The Financial War EscalatesJun 20, 2019·Alasdair Macleod
Behind the scenes, the financial war between America and China is escalating dangerously into a war to secure global financial resources.
At a time of growing liquidation of dollar assets by foreigners, the US Treasury’s internal analysis will highlight future government funding problems in the light of a developing US recession. This will result in an overdependency on inflationary financing, threatening to destabilise the dollar’s purchasing power. For these reasons, America needs foreign portfolios to invest in US Treasuries, at a time when China also needs them to help finance her infrastructure plans and future development. We face a battle for these funds, and the outcome will determine all our futures.
When you see a rash, you should look beyond the skin for a cause. It has been like this with Hong Kong over the last few weeks. On the surface we see impressively organised demonstrations to stop the executive from introducing extradition laws to China. We observe that university students and others not much older are running the demonstrations with military precision. The Mainland Chinese should be impressed.
They are unlikely to see it that way. The build-up of riots against Hong Kong’s proposed extradition treaty with the Mainland started months ago, supported and driven by commentary in the Land of the Free. America is now coming out in the open as China’s adversary, no longer just a trading partner worried by the trade imbalances. And Hong Kong is the pressure point.
This happened before, in 2014. The Chinese leadership was certain the riots in Hong Kong reflected the work of American agencies. The following is an extract translated from a speech by Major-General Qiao Liang, a leading strategist for the Peoples’ Liberation Army, addressing the Chinese Communist Party’s Central Committee in 2015:
“Since the Diaoyu Islands conflict and the Huangyan Island conflict, incidents have kept popping up around China, including the confrontation over China’s 981 oil rigs with Vietnam and Hong Kong’s “Occupy Central” event. Can they still be viewed as simply accidental?
I accompanied General Liu Yazhou, the Political Commissar of the National Defence University, to visit Hong Kong in May 2014. At that time, we heard that the “Occupy Central” movement was being planned and could take place by end of the month. However, it didn’t happen in May, June, July, or August.
What happened? What were they waiting for?
Let’s look at another time table: the U.S. Federal Reserve’s exit from the Quantitative Easing (QE) policy. The U.S. said it would stop QE at the beginning of 2014. But it stayed with the QE policy in April, May, June, July, and August. As long as it was in QE, it kept overprinting dollars and the dollar‘s price couldn’t go up. Thus, Hong Kong’s “Occupy Central” should not happen either.
At the end of September, the Federal Reserve announced the U.S. would exit from QE. The dollar started going up. Then Hong Kong’s “Occupy Central” broke out in early October.
Actually, the Diaoyu Islands, Huangyan Island, the 981 rigs, and Hong Kong’s “Occupy Central” movement were all bombs. The successful explosion of any one of them would lead to a regional crisis or a worsened investment environment around China. That would force the withdrawal of a large amount of investment from this region, which would then return to the U.S.”[i]
That America is stoking and organising discontent anew in Hong Kong is probably still China’s view today. Clearly, the Chinese believed America covertly managed “Occupy Central” and therefore are at it again. Apart from what their spies tell them, the protests are too well organised and planned to be spontaneous. This time, the attack appears to have a better chance of success. The plan is coordinated with American pressure on Hong Kong’s dollar peg in an attempt to destabilise it, principally through the threat to extend tariffs against China to Hong Kong. This second attempt to collapse Hong Kong is therefore more serious.
Hong Kong is critical, because through Shanghai Connect it is the only lawful channel for foreign investment flows into China. This is important to the Americans, because the US Treasury cannot afford to see global portfolio flows attracted into China at a time when they will be needed to invest in increasing quantities of US Treasury stock. Understand that, and you will have grasped a large part of the urgency behind America’s attempt to destabilise Hong Kong.
Qiao Liang makes this point elsewhere in his aforementioned speech, claiming American tactics are the consequence of the ending of Bretton Woods:
“Without the restriction of gold, the US can print dollars at will. If they keep a large amount of dollars inside the US, it will certainly create inflation. If they export dollars to the world, the whole world is helping the US deal with its inflation. That’s why inflation is not high in the US.”
While one can take issue with his simplistic analysis, that is not the point. What matters is what the Chinese believe. Qiao concludes:
“By issuing debt, the US brings a large amount of dollars from overseas back to the US’s three big markets: the commodity market, the Treasury Bills market, and the stock market. The US repeats this cycle to make money: printing money, exporting money overseas, and bringing money back. The US has become a financial empire.”
Conceptually, Qiao was broadly correct. His error in these two statements was to not explain that ownership of dollars means they are deployed exclusively in America, but perhaps he was simplifying his argument for a non-technical audience. All dollars, despite foreign ownership, remain in the American economy as a combination of US Treasuries and T-bills, investment in US listed and unlisted securities, physical assets such as property and also deposits through correspondent banks held in New York.
