Currencies | Mar 25 2009
By Greg Peel
As I have often noted, China’s twenty-first century export boom was assisted by the fact the Chinese government chose to peg the renminbi within a range against the US dollar. In so doing, Chinese goods were lapped up by Americans (using debt of course) but there was no resulting appreciation in the renminbi against the dollar to slow demand. Modern economics suggests such a mechanism should have been allowed to prevent excessive imbalance. It wasn’t, so US consumption of Chinese goods continued to grow and grow, providing the US with an ever growing current account deficit and China with an ever growing surplus.
The reason China chose to peg the renminbi was because China watched its “Little Tiger” neighbours in Asia blow themselves up in the Asian Currency Crisis of 1997 as they allowed their currencies to appreciate out of hand without building sufficient foreign reserves to back them up. China thus swung the other way, and in so doing created a new problem in the other direction.
The new problem was that the Chinese government knew full well that the growing current account imbalance between the two countries was dangerous as it simply continued to feed on itself and grow exponentially. At its height, economists calculated that on an equivalent purchasing power parity basis the renminbi was about 40% undervalued. But were the Chinese government suddenly to let its currency revalue by 40%, the wheels would have immediately fallen off the Chinese economic freight train. Americans (or anybody else for that matter) would not suddenly be happy to pay an extra 40% for a Chinese fridge, given the cheapness of the Chinese fridge was exactly what the attraction was in the first place. The Chinese export miracle would have collapsed and China would have suffered yet another hard landing in its attempts to embrace capitalism.
Instead, the Chinese government chose to revalue the renminbi on a “softly, softly” approach. The target Chinese economic growth rate has always been 8-10% as about 8% growth is required to simply provide enough new jobs for the country’s ever growing population. Anything below 8% growth in China is effectively a recession (we’re looking at about 6% at present). But China’s economic growth rate reached 13% in 2007. Clearly “softly, softly” was just too soft.
China thus continued to build up an excess of foreign reserves from the US and across the globe as receipts from its export sales. China did not simply want to sit on the cash, as inflation would erode its value over time. Instead, China recycled the bulk of its receipts back into the reserve currency – the US dollar – by buying low risk, low yield US Treasury bonds.
The choice of US bonds was not necessarily a good one, given the world began to sell the US dollar once it was realised the imbalance between the US and Chinese current accounts in particular was too large and growing at pace. This eroded the value of the recycled reserves. The US Fed in the meantime had been ticking up its cash rate to combat growing inflation, increasing the nominal yield on US bonds. This had the effect of at least slowing the US dollar’s slide.
Interestingly however, the world was fooled by what was otherwise relatively low core inflation. China’s seemingly insatiable demand for raw materials was forcing up prices and thus global inflation, but cheap Chinese exports coming out the other side were dampening the rise in inflation. The world was lulled into a false sense of inflation security by what was a direct result of the renminbi being pegged to the US dollar.
Then the subprime crisis hit and all hell broke loose. Judging core inflation to not be too much of a threat, the US Fed reacted to the credit crunch by slashing its cash rate. And slashing and slashing and slashing all the way to zero as the GFC unfolded. There was a pause in the middle, around early 2008, when suddenly inflation did become a problem.
Speculation that China’s economy would replace the US economy as the world’s main driver sent commodity prices soaring. To top things off, Chinese wages (which were low enough previously to be the original source of cheap export goods) had now risen to more realistic levels. Chinese export deflation was no longer offsetting Chinese commodity demand inflation. With a global rush on for everything from oil to rice and pork, China’s own inflation rate pushed over 10% and became a new threat to economic growth.
China was ropable. The US dollar decline as a result of the trade imbalance was one thing, but China felt the danger could be managed (softly, softly). But now the US dollar had collapsed as a result of its own subprime mess. Chinese recycled reserves were thus also collapsing in value. And the weak dollar was sending Chinese inflation through the roof.
It was at this point that the first angry statements began issuing forth from Beijing. We might have to look at selling our holdings of US bonds, said the odd government official. We might instead look at euro investments and maybe yen, and maybe gold. Had this been the case, the US dollar would have fallen out of bed.
But just as one Peking duck would pop up at the shooting gallery and say one thing, he would be shot and another would pop up to say no, no, no, no no – of course we won’t be suddenly selling all our US bonds. And the reason is simple. If the US dollar, and the US economy, goes down the drain, so too does the renminbi and Chinese economy.
