Chinese Mercantilism

I will start with an apology that it is so long since my last post, which is due to my having been busy with my 'real' work. There were a host of subjects that I would like to cover, but the subject that grabbed my interest was China.

One story about China of particular note was an Economist article on the situation of labour in China. The increasing cost of labour in the coastal areas is creating ever more incentive for the movement of less skilled work into inland China, and that this will see/and is the result of the coastal provinces continuing their steady rise up the value chain. This process has been ongoing, and will allow (in principle) for China to maintain economic growth for a long time yet, all the while without losing the ability to compete in the lower value added industries on which its initial success was founded.

For the rest of the world, this ability to manage a transition from low value added to high value added whilst retaining the former, presents an ongoing problem for competitors. This is the key difference between the emergence of China and countries like Japan, South Korea and Taiwan; the depth of China's labour market. This depth will allow China to compete in every segment for a long while yet, allowing an ever greater dominance of Chinese exports.

Another aspect of the Economist article that was interesting was the concentration of strikes in China in foreign enterprises, reflecting points I made a long, long time ago. The point in question was the way in which China seeks to bring in foreign investment, methods and technology, whilst at the same time weighting the dice against the foreign companies. In the case of strikes, the authorities seem very willing to look on (and take no action) in the case of strikes in foreign companies, but far less willing to tolerate stikes within domestic enterprises. In a post I made a long time ago, I pointed out the many ways in which China sought to disadvantage foreign companies, and it seems the policy is ongoing.

Although in some respects investing in business in China is a risky choice, China is managing to weight the dice even further in their favour. A while ago, I discussed rare earth metals, and that China (which is the dominant producer) was seeking to restrict exports. This is a recent article on the subject:

The United States Magnetic Materials Association (“USMMA”), a trade association representing domestic high performance magnet producers and suppliers, today warned of impending shortages of rare earth materials needed to support domestic manufacturing in support of emerging green technologies like wind generation, hybrid vehicles, and new battery development, high-tech consumer products like mobile phones, PDAs, MP3s, and national security and defense systems.

Late last week, China, the world’s largest rare earths producer, announced new plans to cut rare earth export quotas by 72 percent for the second half of the year. According to China’s Ministry of Commerce, foreign shipments will be capped at 7,976 metric tons, down from 28,417 tons for the same period last year.

In restricting exports, until such time as alternative sources can be brought on stream (15 years according to the US government), China is effectively forcing companies that use rare earth metals to set up operations in China. In so doing, they will rapicly accelerate the process of manufacture of high-tech devices and the importation of other technologies. All the while this is taking place, despite discussion of RMB revaluation, the RMB remains undervalued. The head of the IMF China mission recently had this to say:

WASHINGTON (Dow Jones)--China's currency is "substantially" undervalued despite Beijing's recent decision to appreciate the yuan, the head of the International Monetary Fund's mission to China said Wednesday.

China has held up the IMF staff report for the fourth year running, objecting to the fund's characterization of its currency and pressing the board to omit its finding.

"The RMB remains substantially below the level that's consistent with current fundamentals," said IMF China Mission Chief Nigel Chalk, referring to the renminbi, another name for the yuan, on a conference call with reporters.

Under pressure from Beijing, the IMF board was at odds how to define China's exchange rate. "Several directors agreed that the exchange rate is undervalued," the IMF said in a notice posted late Tuesday evening. "However, a number of others disagreed with the staff's assessment of the level of the exchange rate, noting that it is based on uncertain forecasts of the current account surplus."

What we are really seeing is yet more of China's strategy of mercantilism, in which they continue to seek any advantage that they can get, without any regard to the concept of free and fair trade. Of course, the most interesting point about China's mercantilism is the resultant strength of China's export machine. In a recent article in the Telegraph, Edmund Conway illustrates the essential problem that is confronting the Western economies:

[Mervyn King]Sitting at a summit listening to his fellow central bankers and finance ministers go round the table and explain how they would escape from the economic doldrums, he realised, with both horror and amusement, that they all had precisely the same plan: export their way out.

[and]

In other words, the US and UK's plans to focus on exports as a source of growth in the future are dependent on the world's big exporters – and specifically China – suddenly discovering an appetite for those American and British goods. Fail in this and a double-dip recession is almost assured.

