent why it is important in the current crisis.

Today, however, I will briefly move away from these subjects, and will postpone my post on central banking. The reason for the diversion is that I have seen some interesting news today, and I have kept in mind a question on a recent comment on a post from 'Jonny'. The post Jonny commented on was made about 2-3 weeks ago, and I said the following:

Whatever the final push, I now believe that we are on the edge and, as such, I will brave a timescale. I would now say with considerable confidence that we are within three months of the plunge. By plunge, I mean the serious collapse in either the $US or the £GB, either of which will shortly after precipitate the collapse of the other. I am not tempted to say how far they will fall, but it will be a dramatic fall over a period of about two weeks, sufficient that we will all look on in complete shock. I am not talking about 10% but tens of percent. Once the sell-off starts, I am not sure where it will stop.

Jonny asked what drove me to such a conclusion, and I am hoping that the reason for my concern has since become apparent. However, it should be noted that this, like any prediction, is a matter of my being confident, not certain. There are no certainties in these situations, but there are likelihoods. In the meantime events appear to be bearing me out.

The first point that supports my contention is that one of the factors in the collapse that I have proposed was the possibility of some governments being unable to continue to borrow. I have mentioned several factors here, such as the fact that, at this moment in time, governments all over the OECD are massively increasing their borrowing all at the same time. In this situation, it is apparent that there will be competition for a finite amount of money, and only the economies judged to be the strongest will win. I have pointed out in previous posts that the UK will not inspire the confidence of lenders. This returns me to the news that prompted this post.

The ferocity of the downturn has led to a sharp jump in borrowing costs for the Spanish state, which lost its AAA credit rating from Standard & Poor's last month.

A €7bn treasury auction of 10-year Spanish bond on Tuesday saw yields jump to 137 basis points above German Bunds, a post-EMU high. Foreign investors were conspicuously absent, leaving Spanish banks to soak up the debt.

The most interesting thing about Spain is that the Spanish banks are in difficulties, but are in much better shape than the UK banks. The Spanish economy is falling faster than the UK, but Spain is a Euro economy such that its currency is not vulnerable in the way that the £GB is vulnerable. Unlike Spain, therefore, the UK national currency is subject to the state of the UK economy.

As an aside, I long ago suggested that the cohesion of the Euro might be strained as the economic crisis progressed, and there have been an increasing number of articles recently mirroring this view. I still believe that the Euro may not come through this crisis, and think the likelihood of either a partial falling apart, or complete abandonment of the Euro is possible. We could yet see the return of the mighty Deutsche Mark. As such, if you hold any Euros, make sure that they are held in a German bank in Germany....

Returning to the UK, for a long while now, I have been arguing that the UK is seeing a money-go-round, in which the government finances the banks, and then the banks finance the government. This can go on for a while, provided that others outside of the money-go-round are stepping in with at least some financing. However, in the current level of competition between countries to win over lenders, the UK is going to be seen as a relatively poor risk. I do not think that the UK is going to win in the competition for financing, and the Spanish experience illustrates this. In particular, lending to Spain does not have the same level of currency risk as lending to the UK.

Meanwhile, we are already seeing the UK adopting a policy of quantitative easing - or money printing - and this of itself makes the £GB look very vulnerable. Added to this are the ever greater open ended liabilities being taken on by the government, and the rapid accumulation of reports saying that the UK is going to be one of the worst hit countries in the crisis. Just for good measure, you can add in a dose of negative sentiment, such as that expressed by Jim Rogers. The real question is this - given a choice, would you put your money in the UK at the moment? In other words continued financing for the UK from outside creditors looks unlikely.

There are two ways that this can play out. The first is that, at some point in time, the money-go-round will be unable to support a government sale of debt. There will be no other lenders wanting to step in, and without being able to raise further money the government will be bankrupt, and the £GB will fall.

