Sunday, September 1, 2019

China's Currency Problem Is Worse Than It Appears

China's currency woes are worse than many people think and this is putting the yuan under pressure. When people point to China's large holdings of U.S. Treasuries as proof of China's solvency they frequently discount the amount of debt that has grown in the Chinese system. It is true the Chinese own a lot of U.S. debt, $1.123 trillion as of December 2018. Together Japan and China own about ten percent of  the U.S. debt, 5.1%, and 4.7% respectively. Japanese-owned debt doesn't receive nearly as much negative attention because Japan is seen as a friendlier nation and the Japanese economy appears more stable. While many Americans tout that China has us by the throat it is not true. Considering how rapidly debt and credit have increased over the years, it could be argued that a trillion dollars of debt is not nearly as relevant as it was a decade ago.
China Only Holds A Small Percentage Of US Debt

The main reason China bought up so many U.S. Treasuries over the years is that it wanted its currency pegged to the dollar. Dollar-pegging adds stability to the yuan since the dollar is viewed as one of the safest currencies in the world. This has been a common practice for many countries since the 1944 Bretton Woods Conference. Still, even though China owns these U.S. Treasuries, China is running a massive U.S. dollar shortage both on a corporate and a national level. Much of the problem stems from Chinese companies having roughly $2 trillion U.S. dollar-denominated debt owed to international investors.

Loans of this type are not uncommon, especially in developing nations. Much of global debt is denominated in U.S. dollars. This means the companies owing it need to pay both the principal and the interest payments to their lenders in U.S. dollars. This results in a demand for dollars and usually a constant flow of dollars out of the country. This is a totally separate issue from individuals or companies shifting wealth out of China to avoid the pain of currency devaluation or to escape its repressive regime. An article titled; China Continues To Prop Up Its "Unpropable" Economy, delves into how China continues to prop up a financial collapse and how China suffers under crushing debt. It contends due to the huge amount of debt China's demise can only be postponed but not stopped.

China's Debt Soared After 2008 (click to enlarge)
It expands on the proposition that since the 2008 financial crisis Chinese bank assets, and by implication liabilities, have exploded by an astounding $15 trillion, bringing the total to over $24 trillion. In other words, China has expanded its financial balance sheet by 50% more than the assets of all global central banks combined. This means that China's debt is now creating instability and has become the biggest wildcard in the global financial system. Continuing along this "one-way path," in January of 2019, Beijing injected a staggering $685 billion in new credit into its financial system. This injection was greater than the GDP of Taiwan the world's 21st largest country. 

Many of us are drawn to a good illusion and in some ways, it could be said that our culture has become obsessed with avoiding what is real. With this in mind, we must remember that politicians and those in power tend to go to extreme efforts to avoid taking responsibility for the problems they create and this has been done in China. History shows that one way a country can kick their gross domestic product higher is to build a false economy based on infrastructure or war. China's version of this is apparent in its "ghost cities." Unfortunately, when a country gorges at the trough of deficit spending that generates a big temporary boost in its GDP it also creates a wall of debt. One of the best examples of building an economy on such a foundation was demonstrated by Germany when it turned its economy into a war machine during the 1930s.

To understand the ramifications of the situation China now finds itself in we need only look at the finding of the 2009 bestselling book titled, "This Time Is Different." The book written in 2009 by Carmen Reinhart and Kenneth Rogoff. It chronicles eight centuries of financial follies in which financial meltdowns have typically followed real-estate bubbles, rising indebtedness, and gaping deficits. Their work adds credence to the belief that debt has consequences. The authors highlight a clear pattern of similarity between many of the defaults that have occurred throughout history and the situation developing today. Debt has been growing at an incredible rate across the globe but even more in China.

For years as they debate the true strength and sustainability of China's economy and its role as a global player has been debated by China watchers, economists, and investors. Those of us that paint a picture of future collapse and a day of reckoning are often accused of spreading "doom-porn" when we claim that the Chinese have masked over their dire situation by continually expanding credit. It is important to note that over the years each new wave of money has begun to lose its impact as the efficiency of stimulus waned and more and more of the credit was absorbed in supporting existing debt. The fact is few good investment opportunities currently exist in China and this causes much of the newly printed money to leak across the border inflating asset bubbles in other countries.

