FYI | Apr 27 2009
By Greg Peel
“Oh, East is East, and West is West, and never the twain shall meet,
Till Earth and Sky stand presently at God’s great Judgment Seat;
But there is neither East nor West, Border, nor Breed, nor Birth,
When two strong men stand face to face, tho’ they come from the ends of the earth!”
– Rudyard Kipling (1889)
The concept of “the West” and “the East” is a geographical simplification referring to the western hemisphere containing the US and Europe on the one hand and the eastern hemisphere containing China and Japan on the other. The labels still live on today, although they have been rendered merely symbolic – a reflection of “old world” economies versus “new world” economies, or if you like, “developed” and “developing”.
To that end, we can put Australia in as “west” despite being in the eastern hemisphere. We can effectively put Japan in as “west” as well given its economic maturity. Under the “east” category we can add Brazil to China and India, despite being in the western hemisphere, and Russia, which straddles both. It is thus appropriate that Kipling should suggest “there is neither east nor west… when two strong men stand face to face tho’ they come from the ends of the earth”.
That was exactly what was going on in Washington over the weekend.
Beginning on Friday, Washington played host to a meeting of the G7 finance ministers, followed by a forum of the G20 finance ministers, followed by regular spring meetings of the International Monetary Fund and World Bank. The “G” meetings are a follow-up to the meeting of G20 leaders in London three weeks ago, at which plans were hatched to save the world.
The Group of Seven comprises of the US, UK, Germany, France, Italy, Japan and Canada. The justification for the eliteness of this group is their globally relative economic power. While six are indeed within the top ten by GDP in 2008 according to the IMF, Canada has slipped to eleventh place behind Russia, Spain and Brazil. And everyone bar the US and Japan were beaten by China, which will take up second place in 2009 with little effort.
Indeed, the IMF table of GDP performance could well look rather different in 2009 from 2008. The IMF currently predicts the US economy will contract by 2.8% this year, but the US is in little immediate danger of losing its top spot. Collectively the European Union is an economy about the same size as the US, but the IMF expects the UK economy to contract by 4.1%, Germany by 5.6%, France by 3.0%, and Italy by 4.4%. Japan is expected to contract by 6.2% and Canada by 2.5%.
On the flipside, Russia is in eigth spot but is forecast to contract 6.0% while Brazil (10) stands to lose 1.3%. China (3), on the other hand, is expected to grow by 6.5% and India (12) by 4.5%.
There is hence a viable argument that the current G7 is both inconsistent (without China) and overly elite. That’s one reason why the G20 has become more important in the global financial crisis, because the G7 needs help from Argentina, Australia, Brazil, India, Indonesia, Mexico, Russia, Saudi Arabia, South Africa, South Korea and Turkey in order to implement any global rescue plan. While the current G7 is loathe to concede its status, it needs the help of China at the very least. The G7 members argue that while the G7 might be under-represented, it’s too hard to reach decisions within an entire G20. Perhaps we may soon see a G-something else in between.
But as far as the “G” meetings were concerned on the weekend, the G7 together declared “Recent data suggest that the pace of decline in our economies has slowed and some signs of stabilisation are emerging”. US Treasury Secretary Tim Geithner added “we are not close to emerging from the darkness”. The G7 is sticking to its line that global economic activity will begin to recover towards the end of 2009, but admits that risks persist.
Having made the executive statements, the G7 proceeded to expand to the G20 for a “forum” to let everyone know what the elders of the tribe had decided.
Three weeks ago in London, the G20 agreed to ongoing global economic stimulus through the tripling of IMF funds to US$1 trillion. Most importantly, it agreed to an immediate injection of US$500bn as an emergency facility. Already there are desperate economies lining up for a hand-out. The US, EU and Japan all pledged US$100bn into the new fund, but that leaves US$200bn unaccounted for. It was hoped that at this weekend’s meeting the balance might be found.
In London, British Prime Minister Gordon Brown said China was ready to lend US$40bn into the fund but China never actually confirmed this injection. There were also smaller pledges from the likes of Canada and Norway. But if there is any economy capable of effectively contributing, it has to be China. The ball is now in China’s court.
And don’t think China doesn’t appreciate its position.
If the G7 has an “old world” bias to it, the IMF is very much the same. The IMF was created as part of the Bretton Woods agreement post-WWII and the distribution of voting rights very much reflects the economic power of the day. The US is thus dominant, with Europe also holding a major influence.
After lengthy negotitations, however, the IMF announced in 2008 that the voting share of developing nations would increase by 5.4 percentage points and be revisited in 2013. Brazil’s vote increaased from 0.3% to 1.7%. China’s increased from 0.9% to 3.8%. The increases, however, are not yet in effect. Even when they become effective, China will only have voting rights in line with the Netherlands (ranked 16 by GDP in 2008) and Belgium (20).
Yet the world is expecting China to be a major contributor to a fund over which it has little control.
The US is not beyond allowing the BRICs more control within the IMF. However it is not US power under threat. It is Old Europe which stands to be the major loser if developing countries need to be accommodated. But that’s just voting rights. The reality is that the US dollar remains very much under threat as the world’s reserve currency.
Back in March, Chinese central bank governor Zhou Xiauchuan called for the eventual replacement of the US dollar as reserve currency, and suggested the IMF Special Drawing Rights as the replacement. The SDR was created in the early 1980s as an alternative currency for global trade, intended to reflect the growing strength of the economies of Germany and Japan since WWII and relieve those economies of inbuilt dollar-inflation. The SRD was created as a basket of the US dollar, German mark, French franc, British pound and Japanese yen. Today’s version comprises 44% dollar, 11%, pound, 11% yen and 34% euro.
