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

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as I have recently managed to get around to reading my print edition of the Economist, which is already over a week out of date.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

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

A good starting point in considering the article is a part with which I can agree, which is as follows:

'Of course China manipulates its exchange rate—in the sense that the level of the yuan is not set by the market, but influenced by foreign-exchange intervention.'

Whilst I agree with this statement (obviously) and have previously highlighted some examples of intervention / manipulation to support the $US, this is not the whole story. On top of the active interventions in the market China has a raft of capital controls in place, which prevent the free movement of capital in and out of China (the article linked to is about some loosening of the controls). The point about such controls is that the utility of the currency is severely limited i.e. for uses such as purchasing for import of goods and foreign direct investment into China. Quite simply, if China removed the controls, then the RMB would emerge as a major world currency, and quite possibly as a reserve currency. The article in the Economist conveniently forgets this small detail.

As for the main thrust of the article, and this sort of argument is common, the rest of the article is a discussion of what the RMB exchange rate should be. I will not repeat all of the detail of the argument, but will quote their conclusion as follows:

The evidence that the yuan is significantly undervalued is hardly rock-solid. It probably is still a bit too cheap, and it would certainly be a mistake for Beijing to allow it to fall, not least because this would risk a protectionist backlash from abroad. In the longer term, the yuan needs to keep rising against a basket of currencies. But for now, some of the accusations being thrown at China are wide of the mark.

The problem is that, all of these arguments are completely irrelevant. Having lots of economists contemplating what the RMB should be is entirely beside the point. If the RMB is not significantly undervalued, then why does China intervene, and why the capital controls? A million and one economists can produce a million and one justifications for the RMB being 'about right', but then why does China not just let the currency loose? As it is, the arguments for the RMB not being undervalued are very poor, but that is beside the point.

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

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

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

http://www.ft.com/cms/s/0/ba857be6-f88f-11dd-aae8-000077b07658.html?nclick_check=1

I will quote sections from the article, and I think you will see why this is so odd:

China will continue to buy US Treasury bonds even though it knows the dollar will depreciate because such investments remain its “only option” in a perilous world, a senior Chinese banking regulator said on Wednesday.

And:

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

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

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

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

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

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

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

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

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

With regards to the situation as it stands, as I pointed out in a recent post the Telegraph reported the following:

Where is the money to come from? China, the Pacific tigers and the commodity powers are no longer amassing foreign reserves ($7.6 trillion). Their exports have collapsed. Instead of buying a trillion dollars of extra bonds each year, they have become net sellers. In aggregate, they dumped $190bn over the last fifteen weeks.

I have tried to find out who these sellers are, but have been unable to find the information (any comments/links on this appreciated). On the other hand, the US is still managing to sell bonds, albeit that the 'The Treasury had to pay a little more than expected'. I have read other similar stories recently. It is also apparent that there is contradictory information, with another article suggesting that foreign central banks are buying US bonds, and another article reporting 'Long Bond Crumples Amid Selloff'.' I will confess that the aggregate real position eludes me at the moment, as there are wide variations across different types of bonds (the Lehman aggregate index shown in the link includes other bonds such as mortgage backed). I will freely confess here that my knowledge of the technicalities of the bond market is insufficient to make sense of the data directly, and I am therefore relying on reports on the data.

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

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

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

....as always, comments are welcomed.

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

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

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

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

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

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

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

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

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

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

China Propping up the $US

I have discussed the position of China in the world currency system previously. I have made the point that China needs to be challenged to open up the RMB to be being a completely free currency, as this is one of the absolute necessities for rebalancing the world economy. The simple fact of the matter is that, as long as the RMB does not trade freely, the Chinese economy can use the currency to subsidise exports. I do not believe in any forms of currency controls, but even for apologists for such a system I can see little justification on the RMB.

Bearing all of this in mind, I was fascinated to read an article in the Telegraph newspaper, which had the following to say:

'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...'

And...

'Beijing has raised the reserve requirement for banks five times since March, quickening the pace with two half-point rises in late June.This is having major spill-over effects into the currency markets because banks in China have been required over the last year to hold extra reserves in dollars rather than yuan. The latest moves have lifted the mandatory deposit from 15pc to 17.5pc of total lending since March'

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 have also pointed out in previous posts that China has sustained an implicit policy of allowing wholesale intellectual property theft (a generous interpretation of China's policy can be found in an article here). However, there is more to the story of Chinese economic aggression than currency manipulation and intellectual property theft. Last year, whilst living in China, I came up with a rather startling thought about China and the way in which it is managing trade and the economy. It occurred to me that China was waging and economic war against the US, Japan and Europe. Having come up with the idea, I explained this to some friends who lived in China. As you would expect, they were initially aghast at the idea and were disbelieving. However, after I showed them some recent articles, added to the RMB policy and intellectual property policy, they agreed that there was merit in what I had to say.

