The RMB as a Reserve Currency: Breaking Habits of Thought

The economic power and influence of China continues to grow. In September, 2009, I wrote the following:

The last line of reasoning I considered appears to be the most probable. It is simply that China's wealth is indeed denominated in the $US, and they are just doing enough to hold the $US from free fall. The reason is that this allows them time to use the $US, which they are still accumulating in large quantities, to prepare themselves for the post-$US world. Returning to the speculative post in which I imagined what I might do if I were China, I suggested that they would also diversify their holdings into commodities (in particular gold), other currencies, and would continue and accelerate their purchase and control of commodity/resource companies.

Some quotes from a recent article from AFP:

Chinese firms have become more active in mergers and acquisitions since the global financial crisis that began in 2008, as economic distress has thrown up bargains around the world.

[and]

Between 2005 and 2011, the number of China's overseas acquisitions tripled to 177 and jumped five-fold by value to $63 billion, according to law firm Squire Sanders and intelligence service Mergermarket.

[and]

But academics said more was at work than commerce, as China seeks growing stature and competes with other countries for resources.

If you can cast your mind back to 2007, how did you think of China? The AFP reports on the unease being felt by China's growing influence. If jumping back in time to 2007, if somebody had suggested that China would be this influential, would you have taken them seriously? Whilst China was seen as important, the idea that China would be causing this kind of unease would have been dismissed as fanciful. Another point that I long ago made, at about the same time as discussing China's potential shopping spree, was that China would seek to displace the $US as a reserve currency, and develop the RMB as a potential replacement. This from April 2009:

I have a very curious sense at the moment of the world moving in slow motion. I had thought that the economic crisis would create dramatic moments, but in some respects it appears to be moving through a gradual shift.

One of the predictions that I have made, on two occasions, is the collapse of the $US and the end of the reserve status of the $US. However, it appears that the end of reserve status is being achieved with little drama, as it is apparent that the RMB is slowly but surely being positioned as a replacement of the $US as the reserve currency. We have this latest news from the China Daily:

Five major trading cities have got the nod from the central government to use the yuan in overseas trade settlement - seen as one more step in China's recent moves to expand the use of its currency globally.

From these modest beginnings, the process of moving the RMB to reserve status has continued, and I have occasionally given examples in my posts. This is recent development:

Cracks are beginning to appear; the latest sign is that China and South Korea have come to an agreement in which banks from either country are able to borrow funds from a swap line that makes loans available to companies for deals in local currencies. (Source: “China, South Korea to Boost use of Local Currencies in Trade,” Bloomberg, December 4, 2012.)

This is analysis from Reuters:

Fed up with what it sees as Washington's malign neglect of the dollar, China is busily promoting the cross-border use of its own currency, the yuan, also known as the renminbi, in trade and investment.
The aim is both narrowly commercial - to reduce transaction costs for Chinese exporters and importers - and sweepingly strategic.

Displacing the dollar, Beijing says, will reduce volatility in oil and commodity prices and belatedly erode the ‘exorbitant privilege' the United States enjoys as the issuer of the reserve currency at the heart of a post-war international financial architecture it now sees as hopelessly outmoded.

Zha Xiaogang, a researcher at the Shanghai Institutes for International Studies, said Beijing wants to see a better-balanced international monetary system consisting of at least the dollar, euro and yuan and perhaps other currencies such as the yen and the Indian rupee.

However, I would not want to give a false impression that everyone thinks that the RMB as a reserve currency is likely. For example, this rather curious article from Forbes gives a consideration of the many ways in which the RMB's status is accelerating before then oddly concluding:

Does all this mean China is about to overtake the dollar as the world’s reserve currency? Not anytime soon. A reserve currency, in our view, requires deep and credible government bond markets, an open capital account and critical mass in global financial systems. China’s central bank has laid out a 10-year plan for “internationalization” of its currency. China’s FX bands are widening, but in an incredibly cautious way. Dollar holders need not panic.

