How China is Deleveraging from the USD (FREEPOM)

Economics, FREEPOM, Multilateral Investment Strategies19 Comments

By JC Collins

On December 29, 2015, in the post The Myth of China Dumping US Dollars, I wrote the following in regards to the past accumulation of USD by the People’s Bank of China:

“The PBoC continues to keep the renminbi weak against the dollar for the purpose of purchasing US dollars which are accumulated by Chinese business and exporters.  The People’s Bank of China borrows renminbi in order to purchase these dollars.”

“Once purchased, the PBoC cannot sell renminbi as it would be inflationary. Same as the US with dollars.  In order to prevent excess inflation, the PBoC issues new debt and raises the required reserve ratio of capital held by Chinese banks.  This has led to the increase of domestic debt within China.”

This increase of domestic debt amounts to the large printing of renminbi which was used to purchase US dollars.  This is in essence the forming of a bubble within China.  This bubble debt was used to further modernize the country and build infrastructure and “ghost cities” which will be used to house a growing middle class as China migrates 100 million of its rural population into these cities between now and 2020.

The POM article continues:

“The effect of all this is that the PBoC owes renminbi which it sold at low valuations, based on the exchange rate, and owns dollars at high valuations, based on the same exchange rate.”

The article further explains why China could not simply “dump” US dollars as a method of financial warfare on the United States.  That is the most misunderstood part of the China/America dynamic.  The People’s Bank of China prints/borrows RMB to purchase the dollars which have accumulated in its foreign exchange reserves.

In order to reduce these USD denominated reserves, the PBoC has to sell USD from its foreign exchange reserves to buyback RMB from circulation.  As the Federal Reserve increases interest rates, the demand for dollars increases, at least initially, and it is expected that RMB will depreciate as investors fear a capital flight from China, or other emerging markets.

In the post Renminbi Internationalization, Interest Rate Increases, Market Volatility, and the POM Analysis we review in more detail how this dynamic will play out.  From the post:

“China, and the rest of the world for the most part, will have to weather the initial financial storm from the Fed’s first rate increase.  It appears now that things are beginning to settle down somewhat after a week of market turmoil.”

“In fact, the PBoC is now announcing that they are going to implement further interest rate liberalization, increase renminbi internationalization, and make further changes to the exchange rate management structure of the renminbi.  This is exactly what has been discussed here on POM.”

This fits with the POM thesis that there will be a push and pull of Fed rate increases and renminbi internationalization, both of which will work towards balancing the international monetary system.  What so many fail to recognize is that this push and pull, or waxing and waning of volatility, is purposeful and by design.

One of the tools used by the PBoC is the circuit breaker mechanism which is meant to halt trading if the Chinese equities market begins to drop too fast.  This breaker was utilized a few times last week to prevent capital flight and manage the deleveraging of RMB debt.  Keep in mind that this debt is based on the accumulation of dollars, as defined above.

It is assumed that investors are losing faith in China.  That is a simple way of explaining the process.  Investor reactions are well strategized and measures to address the emotion based herd mentality of investors are designed and implemented at timed intervals.

The “breaker” mechanism described above is one strategy.  Another is the slow and gradual internationalization and liberalization of the renminbi to pace the frequency of interest rate increases by the Federal Reserve.

It is always possible that American strategists could attempt to play with this pacing and sequencing in attempts to further weaken China’s domestic financial market.  It is also probable that China is aware of this and has placed its own not-so-obvious mechanisms to prevent a larger volume of capital flight than would be expected.

It is estimated that China’s foreign exchange reserves dropped by just over $500 billion in 2015.  The current level of foreign reserves now stand at $3.3 trillion.  It would be my conclusion that Chinese authorities are “deleveraging” these reserves down to the $300 billion range over the next two to three years.  This will take place, as described above, through RMB internationalization, and the selling of USD reserves for RMB.

It is also important to understand that the RMB internationalization, being the increase of renminbi denominated financial products offered to foreign banks and institutions, will help offset the domestic influx of renminbi.  This will reduce the chances of unwanted inflation and facilitate the coming appreciation of the Chinese currency.

Readers can also reference the POM post titled Renminbi Demand is about to Explode, which covers the AIIB and BRICS Development Bank.  Both institutions will be giving development loans denominated in RMB beginning around the mid-point of 2016.

The complexity of this monetary and financial waltz can be frustrating and confusing when so many analysts and commentators produce articles which do not take into account the multilateral monetary transition, and the need to balance the international system.