It is not the dollars that flow, but their ownership that changes. Dollars are bought and sold for foreign currencies by central banks, sovereign wealth funds, commercial banks, insurance companies and pension funds. The currencies in which these entities invest matters, and investment decisions are obviously affected by currency prospects. It allows the US Treasury to attract these flows into the dollar by simply making other currencies less attractive. Foreign owners of foreign currencies can easily be spooked into the safe havens of the dollar and US Treasuries. This is the way foreigners are corralled into funding the budget deficit.
A weakening yuan-dollar exchange rate will dissuade international portfolios from investing in China’s projects, for which the Asian Infrastructure Investment Bank was established. China should respond to moves to undermine her currency, seeking to enhance the attractions of her investment opportunities to international investment funds by taking measures to support the yuan. If not, global investment funds will simply not come China’s way.
Besides attracting portfolio flows into the US, a rising dollar is also a threat to foreign governments and corporates who have borrowed dollars and then have to pay them back later. This was what mauled South-East Asian economies in the 1997 financial crisis. China as a state is not in this position, though some of her regional trading partners will have fallen into this trap again.
It is clear from elsewhere in Qiao’s speech that the Chinese understand America’s motives and methods. Therefore, they will anticipate American actions to undermine the yuan. If the Americans succeed and with the yuan made unattractive, international portfolio money that is already invested in China will be sucked out, potentially crashing China’s capital markets.
With the Hong Kong Human Rights and Democracy Act going onto the US statute book, President Trump will be able to use the link to the Emergency Economic Powers Act to impose sanctions against trade, finance and technology. The concern in Hong Kong is personal wealth will now decamp and that Hong Kong property prices will implode.
The British involvement
America’s strategy has included putting pressure on her allies to fall into line with her interests against China. All NATO members have been told not to buy Huawei equipment. Protective of the special relationship, the British have gone along with it. But Cheltenham’s GCHQ (the UK’s cyber monitoring agency) has at least given Huawei the opportunity to address the security issues that have been raised.
A greater problem is bound to arise, and that is the role of the City of London. In 2014, the then Chancellor of the Exchequer, George Osborne, agreed a plan with the Chinese leadership for the City to work with Hong Kong to internationalise the yuan. The Chinese wanted to bypass New York for obvious reasons.
The request to meet Osborne went through Boris Johnson, at the time Mayor of London and leading a trade delegation to China on behalf of the City. Johnson is now odds-on favourite to become the next Prime Minister and if appointed will undoubtedly find himself in a difficult position. He will have to walk a very fine line between Britain’s developing Chinese interests, her special relationship with America, his new friendship with Trump, and also the trade agreement with America which both Trump and Johnson are likely to prioritise following Brexit.
Depending on how Johnson acts, China may have to put her plans to internationalise the yuan on hold. The risk for China is that with her international financial plans threatened and the Americans determined to strengthen the dollar in order to undermine the yuan, she will not have access to the international portfolio flows she needs to help finance her infrastructure plans and her Made in China 2025 project.
Put another way, we face no less than a dangerous escalation of the financial war between America and China, with America trying to close off international finance to China.
China’s policy predicament
In a tactical retreat, Hong Kong has put plans to introduce the new extradition legislation on hold. All it has achieved is to redirect demonstrators’ demands towards Hong Kong’s Chief Executive to resign, and the demonstrations continued.
The question now arises as to how the Chinese will proceed. So far, they have played their hand defensively in the financial war against America, but things are now coming to a head. Obviously, they will protect Hong Kong, but more importantly they must address capital flight through the Shanghai Connect. One option will be to suspend it, but that would undermine the trust fundamental to future inward portfolio flows. It would also be a huge setback for the international yuan. In any event, action must be taken to underwrite the yuan exchange rate.
One option would be to increase interest rates, but this will risk being read as a panic measure. In this context, an early and definite rise in interest rates would be better than a delay or a lesser adjustment to monetary policy. For the domestic economy, this would favour savers in an economy already savings-driven, but disadvantage exporters and many small and medium-size businesses. It would amount to a reversal of recent economic and monetary policies, which are intended to increase domestic consumption and reduce export surpluses.
The economic theories that the central planners in Beijing actually believe in will become centre-stage. China has adopted the global neo-Keynesian standard of economic planning and credit expansion. When the country moved rapidly from a peasant economy, credit was able to expand without the regular pitfalls of a credit cycle observed in an advanced economy being noticeable. This was because economic progress eclipsed the consequences of monetary inflation.
But China is no longer an economic green-field site, having become predominantly a modern economy. Consequently, she has moved from her pure mercantilist approach to running the economy to a more financial and monetary style of central planning.
Through deploying similar monetary policies to the Americans, it might now occur to Beijing’s central planners that they are at a severe disadvantage playing that game. The dollar and the yuan are both unbacked credit-based currencies bedevilled with debt. But if the dollar goes head-to-head against the yuan, the dollar will always destabilise the yuan.