Indeed, most articles, including the Reuters one quoted earlier, give caveats, express doubts etc. It is all rather odd, as the expansion of the international role of the RMB is an actuality. Indeed, as long as I have been tracking this steady expansion, the same things are said with each new step, and always that reserve status is something for the distant future. There is a growing conflict between what is taking place, and the analysis of what is taking place. This is a habit of thought and I made the point in an article for Trade and Forfaiting Review in November 2009:

Imagine a world in which there was no international reserve currency, but that an organisation was proposing that the US dollar ought to be the future reserve currency. Would you take such a proposal seriously?

Your response might be that the US dollar sits atop mountains of debt, a shrinking economy and you would point out that the US monetary authorities are printing money to fund record government borrowing. You might actually laugh at such a prospect.

On the other hand, how would you view the Chinese renminbi? You might point out that China holds large reserves of other currencies, the renminbi rests on top of a massive current-account surplus, China’s economy is growing and that the prospects for future growth are all positive. Furthermore, China is a country of savers, with a small fiscal deficit and is an export machine selling goods around the world, ensuring an ongoing utility for the currency in trade.

I do not have a copy of the full article to hand, but recall that I argued something along the lines of the $US as a reserve currency was a habit of thought, rather than a rational assessment. Time has moved along since I wrote the TFR article, and time has supported my case, and still there is a sense that it just isn't possible, even though the step-by-step expansion of the RMB into a reserve currency progresses forwards.

However, at this stage, I am not so certain that the RMB will be the major reserve currency, but not for the reasons that are generally given (e.g. deep bond markets). As regular readers will be aware, I am increasingly cautious about the overall position of the Chinese economy. I am not entirely convinced that China can sustain its economic miracle and, as ever, see political risk in any major slowdown in the growth of the Chinese economy.

Nevertheless, if China does manage to continue its growth, then the indications are that it will continue to chip away at the reserve status of the $US. Returning to the start of the post, the influence of China continues to expand, as the Chinese state encourages firms to seek out and purchase access to resources, and also expand internationally. It is but one example of the astonishing growth in China's economic heft. That influence is being felt throughout the world, and the influence just further enhances China's credibility as a 'major player', and that, in turn, enhances the credibility of the RMB as a reserve currency. Set against this, the economic policy of the US can only continue to erode the influence of the $US. The following is a commentary on the $US and the challenge of the RMB:

Rome in its day held the reserve currency of the world, and how the mighty have fallen. Unless real changes are made, we might be witnessing the beginning of such a shift here. The rising U.S. debt levels are raising questions by many countries around the world as to the legitimacy and viability of the U.S. dollar as the reserve currency.

Politicians in Washington must wake up to the realization that the U.S. dollar’s status as a reserve currency is not written in stone. The financial markets are currently more dynamic and fluid than ever before. It takes only the click of a mouse to move money around the world.

Unless America gets its fiscal house in order, I believe we will see more agreements, such as this one with China and South Korea, which will avoid the U.S. dollar and increase the continuing questions about the viability of its reserve currency status.

The author has a point. After all, if the $US was not already the reserve currency, would you pick it out as a new reserve currency? I think that this unlikely, but perhaps you would disagree?

Krugman: The New Luddite

I know, I post too often on Krugman's musings in the New York Times. However, I could not resist the later missive from Krugman regarding automation (robots, and I presume he also means software that automates tasks currently performed by humans, but that is a guess):

If this is the wave of the future, it makes nonsense of just about all the conventional wisdom on reducing inequality. Better education won’t do much to reduce inequality if the big rewards simply go to those with the most assets. Creating an “opportunity society”, or whatever it is the likes of Paul Ryan etc. are selling this week, won’t do much if the most important asset you can have in life is, well, lots of assets inherited from your parents. And so on.

I think our eyes have been averted from the capital/labor dimension of inequality, for several reasons. It didn’t seem crucial back in the 1990s, and not enough people (me included!) have looked up to notice that things have changed. It has echoes of old-fashioned Marxism — which shouldn’t be a reason to ignore facts, but too often is. And it has really uncomfortable implications.

But I think we’d better start paying attention to those implications.

