On August 10th I blogged (see The Coming Yuan and the Falling Dollar) about a recent Economist article that attempted to explore what would happen “if” the Chinese yuan achieved global currency reserve status. I thought the Economist article was poorly titled: there is no “if” here in my mind; it is more a discussion of ‘when’. Thus I felt the excellent analysis was simply couched incorrectly and I didn’t feel there was enough analysis of what might happen along the way.
In my blog I explore the relationship between the now trade-debtor status the U.S. enjoys along with the trillions of dollar denominated debt held by China. China clearly needs to both support the dollar enough to preserve some semblance of global economic order (else its own holdings fall in value) while at the same time lower its dollar denominated debt (and/or demand for same) and most likely use some of its burgeoning exchange surplus. Lastly I suggested that big banks must be playing currency and trade games to play out various scenarios. This journey is going to be a challenge, and probably quite painful for many.
I noted today a really thought provoking article on CNBC that basically explores this scenario: China’s ‘QT’ [quantitative tightening] is the real global economic threat. The article suggests that China, in its attempt to shift its debt-laden construction driven economy into a consumer driven market economy, will have to de-lever much of its debt: this means dollar denominated debt. To ensure a ‘managed’ exchange rate China can defend its currency, when needed, by selling some its vast dollarised FX reserve. In other words China has all the cards: though not all cards are aces. Selling US debt won’t be easy: who else can afford it? What happens to US interest rates if no one wants the U.S. debt? The U.S. will be less able to live beyond its means. The pressure on those U.S. rates will be UP, just at a time the fragile US economy might not want such increases.
So this global re-balancing act is fraught with risks. I stick to my point in my blog: smart bankers are working on some scenarios in order to figure out how to navigate the changes that must come. The ‘Fed must be working on the same analysis. Only trouble is, the ‘Fed may not have as many cards left to play.
In my ongoing studies of UK monetary policy between the wars, and how war debts and inflation were ‘managed’ globally, it is clear from this vantage point that Britain knew it was sliding into deep financial trouble: Britain was bled dry by the war, financially. Many allied nations owed each other vast sums in war debts; global trade was kaput and no one had any capital to buy food or raw materials needed to kick start trade. I get the feeling that at the time the U.S. basically ‘stuck it’ to Britain, due in part to innocence (no economist had lived through such globally complex issues before) but also deliberately in that an opportunity had arisen for the U.S., and the dollar, to usurp Brtain and sterlings’ hegemony.
The U.S. had no interest in collapsing and reconciling reciprocal war debts, that would have enabled Britain to contribute more usefully in reconstruction in mainland Europe. This decision tied the hands of the financially strapped UK. It paralysed progress and facilitated wild inflationary and currency swings due to the resulting global monetary instability Of course the resulting failure of monetary policy and lack of coordination led to disastrous economic results and conditions that contributed significantly to a positive environment for polical crisis in Germany. The result was World War Two and after that, a cleaner changeover in the order from sterling to the U.S. dollar.
We don’t have world wars to contend with, that is for sure. But there are growing similarities between the siutation of the UK Treasury and UK economy in the 1920’s and the Fed and U.S. economy in 2010’s. Only now it is China that is in the 1920 shoes of the U.S., and the U.S. that it is in the 1920 shoes of the UK. Thankfully the similarities are only that, and not even universal or completely consistent in every way. But the similarities are interesting enough that observed behavior of nations might follow. Will China ‘stick it’ to the U.S. economy? I don’t think so, at least not deliberately. But deliberately China will do what it thinks it needs to do to push the yuan to currency reserve status. And so the same ‘innocence’ we saw in the 1920’s may yet repeat.