China or US?Sep 5, 2019·Alasdair Macleod
China has made some silly errors in its conflict with the US, reflecting the arrogance that often afflicts every state actor. But the appearance that China is being backed into a corner over Huawei, trade tariffs and Hong Kong is misleading. China is progressing her own plans, and they do not require an accommodation with America. With Russia in tow, she is now the chief foreign influencer for up to three-quarters of the world’s population, so it is American hegemony that’s being backed into a corner. One day, this will be reflected in a currency shoot-out. This article concludes that the dollar is more at risk than the yuan, the opposite of perceptions in western capital markets.
In the undeclared war between the US and China, the focus has been on the obvious battles. Huawei has been badly wounded but looks like surviving. The trade tariff battle continues and the battle in Hong Kong is ongoing and yet to be resolved.
China made expensive choices in all three. With Huawei, accusations of security breaches from the Americans perhaps could have been more immediately addressed with British and European governments.
Over tariffs, China should have ignored President Trump’s provocation and not imposed tariffs of her own. Tariffs arise out of political ignorance of the economics of trade imbalances. They are a tax on the people and are therefore self-harming. China should have recognised that it was better to leave America depressing its own economy. By refusing to get involved, China would have also taken the high ground internationally, keeping the objective of free trade open, isolating American trade policy and isolating America itself.
Hong Kong should never have been allowed to escalate. The proposed extradition law should have been killed at birth. Instead, it has given the US an opportunity to encourage riots in Hong Kong. China’s intelligence services were well aware of America’s involvement, and there’s no excuse for this blunder. Now that this has finally been recognised with Hong Kong dropping the proposed law only this week, it remains to be seen whether the rioting subsides.
Hong Kong was also the most serious of the three errors. The island is the channel through which international money flows freely into and out of China through Shanghai Connect, and international portfolio flows will now be deterred from investing in China and her projects. America’s true objective regarding Hong Kong was probably to undermine China’s future development plans and to divert international portfolio flows to finance US Government spending instead.
China’s errors are certainly serious, but they hog the headlines to the exclusion of the bigger picture. China in partnership with Russia is consolidating control over the Eurasian continent. Furthermore, with Russia being the world’s largest energy exporter, Iran being driven by America under the Chinese/Russian umbrella, and the Saudis increasingly recognising their future lies with Asian energy consumers, China with Russia is positioned to take control of the global energy market. That’s three vital quasi-monopolies: physical gold, rare earths and energy.
As the ace up its sleeve, America obviously believes the world’s dependency on the dollar makes it its prisoner. But the more that ace is played, the shallower other nations’ toleration with America becomes. Through its demand for energy and commodities, China has already forged alliances with all sub-Saharan Africa, helping to turn it into the most dynamic regional prospect outside Asia for the next fifty years. South-East Asia is the cultural preserve of the Chinese diaspora, links with America only being a legacy of the past. Putting the whole of Asia and Africa together with Eastern Europe accounts for three quarters of the world’s population, no longer suited to and slipping from American hegemony.
We can therefore say the informal war between China and the US is far from over. America’s undoing could be accelerated by her new inward-looking foreign policies, rendered by the Trumpian introspective view that the world has been taking America for a ride. But there is another factor: the credit cycle is on the turn and combining with American and Chinese trade tariffs this synergistic mix threatens a crisis likely to change the outlook for fiat currencies entirely. Bolstered by the risk of owning anything else, will the dollar re-emerge as a safe haven, and will the yuan collapse under a sea of debt? This is the focus for the rest of this article.
The dollar and yuan in a crisis
From their tweets and writings, many commentators appear to be aware that too much debt is dangerous, and they seem to buy into a theory of a cycle of credit. How much so is often hard to discern, since very few of them in this Keynesian milieu appear to have a consistent grasp of economic theory, and more specifically a tenable theory of money and credit. This should not surprise us. They are, one must admit, often ahead of central planners in these matters, but then we are setting a very low bar.
Commentary from Western capital markets is also couched in an east versus west theme. China bad, America good. In Europe it’s China not so good, America getting worse. Or for Germany it is America bad for screwing up its exports to China and possibly to America as well. But sticking with money and credit rather than trade, a common theme from American commentators is that China has created too much debt and has expanded credit proportionally at a far greater rate than the US. Presumably, their thoughts are that if there’s a financial crisis, or a new slump, China will suffer catastrophically, and often there is an additional subtext: it will no longer be a threat to American hegemony and world peace.
One can imagine this line of thinking being popular in the White House, where the rock-crushing machinery of trade tariffs and restrictions on Chinese technology is expected to bring China to her knees. But there are two issues with very different considerations. There is the currency and how that is likely to behave in a credit and trade downturn, and there is credit. While their unit values are the same, they don’t necessarily suffer the same fate. It will be the interplay between the two that will determine relative monetary prospects between the US and China.
Which will be the stronger in a crisis: dollar or yuan?
Let’s take the currency first. There are two background considerations ahead of any crisis: the level of government debt and the potential increase of it in a credit-induced recession or a credit crisis (which amounts to the same thing). In this, the Chinese government scores far better than the US, with a government debt to GDP of 51% against 105%.
