China’s & Russia’s Currency War on the Dollar
About a year ago, I said the Chinese economy would not crash, but that it would come in for a controlled landing as Beijing sought to lower it to a target of 7% growth — still excellent growth. So, there’s one I appear to have gotten wrong, given that China is starting to look like a train wreck.
At the time, however, the Chinese stock market had not bid itself into the stratosphere. This year, the Chinese stock market started reaching for all the booze kept on the top shelf in rounds of speculative imbibing that makes the U.S. look like a piker. Once that behavior started, I did agree with others that the Chinese stock market was headed for a crash, and that could be devastating for the entire Chinese economy. So, I, at least, adjusted my position before the events unfolded:
As for an economic crash from China, whose economy I said would not crash last year or the year before and which did not, forecasts have to be adjusted for this year. It has opened a stock exchange that has quickly turned into an enormous bubble. That stock exchange is now in the process of crashing, and that crash will certainly have negative consequences for China and for the global economy, too. (“Predicting a 2015 Economic Collapse“)
Once China decided to copy the Capitalist West, it became crazy-drunk on stock speculation. An analogy would be that China’s choice to take in doses of Western capitalism is akin to what happens to nations that have never imbibed alcohol when alcohol is introduced to their society.
China starts its currency war on the American dollar
Not long ago, China was the largest stakeholder in US debt (and Russian was second). Both China and Russia wanted to divorce themselves from such a supportive relationship with the US, but China had roughly a trillion-dollar treasury of US treasuries (which doesn’t count its holdings in other currencies). In fact, that large sovereign treasure is why I said China would not have a hard landing. It has lots of cash in order to apply throttle and slow its rate of descent when it wants to. It’s hard to conceive how a nation with that big of a surplus would crash.
China and Russia have conspired to ditch the dollar because the US dollar’s nearly unchallenged status as a global trade currency strengthens the US in all foreign affairs. Both want to end US hegemony. However, for both China and Russia, divesting of such massive holdings is more easily said than done. Because they own so much US debt, a sudden sell-off would crash the value of their holdings. Just as a forest fire is so large that it creates its own windstorm, China is so large in US treasuries that a rapid sell-off would blow bond prices to pieces. China would lose its fortune.
Last month, however, the crashing stock market gave China the perfect combination of necessity, timing and cover for disengaging from US debt. China has dumped a record $200 billion in US bonds this year without any damaging affect on bond prices. $100 billion of that came in just the last two weeks, as it sold its US treasuries in order to get the cash it needed to bail out its trainwreck of a stock market.
There are two ways China’s present calamity helps it divest itself of dollars: One is that it doesn’t look like it’s trying to damage the dollar, so it can make the move without creating other kinds of panic or US intervention. It has cover for the move because it really does need to do this if the government is going to intervene as a means of trying to save China’s stock market. The US doesn’t want to see the Chinese stock market crash because of collateral damage that brings to the US stock market … as we’ve already seen, despite those who claimed we were immune to anything that happens in China’s stock market. While China doesn’t want its own market to crash, the crash does create the necessity for China to do some of the divesting it has wanted to do.
The Chinese stock market crash has created the opportunity to sell vast US treasury holdings without damaging their value. Because the Chinese stock market crash is rapidly spilling over to the US stock market, it has created a huge surge of investors who are seeking safe refuge for their money in US bonds.
Because the US was not selling a lot of bonds right at the moment, China suddenly faced a swell of demand large enough to greet its supply of US bonds. In fact, bond prices went up, even as China rapidly divested.
China still has about $800 billion in US treasuries it could get rid of (holdings in excess of what it likely needs to buffer trade). I suspect (but certainly do not know) that a couple of major reasons China is still holding that $800 billion is that 1) it could only sell what the market would bear without a price drop, and 2) it will need more reserves down the road to continue stabilizing its stock market and now to balance its currency (see below).
The crash in oil prices and the slowing of China’s economy (which means it doesn’t need as much oil) also puts China in a position of not needing as many US dollars in reserve for buying oil on the dollar-based oil market. So, there is abounding opportunity for China to free itself of US treasuries.
As China’s trade diminishes, its need to hold US dollars for trading purposes drops, too. It may be that China has divested even more of its surplus in US dollars than the figures above indicate. Over the past five quarters, China’s treasury has sunk, according to JP Morgan Chase’s calculations, by over half a trillion dollars, but it’s not known whether all of that is in US assets.
So, the currency war is on; but it is a much more significant war than the US seems to realize. If the Fed and the US government do realize it, they are being completely hush about it.