Welcome to the new Luddite approach to the improvement of the human condition. The robots will move wealth to the holders of capital from the workers.....and that is bad for us all. And what, might I ask, does he think happened in the industrial revolution? The hand loom weavers were put out of business due to automation. It was one of the heralds of the greatest changes in the history of mankind, and one from which we all now benefit. The industrial revolution was, in some respects, a painful process, but also served to create the potential for the huge benefits that we now enjoy.

In the modern and developed world, the adjustment to this new source of productivity should be less painful, albeit that the transition will not be easy either. However, unlike the industrial revolution, we are not transitioning from a system that was for many people barely above subsistence. Today, we are not barely above subsistence, but that is not to say that the transition will not be hard for some people. If you have spent years learning to do something like a search for legal precedents, the automation of this process will be a hard blow. However, for all of this pain, automation will have positive benefits alongside of these costs. In the case of legal services, access to the support of the law will be more affordable to those who would otherwise struggle to have access to the services, and that may matter a lot to many people. It is no different to the access to relatively cheap cloth that will have made new clothes more affordable to poorer people; at a cost to the hand loom weavers in the short term.
Just as the spinning jenny benefited the capitalists, the providers of automated legal searches will benefit the owners of law firms who adopt the technologies that are now available.

The examples of automation creating wider economic benefits are so many that it is difficult to know where to start. The end of canals in the face of the competition from more efficient trains (which created a boom and bust that left the UK with a railway system paid in full by the loss of the capital owners), the redundancy of the typing pool with the advent of the PC and so forth. In all these cases, automation has the result of getting more from less labour, and that means more 'stuff' per unit of employed labour, even in the case of the indirect effect of removing the typing pool. As fast as labour is being removed, more output is being created per worker, meaning that more 'stuff' is available per worker. With greater output of stuff per unit of labour, labour is freed to do new things. It is, just as happened in the industrial revolution, a situation in which new jobs arise to replace the old jobs, as people find new stuff to produce, as the emerging surplus of labour is absorbed in producing 'stuff' that was previously only afforded by the few. It is the process which generates greater wealth.

One wonders, when Krugman says that there are 'uncomfortable implications' and suggest that those implications 'need attention', what exactly he might mean? Does he mean that we should halt the current process of automation, perhaps smash the robots? I mean really, what does he mean? He leaves his article vague and open, hinting at ominous consequences. However, those consequences have precedents that (for once in economics) are clear. We see the result of the precedents all around us in the developed world; more than enough food, better health, heated and comfortable homes, our many forms of entertainments, our freedom to access information, and so the list goes on.

Think of the example of the impact of the PC on the typing pool. It saw what was a hard earned skill eventually made redundant (however, I taught myself touch typing, so not entirely redundant, but I do not need the level of skill of the typing pool where there is no 'backspace'). Should we have looked at the 'uncomfortable implications' of this shift? For a typist, it was undoubtedly not a good situation. However, would we turn back the clock, and stop this change if we could? We could certainly reverse the change, by making word processing software illegal, and blocking any web services that might offer a similar facility. In a few year time, with the magic of backspace button gone, we would have huge numbers employed in typing pools. Those same individuals will be drawn from the labour force, and will be an opportunity cost; the opportunity to do something else which is genuinely in more demand.

What we are discussing here is nothing more than a variant of the broken window fallacy; that breaking a window is a good thing as it creates employment. In breaking the window as a deliberate act, it creates employment, but employment with no real point. Better that the people employed in repairing the window are engaged in productive labour with a genuine demand, rather than an artificial 'created' demand. In the same way, better people are employed in new avenues than artificially supporting, or creating, employment through the rejection of more efficient means of engaging the same labour. It is a make-work scheme where there is no need for the work. Better that the labour is employed in creating real value.

If ever there were evidence that Krugman has nothing to offer, this rather odd article is the evidence. It is no wonder that he leaves the 'implications' and solutions unsaid. If he were to say clearly what his article implies, he would be ripped to pieces. It is, as the title of this post implies, nothing more than a disingenous revival of Luddism. Krugman hides in ambiguity, but the 'implications' are clear; break the machine to save the interest of labour. He cannot see that, painful as the adjustment might be, labour is also the recipient of the benefits of automation.