Supping from the Keynesian cup is China’s principal weakness. She cannot afford to face down the dollar, and the Americans know it. For the Chinese, the path of least risk appears to be the one China has pursued successfully to date: do as little as possible to rock the boat, and let America make the mistakes. However, as I shall argue later, the time is coming for China to take the offensive.
Meanwhile, Chinese inaction is likely to be encouraged by another factor: the escalation of US embargoes on Iranian oil, and the increasing possibility of a new Middle-East conflict with Iran. This is bound to have a bearing on Chinese-American relations.
False flags and Iran
Last week, two oil tankers suffered an attack by parties unknown after leaving the Strait of Hormuz outward-bound. Predictably, the Americans and the Saudis blamed Iran, and Iran has denied involvement. The Americans, supported by the British, have been quick to point out that Iran had the motivation to attack and therefore was the guilty party. As a consequence of US sanctions, her economy is in a state of collapse and Iran needs higher oil prices. The US has been building up its Gulf fleet provocatively, increasing tensions. According to Al-Jazeera, Iran’s President Hassan Rouhani warned last December that “If one day they (the US) want to prevent the export of Iran’s oil, then no oil will be exported from the Persian Gulf.”
Perhaps that day is close. Tehran must be desperate, and she blames the Americans and Israelis for a false flag attack, an accusation that bases its credibility on previous incidents in the region and a suspicion that Israel backed by America wants an excuse to attack Iran. The Syrian bridge to Hezbollah threatens Israel to its North, so its involvement is logical, and it looks like a Mossad operation. By driving Iran into a corner, it is hard to see any other outcome than further escalation.
If America does get tied up in a new war in the Middle East, she will be fighting on two Asian fronts: militarily against Iran and financially against China. It could descend rapidly into a global crisis, which would not suit China’s interests or anyone else’s for that matter. However, an American attack against Iran could trigger the widespread flight of investment money to the safety of the dollar and US Treasuries.
If America achieves that objective before sending in the troops, she could then compromise on both Iran and on tariffs against China. Assuming Qiao Liang’s analysis still has traction in Beijing, this is the way American strategy might be read by the Chinese war-gamers.
Meanwhile, China is securing her defences. Besides aligning with Russia and both being expected to vote at the UN against Israeli/American attempts to escalate tensions in the Gulf, Russia can be expected to covertly help Iran. Beijing is also securing a partnership to protect North Korea, with Xi visiting Pyongyang this week in order to head off American action in that direction. The whole Asian continent from Ukraine to the Bering Sea is now on a defensive footing.
How will it be resolved?
If the funding of the US deficit is the underling problem, then a continuation of China’s longstanding policy of not reacting to America’s financial aggression is no longer an option. A weaker yuan will be the outcome and a second Asian financial crisis involving China would be in the offing. It also means the progression of China’s economy would become more dependent on domestic inflationary financing through the expansion of bank credit at a time when food prices, partially due to the outbreak of African swine fever, are rising as well.
There is bound to be an intense debate in the Chinese Politburo as to whether it is wise to abandon neo-Keynesian financing and revert to the previous understanding that debasing the currency and the inflation of food prices impoverishes the people and will inevitably lead to political destabilisation. The logic behind the state accumulating a hoard of gold, encouraging citizens to hoard it as well, and dominating international bullion markets was to protect the citizens from a paper money crisis. That paper money crisis now threatens the yuan more than the dollar.
It must be clear to the Chinese, who are no slouches when it comes to understanding political strategy, why America is taking a far more aggressive stance in their financial war. The absence of foreign buyers in the US Treasury market could turn out to be the most serious crisis for America since the end of Bretton Woods. The Deep State, driven in this case by the US Treasury, will not permit it to happen. For both China and America, these are desperate times.
There was always going to be a point in time when mundane chess moves end up threatening to check and then checkmate one or the other king. China now finds her king under serious threat and she must make a countermove. She cannot afford portfolio flows to reverse. The financing of her Made in China 2025 plan and the completion of the silk roads are vital to her long-term political stability.
China must therefore counter dollar strength by means other than simply raising interest rates. Inevitably, the solution points towards gold. Everyone knows, or at least suspects that China has accumulated significant undeclared reserves of gold bullion. The time has probably come for China to show her hand and declare her true gold reserves, or at least enough of them to exceed the official gold reserves of the US.
It is likely a declaration of this sort would drive the gold price significantly higher, amounting to a dollar devaluation. By denying gold is money, America has exposed itself to the risk of the dollar’s reserve status being questioned in global markets, and this is China’s trump card.
If Xi attends the Osaka G20 at the end of this month, the purpose would be less to talk to Trump, but more to talk to the other leaders to make it clear what the Americans are up to and to ensure they are aware of the consequences for the global monetary system when China takes positive action to protect her own currency and domestic capital markets.
[i] See http://chinascope.org/archives/6458/76
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