China’s other big offensive against the US dollar
Of course, the other disturbing news for many was China’s choice to decouple the yuan from the dollar. The US has been demanding China do this for a long time. Now that China is moving to establish the yuan as a global replacement for the dollar, it has its own reason for decoupling. The yuan needs to be able to stand on its own if its going to supplant the petrodollar.
China has moved the yuan toward finding its own price in the currency-exchange markets by devaluing its currency at the same time, which it hopes will boost Chinese exports. Many fear that is the start of a global currency war, as other nations don’t want China to take more of the import-export market share. While the US seems content to let its currency go up in value against all others, in spite of how that reduces US exports by raising their cost for others, all other currencies have been aimed low in order to boost their own exports.
As China drops the value of its currency on the global financial markets, it makes all imports into China pricier for Chinese buyers, dropping demand for those while raising demand correspondingly for overseas for its own products. This helps boost China’s economy from a hard landing, but it creates a race to the bottom in currency values with all of China’s trading partners.
All nations that were counting on exports to China to help to their own economy will now get less help from those exports. China, in other words, is launching a trade war with all other nations, particularly with those oil-exporting nations whose currencies are pegged to petrodollars.
Balancing the yuan from day to day along with saving its stock market is eating up China’s reserves quickly, and Bank of America has said that currency balancing alone could eat up as much as a trillion dollars in reserves. BofA notes that China has the capacity to do that. I wonder, though, if anyone has considered the possibility that the Chinese might have built up the world’s largest reserves in the first place in anticipation of that need. Maybe it held off on its currency war with the dollar until it knew it had sufficient fire power to wage a war it might otherwise lose by attrition. China for years built its reserves, and now the currency war is on … unannounced. I certainly don’t know, but if China really wants to replace the US dollar or make it much less relevant, the path to doing that might look a lot like this one.
Bear in mind that all of this is happening during the same year in which China is courting the International Monetary Fund in order to persuade it to officially add the Chinese yuan to the basket of global reserve currencies that it uses for special drawing rights (SDRs) on all the loans that it makes. Those loans have become a major part of the global economy since the Great Recession brought on more IMF involvement in shoring up national economies.
Getting into that basket is vital to becoming a global reserve currency — i.e. a currency in which many other nations bank their reserves — because being in the SDR basket means you’re a big-league player. There are only four currencies in that basket — the euro, Japanese yen, pound sterling, and the US dollar — and adding or changing currencies in the basket is something the IMF considers only once every five years. China will have a long wait if they’re going to get into that basket at another time. So, I suspect all the recent changes in China’s currency and reserves are not without some calculation that seeks to distinguish the yuan from the dollar and show that it is fully capable of standing on its own.
The IMF states, “The criteria [for a currency to be included in the SDR basket] … establish that the SDR basket comprises the four currencies that are issued by members or currency unions whose exports of goods and services had the largest value over a five-year period, and have been determined by the Fund to be ‘freely usable.'”
“Freely usable,” it says means “widely used to make payments for international transactions and is widely traded in the principal exchange markets.”
The IMF also stated, “The Chinese renminbi (RMB) [also called the “yuan”] is the only currency not currently in the SDR basket that meets the export criterion. Therefore, a key focus of the current review will be whether the RMB also meets the freely usable criterion in order to be included in the SDR basket.”
Subsequent to the most recent events, the IMF has said, “a more market-determined exchange rate [for the yuan] would facilitate SDR operations in case the Renminbi were included in the currency basket going forward.”
Since there are only four currencies allowed in the basket by current rules, China’s inclusion, means one of the current four gets bumped out (unless the IMF changes its rules). So, maybe China is not the dim-witted economic child that many of television’s talking heads seem to think it is as they give their current commentaries on China’s recent currency plays. What if China is actually playing a very smart hand with a poker face?
China would have to be subtle in its plays because the US has the greatest sway in any decision over what currencies get included in the IMF’s SDR basket. Appearing to be overtly trying to topple the US could get it excluded.
While China’s change makes the yuan more volatile and requires depleting reserves to stabilize the currency, that change also enables the yuan to enter the big leagues of becoming a global reserve currency, finally undercutting US hegemony. Divesting from US treasuries as they utilize those reserves in that manner won’t be seen as dumping dollars to the hurt the US.
