China Is Killing The Dollar
From Gold Money
By Alasdair Macleod
In the wake of the Fed’s promise of 23 March to print money without limit in order to rescue the covid-stricken US economy, China changed its policy of importing industrial materials to a more aggressive stance. In examining the rationale behind this move, this article concludes that while there are sound geopolitical reasons behind it the monetary effect will be to drive down the dollar’s purchasing power, and that this is already happening. More recently, a veiled threat has emerged that China could dump all her US Treasury and agency bonds if the relationship with America deteriorates further. This appears to be a cover for China to reduce her dollar exposure more aggressively. The consequences are a primal threat to the Fed’s policy of escalating monetary policy while maintaining the dollar’s status in the foreign exchanges.
On 3 September, China’s state-owned Global Times, which acts as the government’s mouthpiece, ran a front-page article warning that
"China will gradually decrease its holdings of US debt to about $800billion under normal circumstances. But of course, China might sell all of its US bonds in an extreme case, like a military conflict," Xi Junyang, a professor at the Shanghai University of Finance and Economics told the Global Times on Thursday”
The pecked line divides 2020 into two parts. First, we experienced the intensifying deflationary sentiment leading to the Fed’s rate cut to zero on 16 March, and then its promise of unlimited inflation in the FOMC statement which followed on 23 March. The second part is the inflationary period that commenced at that time as a consequence of those moves. The S&P 500 index then reversed its earlier fall of 33% and started its dramatic move into new high ground, and the dollar’s trade weighted index peaked, losing about 10% since then. Gold took the hint and rose 40%, while commodities turned higher as well, gaining a more moderate 20% so far. The gold/silver ratio collapsed from 125 to 72 currently, as the monetary qualities of silver resumed an importance. The S&P GCSI commodity index was initially suppressed by the WTI futures contract delivery debacle in April, but crude oil’s recovery has resumed. Both gold and commodities are clearly adjusting to a world of accelerating monetary inflation, where bad news on the economic front will accelerate it even more.
If China’s decision to increase the rate of importation for commodities and raw materials did occur at that time, it is very likely that rather than solely based on geopolitical reasons, the decision was driven by China’s reading of prospects for the dollar. When all commodity prices are rising, there can only be one answer, and that is the currency common to them all is losing purchasing power. And from its timing that is what appears to be at least partially behind China’s decision to accelerate purchases of a wide range of industrial and agricultural materials.
With a reasonable level of commodity stockpiles before 23 March, China might have taken the more relaxed view of buying additional imported commodities as and when needed. But the one stockpile she has in enormous quantities is of dollars, of which about forty per cent is invested in US Treasuries and agency debt. A short trillion or so has been loaned to trading partners, predominantly in sub-Saharan Africa and South America, as well as partners in the land and sea silk roads. The indebtedness to China of her commodity suppliers makes further protection from American interference more difficult perhaps, supporting the thesis of China dumping dollars. Furthermore, we should add it is possible that China has hedged some of her dollar exposure anyway. If so, against what is not known but important commodities such as copper would make sense.
That China owns and is owed massive amounts of dollars confirms her primary interest was in a stable dollar. In March she will have found that position no longer tenable. She has cleared the decks with the Global Times front-page article, which assumes America will continue to escalate trade and financial tensions, thereby ignoring China’s warning.
The likelihood that she has now abandoned a stable dollar policy has been missed by the mainstream commentary cited at the beginning of this article, yet the consequences for the dollar will be far-reaching. China is only the first nation using dollars for its external purchases to take the view it should get out of dollars as money and into something tangible. Others, initially perhaps other members of the Shanghai Cooperation Organisation, seem bound to follow.
The monetary consequences for America
The switch from a deflationary outlook to one of indefinite monetary inflation commits the Fed to purchase US Treasuries without limit. For this to be achieved will require the continued suppression of the cost of the government’s funding, which in turn will assume that the consequences for prices are strictly limited, and that existing holders of US Treasuries do not turn into net sellers in unmanageable quantities. If the Fed is to succeed in its monetary objectives it will be required to absorb these sales as well, which could be on a scale to ultimately defeat the Fed’s funding efforts.
According to the latest US Treasury TIC figures, out of a total foreign ownership of $7.09 trillion US Treasuries, China owns $1.073 trillion of which according to the Global Times $300bn will definitely be sold.
In the case of the US, the accounting identity which explains how the twin deficits arise informs us that in the absence of the balance of payments surplus which America has enjoyed heretofore we must consider new territory. If foreign importers dump their dollars there are two broad outcomes. Either the quantity of dollars in circulation contracts as the exchange stabilisation fund intervenes to support the exchange rate, thereby taking them out of circulation. Or they are bought by domestic buyers, at the expense of the exchange rate but remaining in circulation. It should now be apparent that attempts to maintain the exchange rate and accelerate monetary stimulation, which is the Fed’s post-March policy, are bound to fail.
Whether America decides to increase tariffs or ban Chinese imports altogether is immaterial to the outcome. The problem is rapidly becoming one of increasing quantities of inflationary money chasing a reducing quantity of American produced goods while imports are tariffed or blocked. And domestic production is also hampered by coronavirus lockdowns and the desire of bankers to decrease lending risk to the non-financial sector.