The dollars which China is selling for RMB will eventually make their way back into America’s domestic financial markets.  The slow and prudent pace of this deleveraging will not cause the collapse of the USD which many have predicted.  But it will facilitate a gradual depreciation of the USD.

As stated, no massive “dumping” of USD by China can happen as it would have negative effects on both countries.  Probably more so on China, as its newborn offshore renminbi market would be unable to absorb that amount of USD deleveraging, and the domestic onshore market would be flooded with RMB and cause series inflation issues.

As most POM readers know, a depreciation of the USD is desired by the United States, as it will decrease the cost of American made goods and help increase exports.  This increase in exports will see an expansion of jobs in America and help adjust the debt-to-GDP ratio.  This is the origins of Trumps “Make America Great Again” meme.

The bigger pieces begin to come into focus.

Let’s recap and add a few other dynamics.

China’s accumulation of USD will slow and eventually reverse.  In essence, it already has.  This reversal of reserve accumulation by the PBoC will be supported by the broader internationalization of the renminbi.  The internationalization of the renminbi has been supported by its inclusion into the Special Drawing Right basket of currencies held by the International Monetary Fund.

This means more central banks around the world will begin accumulating RMB in their foreign exchange reserves.  This diversification away from USD denominated reserves will help balance the international monetary framework.

The international demand for RMB will be supported by some commodities trading being denominated in renminbi (see POM post China’s New Crude Benchmark) and derivatives priced in renminbi.  A wide array of additional RMB denominated financial products will also be developed, such as the loans through the Asian Infrastructure Development Bank and BRICS New Development Bank.

The RMB currently has three distinct markets.  The onshore renminbi market (CNY) operates separately from the offshore renminbi market (CNH).  Both have different valuations but will eventually converge into one as the offshore liquidity grows with the RMB internationalization.

The offshore RMB had its largest one day appreciation ever just a few days ago.  The fact that this came in the midst of serve market turmoil and volatility is a testament to this thesis.

The third market is the NDF, or Non-Deliverable Forward Market.  This market has been used to allow foreign investors to take a position on the RMB.  This market will wane as the offshore (CNH) market grows and converges with the onshore (CNY).

The consolidation, or convergence, of these RMB markets will also be gradual and will pace the sequencing of Fed rate increases and renminbi internationalization.

The RMB may still feel downward pressure in the months to come as the early phases of this process complete.  Eventually the internationalization of the renminbi and the reversal of USD accumulation will force a depreciation of the USD.  Further deleveraging and price-clearing of the USD based renminbi debt will eventually find a floor and the Chinese currency will begin an upward trajectory.

How long this takes will be influenced by many factors.  Some which include the ability of American and Chinese authorities to manage the transition pieces and maintain a slow deflating of the USD denominated bubble without undermining each other’s positions.  Something which is detrimental to both.

The trend which can be determined from the above scenario is a gradual depreciation of the US dollar against the currencies of its largest trading partners.  This also means an appreciation of the renminbi.

The recent collapse in crude and other commodities will be reversed as renminbi denominated development loans spur massive infrastructure development in emerging markets such as India, Malaysia, Thailand, etc..  It is estimated that Asia alone will require $8 trillion worth of infrastructure development over the next ten years.  This trend bodes well for both the renminbi and commodities.  – JC

Also see post The Coming Commodities Boom – Redux and China Just Ended the Dollar Peg – For the Most Part.

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19 Comments on “How China is Deleveraging from the USD (FREEPOM)”

  1. JC- thanks for sharing this.

    Question- you seem to be advocating for a relatively stable transition from a unilateral to a multi-lateral monetary system where the RMB plays a bigger part.

    However, does all of the outstanding accumulated debt affect this transition from occurring in a peaceful manner? US public debt has gone parabolic, increasing from ~$8T before 2008 to ~$18T currently. This does not include the present value of Medicare, Medicaid, SS, etc. which is over $80T.

    The last time the US ran a budget surplus was 1969, and this was for about $30Bn. We do not appear to have a true surplus since then. Raising interest rates by 1% results in an annual debt service expense increase of about $300Bn. Therefore, it does not appear likely the US can ever payback its debt?

    China also has increased their public debt from ~$8T in 2008 to ~$32T currently. Unlike the US debt, however, most of this debt is owed within its system. However, it appears more likely that this debt will be defaulted/ forgiven, rather than paid back?

    My question is- how does this transition occur with debt loads this great? It it possible to have a peaceful transition with all of this debt default looming?