The second is that the UK government starts to fund itself directly through money printing, or sees the crisis coming and speeds up the printing presses to inject ever greater money into the money-go-round. In this event, at some point, somebody will notice the impossibility of the ability of the government to endlessly finance itself by borrowing from banks that are themselves insolvent - and reliant on government lending to keep them afloat. It will become apparent that the government is, one way of another, increasingly reliant on the printing presses to fund itself, and the £GB will fall.

Perhaps the greatest indication of the severity of the situation for the UK was that Gordon Brown felt that he needed to defend the UK against the charge that it was 'the next Iceland'. That a prime minister feels that there is such a necessity is a clear indication of the state of the economy is very, very fragile indeed. Another indication of the state of desperation is the official UK change of status of Tibet to a status that appeases China. As one article points out, a cynical interpretation of such an action would be that the UK has 'sold' the status of Tibet - in other words this change of policy has been exchanged for a better prospect of continuing Chinese credit for the UK (possibly indirectly by ensuring that the IMF is able to fund a UK bailout). Whatever might be thought of Gordon Brown, I do not think he would make such a move except in extremis. The question that this raises - has he purchased a breathing space?

If he has, then it may be that China will step in with the finance when needed, but we will see. Such factors are not visible, and this is why nothing is certain.

So far I have just been looking at the UK. In the case of the $US I have devoted a whole post to the vulnerability of the $US, so will not repeat it all here. Instead, what I will note is that the tensions of issuing endless $US are starting to show. At Davos, Putin was calling for an end to the $US hegemony, and China is increasingly taking a negative view towards the endless issue of $US. Add in the war of words started by U.S. Treasury Secretary Tim Geithner on China's currency manipulation and you have a heady cocktail. As a final problem there is the ever more controversial 'Buy US' measures that are looking to be included in the US 'stimulus'.

What this is starting to point to is the inevitable 'showdown' that I have identified at many points in this blog. The US can not allow China to continue to subsidise exports, but in order to confront China the US risks China selling some of the massive $US reserves into the market . If China starts this sale, the $US will collapse. The tension that is inherent in the current system must come to a resolution at some point. However you look at it, it is impossible to sustain.

This is the actual situation. The US needs overseas finance to continue to fund government borrowing and those borrowing requirements are increasing. At the same time, the US government is printing money, such that they are diluting the value of all $US holdings. Those $US holdings are already unusable, because if they are sold, they might precipitate a $US slide, thereby destroying the value of the holdings. If the lenders do not continue to lend, then the US government will be unable to fund its borrowing requirement. If the US can not fund its borrowing it must either print ever more money, or default. Both will destroy the value of all $US assets, of which the creditors to the US hold monstrous amounts, and amounts they must increase to support the value of the $US.

The US is presenting the world with the choice of continuing to lend in return for paper whose value will decrease, or not lending and seeing the value of their current $US assets fall. Both sides are locked together - the US and their creditors are tied together in a very uncomfortable embrace.

If we see the argument between the US and China over currency manipulation in this context, it is possible to see that both sides are about to fight on the edge of a cliff, with both sides likely to fall off the edge of the cliff if they put a foot wrong. However, knowing that the cliff is there does not mean that they will not enter the fight. China needs to keep the export machine turning to save its economy, which means that the US will see the imbalance of trade and hollowing out of its economy continue. If it allows this, then the ability to ever service the debt will become ever more impossible. On the other side, China must continue to accept ever more useless $US assets to support the irresponsible and profligate spending of the US government.

Quite simply it is all madness. It can not continue. The whole situation is fraught with contradictions. The war of words between the US, the rise in protectionist measures all point towards a climax. The collapse of the £GB, I believe, will be the push that gets it all started. When a major economy, with a similar underlying economy to the US, fails it will be the shove for people to revise their view of the sustainability of current contradictions. The UK is just such an economy and is an economy on the edge of failure.

What we have in essence is a situation which is impossible to sustain. It is just a question of 'when' rather than 'if' it unwinds.

