*My apologies to BGE for getting this up so late. It’s been an odd morning. It’s still a very important thing to get out there. – SAH*
The Chinese Matter – by BGE
In November 1971, not long after the Nixon administration ended the dollar’s convertibility into gold, then Treasury secretary John Connally told his counterparts during a G10 meeting that “the dollar is our currency, but your problem.” Despite the Bretton Woods era being long gone, this remains true today. The US Dollar is the world’s reserve currency and this simple fact is the root of our “Exorbitant Privilege” and a primary reason that China’s huge holdings of US Treasuries are their problem, not ours.
Certainly, China could dump their holdings or choose not to take up the waves of Treasuries coming on to the market, but only at the cost of completely wrecking their economy. The logic of tyrants is not the logic of a free society, but even a tyrant must ensure that those who maintain him in power are fed and well-oiled or he ends up dead, often messily. Wrecking the Chinese economy, which is weaker than popularly believed, would damage those on whom the tyranny depends for support. Crucially, this includes the Army and Intelligence functions whose senior officers have become rich through state-owned corporations.
Finally, it might not work as intended. The conventional wisdom seems to be that China’s dumping US treasuries would cause interest rates to increase (bond prices move opposite to rates; high rates mean low prices and low rates mean high prices,) thus driving up US interest payments and, in classic mercantilist fashion, wrecking US exports and giving China comparative advantage through a weak renminbi. Certainly, it would produce a couple of interesting days on the markets but, unless a new reserve currency emerges, a return to economic normality would also mean a return to the dollar shortages that existed up to the day the world hunkered down. That there was, and will be again, a shortage of dollars may seem paradoxical, but it is very real and arises from the dollar being the world’s reserve currency and China faces the largest dollar shortage of all.
So then, what is a global reserve currency? Simply put, a global reserve currency is a means of exchange for world trade. Before the war, it was gold and silver, since the war it’s been the US dollar. The world needs dollars to intermediate global trade. The more global trade, the greater demand for dollars.
To give an example, a Swedish export firm is selling product to a Japanese import firm, delivery in three months . The Japanese firm doesn’t go out and buy Swedish Kronor, rather the Japanese firm goes to its bank and buys a Eurodollar deposit maturing in three months. The Japanese bank sells Eurodollars forward for three months for kronor to the Swedish firm’s bank, who provides Kronor to the Swedish firm. (this example and several that follow come from Jeffery Snider at Alhambra Investments.) While this seems unnecessarily complicated, scale and liquidity make it routine and much more efficient than the Japanese firm trying to find someone who is selling Kronor.
The key here is the notion of the Eurodollar. A Eurodollar is simply a dollar liability outside the United States, mostly in London and Tokyo. The term arose during the 1970’s as oil producers put the proceeds of oil sales into European banks outside the control of US authorities. These banks, and this includes the overseas parts of American banks, began to use these deposits as funding for US Dollar lending and the money multiplier allowed the supply of dollars to increase immensely while the US money supply need not change. This seemed to overcome Triffin’s Dilemma, the conflict of interests between short-term domestic and long-term international objectives. There’s a catch, which we’ll come to later.
Let’s turn, then, to China. Dollars flow into China through investments and the proceeds of merchandise trade. China ships goods to the United States and is paid in dollars provided through the Eurodollar system. The Peoples Bank of China (PBC) ends up with a lot of them and buys US Treasuries. At the same time, the PBC issues Chinese currency, the renminbi. The renminbi is not a convertible currency, it’s essentially domestic scrip. China has few natural resources and needs to import most raw materials. For that they need dollars. Since no-one outside China wants renminbi, it is not a stretch to say that the Eurodollar is the Chinese currency, as it is for most countries world-wide. Europe, the UK, and Japan have large enough internal markets that their currency has value apart from the dollar, but for China and the rest, no. For international trade you need the dollar.
This is power, this is hegemony, this is the exorbitant privilege that d’Estaing spoke of. The military might of the US helps keep it in existence and the productivity of the American economy makes it credible, but it’s the power of the dollar that keeps ally and enemy in line. The United States can do what other nations cannot and there’s little the other nations can do about it.
We’ll return to China, but first let’s return to the Japan/Sweden example. The banks perform two key intermediate functions here, first is facilitating trade between currencies (here Kronor and Yen) the second and more important is time. Delivery is in three months and the bank has done what is called maturity transformation. They have taken money today for delivery three months from now. Maturity transformation is the fundamental social function of bank’s always and everywhere. They borrow short and lend long. This is by nature unstable and, when coupled with leverage, the cause of all banking crises, but it is the key step that allows strangers to trade at a distance and its benefits have long outstripped its cost.
Now the catch I mentioned above. Money and Banking textbooks begin with the notion that policy makers decide on money supply and execute through some sort of reserve ratio, either to gold or deposits with the central bank. It isn’t that way and hasn’t been for a long time. The money supply is limited only by the balance sheet capacity of the participating banks and the balance sheet capacity is limited by the amount of good collateral available. The Eurodollar market is funded by something called a Repurchase Agreement or repo. Essentially, a money market fund lends money, usually overnight, to a financial institution secured by collateral. Before 2008, a great deal of the collateral was prime commercial paper, which included (e.g.,) mortgage obligations. Since then, only first world government bonds will do. This is why German or Japanese bonds can have negative interest rates. The banks do not hold them to earn interest, they hold them as collateral to meet the margin call when BofNY Mellon comes calling. For dollar loans, only US treasuries will do and there’s not enough of them to meet all the calls on them. This is the dollar shortage I spoke of. Triffin’s Dilemma is alive and well.