    Thanks,

    Rob L (POM subscriber)

    1. Rob, there will be some volatility for sure. Even some bankruptcies and defaults. Sovereign debt restructuring will become a bigger topic in the months and years to come. But I would think it will relate more to 2nd tier players.

      When it comes to the US debt, it doesn't need to be paid off. That's not the point of the debt. It's all about debt management. In that regard, today the American debt-to-GDP ratio is around 104%. After WW2 it was over 140%. With a depreciation of the dollar, and an increase in exports, equating to domestic job growth, the debt-to-GDP ratio should adjust accordingly. Remember, there is a reason China has invested so heavily in US factories, banks, etc..

      On the geopolitical front, we are seeing the balance of power shifting, just like the reserve accumulation. I do not see a major war, but I can see the possibility of regional wars between proxy players, such as Iran and Saudi Arabia. All the big players want this monetary transition to happen. It is likely this will be enough leverage to keep a lid on big war.

  2. A great post JC and accompanied with a wonderful SOUA last night that has parts that are so.....POM! Here are a couple extracts from the State of the Union Address last night.

    "We live in a time of extraordinary change – change that’s reshaping the way we live, the way we work, our planet and our place in the world."

    "We did not, in the words of Lincoln, adhere to the “dogmas of the quiet past.” Instead we thought anew, and acted anew."

    "Anyone claiming that America’s economy is in decline is peddling fiction. What is true – and the reason that a lot of Americans feel anxious – is that the economy has been changing in profound ways, changes that started long before the Great Recession hit and haven’t let up."

    Here is the entire SOUA from the White House as prepared for delivery.

    https://www.whitehouse.gov/the-press-office/2016/01/12/remarks-president-barack-obama-%E2%80%93-prepared-delivery-state-union-address

  3. Along with thoughts on the SOUA is the fact that the audit the FED bill failed to gain enough support among legislators. I suspect that even if there is wrong doing on the part of the FED it would be too detrimental to the economy and the stability of the world to unveil now.

    I would also like to state the President is a puppet controlled by Wall Street and what he has to say is double talk. The words have two meanings and what seems like positive affirmations are also declaring our enslavement if left unrestrained. I would guess that just like no one listens to main stream media these days no one is really listening to the President anymore. What's his rating approval less then forty something percent?

    1. With only 2 terms I am not surprised you have to kow tow to institutions that have been around 10 times that in order to try and get things done. I mean what's 2 terms at the moment - the average time of one boom , bust cycle?

  4. I have read some comments where Big Oil Companys are complaining about low oil prices which are damaging profits.

    Do you think JC, that it is a hegelian argument for justify possible takes over o mergers in a near future among the seven ó eight big west oil companys, given that prices have some room be lower? It seems....so, at least to me.

    Best Regards.

  5. JC I understand there is as many as a billion naked shorted, counterfeit shares being sold into the US market DAILY!
    This has being happening daily for a very long time so the accumulation has got to be in the trillions
    How does this mess get cleaned up, any thoughts?
    GW

    1. First I understand about investing in gold in a stable environment, however volatile, but stable. But I have never understood how people think that gold will get them out of an unstable environment unless you have grown up and forged a controlling stake in such an environment ie criminal underworld. I have been in some tight situations when doing any trade in some parts of Africa and gold would not have always been the strongest currency. I say this only to remind you that all systems need balancing and if you look at anything long enough it all begins to sparkle... Precioussss:-) . Tony read JCs free epublication re engineering the dollar for a more balanced view on the pom analysis. There he offers a few alternatives one in which even gold plays apart.

      1. Greetings Peter;
        I think I can understand what you are saying...
        BUT, on the other hand there has to be some subliminal reason
        why China is buying up & hoarding so much gold...
        The Shanghai Gold Exchange supposedly processed for sale over
        2500 tonnes of gold last year...That's more gold than the free world produced, as China does not export any gold [while being the largest producer of gold]...
        I don't know the reason for them doing it...
        ""BUT"" I'm sure we'll know at some point in the near future..

        Tony

        1. Hi Tony
          Thanks for understanding I'm quite a simpleton when it comes to all these things but I'm determined to learn. I'm not sure why your here exactly , perhaps looking for answers like the rest of us. Did you read re engineering the dollar eBook by JC.

          Also I found this article http://dailyreckoning.com/u-s-helping-china-accumulate-gold/

          I prefer the POM analysis though as it others more thorough descriptions. I'm still working my way through the archives they are pretty good you should try them.

          Peter

      1. Hi JC,
        I would also like to know about investing in the SDRF program but it seems the website only brings up information about courses and not any of the investment information that you wrote about in your blog.

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