Currency Wars by James Rickards PART 3

Posted by admin_akashic on Aug 7th, 2021 in Space

Beijing

What is most striking about Chinese history is how often and how suddenly it has swerved from order to chaos through the millennia. Despite the appearance of economic dynamism in China today, sudden collapse is entirely possible and could be caused by things such as inflation, rising unemployment, ethnic tensions or a burst housing bubble. Prolonged and widespread unemployment is potentially more destabilizing in China than in the more developed economies, especially when combined with lost upward mobility for tens of millions more citizens.

In addition to normal population stresses, China is sitting on a demographic powder keg in the form of twenty-four million “excess males”—the result of the murder of newborn girls through infanticide and sex-selective abortion under China’s one-child policy. Many are now in their early twenties. It is a sad fact that single, unemployed men in their early twenties are often associated with forms of antisocial behavior, including gangs, murder, drugs and alcohol.

Internal social instability caused by the excess population of single men along with food price inflation and mass unemployment is a greater threat in the eyes of Chinese rulers than the U.S. military. This instability can be smoothed over in part through infrastructure investments that create jobs, which China depends on its currency reserves to finance. What happens when the United States devalues those reserves through inflation? While inflation may make sense to U.S. policy makers, the resulting wealth transfer from China to the United States is viewed as an existential threat by the Chinese. Maintaining the real value of its reserves is one of China’s keys to maintaining internal social control. The Chinese are warning the United States that they will not tolerate dollar inflation and will take countermeasures to prevent a loss of wealth. The U.S.-Chinese currency war is just getting started, and the Fed’s quantitative easing makes it entirely plausible to say the United States fired the first shot.

The clearest exposition of Chinese thinking on financial warfare is an essay called “The War God’s Face Has Become Indistinct,” included in a book on unrestricted warfare written in 1999 by Colonels Qiao Liang and Wang Xiangsui of the People’s Liberation Army. One passage in particular is worth quoting at length:

Financial warfare has now officially come to war’s center stage—a stage that for thousands of years has been occupied only by soldiers and weapons…. We believe that before long, “financial warfare” will undoubtedly be an entry in the . . . dictionaries of official military jargon. Moreover, when people revise the history books on twentieth- century warfare . . . the section on financial warfare will command the reader’s utmost attention…. Today, when nuclear weapons have already become frightening mantelpiece decorations that are losing their real operational value . . . financial war has become a “hyperstrategic” weapon that is attracting the attention of the world. This is because financial war is easily manipulated and allows for concealed actions, and is also highly destructive.

Consideration of such military doctrine suggests that the future of geopolitics might not be the benign multilateral ethos of Davos Man but a rather more dark and dystopian world of resource scarcity, infrastructure collapse, mercantilism and default. China’s call to replace the U.S. dollar as the global reserve currency, routinely dismissed by bien-pensant global elites, might be taken more seriously if they were as familiar with Chinese financial warfare strategy as with Keynesian theory.

China’s main link with the global financial system is the U.S. government bond market. China may be history’s oldest civilization and a rising superpower, but on Wall Street it is more likely to be viewed as the best customer in the world. When China needs to buy or sell U.S. Treasury bonds for its reserves, it does so through the network of primary dealers. Large customers like China prefer to trade with primary dealers because their privileged relationship with the Fed gives them the best information about market conditions. Relationships are the key to knowing what is really going on in markets, and China taps into those relationships.

When China calls a bank dealer, the call never goes to voice mail. Direct lines are installed from China’s central bank and sovereign wealth funds to arena-sized trading floors at UBS, J. P. Morgan, Goldman Sachs and other major banks. A salesperson knows China is on the line before she picks up the phone. Code names are used so the salesperson and trader can engage in market-making conversations safe from eavesdropping. When China wants to trade U.S. bonds, it typically calls several dealers at once and makes dealers compete for the business. China expects—and gets—the best bids on its bond sales in exchange for the massive volume of business it provides.

Figures on China’s purchases of U.S. Treasury bonds are difficult to ascertain because China is nontransparent about its holdings. Not every dollar-denominated bond is issued by the U.S. government and not every government security is issued by the Treasury. Many U.S. government securities are issued by Fannie Mae, Freddie Mac and other agencies, and China holds some dollar-denominated bonds issued by banks and others not part of the U.S. government. There is no doubt, however, that the vast majority of China’s dollar holdings are in U.S. Treasury bonds, notes and bills. Official U.S. figures put Chinese holdings of Treasury securities in excess of one trillion dollars, but when government agency securities from Fannie Mae and Freddie Mac are taken into account, the dollar-denominated government securities total is much higher.