Russia declares currency war on the dollar
It’s fairly well known, I think, that China and Russia are teaming up to make the Chinese yuan a replacement to the petrodollar as a global reserve currency, but not presumed anywhere (that I’ve read) that it would happen this way. If you’ve been reading The Great Recession Blog for awhile, you may remember that I said China and Russia would team up to take down the dollar back in 2014:
China and Russia have been the largest backers of U.S. debt, but it is unlikely either are inclined to buy U.S. bonds right now. Both are more than likely getting out of U.S. bonds, and that will make things shakier for the U.S. China’s been getting out for some time. (Also a tale told here in rational speculation before it appeared in the news elsewhere.) Russia will do its best to diminish the U.S. dollars as the world’s international trade currency. (“Economic Forecast 2014: Strong Headwinds Face Global Economy“)
Now Russia is making that policy official.
Russian President Vladimir Putin has drafted a bill that aims to eliminate the US dollar and the euro from trade between CIS countries.
This means the creation of a single financial market between Russia, Armenia, Belarus, Kazakhstan, Kyrgyzstan, Tajikistan and other countries of the former Soviet Union.
…Outside the CIS and EEU, Russia and China have been trying to curtail the dollar’s dominance as well.
…In 2014, the Russian Central Bank and the People’s Bank of China signed a three-year currency swap agreement, worth 150 billion yuan (around $23.5 billion), thus boosting financial cooperation between the two countries. (Russia Today)
While Russia has been edging the dollar out in trade with all of its former satellite nations, it is now seeking to ban the dollar entirely. Currently, use of the dollar has remained an option while being discouraged. But that’s not all:
Last December Russia began unloading their US dollar reserves, selling off 20% of its US Treasuries. This reduced its holdings in US dollars to the lowest level they have been since 2008. (Did anyone really think Russia was not going to retaliate for the sanctions that the West has placed on it? Putin is sitting quietly because he knows that he and China have a plan in play that will dethrone the United States as the currency capital of the globe, which could raise US debt costs.)
A confluence of forces waging war on US currency
One affect of China’s divestment on the US economy is that it negates the intended benefits of quantitative easing. The Federal Reserve has been lapping up US treasuries because that has the affect of suppressing interest rates overall, including mortgage interest. If China sells US treasuries as fast as the Fed lapped them up, that negates the Fed’s easing.
It is not just mortgage interest that will be affected, QE has kept down the US government’s cost of rolling over its enormous debt. Any effect that runs counter to QE risks running up the cost of US debt, which could destroy the US financially. China just accomplished a move in that direction with no detrimental affect to itself for a tenth of its US holdings in two weeks. It will certainly look for other such windows.
There is a more significant way in which China’s and Russia’s divestment from US treasuries will raise the cost of interest on the United State’s debt. To the extent that China and Russia stop rolling over their own holdings into new bond and treasury-note purchases, the US has to entice other buyers.
This happens at the same time that a drop in oil prices means all other nations can reduce the reserves they hold in US bonds for use in buying and selling oil (petrodollars). Partially because of China’s decoupling from the US dollar and partially due to the drop in oil prices, oil-exporting Kazakhstan just unpegged its currency, the tenge, from the dollar, too. That may also have been related to the dollar-trade changes being engineered by Russia where Russia’s neighbors are no longer trading amongst themselves in dollars.
One by one, the pegs are falling as the need for petrodollars diminishes.
Saudi Arabia is another nation with large dollar holdings due to its oil trade and another nation whose currency is pegged to the dollar for oil-trade reasons. With its costly war against ISIS and falling oil revenue it has also begun selling off US treasuries in order to finance its war and its other internal needs.
In short, Middle East dollar reserves are drying up.
In 2006, oil-exporting nations increased their holdings by about half a trillion in US treasuries because the price of oil was high and use was increasing. By 2012, they reduced their annual increase in US dollar holdings by half to $248 billion. In 2013, their expansion of US dollar holdings was only $60 billion. And, finally, in 2014, those purchases of US treasuries reversed to where oil-exporting nations are now reducing their holdings in US treasuries.
That’s partly due to choices they’ve made among themselves to trade in other currencies; it’s partly due to the Fed raising the value of the dollar so high compared to other currencies; and its largely due to the huge fall in the price of oil, meaning those nations have no profits to bank. The flow of oil money into US treasuries has ended. The petrodollar is over.
As major as this transition is, it has been so insidious that it has hardly received comment by the Fed or the US government or the media. Yet by such practically unseen change, the US is already in different era in which it will have to attract many new buyers of US treasuries in order to keep rolling over its debt without defaulting. For the moment, the flow of money from stocks to bonds is soaking up the blood.
The most likely way to create so much new demand in the long term is to raise interest on those treasuries enough to entice other buyers. If the US has to do that, it could be game over for the US as an economic superpower without a single military shot being fired.