[and]

The reality is that just as the US and UK are in most need of demand from Chinese consumers for their goods, Beijing is facing an economic crisis of its own, and is resorting to its most reliable weapon: exporting the hell out of it.

This is the problem writ large. China will do anything to keep economic growth going and, as long as they do so, their export policy will hinder any possibility of rebalancing of trade, and will continue to see the hollowing out of Western productive capacity, increasingly including higher added value goods and services. The most puzzling aspect of this is that, despite lots of noise from China's competitors, the noise just remains that; noise. It never translates into substantive action, in particular from the US.

For the underlying reason for the lack of action, the answer must lie in the reliance of the US government on Chinese funding of deficits. It is a spiral of decline, in which the purchase of treasuries by China holds down the value of the RMB, China uses the low valuation to support exports, the exports depress and destroy productive capacity in the US, and the US needs to borrow more money from China, to make up for their poor economic performance. The more money they need to borrow, the more fearful the US government becomes about taking action to halt the spiral. As I have long argued, China must be confronted, but in order to do so, the US must take the pain that will follow such action.

And such action will indeed be painful....but the potential extent of the pain just keeps growing. That is the nature of the spiral.

Note:

None of this is to say that all is perfect in the Chinese economy. For example, as I posted a couple of years ago, the Chinese construction boom has been spurred by the purchase of apartments that have been left empty, and which have been purchased as speculative investments. This trend has (finally) been noted by several analysts, and suggests that a severe bubble is in place.

I have also been looking at some of the HSBC reports on China, and they have made interesting reading. China, due to the opaque nature of the government, is a country where you feel that analysis is somewhat like trying to read tea leaves for the signs of the future. One interesting report was that there are some problems on the horizon for China's local government, with this from an HSBC (1):

New Century Weekly – a financial newspaper in China – reported this week that a recent China Banking Regulatory Commission (CBRC) investigation had found that of the RMB7.7trn extended to local financing vehicles as part of stimulus funding, 23% (or RMB1.8trn) went towards projects that may ultimately have problems in servicing their loans.

The problem was that, as part of the Chinese fiscal stimulus, local governments were forced to borrow from banks to fund infrastructure projects, and these loans are now going sour. It seems that, even in a country like China, where there is a strong need for new infrastructure, fiscal stimulus presents risks that (to use a cliche) bridges will be built to nowhere.

There are plenty of other signals that suggest that the dragon may not be as fit as it appears, and it will be interesting to see how China fares in the coming year. As I have mentioned the opacity of China is such that analysis of what is taking place is never easy.

(1) HSBC Research, 29 July, 2010, China Economic Spotlight,

The Great 'Shift' - China and the West

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

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

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

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

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

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

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

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

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

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

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

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

[and]

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Rise and Rise of China

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The key difference that arises from such scale is that China has the potential to massively impact upon any market with which it is involved. The sheer size of their reserves means that they can swing any market up or down according to their actions. Aside from this difference, which requires a circumspect approach from China, I would probably find myself having made the same recommendation that I made to individuals nearly a year ago. This was that gold was the best prospect and an asset that might survive the turmoil (though I offered many caveats to this advice, as I am not an investment advisor).

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

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

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

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

I mentioned at the start of the post that gold represented a good opportunity for China, but there are limits to how far China might take such a policy. The same might be said for other precious metals. However, it does seem quite likely that precious metals will play a larger part in China's overall mix of assets. This still leaves the central problem of what else China might move into, if it moved out (is moving out of?) of US treasuries? The same analyst who points out that China can not shift into gold, also argues more broadly that there are no credible alternatives to US treasuries.

However, the analyst makes a basic error in thinking that China would have to take an all or nothing approach. He does not consider that China might spread their reserves over a wide range of assets, and this is my best guess for the direction of China's policy. If they follow this strategy, and implement it with care, China has the potential to rapidly jump towards becoming the world's most powerful economy.