Further, Krugman writes from a US perspective, and the potential benefits to the US worker are obvious; the cost of labour differential is diminished through automation. Maybe the labour will no longer be the crude repetitive labour of yesteryear, but all those 'on-shored' factories that benefit from automation will nevertheless create new employment opportunities. There may, in other words, be losers from automation, but there will be many more winners; and the win will keep on delivering, just as the industrial revolution today reverberates to the benefit of all in our day-to-day lives. 

The UK Mid Year Budget Statement

The mid-year budget statement has prompted concerns about the UK economy. It is a classic case of 'incrementalism' and fiddling. For example, see here for benefits reform and the silliness of framing the limited reform with the discussion of 'Mummy Tax'.

This is gloomy pre-statement commentary from Alexander Heath in the Telegraph:

Psychologists call this cognitive dissonance; unkind folk would see it as plain cowardice. What is clear is that such self-deception has reached epidemic proportions when it comes to the economy, and has contaminated all major political parties as well as many professional forecasters.

In the absence of shock and awe supply-side and tax reforms, which are not on the cards, our long-term growth prospects are bleak. George Osborne’s greatest problem, as he prepares to deliver the Autumn Statement, is that the British economy is stuck in a rut.

He has grasped something of the reality. In the UK, we are now starting to see something of the negative spiral that follows in the wake of attempts to incrementally cut government borrowing growth in the face of an economy that is structured around servicing the growth in borrowing (sorry, for the convoluted sentence). However, this from the WSJ:

The U.K Treasury painted a grim economic picture, acknowledging that growth was weaker than the government expected and that a tough austerity plan would drag on longer than planned.

Treasury chief George Osborne, who presented his closely watched twice-yearly economic update Wednesday, delivered a triple whammy of bad news. He conceded the economic recovery was taking longer than expected; that he would likely fail to meet a key self-imposed debt goal; and that government cost cutting would continue until 2018, three years longer than initially planned. At that point, the U.K. will have experienced eight straight years of austerity.

Mr. Osborne and the Conservative-led coalition government is halfway through its five-year term. Having come to office promising to fix Britain's weak economy, Mr. Osborne is under immense pressure to demonstrate that his strategy is working ahead of the next general election, due 2015.

Except for the misuse of austerity, it is a reasonable summary. The pressure is no doubt building to get the money printing presses running again:

Sterling edged up from one-month lows against the euro on Wednesday after a gloomy UK budget statement which traders said was in line with expectations.

But forecasts from finance minister George Osborne that Britain would miss its debt-reduction and growth targets left the currency looking vulnerable.

Analysts said the poor UK economic outlook might revive prospects of more monetary easing by the Bank of England and increase the risk of a credit agency cutting the UK's top-notch rating, both of which would be negative for sterling.

 The OBR is taking a negative view, saying that:

The independent Office for Budget Responsibility predicted the UK economy would shrink slightly this year and grow less over the next four years than it had forecast in March. Robert Chote, chair of the watchdog, said: "What's striking is the weakness of the recovery over an extended period of time."

I hope that, for regular readers of this blog, that the 'weakness of the recovery' is in fact unsurprising, and that they already realised that the UK economy has only now just started an unavoidable process of shrinkage i.e. any economy which is structured around servicing debt growth cannot shrink the debt growth without negative consequence. Worryingly, the current state of affairs is leading to threats to the UK credit rating:

The chancellor's statement did nothing to dispel fears that the UK could be stripped of its triple A credit rating. Both Moody's and Fitch, two of the three major rating agencies, put negative outlooks on the UK's rating this year.

Whilst the ratings agencies are generally hopeless, they are still important. They make a major difference due to their role in banking regulation and their pronouncements have real impacts. I seem to recall that George Osborne placed the credit rating of the UK as one of the drivers for his policy, so any significant downgrade would certainly add to the pressure now being placed upon the government. This is Bloomberg's view on the mid-year budget statement:

In lieu of real change, he proposed a set of well-intentioned but ultimately insignificant policies, restricted by the need to make the package as a whole fiscally neutral. Osborne did not need to be this cautious.