Furthermore, the Congressional Budget Office forecasts a baseline of projected budget deficits of $903bn for next year rising to $1,138 in 2023, assuming real GDP growth in the US averages 1.7%. Obviously, in a recession, US budget deficits will turn out to be far higher even without allowing for the cost of rescuing the financial system in a credit crisis.
How China’s government finances will hold up in a recession is a more complex question. It is not burdened with the welfare costs that bedevil more democratic mature nations, so government borrowing is likely to rise at a lesser pace than that of the American government. Instead, China uses its state-owned banks to expand credit to contain unemployment and promote GDP growth. In other words, with its five-year plans laying down political and economic objectives China will attempt to carry on regardless.
A key difference between the dollar and the yuan is that America has replaced its savings driven culture with consumer credit as the mainspring of economic progress. While consumer debt in the US continually increases, China is overwhelmingly savings driven. On this factor alone, the yuan’s purchasing power should be more stable than the dollar’s in a global credit crisis.
US-centric commentators claim the opposite; that in a crisis everyone needs dollars to cover the contraction of bank credit. They have a point, but only relevant if the Fed fails to flood the system with money. Furthermore, speculative money flows (financial balances that have little to do with the non-financial sector) currently tend to be long of the dollar and short of other currencies, so if there is a grand credit shakeout, the flows could turn out to be the other way.
On the most recent US Treasury TIC estimates, foreigners own $19.4 trillion of investments in the US (June 2018, up from $18.4 trillion in June 2017) and they had cash balances in the banking system of $4.5 trillion, giving a total of $23.8 trillion.[i] This compares with US ownership of foreign assets recorded at $12.4 trillion at end-2017, suggesting that in a general liquidation the dollar will come under pressure from adverse flows, other things being equal. Of that figure, only $162.3 bn was in China, less than US residents’ exposure to Sweden.[ii]
US residents and multi-nationals accounting in dollars have relatively illiquid investments in production facilities in China. These may or may not be hedged against currency risk. Given a tendency for all international corporations to reduce foreign exposure when global trade contracts, it appears there are substantially more ready dollars in foreign ownership (the $4.5 trillion referred to in the previous paragraph) than foreign currencies in American ownership. China’s yuan should fare better than the dollar on this score, as well as China’s lower level of government debt to GDP.
Against this, the dollar is the world’s reserve currency, and ingrained conventional thinking is that Triffin’s dilemma will always hold; that America runs deficits to provide the dollars for international trade to act as its reserve currency. While that has been true at a time of increasing international trade, the opposite is true when trade contracts, a condition that has demonstrably already started.
Ahead of a potential credit crisis, the figures show that when it arrives currency flows are likely to differ from last time. In a global dash for cash, the dollar index rose from 77.7 when Lehman went bust in August 2008 to 88.2 by mid-November. By the following June, total foreign investment in US long- and short-term holdings had fallen by $681bn from the previous year, the first decrease since 2002. It wasn’t foreigners buying dollars that drove the dollar higher, but US corporations and investors reducing equity and bond investments in foreign currencies, which they did to the tune of nearly $3 trillion.[iii]
Today, foreign investments in dollar assets will have risen from 70% of US GDP when Lehman failed, to 115% of US GDP currently. US holdings of foreign investments has also risen, with the most recent total being $12.4 trillion at end-2017, a sharp jump on 2016. However, the volatility of total US investment in foreign securities strongly suggests that changes are predominantly liquid portfolio flows, with hedge funds and others buying foreign securities when the dollar is falling and selling them when it rises. Furthermore, American corporations had been accumulating global profits offshore to avoid corporation tax, an anomaly that was removed by President Trump after 2017. So, if one combines the strength of the dollar since 2017 with the repatriation of foreign-earned profits, exposure to foreign currencies will have already fallen considerably.
Nevertheless, the initial reaction on a developing recession is likely to see the dollar marked up. Perhaps we are seeing that now, with the trade-weighted index approaching 100 and the Yuan rate to the dollar having fallen a little less than four per cent in the last six weeks. But in evolving monetary conditions, markets tend to take only one step at a time: traders will foresee a move into riskless liquidity (conventionally dollar cash and US Treasury bills) and only later look any further. Therefore, the dynamics of foreign exposure to the dollar and Americans’ exposure to foreign currencies will probably play out subsequent to a dollar rally.
While the initial reaction may be for the dollar to be marked up, contraction of global trade and America’s overt protectionism is therefore likely to then drive the dollar down. To this we must add the appraisal markets will make with respect to government finances, with prospects for government indebtedness becoming an important consideration. With China’s official base rate currently set at 4.35% there is also the sheer cost of maintaining a speculative bear position against the yuan while being a bull of dollars.
China’s credit markets
Having debated the currency outlook, we now turn our attention to credit. China’s critics point out that at over 300% to GDP, in its economy China has proportionately greater debts than almost any other nation. However, unlike nations with underdeveloped capital markets, debt in China is overwhelmingly in yuan. External debt in all foreign currencies across the whole economy is estimated to be nearly $2 trillion equivalent, about 5% of the total, and less than China’s foreign currency reserves of $3 trillion.