The first step is to manage the sale of US treasuries with the greatest of care, such that they gain as much value of the sales as possible before the $US collapses. As they move out of $US they would likely buy as many precious metals as possible without driving the price too high, as well as buying into emerging market, European and Japanese bonds. In doing so, they will be taking risks but with the benefit that they will be positioning the RMB as the next reserve currency. Furthermore, it is no secret that China has been trying to buy into various commodity companies (or natural resource companies), such as the ongoing saga of the Chinalco purchase of Rio Tinto or their wider expansion of investments in this sector.

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

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

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

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

[and]

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Economics and Power - The Loss of US Power

Regular readers will know that I avoid discussion of wider political issues with regards to the economic crisis, but events are suggesting that the two are becoming ever more closely entwined. In particular, I have long been concerned at the appearance of an aggressive nationalist agenda in China, and wrote an article expressing my concerns a long while ago:

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.

Later in the same post, I discussed an article in which it was apparent that China was intervening to prop up the $US:

'China has resorted to stealth intervention in the currency markets to amass US dollars, using indirect means to hold down the yuan and ease the pain for its struggling exporters as the global slowdown engulfs the economy...'

My comment on the news was as follows:

There are many motivations that could be given to justify this action, some of which are more forgiving than others. It might be argued by apologists for China that they are doing this to protect the value of the $trillion+ reserves of $US. However, such a move can only delay the day of reckoning for the $US, so I do not believe that this would be why the policy is being enacted. Furthermore, it is just multiplying the problem of increasing the holdings of a currency that is structurally weak, meaning that the problem that it is trying to solve would just be getting more acute. However, I agree with the article that China is using unfair means to subsidise exports.

I later added that China had already made indirect threats to destroy the $US:

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.

You may wish to read the full post (including some of the notes in which I respond to some reader comments) before continuing with this post. It outlines some of the aggressive 'mercantilist' policy pursued by China. You may also wish to see my article on China from July of last year, in which I outlined/predicted my view of the future of the Chinese economy through the crisis (a less worrying post). The reason I am returning to the subject is that I recently dug out a report that suggests that Chinese Banking Regulators were aware over two years ago that the US was going to suffer a financial crisis:

The Xinhua News Agency has a headline news story about a recent statement by Liu Ming-kang, chairman of the China Banking Regulatory Commission, claiming that the Commission anticipated the current financial crisis over two years ago.

The report goes on to say:

“With almost everyone immersed in the excitement of (financial) innovation and large-scale liquidity for the past two or three years, the China Banking Regulatory Commission long ago predicted that the current financial crisis was soon to occur, as well as the fact that its occurrence was inevitable. We gave early warnings. In June
2006, at a symposium jointly held in Beijing by the Bank of Communications and HSBC, we warned the industry that they must guard against the liquidity risks caused by inappropriate financial innovation - derivative products in particular. At the same time, the CBRC adopted quasi-periodic adjustment and regulatory counter-measures, and warned financial institutions in the Chinese banking industry on numerous occasions of risk, demanding that they adopt strict preventative measures during this period of constant economic growth.”

That China could see the disaster coming but still continued to invest in an economy that it knew was going to suffer major trauma is most unusual. Why did they seek to prop up the $US, and why increase their reserves?

I observed some time ago that the UK suddenly, for no clear reason, changed the diplomatic status of Tibet to a status that was more to China's liking. I wrote the following:

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).

We now have a fascinating article from the Times of India, in which they detail the many ways in which China is flexing economic muscles:

The financial crisis is proving to be a major diplomatic opportunity for China on three levels: placating a desperate United States with purchases of its treasury bonds, buy accolades from poor nations with promises of more funds and extend the international influence of the Renminbi.

The article goes on to detail the many ways in which China is using economic weight to create influence more widely, and I therefore recommend a full reading of the article. In a recent trawl through various articles I also found that China announced a new initiative in Asia to use the RMB for settlement of trading with several neighbours, in a move which suggests that the Chinese government is looking to initiate a reserve currency status for the RMB. The timing of the announcement was December 24th 2008, a time when most Western agencies would not be paying attention (sorry, could not find the original Reuters article about this, so the link is to a less reputable source). The timing of the announcement at Christmas is a good way to bury a story for Western analysts and politicians.