Anything the US Government does in an attempt to reduce the trade deficit without reducing the budget deficit is bound to lead to additional price inflation, or put another way, a reduction in the dollar’s purchasing power. We don’t know for sure, but it is reasonable to assume the planners in Beijing will have worked at least some of this out for themselves. If so, America’s exorbitant monetary privilege will no longer be at China’s expense.
It is increasingly difficult to see how a cliff-edge for the dollar can be avoided. Decades of benefiting from Part 1 of Triffin’s dilemma, whereby it is incumbent on the provider of a reserve currency to run deficits in order to ensure adequate currency is available for that role, is coming to an end. Those who cite Triffin tend to ignore the stated outcome; that Part 2 is the inevitable crisis that arises from Part 1. And with over 130% of current US GDP represented by dollars and securities in foreign hands, Triffin’s cliff-edge beckons.
China’s forward planning
If China is to prosper in a post-dollar world it must be ready to adapt its mercantile model accordingly. The evidence is that it planned a long time ago for this eventuality. Its Marxist roots from the time of Mao informed China’s economists and planners that capitalism would end inevitably with the destruction of western currencies.
Since those days, China’s economists have adapted their views towards the macroeconomic neo-Keynesianism of Western governments. While this is a natural process, the extent to which their earlier Marxian philosophy has been changed is not clear. And while this leaves a potentially dangerous lack of theoretical understanding of money and credit, we can only assume Western currencies are still viewed as inferior to metallic money.
It was Deng Xiaoping who led China following Mao’s death until 1989 and authorised monetary policy. And it was he who set China’s policy on gold and silver. On 15 June 1983 the State Council passed regulations handing the state monopoly of the management of the nation’s gold and silver and all related activities, with the exception of mining, to the Peoples Bank of China. Ownership of both metals by individuals and any other organisation remained unlawful until the establishment of the Shanghai Gold Exchange in 2002, since when it is estimated on the basis of withdrawals from the SGE’s vaults that publicly owned gold has accumulated to over 15,000 tonnes.
Since then, China has moved gradually but surely to gain control over physical gold markets and to become the world’s largest miners, both in China and through the acquisition of foreign mines. The Shanghai Gold Exchange dominates physical markets both directly and through ties with other Asian gold exchanges. Joining these dots leaves one dot concealed from us; and that is the true extent of physical gold owned by the Chinese state.
We can assume that China started from a position of some gold ownership when the 1983 regulations were enacted. The fact that precious metals other than gold and silver were excluded is in accordance with the Chinese view of gold and silver as monetary metals. And the permission for the general population to buy gold and silver on the establishment of the Shanghai Gold Exchange in 2002 suggests that in the nineteen years since 1983 the state had accumulated sufficient gold and silver for its anticipated needs.
In Deng’s time, foreign exchange activity at the Peoples’ bank was frenetic, with inward capital flows as foreign corporations established manufacturing operations in China. From the 1990s, while these flows continued, they were more than compensated by growing trade surpluses. Taking into account these flows and the contemporary bear market in gold prices, it is possible (though not provable) that the state accumulated as much as 20,000 tonnes.
Whatever the actual amount, little or none of this is declared as monetary gold. A strict policy of no gold exports has been enforced ever since — with the sole exception of limited quantities for the Hong Kong jewellery trade, which ends up being bought and reimported by day-trippers from the Mainland.
Even though state economists have increasingly used neo-Keynesian policies to artificially stimulate China’s economy, we should be in no doubt about China’s Plan B. It is not for nothing that she has deliberately taken control of physical gold and even run advertising campaigns through state media, following the Lehman crisis, urging her people to acquire it.
We cannot yet say when, how or if China will introduce gold-backing to ensure the yuan survives intact the problems faced by the dollar. But for now, with the new policy of a rising yuan illustrated in Figure 2 above, the impact on domestic costs for imported raw materials will be reduced and we can expect the yuan/dollar rate to continue to increase accordingly.
China’s threat to dump US Treasuries “in an extreme case, like a military conflict” is an important development for the dollar. It was a clear shot across America’s bows, and will have been seen in that context by the American administration. We have yet to see a response.
A firm plank of American monetary policy has been to suppress the price effects of monetary inflation. In the case of commodity prices, this has been achieved through the expansion of derivative substitutes acting as artificial supply. For the moment, the deteriorating outlook for the global economy persuades the macroeconomic establishment that demand for industrial commodities and raw materials will ameliorate, leading to lower prices. But this view does not take into account the changing purchasing power of the dollar.
At some point the threat to the dollar will be taken seriously. But before then, the political imperative in the run up to the presidential election is likely to continue and even intensify pressure on China. But China’s renewed determination to dump both dollar denominated bonds and dollars is a developing crisis for America and the Fed’s monetary policy. We can expect further threats to materialise from the Americans to China’s ownership of US Treasuries and agency bonds. It is a situation that could threaten to escalate rapidly out of control before China has disposed of the bulk of her dollar-denominated bonds.
The certain victim will be the dollar. And as the dollar sinks, China will be blamed and tensions are bound to escalate between China and her Asian partners on one side, and America and her security partners on the other. The start of this additional crisis was the turning point last March, when the Fed publicly stated its inflation credentials. With nearly $3 trillion in its reserves, it is not surprising that China is acting to protect herself.
With so much dollar debt and dollars in foreign ownership, it is hard to see how a substantial fall in the dollar’s purchasing power can be avoided and the Fed’s funding of the budget deficit badly disrupted.