Chinese firms need dollars to buy raw materials today for delivery for dollars in the future. For this, they go to Chinese banks who borrow short and lend long. The key difference is that both the borrowing and the lending are in dollars not renminbi and the borrowing is usually off-shore. The big four Chinese banks used to have a surplus of dollar assets over liabilities (around $125B in 2013,) but have had a deficit since the end of 2018. They have huge, mismatched short-term liabilities that they need to roll over continuously and their counterparties require US Treasuries as collateral. The only source of this collateral is the US Treasury holdings of the PBC. Were the collateral to be insufficient the banks would have to reduce their lending or, potentially, call loans in, which tends to lead to rolling defaults.
China was an economic basket case before the Wuhan Flu. Debt to GDP ratios had skyrocketed and there was a great deal of over capacity in the system. All numbers out of China are suspect, but the reported GDP growth rates were a function of growth in leverage not growth in productivity. They had reached the Ponzi finance stage that Minsky described. They resemble Japan in the early 1990’s where demographic weakness and excessive leverage blew a bubble that the Japanese economy has not fully recovered from almost 30 years later. The key difference is that Japan was rich and China is not and Japan had accumulated genuine capital through their innovation and reputation for quality. China does not innovate, it steals, and has squandered what little reputation it had.
The rot in China is concentrated in the state-owned conglomerates. These state-owned firms are hugely inefficient and there is massive over-capacity. They have built empty cities, bridges to nowhere, railroads that don’t work, and hospitals that fall down. Their products are shoddy where they are not actively dangerous. The contaminated virus tests and PPE that fall apart when touched are recent examples of Chinese build quality.
These firms are owned by the state, but the returns go to highly placed state functionaries including high ranking military and intelligence officers. They have become rich and powerful and are the constituency that Bloomberg spoke of when he said that Xi had to “satisfy his constituents or he’s not going to survive.” The common people of China are no concern to Xi, but he must look after those who maintain him in power. This is the logic of tyranny.
Thus, to Xi’s dilemma. To work off this over capacity and maintain his power, China must increase exports, since, as a centrally planned state, it cannot burn off the excess since doing so would lead to a crisis in the regime. They cannot increase exports because there was excess capacity throughout the world in the period leading up to the crisis and that excess capacity has increased since. Oil futures have never “sold” at a negative price before.
With all that has gone on, who will buy and who would buy from China? If they cannot export, they face collapse since they are all highly leveraged, in dollars so the central bank cannot simply print money. What they can do is horde US Treasuries and buy as many as they can to shore up the state-owned industries.
Were they to fail, the collapse would roll through China destroying the middle class and possibly leading to famine in the provinces. Xi does not answer to the people, but he does require the military to fire on the crowd if necessary and the military must count on its soldiers, or at least its sergeants. They backed the regime at Tiananmen Square, but it is not clear what they would do if called on to fire on a crowd when their people back home are starving. Famine has been the cause the removal of the mandate of heaven from many a Chinese emperor and could well be again.
So, China is very weak and the biggest risk to the rest of the world is error, either on our part or theirs. Regarding our part, we really must question how far China’s corruption is embedded in our political, business, and media institutions. We must also question why our politicians seem hell bent on destroying the economy. Stupidity and fear are usually sufficient explanations for folly, but at the very least we should question whose interests are being served and why.
For China’s part, the biggest risk is human error. There is a logic to tyranny, but tyrants are human and humans are not always logical. Tyrants also rule alone and there is very limited resilience in a centrally controlled economy. Lastly, the Chinese are often degenerate gamblers. As drink is to the Irish, gambling is to the Chinese. Xi is a tyrant, no-one is likely to tell him the truth since the truth might get the messenger killed, rather they will tell him what they think he wants to hear and he has been gambling not knowing the true odds and, thus, making mistakes. His handling of the virus has been disastrous and he is making a very bad mistake in Hong Kong.
I mentioned above that there are two sources of dollars for China, investment and the proceeds of merchandise trade. Much of the foreign investments come into China through Hong Kong since, under the one country two systems agreement, you could get your investments out of Hong Kong. The risk was seen to be much lower. No more. By crushing dissent in Hong Kong, China risks losing a large portion of their dollar funding. What price ego? If they lose their dollar funding, where will they get oil or any of the other things they would need to make war
So, while China seems strong, it is weak. Its economy is very shaky and Xi’s gambling could wreck it and cost him his life. The US appears weak but is strong and that strength is why the dollar remains the world’s reserve currency. The US economy before the current stupidity was a function of two things, the first is productivity, the US worker continues to be the most productive in the world. The second is demographics. The US had an “echo-boom” as its baby boomers had children. Europe didn’t, Japan and Korea didn’t, China put in the one-child policy and managed to produce a slow-moving demographic disaster.
Precipitous action by China either through dumping their treasuries or invading Taiwan would be disastrous for them and fatal for Xi. The world runs on dollars and the demand for them is still higher than supply. The only risk to is our politicians and I truly believe they are also gambling not knowing the odds. We must defend our liberty and, if we do, all will be well.