China’s great fear is that the United States will devalue its currency through inflation and destroy the value of these Chinese holdings of U.S. debt. There has been much speculation that China, in retaliation for U.S. inflation, could dump its one trillion dollars of U.S. Treasury securities in a highly visible fire sale that would cause U.S. interest rates to skyrocket and the dollar to collapse on foreign exchange markets. This would result in higher mortgage costs and lower home prices in the United States, as well as other major financial dislocations. The fear is also that China could use this financial leverage to sway U.S. policy in areas from Taiwan to North Korea to quantitative easing.

These fears are dismissed by most observers. They say that China would never dump its Treasury securities because it has far too many of them. The Treasury market is deep, but not that deep, and the price of Treasuries would collapse long before more than a small fraction of China’s bonds could be sold. Many of the resulting losses would fall on the Chinese themselves. In effect, dumping Treasuries would mean economic suicide for the Chinese.

This easy logic ignores other things the Chinese can do that are just as damaging to the United States and far less costly to the Chinese. Treasury securities are sold in many maturities, ranging from thirty days to thirty years. The Chinese could shift the mix of their Treasury holdings from longer to shorter maturities without selling a single bond and without reducing their total holdings. As each long-term note matures, China could reinvest in three- month instruments without reducing its total investment in Treasuries. These shorter maturities are less volatile, meaning the Chinese would be less vulnerable to market shocks. This shift would also make the Chinese portfolio more liquid, vastly facilitating a full Chinese exit from Treasury securities. The Chinese would not have to dump anything but merely wait the six months or so it takes the new notes to mature. The effect is like shortening the time on a detonator.

In addition, the Chinese are aggressively diversifying their cash reserve positions away from dollar-denominated instruments of any kind. Again, this does not involve dumping and reinvesting by China, but simply deploying its new reserves in new directions. The Chinese earn several hundred billion dollars each year from their trade surplus. This is a massive amount of new money that needs to be invested alongside the reserves they already have. While existing reserves may remain mostly in U.S. Treasury debt, new reserves can be used in any way that makes sense to the Chinese.

Investment options in other currencies are limited. The Chinese can buy bonds in yen, euros and sterling issued by governments and banks outside the United States, but the choices are few—there simply aren’t enough of them. None of those other markets has the depth and quality of the U.S. Treasury market. But China’s choices are not limited to bonds. The other leading investment—and the one the Chinese now favor—is commodities.

Commodities include not only obvious things like gold, oil and copper, but also the stocks of mining companies that own commodities—an indirect way of owning the commodity itself—and agricultural land that can be used to grow commodities such as wheat, corn, sugar and coffee. Also included is the most valuable commodity of all—water. Special funds are being organized to buy exclusive rights to freshwater from deep lakes and glaciers in Patagonia. The Chinese can invest in those funds or buy freshwater sources outright.

These commodity investment programs are well under way. Most prominently, between 2004 and 2009 China secretly doubled its official holdings of gold. China used one of its sovereign wealth funds, the State Administration of Foreign Exchange (SAFE), to purchase gold covertly from dealers around the world. Since SAFE is not the same as the Chinese central bank, these purchases were off the books from the central bank’s perspective. In a single transaction in 2009, SAFE transferred its entire position of five hundred metric tons of gold to the central bank in a bookkeeping entry, after which it was announced to the world. China argues that the secrecy was needed to avoid running up the price of gold due to the adverse market impact that arises when there is a single large buyer in the market. This is a common problem. Nations usually deal with it by announcing long-term buying programs and giving themselves flexibility as to timing, so the market cannot take undue advantage of one buyer. In this case, China went beyond flexible timing and conducted a clandestine operation.

What other financial operations are being pursued in secret today? While the Chinese proceed on numerous fronts, the United States continues to take its dollar hegemony for granted. China’s posture toward the U.S. dollar is likely to become more aggressive as its reserve diversification becomes more advanced. China’s hard asset endgame is one more ticking time bomb for the dollar.