I have to emphasise that nothing is certain. The direction at the moment does point towards a climax, in particular as every side is starting to absorb the horrible nature of the problem. I have no doubt that the various sides are talking and trying to find a solution in which the contradictions resolve without disaster, but can see no such solution myself. It is always possible that a compromise will be made which will delay the collapse, but delay is the best outcome that I can see from a compromise - and the cost of delay will be a greater problem later.

However, I may be wrong. Maybe there is a solution to the impossibility of the current situation, a way to unwind the imbalances without pain. If so, then it needs to be found fast....

Free Trade, 'Yes' - Mercantilism, 'No' - Why China Should be Shut Out

I have had several comments on the subject of free trade and protectionism, and thought the best way to answer this would be to dedicate a post to the subject. Much of the discussion revolved around some of the points that I made around the subject of China in the world trading system in recent posts, such as the notes at the end of my post on 'UK Bank Bailout - Round 2 Begins?'

The best way to start is to highlight my underlying principle, which is that free and fair trade is a good thing, and that such free and fair trade offers considerable benefits to all.

When I discuss fair trade, I would like to highlight that this is not the fair trade of 'fair trade coffee' and other such causes. I actually believe that such so called fair trade is grossly unfair and serves to create market distortion.

In the case of the coffee market, the reason for the fair trade movement was the collapse in coffee prices that was resultant from the decision by the government of Vietnam to expand the coffee business (yes another government distortion in the free market causing problems - see post here for an argument for free markets). The resultant glut in the coffee market caused considerable difficulties for other producers:

Apart from oversupply, there are two types of paradigm shifts underlying the current situation:

1. A structural change in the nature of supply, particularly increases in both the quantity and quality of Brazil and Vietnamese coffees.
2. Structural changes in demand, comprising increasing demand for high-end, differentiated products, new technology allowing greater flexibility in blending, and geographic-generational shifts in the appeal of different types of coffee products.

There are dramatic changes in the nature of this new supply. Of particular note is that global supply has become more concentrated. During the previous period of low prices in 1992, USDA data shows Colombia, Brazil, and Vietnam produced 44 percent of world production. In 2002-2003, 60 percent of world supply came from these three producers, and this figure is likely to increase unless production in other countries significantly reverses its decline. For some roasters, these three suppliers can provide almost everything they need, leaving them to buy only small amounts of coffee from other countries. (1)

The response to this shift in supply was to create the 'fair trade' coffee movement. At the heart of the movement were arguments about the immorality of the high prices charged for coffee in the West (Starbucks would often figure in these discussions), and the low prices achieved by farmers. This was apparently 'unfair'.

The result was that the fair trade movement instigated a system of guaranteed minimum wages for coffee farmers in particular regions, on a selective basis. In doing so, they offered prices for coffee that the market would not otherwise stand. This has created one central problem. If there is a glut in supply, and you guarantee prices, guarantee a living wage, you create a situation where a) you encourage otherwise inefficient producers to remain in the coffee market b) encourage new entrants into the market. In doing so, you are just prolonging the problem of oversupply in the market. Furthermore, on what basis do you award the guarantee to whom? Is it fair that farmer x gains a guarantee, even if he is an inefficient producer, but deny the same to farmer y, an efficient producer? What would be a fair basis to offer this guarantee? If farmer y is very hard working, very efficient, why would it be fair that he must compete in a market in which an artificial glut is maintained through price support for inefficient producers?

In this respect it is unfair trade. On the other hand, if we view it as a marketing tool, it is perfectly fair trade. If a company can persuade people to buy coffee on the basis of benefits to their sense of moral righteousness, then that is a good marketing ploy, and conveys a competitive advantage. They are no longer just selling coffee but a 'feel good', emotional benefit. However, that this is a genuinely moral activity is at the very least dubious. It is fair trade in the sense that a point of differentiation is created, but it is certainly not fair trade in the sense conveyed by the supporters of the fair trade movement.