Will the Federal Reserve fight back in this currency war?
To battle against that devastating outcome, the Fed could launch QE4 — another round of massive Fed bond buying. In that scenario, the US will lick up all of its own blood by buying from its own hemorrhaging bond market — creating its own demand so that it doesn’t have to pay higher interest on its debt. The Fed is practically being trapped by China and Russia into doing so, but the Fed wants badly to end QE in order to prove its recovery a success. The Fed also wants to reduce its balance sheet, not expand it at an even faster rate. If the Fed is forced into seemingly endless QE to finance the national debt because there are not enough other buyers without raising interest rates substantially, all confidence in the US economy throughout the world will erode. So, this is a death trap for Fed and the US government, but also for the global economy that is so wedded financially to the US.
Those of us who don’t wear the government-issue, rose-colored shades all know how everything craters out in the end when a nation resorts to buying its own debt. The world is riddled with derelict examples of nations that have printed money in order to finance their debt, allied “monetizing the debt.” In my mind, the Fed buying US bonds is barely different from the US government buying its own bonds — since the Fed is a quasi-government entity and comptroller of the nation’s currency. It’s just smoke and mirror that tries to deny the government is monetizing the debt.
Common sense should tell anyone that you cannot finance your own debt, even if you do own the money printing presses. It makes your money meaningless. “Hey, we need a bazillion dollars to improve all our roads. Let’s issue government bonds to raise the money. Because we’re hard-pressed for bond buyers, we’ll buy our own bonds by creating a bazillion new dollars. That way the roads will be free because it costs us nothing to create new money on computerized accounts.” It’s absurd.
Question is does the Fed see and understand what is happening to its currency? I doubt it would be questioning whether to raise interest rates if it recognized it may have to start QE4 just to finance the US debt. It does not appear it has connected the dots in the way that I see them connecting in order to realize how much ground it has already lost in the currency war. The opportunity for China to move quickly, whether by design or fortuitous circumstance, materialized so suddenly that I doubt the Fed will piece it together before its September meeting. They don’t seem really good at thinking outside the box that is created by their own plan.
I suspect that the Fed’s perspective on China’s financial moves is that China is playing in the adult play room in a way that risks creating global currency wars among all economies other than the US. Because the Fed has no intention of entering a petty currency-war game, if that is how it sees this, it won’t respond because it is seeing the risk the wrong way. Hubris could cause them to think of China as a child in the currency play pen so that they don’t see China’s sudden “need” to sell of US treasuries as a planned assault on US currency but simply as the desperate result of reckless actions to move trade in China’s favor.
Maybe — just maybe — China intended to create a climate in which such actions could happen under the radar. Maybe pretending to be the dim-witted child in the economic play pen is just China’s way to keep the Fed from seeing what is happening. Or maybe it’s just that time and chance are playing into China’s hand.
Either way, I doubt the Fed sees the kind of risk I’ve outlined above. That is so often the fate of those who believe they are too big to fail. Giants do not necessarily go down because someone so much bigger crushes them. Sometimes they fall and die because their own pride in their huge strength causes them not to realize that a small rock from a child’s slingshot right between the eyes can take them down, regardless of their great strength.
How does this currency war end?
I don’t think any of this means China and Russia will come out on top. Rather, I think it means the world will go into global economic meltdown as a result of too many giants playing rough in the play pen.
If China is creating this situation and the ruckus is not just a fortuitous opportunity to China to divest from US treasuries, then maybe I wasn’t so wrong about China not coming in for a hard landing. It could be creating a situation that allows it to divest from the US unharmed, but damage done to the US to reduce its financial influence in the world, which it always uses for political influence, will hurt China just as much in the end by reducing their biggest trade partner.
I am more inclined to believe this is just a opportune moment being exploited for Chinese divestment because I don’t think any country is willing to risk engineering its own stock market failure in hope that it will cause the next country over to have a stock market failure just so that it can sell bonds without losing money.
It just fits so well with the intentions China and Russia have conveyed in recent years and with the desires of their partner BRICS countries that I cannot help but ponder whether or not it is a conspiracy.
I’m not one inclined to believe in massive conspiracy theories, other than the one know as the Federal Reserve. Clearly all of the United States’ most powerful bankers get together routinely to plot the nation’s financial and economic course … or, at least, to try to plot that course. Since the central banks of the United States and Europe plan together (by definition “conspire”) how they are going to save their national economies, perhaps the central banks of China and Russia have realized they need to do the same if they are going to break past US dominance.
Conspiracy or not, the currency war plays in favor of China’s and Russia’s desire to reduce US influence.