 China's Yuan Is A Small Player (click to enlarge)
Much of what is occurring in global currency markets has been "scrubbed away" by our complex financial system that tends to soften the edges of harsh moves obscuring their importance. Many people think things move and unfold in a logical way but  we should also consider the possibility the currency market is a manipulated scheme by central banks to create the illusion of stability. For a long time, I have maintained the view that currencies are trading in a false paradigm created by the coordinated collusion of the major central banks to limit currency volatility. The central banks know the collapse of any one of the world's four major reserve currencies would shatter the myth that the major currencies of today are immune to the fate that has haunted currencies throughout history.

In our modern global economy, a huge percentage of our wealth is contained within the rather closed system of fiat money. The laws and rules governing this system by their nature discourage freedom of movement into tangible assets. History shows that when the nations granting a currency have proven unable to control their budgets and are crushed under the weight of debt bad things happen. This situation frequently results in inflation. A key reason inflation has remained so low since 2008 is because people have been willing to store their wealth in paper instruments. The good people of countries like Argentina, Venezuela, Iran. and Turkey that held on to their country's currency have been financially raped as the currencies have fallen in value. Today they are far less wealthy compared to people in countries that have seen their currencies remain stable.

The rubber will meet the road as more countries that export to China question the value of the Chinese currency and demand payment in dollars and refuse the yuan. While China enjoys a trade surplus with America this is used to support trade deficits with many other nations. If at some point China decides to or is forced to sell its FX reserves to get access to U.S. dollars to help prop up systemically important firms it becomes a bit of a self-defeating exercise. When a currency implodes or fails, wealth is transferred from those improperly invested to survive such an event to those positioned to benefit. The canary in the coal mine portending of such an event may be the stories we hear of central banks and countries buying gold. In the future investors would be wise to prepare for a rude awakening due to a huge shift in the values of currencies.

Footnote; A recent article by on The Sounding Line delves into the idea the Chinese stimulus is not working anymore. The link to that article can be found below.


  1. In the middle of reading this book, which is relevant to this blog article. As well as debt, there a few other things that make for severe headwinds , in regards to China.
    I'd suggest that the result of all this will be a reversal of the Global deflationary force ( cheap goods ) that China once was.
    This will add to the inflationary force of people losing confidence in fiat currencies.... in my view

    ps.. Advancing time is one of my favorite blogs

  2. roelof, Thanks for the comment and kudos!

    Because of my disdain for Amazon I must remind readers this book is also available at Barnes and Noble. Again I must say, Boycott Amazon!

  3. Exactly, China is in between the proverbial rock and hard place. Devaluing the yuan has recently been used as a trade war tactic but they can't keep that up for long. The HK situation bears watching because HK is so important for China's access to foreign currency. Nobody wants yuan, and I think the bilateral yuan-swap agreements China has made with various countries like Brazil and Russia are merely for convenience and not any serious play against the dollar, even though it's tempting for some to spin it that way. Russia's import trade with China may justify it, but there is so much dollar denominated debt globally that yuan deals can be only marginal.

  4. Again today we are seeing the PBOC prop up the market by cutting the required reserve ratio (RRR) for all banks by 0.5% effective Sept. 16th. They also cut reserves by 1% for some city commercial banks. The move will release about 900 billion yuan or around $126 billion of liquidity into the economy.

  5. Pretty good article making the point that China is the proverbial "paper tiger." Trump's trade war with China will help hasten their demise and maybe return some manufacturing to the US. That seems to be the plan, anyway.

  6. This article ties in to a more recent one focused on currencies seeming to be locked in a narrow trading range. This could be another indication that Central Bank manipulation has gone nuclear. The dollar's strength is largely a result of many countries having adopted even worse policies than those America's leaders have chosen to pursue.

    A strengthening dollar sends a signal that the global economy is unstable which is something central banks want to avoid at all costs. This may account for why central banks all seem to be marching in lockstep as they take turns injecting more liquidity into the system.

    The important part of this theory that central banks have rigged the currency markets is based on the idea several currencies are moving closer to failure. More on this subject in the article below,

    https://Dollar Locked In Narrow Trading Range To Avoid Crisis.html

  7. How can China PBOC print trillions Yuan without Inflation ? How can Japan print trillions Yen without inflation ? Have they found perpetual properity formula or kicking the can down the road ?