On top of all this, we now have a rash of news stories (e.g. here) about Chinese proposals to develop an IMF based reserve currency, and even more discussion of the growing importance of the RMB (as in the Times of India article), including as a potential reserve currency. I recently speculated on the ways in which China might utilise the economic crisis, and a forthcoming $US crisis to introduce the RMB as a replacement for the $US as the world reserve currency:

Inevitably, such a large fall/collapse in the $US will see the undermining of the status of the $US as a reserve currency. The Euro is now in a position of such instability that it will not have the potential to act as a replacement. The Japanese Yen might have some potential as a replacement, but the RMB will be better positioned as the strongest contender. In particular, the Japanese will likely act to rescue the $US during the crisis, but will fail to stem the tide, and undermine the credibility of/weaken the Yen in the process.

If China was to follow such a course, it would put itself in the position of being the major world economic power, or would do so at least in principle.

What we have been witnessing of late is a game of cat and mouse, in which China both warns the US against irresponsibility in the management of their economy, whilst at the same time offering reassuring noises about continued purchases of treasuries. Such purchases are the only serious remaining lifeline for the US government to continue with the various bailouts and stimuli. In the meantime, the US government has started quantitative easing, including the purchase of treasuries. The US looks like it is increasingly concerned that the previous and main sources of financing government debt are about to dry up.

Then we come to the crunch.

China appears to be testing its power in the disputed region of the South China Sea, in particular the area surrounding the Spratly Islands. After unarmed clashes with a US ship (probably a spy ship), the tensions are rising:

A day later, Admiral Timothy Keating, head of the U.S. Pacific Command, sounded a strong alarm, calling the incident “a troubling indicator” that China isn’t “willing to abide by acceptable standards of behavior or rules of the road.” The country’s “behavior as a responsible stakeholder has yet to be consistently demonstrated,” he told the Senate Armed Services Committee.

Some of China’s neighbors may be similarly concerned. On March 11, Xinhua News Agency reported that China dispatched a 4,450-ton fisheries patrol boat to protect its interests in the South China Sea, which include the disputed -- and potentially oil-rich -- Spratly Islands. More vessels may be added to the mission, the state-run China Daily newspaper reported.

Whilst some analysts point to a similar incident at the start of the Bush presidency, I am not convinced that this is similar. There are strong economic interests at stake in the Spratly region, and the action of the Chinese government does not appear to be comparable.

At this stage, I think that you may be guessing where this is all leading. A good starting point is to ask why China kept pouring funding into the US whilst being able to see the coming economic storm? Why did they keep lending ever more money into an increasingly precarious economy? Why are they now courting countries with the offer of the RMB as a new stable currency for exchange? What are the private demands being made of the US government for continued purchases of treasuries? We can all remember the recent Clinton visit to China, in which she offered her thanks for China's continuing purchase of treasuries....we do not know the subjects of private discussion.

Sceptics might point to the Chinese proposal for an IMF reserve currency, but it is difficult to see how this might work. The proposal might be interpreted as a smoke screen whilst they establish the RMB as the replacement for the $US as the world reserve currency?

It is possible to make a summary from the more recent news and some of the news identified in older posts. If we take the activity in aggregate, it looks very much like a plan for China to extract the maximum out of their new found economic power. They will play the US as far as they can, extract as many concessions as possible - use the power to show that they are now the country with the real influence. As soon as the US is finally in a corner and comes out to confront China, they will simply floor the $US. At that point, as I discussed in my speculative post, they will go on a shopping trip, and pick up all the technologies, all the companies that they need to take their place at the front of the world economy, and as the new economic power in the world:

With the US in shock, China can then use the remaining holdings of $US to go on a shopping spree into the US. In particular, China can offer to enter the markets with an offer of salvation - but at the cost of unopposed access to purchase the companies that might provide a leap into the high added value industries with technology or specialist skills. They will not put it this way but, in a climate of economic panic, they will be in a position of calling the shots, as the only significant player able to halt the slide. As a result of the panic, they will be able to buy even good companies at fire sale prices. As such, they will be able to use whatever $US assets they still hold to take a major leap up into added value industries.

