Following on from last weeks well received article we look once again at the implausibility of a genuine currency war between the US and China. This time we focus more on why it simply doesn't make sense from a Chinese perspective.
Last week, we gave a broad explanation of the evolution of the global monetary system and the centrality of the USD for global trade. We argued that, from a US perspective, it was rather unlikely that regulators would take steps to move towards an outright currency war predicated on competitive devaluations simply for the reason that the US would find it hard to do so given the artificial demand for USD and an innate built-in inability to control supply. This week we continue to explore the notion of a currency war and its implausibility from the other side of the equation i.e. from the perspective of China.
Much has been said about the fact that the Chinese have historically kept a lid on their own currency in order to give an unfair advantage to their own domestic firms and their exporters. While this argument does have some grounding, it is a bit of a generalisation, especially where it concerns the USD - RMB relationship. To say that they would prefer to see a low RMB is, in fact, far from the truth in the current context. The key, rather, is to maintain balance.
Understanding Chinese Policy Incentives
In his book, ‘The Origins of Political Development’, Francis Fukuyama argues that the fundamental premise upon which Chinese state development has always taken place is ‘balance’. In the days of imperial power, this was known as the ‘mandate of heaven’ to justify an often despotic rule. In essence, China, Fukayama argues, developed a prolific state apparatus quite early in its history (1000 years before modern Europe) without the constraints of the rule of law or any pre-existing frameworks like religion or local elites to curtail the centralisation of power. Starting with the legalists of the Chin dynasty, the central government, in its various iterations, had always maintained an innate ability to rationalise and dictate a wide array of what we would otherwise contend are private interests. In return for protection and order (i.e. balance), the Chinese polity has been willing to give a wide and almost unlimited range of power to its sovereign. And while modern China, with its glossy cities and ever more assertive middle class, might seem a far cry from this historical backdrop, indigenous institutions and conditions must be understood within that context.
So why is the above rationalisation important to understanding the currency wars? To put it simply, while it might seem unfair to us or indeed the US Treasury that the Chinese wish to control the price of their currency, it is a perfectly rational thing to do for a government that seeks to maintain balance and achieve its own related objectives. In the words of Deng Xiaping, ‘what does it matter if the cat is white or black as long as it catches mice.’ The framework developed after WWII, which we elaborated upon in our article last week, is one that evolved to suit the needs of predominantly Western capital markets and Western institutions. Even here, following the effective dismantling of the Bretton Woods agreement, disagreements arose as to what Charles de Gaulle termed the ‘exorbitant privilege’ of the US (i.e. its ability to maintain current account and fiscal deficits without running into trouble thanks to the US dollar being always in demand and hence having an ability pay lower interest without inflation).
From the Chinese perspective, the demands of rapid industrialisation required that they use whatever means necessary, including access to global capital markets. To put it into context this meant that they initially artificially inflated the RMB to control imports during the era of Chairman Mao and its focus on self-reliance and the opposite when they opened up to the world.
With the country’s induction into the WTO under the Clinton administration and subsequent opening up to capital markets, it was hoped by the west that the Chinese would adopt other western institutions including the floating of their currency. This was, however, never on the agenda for the Chinese rulers and indeed, when one understands the Asian Economic Crisis or Turkey or looking at the history of South America, it might be easy to see their distaste for letting free markets take rein when it comes to something they consider to be so fundamental. Hence the Chinese banking system and capital markets are heavily controlled by the state with the PBOC effectively using a top-down approach to control both the demand and supply of both currency and credit in the economy.
This evolution couldn’t be further from what had happened in America. While the US and other western democracies, through the use of the federal reserve system, broadly went towards a laissez-faire system whereby the actual creation of money was effectively gradually outsourced, the Chinese used the same tools to accomplish the opposite. The RMB, despite pressure by global counterparts, was initially pegged to the USD at a fixed rate and gradually partially floated (now being pegged to a basket of currencies). How does this happen in practise?
In effect, the PBOC maps out a midpoint for the CNY each day in consultation with the Chinese dealer banks beforehand to get a sense of trading conditions. It does so by taking into consideration broader policy goals and using this they pick their policy range for the day. However, the goal here would be to select a band which would not require intervention by the bank since, if the currency traded higher or lower, the bank would be obligated to buy USD as necessary at the limits. Which brings us to the first point, which was that when the currency dropped significantly two weeks ago following the US administrations noise around tariffs, the question was why the PBOC did not intervene to keep it within the trading range rather than that the PBOC directly manipulated. Ironically it seems that US officials would’ve preferred that China manipulate the currency to the upside.
So does this mean that the Chinese want a lower Yuan? This is definitely no longer the case. We would contend that Beijing’s primary priority is stability and balance. It would be extremely detrimental to the Chinese economy to have the Yuan fall too low, especially at a time when the government continues to transition its economy towards consumption-led growth. One must remember that China is extremely reliant on global energy markets and imports of basic goods ranging from agricultural commodities to Iron ore. A falling or weak yuan would have systemic impacts upon both inflation and social stability.
Secondly, coming back to the point of the US dollar being the reserve currency, this status also means that China has a decreasing ability to maintain the peg or, in other words, having a high USD adversely impacts upon both monetary supply domestically and credit growth. How? To oversimplify again, let us assume local banks need to borrow $100 every day in short-term eurodollar markets just to keep doing the vital economic and financial things banks do. One day, the eurodollar market demands $110 for whatever reasons including problems on its own end. As the central bank, you promise to help them by giving them the extra $10 because them not having that $10 means they don’t get all of the $100 and therefore all sorts of bad things for you as well as the economy.
You can sell $10 in assets you already own, which means that’s $10 subtracted from the domestic monetary base. It sounds absurd, but that’s really what happens and it keeps the $10 in place for the domestic base while simultaneously giving banks an acceptable liability covering their $10 shortfall.
Again as we suggested last week, the Federal Reserve is effectively the central bank of the world. The point being, you cannot wage a war against your own central bank. All this is to say that a currency war that goes on a beggar thy neighbour approach or logic is, as a matter of practicality, not possible without incurring significant damage to the Chinese economy. While much has been said about the accumulation of US treasuries and the so ‘called war chest’ of the Chinese by way of fiscal savings (including the PBOC balance sheet) it would be expensive to dump the US Treasuries or securities as a weapon or to control the peg enough (to the downside) without creating instability in the domestic economy which goes against everything that a Chinese state is conditioned to do (stability at all costs or risk losing the ‘mandate of heaven’ for those of you who understand the analogy).
Is this to say that this status quo will remain so in the long run? Perhaps not, as the Trump administration continues to take unilateral decisions with regards to sanctions and other punitive measures. We might very well see the gradual de-dollarisation of the planet. It just might be that over the long run, the Chinese look to find alternative measures but this would require a replacement to be found for the USD, in which case they just might have to volunteer their own currency which would run into the same constraints faced by the US (i.e. hence no currency war) and losing much control over it. There is however the possibility of a secular trend where the de-dollarisation occurs gradually. For the US, this might mean that their fiscal and current account deficits might actually matter eventually, though given the resilience and insularity of the US economy (has potential to be both energy and food independent), its impact might be mitigated.
Markets & Commentary
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