China, The World's Banker

Summary

• if the United States does not get its act in order, it is in danger of allowing China to become the world's banker, something Chinese leaders would be happy with.
• Investors are seeing that the banking and investment banking activities taking place in China are outperforming many other areas in the world and China's leaders want more.
• Unfortunately, economic policies over the years have weakened the country and then the Covid-19 pandemic jolted American institutions and markets leaving a disrupted economy behind.
• The future is still in the hands of the U. S. government, but unless it re-focuses and takes a longer-run focus on things, a very patient China may continue to erode it's position.

Funny how taking on more and more debt eventually catches up with you?

You start out with only small amounts of debt and it really helps you get what you want. Then, upon seeing this, you think that adding a little more debt will not hurt… in fact, it may actually make you better off.

And, then you add more debt…and more debt…and more debt…and, things get tough but you feel you can manage the tighter times. But, then, you add more debt… and even more debt.

When does this end?

Well, there is no exact timing as to when the ‘house of cards” might come crumbling down.

It might be a loss of a job. It might be an illness. It might be some bad luck. It might be a pandemic.

The United States has piled up debt for sixty years. Most of the years have been very good years, as the U. S. government adopted a policy of “credit inflation” in an effort to maintain high rates of employment, not just through cyclical swings, but also over time.

Debt piled up, privately as well as publically. And, although some complained about the rising debt load, the general policy of “credit inflation” continued and the debt continued to pile up.

The big change in the economy was that more and more of the money created during this time was directed into the financial circuit and less and less money was directed into physical capital investment.

During the economic recovery following the Great Recession, the U. S. economy grew at an annual compound rate of 2.2 percent, the lowest for a period of economic expansion since World War II. Yet, during this time housing prices rose dramatically and the U. S. stock market hit new historical highs, year after year after year. Asset price bubbles occurred frequently.

In terms of stimulus programs, it is estimated that almost two-thirds of the 2017 tax cut went into stock buybacks and corporate dividends. Very little of the stimulus was directed toward physical capital investment.

Then The Coronavirus Pandemic Hit

In 2020, the coronavirus pandemic came to America, creating a recession and economic distress.

The Federal Reserve responded and pumped billions of dollars into the economy. The government deficits increased. And, debt increased everywhere. The government’s debt load reached 100 percent of Gross Domestic Product, a level not seen since the Second World War.

As Henry Paulson, former U. S. Treasury Secretary, writes in the Wall Street Journal,

The U. S. government has undermined (world trust) through shortsighted actions and long-term fiscal negligence. “

Ruchir Sharma, chief global strategist at Morgan Stanley writes in the Financial Times,

U. S. officials were confident that, in response to the Covid-19 lockdowns, they could print the dollar in limitless quantities without undermining its reserve currency status, allowing the country to keep running large deficits without apparent consequences.”

As a consequence, U. S. companies are sitting on the larges pile of cash ever and the risk/return relationship in the financial markets seem to be “unhinged.” In other words, disequilibrium reigns.

In other words, the “house of cards” seems to be on shaky grounds. And, the role of the United States and the U. S. dollar as the world’s reserve currency seems to be under question.

China is There

Chinese leaders are taking this all in and continue to work toward replacing the United States in as many areas as it can. Being the world’s banker and having the world’s reserve currency is certainly in its sights. But, can it make it there?

Mr. Sharma believes that China’s renminbi will not receive reserve currency status. There is still too much concern about China’s political model: it is too dominated by one party. And, maybe there won’t be just one reserve currency in the world going forward. Mr. Sharma sees digital currencies playing a bigger and bigger role here.

But, Mr. Paulson holds out the possibility that China could become the world’s banker. “Its markets have governance and accounting issues to overcome, but Beijing is working to enhance its regulatory structure to meet global standards and provide greater transparency and better enforcement.”

Furthermore, China has recovered more rapidly from the Covid-19 pandemic and it’s interest rates are relatively higher in the world and since March its currency has improved substantially against other others. Large investment flows are going into China.

And, you get companies like Goldman, Sachs getting more involved in the country as China becomes a real center of financial activity. Mr. Paulson remarks that “Shanghai ranked first among global exchanges for number of IPOs and capital raised through the first nine months of 2020.” China continues to drive toward increasing this by substantial amounts in coming years.

Add to this the trade agreements China is entering into, like the Regional Comprehensive Economic Partnership, or, RCEP, which brings 15 nations together, which includes about one-third of the world’s population and about one-third of the world’s production.

China Plays For The Longer-Run

China realizes, and has realized in recent years, that it must play in the global economic game if it is going to take its place at, or, near the top of the world order. But, it also realizes that it is not going to achieve a real competitive world position overnight. And, so it chugs away. It will not go away.

China is willing to talk…and, in fact, it wants to talk.

The United States needs to respond. Mr. Paulson closes his comments in this way:

America’s leadership in financial services is a core strength of the U. S. economy. But this mantle of leadership isn’t preordained. If it is to endure, America needs to play to the strengths that have made its capital markets the envy of the world. At the same time it must craft a smarter approach to dealing with China, one that avoids unnecessary conflict, and takes advantage of the opportunities that exist to attract more capital.”