I have worried for a long time about the rise of China, and remember an interview with a Chinese admiral (sorry, no link, it was about two years ago and I can not find the interview on the BBC website), who went 'off message' with a discourse that appeared to contradict the official line of 'peaceful rise'. I have avoided anything more than some suggestions of concern about the economics of China on this blog, but see a clear pattern in the emergence of China. It is not a friendly rise. I do not think there is any master plan in the actions, but rather opportunistic exploitation of situations that have arisen. The US has watched on as their economic power has withered. In my earlier posts, I have mentioned that the US (and the world) needed to face down China's threat to the $US, to prevent the situation deteriorating.

The situation has now deteriorated....

When I made my post speculating how China might deal with the coming $US crisis, I emphasised that the post was speculation. As I look at the pattern of China's actions over the last few years, I am concerned that I am no longer speculating but identifying a pattern. I strongly recommend that you take a look at my previous posts, which outline more detail on Chinese policy.

However, I am trying to piece together a picture from many sources of information, and it is quite possible that my interpretation is wrong. It is quite possible that China is acting without any other intention than trying to navigate through each new stage of the crisis to minimise the impact upon their own situation. This is possible, but.....

Note 1: I have several times wanted to join in the excellent debate in the comments section of my last post, but have been distracted by this post. It has been interesting to follow the elements of the debate, and a shame I have not had time to throw in my own contribution. In particular the debate started by Lord Keynes is now too involved for anything but a long answer, and I can only put so much time in....

Note 2: MattinShanghai - excellent link to Rolling Stone. A very good read, but with some caveats about the comments on regulation. The issue of Glass-Steagall Act keeps popping up as one of the problems in the crisis, and I hope to address this question at some point. Matt - did you note the nobleman analogy? Nice to see that others have come up with a similar analogy to the aristocrat which I have used.

Note 3: Lemming, yes, the US bailouts will be used (to a large extent) to support returns to overseas depositors (not the stereotypical little old ladies)...I have no reason to think that the situation is different from that in the UK. You may want to read the link above which, although it does not answer your question, sets and interesting context.

Boing: A very quick reply. One of the key points being made in this blog is that the stimuli simply can not work as they seek to replace consumer over-spending with government over-spending. Over-spending is what got us into the trouble. As for the bailouts, these are simply trying to replace overseas direct lending to banks with indirect lending from overseas investors, but directed through government. Alternatively, they print money to make up for the disappearing overseas investors. And as Lemming mentions (see above) in the comments section of the last post, much of that money is flowing straight out of the banks into the hands of overseas banks/institutions/individuals.....

The Bailout - Foolishness Triumphs

Are you a first time visitor to the blog? If so, then you might want to visit here if you want to understand what is really going on in the world economy. If you doubt the credibility of blogs, you may want to read my (rather long) essay here, and hopefully this will help give the rest of what I write some credibility. Main post continues below.....

After many false starts (including on this blog) it looks like the bailout has finally passed. It took a considerable amount of 'pork barrel', but it has passed (does anyone know the origin of the expression 'pork barrel'?). The fact that it required the dishing out of pork barrel is, of itself, a telling condemnation of both the bailout, and a system that is built upon delusion.

I will not restate my arguments against the bailout, as I have covered this from many angles in previous posts (click here for one example, in this case the 'common sense' argument). However, I will just raise one point in the Telegraph article on the bailout:

'But Mr Bush cautioned that "it will take time before the legislation's full effect on the economy" was felt. Acknowledging public concerns about the sums of their money that will be spent, he expressed optimism that the "tax dollars we invest will be paid back".'

There is a simple answer to this optimism. Why, if these assets are undervalued, are the sovereign wealth funds and other sources of finance not snapping them up at their distressed valuations? They stand to make a killing if they are undervalued, and they have the necessary capital to buy them.

Now that the bailout is being enacted, what happens next? According to the FT (sorry no link) the initial reaction was further falls in US stocks, which goes against the script of what was supposed to happen. Not being within these markets it is is difficult to see how sentiment will move. However, if there is a rally in markets, it will be short lived. It is just a question of weeks, or a couple of months at most, before it becomes apparent that the magic wand of borrowing will not solve the underlying problems in the US and UK economies.

The New York Times, for example, reports that in the 9th month in a row there have been job losses in the US, with September seeing a loss of 159,000. In the same edition, a commentary points out to those who are enjoying the discomfort of bankers that the bankers will take the rest of the economy down with them. As usual, they are getting it the wrong way round, in thinking that the financial system is taking the economy down, when in fact it is the economy outside of finance that is causing the problems within finance (although they are both in mutual feedback systems).