The to-ing and fro-ing of China’s threats and recants on selling US bonds has been going on for a while now. China holds upward of US$2 trillion foreign currency reserves. But the current situation provides a more real threat. Chinese exports to the world, and the US, have collapsed as a result of the GFC. There is no longer much need for China to keep building its US bond holdings because there are fewer fresh export dollars coming in. Yet at the same time, the US government is printing money like there’s no tomorrow and madly issuing more bonds in the hope someone else will lend America the money.
This alone has the capacity to send the US dollar tumbling, but not quite as fast as if China started to actually sell US bonds in earnest (it has made some slight reductions recently). There had been a reprieve in the US dollar slide as the rest of the world’s economic recessions caught up, sending the US dollar back up again. The flight from all risky assets back into US Treasuries ensured US bond prices have remained very high (yields low). And now that the Fed is to begin buying US bonds itself (quantitative easing) even more buying has come in to get the jump on the Fed.
The world knows full well this is a fragile position. The continuous printing of money in the US, without support via bond purchases from the likes of China, Japan and Germany who have always been the main buyers but who now have lost their export markets, is offering up the possibility that the US dollar and US bond prices could indeed collapse from here, leading to hyperinflation.
A fragile stability would also shatter if China decided now was the time to start getting out of its existing US bond holdings.
But the US once again breathed a sigh of relief this week when once again another Peking duck popped up and assured the world China would continue to rollover its US bond holdings and support US debt, reinvesting what’s left of its export inflows. A vice governor of China’s central bank said in a news conference on Monday that investing in US Treasuries is “an all important part of China’s foreign currency reserve investments”.
It doesn’t mean, however, that China isn’t duly concerned. Indeed, earlier this month Chinese premier Wen Jiabao commented that he was “a little bit worried” about the extent of China’s US bond holdings and subsequently called on the US to honour its commitments (make sure it can pay the interest), remain credit-worthy (which it won’t be if it can’t pay the interest), and ensure the safety of Chinese assets.
The premier must watch in horror as every week the US government rolls out yet another stimulus package – the latest being a plan to buy up to US$1 trillion of toxic assets from banks. The money for most plans is coming straight off the Treasury’s printing press. “We are naturally relatively concerned with the safety and profitability of US government bonds,” noted our central bank vice governor.
The G20 leaders will meet in London on April 2, and a sideline meeting had already been set up between Chinese president Hu Jintao and America’s new kid on the block. It would be fun to be a fly on that wall.
But even as one Chinese central banker popped up on Monday to suggest China would not sell US bonds, another popped up yesterday to call for the world to adopt a new reserve currency. That’s not great news for the US, as it could well be the only country on earth to oppose such a move at present.
A quick history of reserves currencies has gold as the reserve prior to World War II (except in temporary extreme cases such as WWI and the Great Depression) such that every currency was pegged to that country’s gold reserves. The Bretton Woods agreement just before the end of WWII retained the Gold Standard, but only to the extent that every major currency was pegged to the US dollar (the currency of the ultimate victor, defeater of Germany and Japan and saviour of Europe) which in turn was pegged to gold. Then in 1971 the US went broke fighting the Vietnam War, and subsequently declared the US dollar to be the only reserve currency, pegged to nothing other than the US economy. Ever since that point, US profligacy has been arrogantly growing until the whole house of cards came tumbling down about mid-2007.
The question is, why has no one much challenged the dangers of a paper-only reserve currency before? Perhaps revered commentator Dennis Gartman has an answer, steeped in earlier reserve currency history:
“We have argued long and often that those making the case that the US dollar would soon lose its role as the world’s reserve currency were simply wrong. We argued that so long as the US remained the world’s dominant military power it would remain the world’s reserve currency, for reserve currency status has always been the cloak upon the shoulders of the strongest nation. The Left may not like that but the harsh reality is that Rome’s was the world’s reserve currency not because of the supremacy of Roman literature but because of the supremacy of Rome’s legions. The harsh reality is not that the British pound sterling was the world’s reserve currency because of London’s elegance and wit, but because of her extended navy that manifest power and empire into the corners of the world. The harsh reality of the past five decades is not that the US dollar has reigned supreme because of American mores and culture, but because men, materiel and aircraft carriers.”