At the time I had read several articles in the Economist magazine that, in isolation, were not too worrying. However, taken together they showed a pattern of Chinese government anti-foreign business policy. For example one article showed how the Chinese press were campaigning against Western companies through the use of slanderous stories about Western companies. Such campaigns could only be undertaken in China with at least tacit support of the Chinese government, and they appeared to be coordinated. The campaigns were clearly intended to undermine the perception that Western brands provided quality and safety. In other words, they sought to undermine the potential for foreign economic success within China. In another article it was demonstrated that there were counterfeits being made of cars in China. The extraordinary thing is that the cars were being sold below any reasonable cost of manufacture. This is what the Economist had to say:

'The great mystery about these copycat cars is their price. Chinese counterfeiters obviously save on research and development costs, but they still have to buy steel and other materials at market prices. Most of them make cars in very small volumes, so there are no economies of scale. That they can sell these cars for half the price of the originals suggests that something odd is going on. They either do not know their own costs (a distinct possibility), have revolutionised carmaking (highly unlikely) or are being subsidised in some way. For the time being, no one knows.'

The only conclusion that can be drawn here is that the government has been subsidising the manufacture of these cars. They are actively trying to destroy the foreign car business in China.

Such articles were just a couple of examples from a brief period when the idea of Chinese economic war was dawning upon me. There have been many more since. We can add to these examples the widespread use of commercial espionage, such as an article here which shows conventional industrial espionage, an article here which shows commercial espionage against the US government and here for commercial espionage in Europe.

As for the attacks on foreign owned businesses in China, these are still ongoing. For example, China has introduced new labour laws and, no surprise, they have actively targeted the laws at foreign multi-nationals, despite the fact that foreign companies are generally much better employers in every respect. An article on this can be found here. Another recent example of unfair trade (restricting car imports, and car part imports) can be found here.

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.

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.

It is very worrying indeed.

Note: At the end of this post there is an always appreciated comment from a regular commentator on the blog, 'Lemming'. I just thought I would respond. He correctly identifies that I have said that there is no 'conspiracy' in a previous post, but the following post suggests otherwise. However, as Lemming correctly identifies, what I am referring to is that there is no conspiracy amongst bankers and the government of the UK, and Western governments. The point of this post is that China may actually really be conspiring. I hope that the intended meaning is clear in the first post, and believe that there is therefore no inherent conflict of opinion / contradiction in the two posts.
It is nice to know that people are paying such close attention to what I have written, which is very heartening, in particular as I had forgotten the details of the original post myself.

Note 2: A quick response to an anonymous comment (see below). If the Chinese government were to seek to destroy the US currency, it is difficult to guess where the US dollar would land. Let's just say at 50% of today's value against a basket of the major currencies, for the sake of argument. Some of the consequences would be as follows:

1. In so doing, the US currency would cease to have reserve status (loss of economic power)
2. There would be hyper inflation in the U.S.
3. The U.S, would not be able to borrow any more money (maybe a good thing)
4. The U.S. economy would collapse
5. The U.S. would be a much poorer country

In reality, the collapse of the U.S. currency would cause chaos, and it is difficult to predict the precise consequences. In a state of chaos it is impossible to say what situation would emerge. However, the one certainty is that the U.S. would be destroyed economically and would emerge from the chaos fatally weakened.

The revaluation would make the adjustment that I have talked about elsewhere in the blog, such that the U.S. would be a much poorer country. This is, in any event, going to happen. However, in this scenario, it would happen in a way in which it would be a dramatic shock. Instead of a gradual adjustment to a new equilibrium, the U.S. economy would plunge. As an analogy think of a person climbing down a ladder compared with falling from a height.

Yes, it would hurt China's exports, and throw the world economy into a tail spin. It would hurt China as well as the U.S. Eventually, the U.S. would recover with export growth, but it would almost certainly never regain the pre-eminent position in the world economy, which would go to China. China would risk social unrest during the adjustment that followed. However, the reward if they were to pull it off would be status as the new economic power.

As for the cost, $600 billion in devaluation of reserves would be a small price to destroy your greatest rival, and assure a pre-eminent position. The foundation of power is economics. If China destroys the U.S. economy, they destroy the power of the U.S.

The threat to sell the dollar I refer to in the blog, is an expression of China's new found power. Whether they are willing to take a gamble on the consequences of use of such power is a point of question. There are major risks to China if they were to carry it out. However, as things stand, the threat has rebalanced world power.