The case of coffee illustrates my point of real fair trade perfectly. Real fair trade is about removing distortions from the market, but the coffee market has seen considerable distortions, including international agreements on quotas and all kinds of interventions (from the same report as above):

At the domestic level, state-managed governing bodies, such as the coffee boards, were often inefficient,and, under the ICO programs, their management of the export quotas gave them opportunities for rent seeking (Bohman and Jarvis 1999). When this rent seeking was combined with the inefficiencies, the marketing boards induced in their markets, it served to divert a significant share of the export value of these crops away from the producer toward either governments, the marketing boards themselves, or the export sector. even if they managed to smooth market signals and responses which most likely contributed to lower domestic volatility (Giovannucci, et al. 2002a). It was not surprising that, in many cases, the end of the ICO quota schemes led to both a dismantling of the coffee boards and a rise in the producers share of the export price.

Or:

Stabilization funds suffer from a number of structural weaknesses. As discussed above, the tendency of commodity prices to have short spikes and long troughs means that stabilization funds have a tendency to run out of money before a recovery can occur. In the case of Papua New Guinea, this led to the fund having to borrow from the government—loans that later had to be forgiven. There is also an assumption that the stabilization fund managers can better invest the levies received during periods of high prices than can individuals, and producer support for stabilization funds may, therefore, be indicative of a problem of lack of access to financial services.

I can not reproduce the entire paper here, but what you see is not a market of free and fair trade, but a market in which there are endless interventions both internationally and at national government level. If we just take the example of Papua New Guinea, the intervention meant that their coffee producers were given an unfair advantage in the market of a subsidy. Someone, somewhere, will lose from this subsidy because they will be faced with less efficient producers than themselves who are still in the market place due to subsidy. It is a classic case of 'beggar-thy-neighbour' policy. The end result of such policies is that everyone tries to manipulate the market, the gluts continue, and the problem of excess supply never goes away.

The end result of such distortions is that there is a lot of land devoted to producing a commodity that nobody really wants, and that means that potentially productive resource is actually not producing anything of value. At the local level, it is easy to make a case for intervention, but each intervention ripples through the market eventually hurting someone else.

As such, if you want true fair trade, then you need to make the markets as free and as fair as possible, which means that the most efficient producers survive, and the inefficient get out of the business. The problem with such a solution is that it meets with resistance in each of the countries that are unable to compete.

The coffee market is world trade writ large as, for some reason, farmers appear to have greater emotive appeal than, for example, a worker in a widget factory. For some reason a farmer going bust has greater emotive appeal than a widget factory worker being made redundant. In both cases they might be thrown into poverty, but for some reason the farmer's poverty counts for more. As such the distorting effects of intervention are particularly more apparent in markets such as coffee.

It is at this point it is worthwhile opening up the discussion of free trade to a broader frame of reference. No doubt, all of the readers will be aware of the bailout of the US automotive industry, and that similar bailouts are being proposed elsewhere (e.g. the UK). Even before the contraction of the world economy that we are now seeing, there has long been a glut in the supply capacity of cars, and the current contraction should have seen the end of the US automotive industry (or at least the end of one of the big three, possible two). Just as with the coffee market, we have a situation in which a government subsidy will create the same beggar-thy-neighbour effect as the intervention of Papua New Gunea in the coffee market. Someone else somewhere will pay the price of this intervention.

In the meantime, there is another problem. In intervening to prop up inefficient industry, it may appear that this is a good thing for the intervening country, but in some respects it will only cause them long term harm. In this case, the money for the car industry is being provided by central government, and that (one way or another) will be paid for elsewhere in the economy. There are several ways that this might cause hurt.

One is that, if it is funded out of borrowing, that money will need to be repaid, and that means that the efficient parts of the economy will have to pay for the inefficient parts of the economy, thereby removing capital from those efficient parts, and therefore constraining their growth potential. If the bailout is paid for by printing money, then it is paid for by a general tax on the economy as a whole, as the value of the existing money is transferred onto the printed money (the tax), and then transferred to the inefficient industry. In both cases, the efficient parts of the economy will be taxed to pay for the inefficient.