Yet Gartman is now prepared to suggest that perhaps this long existing hegemonic concept is changing. And many references have long been made to the US as the “Roman Empire” of the modern world. No one actually defeated Rome, the Empire just became complacent and cocky at home and stretched its tentacles and armies far too wide into the known world, beyond the point of realistic control. Sound familiar?
If the rest of the world no longer can see the US dollar as a viable reserve currency, the question is begged as to what might be an alternative that everyone would be happy with?
The obvious answer is gold, because it was the abandonment of the Gold Standard that got us all into this mess in the first place. However, gold does present some problems.
The first is that countries such as the US and those in Old Europe have lots of gold reserves, while countries like China have very little. The starting point would thus be an imbalance. Moreover, certain countries have, by virtue of a roll of the universal dice, lots of gold reserves underground, such as Australia and South Africa, while others can barely conjure up a nugget. Again that is an unfair imbalance.
The second problem is that gold is just plain difficult to move around, being very weighty and prone to be coveted by people such as Ronald Biggs. The insurance cost of transport and storage is enormous, and it’s a bit hard to send over the internet. In short, gold is just not very practical as a reserve currency.
The third problem is that, by at least one measure, were the Gold Standard to be picked up where it was left off in 1971, against the amount of current reserve US dollars in the system, gold would now be worth US$44,000/oz.
Returning to the second point, although the Gold Standard wasn’t finally abandoned until 1971 there was an earlier move in the 1960s to create a form of “paper gold” against a weighted basket of the currencies of the world’s major economies – the US, Japan, Germany, France and the UK. Thus was formed the “special drawing rights” currency or SDR, with the initial purpose of being a substitute to trying to move gold around the world.
The SDR never really took off, but it does still exist today, although the mark and franc have since been replaced by the euro. One reason the SDR never took off is because it is controlled by the International Monetary Fund.
The IMF was created in Bretton Woods at the same time the Gold Standard added the US dollar go-between. Its purpose was to be an independent financial body charged with ensuring the stability of world currencies and trade balances. It was initially funded with injections of gold and currency from the Bretton Woods signatories, and has spent the last fifty years lending funds to economically stricken nations. The IMF was probably seen by those other than the US as a balance against the domination of the US dollar in the agreement.
But alas, the IMF has ever since been seen largely as a joke, and a puppet of the US. It has come under increasing criticism over the decades as imposing too harsh measures on struggling nations in return for emergency loans, and for growing into an unwieldly bureaucracy of fat cats and idle do-nothings. As the IMF has its own significant reserves of gold, it has over the last few decades constantly sought permission to sell some gold to fund its bureaucracy, but each time the US has told it to pull its head in, rationalise, cut costs and sort itself out instead.
Until recently.
Economists now agree the IMF has began to get itself back on track as a viable body. The US has now granted permission for the IMF to sell gold. Japan has recently been tipping large amounts of yen into the IMF coffers as a way of redirecting its inflating currency into a relevant cause (which is not the US itself). Germany has also injected euro to help the IMF bail out Eastern Europe (to which Western Europe has loaned vast sums) if need be. The IMF is becoming meaningful again. And not before time.
It is thus not a complete surprise that when the People’s Bank of China governor Zhou Xiaochuan called for a new reserve currency yesterday he suggested the IMF’s SDR as an alternative. Dennis Gartman this morning highlighted the nexus of Zhou’s statement, which diplomatically suggested the world’s goal should be to establish a reserve currency that is:
“…disconnected from individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies. The outbreak of the [current] crisis and its spillover to the entire world reflected the inherent vulnerabilities and systemic risks in the existing international monetary system.”
It was nice of Mr Zhou to dryly refer to a “credit-based national currency” rather than just straight out saying “the US dollar”.
Mr Zhou also suggested further reforms to the IMF before suggesting the SDR be adopted as a reserve currency alternative, and declaring that China would “actively” consider buying IMF bonds instead of US bonds were the IMF to be allowed to issue such against its SDR reserves.
Brilliant! Why didn’t anyone think of it earlier? I don’t suppose it’s because the US would fight such a move to the ends of the earth, is it?
Even Mr Zhou conceded that to make the move to such a reserve currency alternative “may take a long time”. But funnily enough, early last year the G20 finance ministers and leaders did agree to make a few currency trades via the SDRs in an attempt to hold up the falling US dollar against the rising yen, euro and pound. Thus the SDR is not dead.
The only problem in using the SDR instead of gold, of course, is that it will not curb potential global hyperinflation caused by all SDR paper currencies being printed at will.