As an interesting note, over the last couple of years, I have been reading several articles in the Economist pointing out that, in the US, many states are also in deep debt. In other words, it is not just the federal government that has been loading up on debt. I have just seen an article that reports that California may need to turn to the federal government for finance. If the Economist reports were correct, this is the first of many. As such, on top of servicing the federal deficit, bailing out the financial system, it is likely that there will be more call for federal aid to the States in the coming months. In one of my previous posts I linked to an article that suggested that the US government was insolvent. In the coming months I think that this idea will be tested.

Meanwhile in the UK, the John Lewis Partnership reported a dramatic fall in trading (a bell weather of middle class spending), there are reports of shrinkage in the service sector. I predicted an end to the service economy, and the result is going to be very ugly indeed, as it constitutes such a large part of the economy. Meanwhile the UK government has extended the deposit guarantee to £50,000, a rather pointless move as it is not enough to restore confidence whilst exposing the government to greater liabilities (regular readers will know that I do not support such guarantees in any case).

Around Europe, the crisis plods on with its own momentum, with the Icelandic boom turning to bust, more and more banks falling over, and so forth. I will not bother listing all of the bad news, and will just point out that it is just one problem after another emerging.

Regular readers will know that I do not just post rehashes of the latest news, so I should come to the point that I am trying to make here. Kecske has left a comment with a link to a very interesting article in the Guardian (thanks for the link, by the way). In my last post I discussed how the 'mainstream' of media, economists, bankers and politicians just do not 'get it', by which I mean understanding the fundamental change in the world economy. In the article it is very clear that China is calling the economic shots and, reading the subtext, it is clear that there is a sense of shock, as people are finally waking up to the shift in economic power.

In other words, the delusions are starting to evaporate. It is becoming very clear that China is winning the economic race. Whilst it is still not a wealthy country, it is racing to the top, and that it is a zero sum game - China is rising as the West falls. In the news I have posted above, I have given some examples from the news that illustrate several points.

The first is that the bailout is just a continuation of the delusion that the UK and US can continue to borrow their way out of economic reality. The other posts are just a series of illustrations that economic reality will have its way (sorry, I am giving an abstraction intentionality here, but you will know what I mean). The service economy is collapsing, and it will take with it large swathes of the US and UK economy with it. As just one example, it is likely that we will see the collapse of at least one of the major US car manufacturers. The US manufacturers have, even during the good times, been struggling for survival, and now that times are tough, they will be in real trouble. The first reports of serious drops in their sales have started.

I pick on the car industry for good reason. In particular I am thinking of Ford, as this is not just another company, but is symbolic of the past successes of the US economy. It might even be argued that Henry Ford invented the modern world of manufacturing. I highlight this, as the failure of a company like Ford will finally create the shock that will really snap the minds of people in the West into the reality of how bad the situation actually is. It is also an illustration of all that is wrong in the Western economies. Ford, and the other US car manufacturers, have been trying to survive with both hands tied behind their backs. I forget the actual figures, but the US car companies have to load into their cost structure something like $1300 (it may be more, I do not have the Economist article to hand) per car, to pay out on pensions, health care etc. There have been numerous negotiations with unions to try to deal with these problems, numerous compromises. However, the unions have never really accepted the severity of the competition that the companies were facing. In the back of their minds was the belief that the companies could not really fail, they were too big and had been there so long...

So it is with the belief about the US and UK economies. We can see the growing competition from places like China in the abstract, but we still insist on our generous welfare and benefits, and insist on loading costs onto our economy. We simply do not believe that we can fail. But we can.

As I look at the potential new leaders on both sides of the Atlantic, I do not see anyone who has yet given any indication that they have the courage to deal with the reality of the economic crisis. I do not hear from any of the politicians serious consideration of real reform, reform of the kind that is needed to return the economies of the US and UK back to competitiveness. All I see is more burying of heads in the sands of easy solutions, of borrowing more money when the answer is cutting back and repayment of the debt....in other words facing the reality that our infrastructures are like that of Ford, that they are bloated and will eventually destroy the source of wealth that we take for granted.