In other words, the U. S. must engage with China in moving forward. It cannot get bogged down in “short-term” thinking, thinking that will take the United States out of the game and vacate the playing field. I believe that this would not be good for the U. S. and it would also not be good for China, in the longer run.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Comments

[greedyfellow]

@John M. Mason

I read the rest of the Ruchir Sharma article the author linked above. It says foreign ownership of US debt went from 50% of outstanding debt to 67% this year. He says an IMF study identified 50% as the point at which crises start.

This can only result in either higher Treasury rates as foreigners exit Treasuries, or several more trillions of dollars of money-printing by the Fed to hold down Treasury yields.

Have to agree with the author that the denouement will come from the currency markets as the Fed prints several more trillion and the dollar keeps going down. The Fed's "deputy director for financial stability" has called for another $3 trillion of QE.

Meanwhile the yuan is strongest in 27 years as China's economy booms, exports and trade surpluses keep reaching new records every month.

[greedyfellow]

@John M. Mason

China doesn't deceive its own people unlike Western central bankers/politicians:

www.bloomberg.com/...

The unrelenting pace of inflows heading for China’s bonds and stocks has one yuan bull predicting the currency could strengthen to a level not seen in nearly three decades.

The yuan has been on a tear since late May,.... Overseas funds have increased their holdings of onshore bonds and stocks by more than 30% this year to records,

[David/David]

In 1930, the Fed and the Bank of England undertook a collaboration to return the UK to the gold standard. The thinking was that absent doing so would condemn the UK to second class citizenship in the world economy. The elite of both countries were convinced of it (much as the leaders of the US were convinced that the solution to the crash and economic decline of 1929-30 was tariffs and tight money, turning a moderate recession into the Great Depression and leading to WW2 and all that went with it). In the process, they managed to consume sufficient wealth from the UK that its second class citizenship was guaranteed. It has never recovered.

Conventional wisdom suggests that Germany should never have recovered from the war with the speed that it did. Maybe conventional teachings aren't always correct?

[greedyfellow]

Jim Rogers in last week's Barrons interview on what happened to the UK:

www.barrons.com/...

"A year ago at this time, America was the largest debtor nation in the history of the world. That debt is now up by trillions of dollars—that’s trillions with a T...

That’s what happened to the U.K. The U.K. was the richest, most powerful nation in the world in the 1920s, and then took the path of “it doesn’t matter, we’ll spend all we want.” Fifty years later, the IMF had to fly into Heathrow and bail them out. They were bankrupt. So, I am afraid of what I see."

[Algorithmic]

@John M. Mason IMHO when you look around the world, you have to ask yourself, maybe the world will be better off with China. In case you havn't noticed, the world is looking pretty grim.

The only looser in that scenario, may be....

[greedyfellow]

@John M. Mason

It occurred to me the three types of institutions whose wealth the Fed transferred towards the Federal Government's borrowing power, have no interest in announcing their misfortune:

1. Banks: a bank run can become self-fulfilling if you reveal that the record low net interest margin and record forbearances will bankrupt you.

2. Insurance companies: if you announce the yield you are earning on your float won't be enough for future liabilities, you will lose customers and counterparties right away.

3. Pension funds: since the managers of state pension funds are chosen by politicians, they have no interest in announcing that the state is in trouble (until after the next election).

The Federal Reserve cannot create wealth, all it can do is transfer it across institutions and across time.

The Federal Government has been able to pay interest on $27 trillion of debt, precisely because the wealth of bank depositors, insurance companies and pension funds (and their taxpayers) are being raided by the Federal Reserve silently but steadily for 12 years.

[cgougeon]

Wow, interesting summary, @greedyfellow. Well put.

[dougkitchen]

Our status in the world will continue to erode as long as we continue running current account deficits. The Chinese understand, all they have to do is stay on coarse while our friendly bankers sell out the future prosperity of Americans.

[xpan]

The trust has been lost. We promised the world to unwind the QE we implemented during the financial crisis, which the Fed started doing so and actually unwound about $400B. Then came a new president, and all of a sudden the Fed balance sheet ballooned. Now the financial crisis looks like nothing.

We badly need to rebuild the trust. Unfortunately, it's so much easier to destroy things than building things.

[mkarpoff]

Same thing people said when Obama sent the debt through the roof. Don't forget, congress played its role in both cases. There is a lot of blame to go around, but there are good counter-arguments that both presidents had to do what they did. If you condemn one, you must condemn the other.

[cgougeon]

Yep, seems to be the one thing both parties agree on. More QE, don't worry about the balance sheet. There will be no consequences.

[User 150320]

The budget deficit for the first two months of fiscal 2021: $429.3 billion ($886.5 minus $457.2). "Defense" spending at $128 billion ($2.1 billion per day) consumed twenty-eight cents of each dollar in tax revenues. Ponder that. The military junta remains firmly in control, everything else is just pretense. China wins without even trying.