Within the total of roughly 300% debt to GDP, consumer credit is recorded as relatively low, with household debt (substantially residential mortgages) at 54% of GDP, compared with 76% for Americans, who have a far greater dependency on unsecured credit. With student loans, credit card debt and car loans, in a recession and in the absence of accessible savings, the US economy is in a worse position in this respect than China.
Instead of consumers, China’s bank credit has been aimed at non-financial businesses, where debt to GDP is at 157%, compared with 74% for all businesses in the US.[iv]
If the level of China’s non-financial business loans existed in the US, there is no doubt it would be regarded as extremely destabilising, but it is a mistake to assume what applies in America automatically applies in China too. In China, there is undoubtedly a high level of malinvestment, which would in another country create severe difficulties for the banks in a credit crisis. The difference is the Chinese government owns the four largest commercial banks, along with other specialist lenders. Furthermore, the 150 or so city commercial banks are also state and local government owned. Private sector bank ownership is insignificant.
Particularly through the largest banks, loans have been directed, which despite lacking a purely commercial imperative, conforms with the government’s strategic objectives. This being the case, loan books may be riddled with bad debts, but the state is likely to never allow them to come to light. And like Japan, with an economy heavily driven by savers, it is unlikely that the parlous condition of bank credit will ever be challenged domestically by bank depositors.
This contrasts with the American position, where a bank failure becomes a public event. As the recession develops, major corporations come under pressure and some will fail. The markets then seek out the banks most exposed and punish them through falling share prices, rising spreads on their bonds and punitive interbank rates.
The implications of ZIRP and NIRP
From statistical and industry survey evidence, it appears increasingly likely that a recession will take hold and we will see the Fed reduce the Fed Funds Rate to zero, and possibly even take it negative. Even if they stick at zero, we can expect the ECB under Christine Lagarde to go more deeply negative, taking along the Japanese, the Swiss, the Swedes and the Danes. Unlike in 2012-13, when it gradually became clear that the post-Lehman world would not face an immediate systemic collapse and therefore interest rates at some stage would return to normality, this time there is no such prospect. Therefore, USD interest rates are likely to remain supressed below the time preference value for everything from commodities to day-to-day goods. Even at zero interest rates, everything will be at or close to a technical backwardation in dollar terms, which means dollars will cease to operate properly as money, not just for Americans, but for all international trade.
Meanwhile, China has savers and an interest rate which is almost certain to remain definitely positive. In the event of a global recession, the Peoples Bank has the room to cut without transgressing the general level of time preference the Chinese population places between current ownership of goods and their ownership in the future.
Summarising so far, China is likely to have a fundamentally sounder currency than America in a deepening recession. Given the relative foreign ownerships of their two currencies, there are more dollars likely to be sold than yuan. In a banking crisis, China has a more authoritarian grip on commercial banks through state ownership. The failure of a systemically important bank will not be permitted, unlike in the Eurozone and America, where the best case becomes a highly expensive and public rescue.
The view that China’s yuan is built on a better foundation is undoubtedly controversial and unpopular in western capital markets. It is likely to be incorrect in the short-term as the recession and credit crisis evolve. But when markets begin to look at the future after an initial rush into the dollar, these fundamentals can be expected to come into play.
It raises a question, while admitting that the Chinese government is not necessarily in control of events. Is it just possible that the war waged against China will be won by the last fiat currency left standing, and is it possible that some far-sighted individuals in the Chinese administration understand enough about the theories of money and credit to plan for this outcome?
It is certainly possible. This is the nation that has taken control of the physical gold market, encouraged its people to accumulate some 15,000 tonnes since 2002, and doubtless as a state accumulated huge quantities of bullion before encouraging its people to do the same.
The problem we have is reconciling a basic understanding of the benefits of sound money and the protection it affords a nation, with the unfettered use of credit expansion to finance economic objectives. It would appear the Chinese have escaped communism (in all but name) only to embrace radical Keynesianism. Furthermore, there is a new generation of central planners since Deng Xiaoping laid the foundations for China’s prosperity, likely to be western-influenced and infected with Keynesian ideas.
On this only time will tell. But we do see a China prepared to be as independent from America as possible, instead concentrating on its own political and economic objectives.
But we must conclude that despite America’s pyrrhic victories against Huawei, trade tariffs and Hong Kong, China’s dependence on trade with America was never going to last, and the Chinese leadership now have other domestic and Asian fish to fry.
[i] See Exhibit 19T on Page 39 of Foreign Portfolio Holdings of US Securities: https://ticdata.treasury.gov/Publish/shla2018r.pdf
[ii] See https://ticdata.treasury.gov/Publish/shchistdat.html
[iii] This is confirmed by USG stats. See Table 1: https://ticdata.treasury.gov/Publish/shc2008r.pdf
[iv] See https://www.forbes.com/sites/mayrarodriguezvalladares/2019/07/25/u-s-corporate-debt-continues-to-rise-as-do-problem-leveraged-loans/#254c4b7a3596
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