The chancellor did act to redirect government money in a few ways likely to produce growth. He said he’d reduce the nominal rate of corporation taxes to 21 percent from 24 percent in 2014 (compared with 35 percent in the U.S.). He also increased by a factor of 10 the amount of capital investment that U.K. companies can make exempt from taxes each year, to £250,000 ($402,300) from £25,000.

Osborne scraped together £5 billion to spend on schools, transportation, and flood defenses. He also set up a body to eliminate the regulatory gridlock that’s blocking development of shale gas in the U.K. and promised tax breaks for exploration, ahead of a new policy aimed at increasing Britain’s production and use of natural gas. These are all intelligent ideas that may boost construction and employment in the near term, and growth in the longer term.

I am inclined to agree that there was no real change, but suspect that, if shale gas lives up to its promise, then this will have very significant impacts through the potential to lower energy costs; a factor in living standards but most importantly in the cost of manufacturing. However, this will not really have any major impact for several years, and before it will be a positive contributor to a more competitive economy and better living standards. In the short term, there may be a small impact through increased investment, with the activity that follows from this, but it will not be enough to significantly lift the economy. As such, although a positive, it does little to address the problems in the short term.

Nor will the rest of the measures. The problem that will now face the government will be the political pressure to reverse course. For example, I disagree with Bloomberg's view, which is inevitably echoing around the media, that the government should give a 'modest boost' to the economy by relaxing budget constraints. The one thing that the government should not do is relax on this issue.  
Regular readers will know my answer is to take more aggressive measures on government spending, at a cost of short term pain, in order to avoid a worse situation in the future. However, I accept that the real pressures mounting for the government to loosen will make this nearly impossible at this moment in time.

As a pragmatic compromise, instead, the government should follow what is (in some respects) sometimes good advice, but which is given as advice for the use of additional borrowing (i.e. the projects will increase borrowing). Rather than funding through additional borrowing, those projects which address genuine problems in infrastructure should be given as a priority but as a priority that displaces current levels of spending on consumption based services provided by the government. 
In other words, the government should cut spending to fund investment (and I mean investment in the sense before the distorted use of the word as a synonym for government spending). Where there is genuine need for certain types of infrastructure (and I here accept the current reality that government will fund this), it is a better way to use borrowed money than borrowing for consumption.This will require cuts in services, and the answers I give on how to cut remain the same.The answer is to ask which services are a priority, and then to make choices according to the priorities.

In my mind, this is best achieved by asking the question of whether service x or y is really the role of the government, and cutting anything which is not a core government function. It is a question of 'luxury' over 'necessity'. The economic question is 'what can the UK afford?' but the answers as to what is necessity and luxury are political questions. The other answer is the one that I have discussed previously in my sections on reform. Having established the priorities, how can they be delivered in a way that is cost effective, but also hold to the principles on which they were established? As an example, I have proposed reforming benefits, such that there is still a (generous) safety net for those who are confronted by bad luck / unexpected difficulties, but where the costs of the system are minimised.

As the situation stands, the UK is continuing down a road which does not address the fundamental problems of the UK, with reductions in borrowing growth that will not address the underlying economic problems, and without the kind of substantive reform necessary to lay a real foundation for economic recovery. I believe that I long ago expressed the concern that the UK government would try to resolve the UK's economic problems with incremental cuts and policy measures, and this is exactly the path being followed. The trouble with this approach is not just that overall debt continues to grow whilst the economy shrinks, but also the problem is that the inevitable contraction in the economy leaves the government open to pressure to reverse course mid-term. It is, in summary, self-defeating even when taking a political perspective.

I can never make up my mind what prevents the solutions that are possible to help resolve the problems of the UK economy; is it lack of courage, political consensus or lack of imagination, or the economists whispering 'easy' solutions in the ears of politicians. Perhaps it is all of them. I started the post with Alexander Heath's article, and who proposes cowardice; in light of the self-defeating nature of incrementalism, perhaps he is wrong? Perhaps it is just lack of imagination?