From this perspective, all seems very clear. Subsidy, it appears, hurts yourself. However, I have emphasised that it also has a beggar-thy-neighbour impact. The point here is that, if you subsidise an industry sufficiently, you have the potential to destroy the same industry in your neighbour. Having destroyed that industry, you remove the glut, and your inefficiently run industry can then achieve a position of profitability and market domination.

It is for this reason that governments intervene to support their industries. It is very rarely ever discussed in these terms, but the central idea behind subsidy is that of supporting an industry until it is the 'last man standing'. I do not mean this in the literal sense, as it is unlikely in most cases that it will be the last man standing, but rather if there are not many men left standing, then the industry can achieve profitability. I recently read an essay in a book (2) in which they discussed the 'rule of threes'. This is the idea that, over time, industries will whittle down to three major players, and that in an increasingly globalised system this is starting to apply internationally. Whilst not agreeing with their entire argument, the principle is roughly right. In such circumstances, whilst having some negative effects on your own economy, subsidy can pay.

From this starting point, we now come on to China. I have consistently argued that there are two fundamental problems with the rise of China. In particular the theft of intellectual property, and aggressive trading practices such as currency manipulation. I had the following to say in an earlier post on China (it is a little clearer in the original context, but the central point is clear enough);

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.

In another post I concluded the following:

China poses a real and ongoing threat to the world economic order, and will continue to grow at the expense of the West, unless the West responds by restructuring of their economies through (real) improvements in education, lowering their cost base, and taking an aggressive approach to intellectual property and fair trade (for why, see here).

And in yet another post:

One of the key elements in the rise of the Chinese economy has been their very lax attitude to Intellectual Property, which is stolen at a rate that is truly astounding. For example, it is nearly impossible in most Chinese cities to buy genuine computer software for individuals, excepting that which is preloaded on new computers. If we just took the example of Microsoft Windows, we can take a reasonable guess that, at least, 100 million computers are running on the software, and the majority of these are illegal copies. At something like $100 retail per unit for Windows, it is not difficult to grasp the scale of the theft. This is just one example. Multiply this across all of the software, and the numbers start to look truly shocking.

I later go on to say the following:

Another problem has been the exchange rate in China. It has been fixed, then moved to a basket with a partial floating rate. In a free trade situation, this is unacceptable. However, the West congratulated China on holding firm on its exchange rate during the Asian financial crisis, thereby hobbling the ability to complain about the problem of the exchange rate later. Had the exchange rate been free, the RMB would have strengthened, making Chinese exports more expensive, and thereby avoided the degree of imbalance that has occurred.

What I am therefore saying is that there was always going to be some pain for the Western economies, but the foolishness/weakness of Western leaders contributed to the scale of the current problems. China always had the potential to grow, but the rise was boosted by two practices which might be described as 'unfair' trade practices. These have accelerated the growth and have contributed mightily to the degree of imbalance that we now see.

As you will note, my stance on free trade has been pretty consistent, and in particular with regards to China. My argument has always been that China has enough advantage without any subsidy, whether that is through the export subsidy and protectionism implicit in exchange rates or through the theft of intellectual property. I believe that, as a result of the implicit subsidy in the exchange rate, in conjunction with intellectual property theft, China has been in a position where it has been effectively been allowed to destroy industries in its competitors. The worst part of this is that China has always had the potential for strong growth without such measures. I have always believed that China deserves its place in the sun, but only on free and fair trade terms.

I should qualify this slightly, as I think that all countries indulge in some unfair practices to some degree or another. This is not to condone any such practices, but at least they should be minimal. The difference with China is that it has practiced two policies which have such a massive impact on the trading position of the country.

The real question in all of this is why the world trading system has not responded, and this is a difficult question. One part of the equation was detailed in one of the posts I have already cited as follows:

On a related subject, in an article a while ago the Telegraph, it was reported that senior Chinese officials were willing to use dollar sales as a way of exerting power over the US. In short, the Chinese have the power to destroy the $US by selling the currency, and therefore have huge economic power over the US. The Chinese government later denied the policy, but those familiar with Chinese culture will know that using such methods of presenting a threat is not unusual.