It never really took off.
China’s promotion of the SDR over the US dollar sent shivers through currency markets. While a basket reserve currency makes a lot of sense, the idea of changing the system at a time when the US is madly printing greenbacks in a stimulus effort is enough to send shivers through currency markets – which it did at the time. China nevertheless qualified its call by suggesting such a switch would only happen over a period of time.
But now there is a new development.
The IMF has also had the right to issue its own bonds since its inception, but never has. Rather it has survived on contributions from major economies. Now that the IMF has been thrust onto centre stage by the G20 it needs some specific means of raising the short term emergency funds it requires. And so, on the weekend, the IMF announced it would probably begin to issue short term (one, two year) bonds, and that they would be denominated in SDR. In short, this move is simply a concession to the will of the BRICs.
If the BRICs are not prepared to hand over money into a fund they don’t control, they are prepared to invest in bonds which offer a diversification away from the US dollar. China in particular has both profited and suffered from its currency peg to the US dollar, which has forced the central bank to recycle its foreign currency surplus into US Treasuries. China has thus been pegged to the fate of the US economy and is not very happy about what Americans have done to it.
While the IMF announced the SRD bonds would be issued only to central banks, the BRICs are pushing for the bonds to be listed on a secondary market to increase liquidity. At that point the bonds would not simply be attractive to Brazil, Russia, India and China, they would be attractive to anyone looking for an alternative reserve currency – an alternative to lending the US money as the “safe haven” when every day the US prints more dollars.
The US is caught between a rock and a hard place. It wants to remain clear world leader but it can’t do that if it shuts up shop and only tries to protect its own economy. Hence it endorses the IMF stimulus plan, the greater involvement of the BRICs, and the issuing of IMF bonds. But it also has a “strong dollar policy”. If the IMF SDR bond represents the first shift away from the US dollar as the world’s reserve currency, the US dollar is toast.
Germany and Japan will also be wishing they had never become so tied in with the US dollar as well, but they had little choice as the defeated. One reason the EU was set up and the euro was introduced was to unite a trading bloc and compete more evenly with the US. The Europeans, and the Japanese, should be happy if their currencies become more important on a world scale, and sought after by the likes of China as an alternative investment. But not right now, please.
If the US dollar tanks as a result of a switch to SDRs then the euro and yen will appreciate, crippling the already suffering export economies of both. It is hardly surprising that European Central Bank President Jean-Claude Trichet reiterated in Washington that he, too, supported a “strong dollar policy”.
So if the US is in a spot, Europe has a major dilemma. Europe needs the increase to IMF funds because it needs the rest of the world, via the IMF, to help bail out Eastern Europe. Western European banks are on the hook for huge loans to the developing East, and those loans are seriously under threat. But if the only way this can be achieved is to give the BRICs more voting power and/or issue SDR bonds then both ways Europe loses.
It is thus also no surprise that France has suggested the remaining US$200bn of unpledged emergency funds could come from the US, EU and Japan all upping their contributions from US$100bn to US$160bn, with China adding the last US$20bn.
For China, however, the SDR bond issue is probably a godsend the Chinese did not expect in such a short space of time. China has already slowly been diversifying out of US dollars, but at the same time being careful not to upset the reserve currency. China has, after all, billions invested in US dollars so neither does it want to see the greenback collapse overnight.
What China can do is redirect new reserves. On Friday, China announced its current account surplus had jumped from US$371.8bn in 2007 to US$426.1bn in 2008. Its foreign exchange reserves totalled US$1.954 trillion at the end of March 2009, up from US$1.946 trillion in December. China has stopped exclusively buying US dollar debt and has begun diversifying into other assets.
Those assets include euro and yen, as well as hard commodities like copper, foreign mines and mining companies (think OZ, Rio Tinto) and, apparently, gold.
According to a report issued by a Chinese newsagency on Friday, China has increased its gold reserves to 1054 tonnes. That’s 76% more than the 600 tonnes reported at the end of March – a figure which has remained unchanged since 2002. The figure makes China the world’s fifth largest holder of gold, ahead of Switzerland. And all achieved without the rest of the world even knowing about it.
The assumption is that China has avoided buying any gold in the traditional international market so as not to inflate the price. China is, after all, the world’s largest producer of gold, representing 12.2% of world output. It recently overtook the US with 9.9%. Beyond that, it is assumed the Chinese authorities have been buying up metal from domestic sources such as scrap, and otherwise on the Shanghai gold market. While US dollar gold has been wavering, the Shanghai gold price has pushed up to levels which usually see demand fall away. But traders in Hong Kong report the Shanghai market remains well-bid by an “unknown” buyer.
The world has long been expecting China to lift its proportion of gold reserves. This is one reason, among others, there are plenty of gold bulls out there. The “old world” holds the majority of the world’s gold reserves, most of which ended up in Fort Knox under the Bretton Woods agreement. That agreement saw the world’s major economies of the day peg their currencies to the US dollar which in turn was pegged to gold. Bretton Woods was abandoned in 1971, and today European central banks agree to sell gold reserves only under a quota system.
Gold was once the representation of economic and thus currency power. China chose to peg its currency to the US dollar to avoid the mistakes by the Asian tiger economies in the 1990s which led to the Asian Currency Crisis. Now it is trying to carefully ease itself away from the peg, but not too quickly as to impact severely on its own export industry. The G7 is encouraging China to revalue the renminbi so as to bring greater balance to world trade.
Gold has now regained its status as the safe haven, and the more a currency is backed by gold the safer it is. This concept is not lost on China. China is becoming more and more powerful by the day.
How’s your Mandarin?