Another factor which is somewhat harder to summarise has been a divide and conquer, carrot and stick approach, in which the two major trading partners of China, the US and Europe, have been played off, one against the other. It has appeared to me that the Chinese government have long played this game, but it is hard to support such an allegation. The carrot has always been the access for each country's companies to the lucrative engineering and infrastructure projects, ease of access to the Chinese market and so forth. The stick is getting unfavourable treatment within the Chinese market. All the time there will be pressure from business on governments to keep China 'sweet', in order to secure the access.

In other words, what has been lacking is a unified stand against the unfair trade practices of China. I believe that, as the severity of the impact of the speed of growth of China's impact on US manufacturing gathered pace, the US would have acted, were it not for threat that China could destroy the $US. By the time the US woke up to the impact of China, it was too late to act, as they had already ceded economic power to China by allowing the massive accumulation of $US reserves.

My argument has always been that it is better to take the risk of economic damage now (the damage to the $US), rather than later. The longer it is left, the greater the accumulation of $US reserves by China, the greater the numbers of industries permanently destroyed, and the greater the long term pain. In other words, the longer that the confrontation with China is delayed, the less able the rest of the world will be to withstand the consequences. When I first wrote about this, the full impact of the economic crisis was just in my imagination, was just a prediction. Now that it is here, the weakness of the economies of West is such that the leverage of China is that much greater. I have long predicted the collapse of the $US, and mainstream thinking such as Willem Buiter, are coming around to the idea. In the situation of an already vulnerable currency......

At the end of this post, I can only conclude that it is time to face up to the mercantilism of China, and finally address the problems that are being caused by such practices. I do not, and will not agree with protectionism, but I do believe that, where a country is systemically mercantalist, then action should be taken, including raising trade barriers and tariffs. I would even countenance a complete embargo on trade.

The trouble is that, as I pointed out in a previous post, China has now placed itself in a position where too large a proportion of the economy is geared towards export. It is destroying the very customers that are supporting its economic growth. If the West were now to act to discipline China, it is a very dangerous proposition. In particular it will wreak even greater damage on the Chinese economy, which is already suffering from the contraction of its major markets. Regardless of the rights and wrongs of the situation, China will cry 'foul', and will proceed to stir up nationalist fervour within China. This will see attacks and boycotts on Western and foreign owned businesses. It will see even greater unrest in China, which is already seeing unrest as a result of world economic contraction, and the situation will potentially become explosive. In letting the nationalist genie out of the bottle, with legitimacy of the Chinese government founded on economic growth and nationalism, we have the makings of a heady cocktail. Where such a heady cocktail might lead can only be a matter of supposition, but it will certainly not be a good direction.

The real answer is that the question of the rise of China should have been dealt with long ago. However, the situation as it stands does need to be confronted. Saying that it should have been dealt with long ago is not very helpful. The trouble is that, because it was not dealt with, a situation has arisen in which the costs of dealing with China have exploded. One commentator mentioned that it seemed that the world trading system appears to be fragile, if China's rise can have so much impact. It is only fragile because the impact was not addressed earlier, at a time when the impact of China could have been the emergence of a strong economy in a (in very loose terms) free trade world.

In short, we have a very, very serious problem at the heart of the world trade system. Not only that, but it is a problem whose resolution can only be painful. However, the problem must be resolved, one way or another.


(1) Lewin, Bryan, Giovannucci, Daniele and Varangis, Panos,Coffee Markets: New Paradigms in Global Supply and Demand(March 2004). World Bank Agriculture and Rural Development Discussion Paper No. 3 .

(2) Sheth, Uslay C, and Sisodia, R, (2008) The Globalisation of Markets and the Rule of Three, in Marketing Metaphors and Metamorphosis, ed Kitchen, P