The China Disequilibria (or why the PBoC is really reducing Treasury Reserves)

Economics, Premium POM

The Coming Floating Exchange Rate Arrangements & Reserve Reductions

By JC Collins

On the morning of November 7, 2009, finance ministers and central bank governors of the G20 countries gathered at the seaside Fairmont resort in St. Andrews, Scotland.  The main topic of discussion was the ongoing financial crisis which began back in 2007.  Though it could be argued that it began during the Asian crisis of 1997 and 1998.

The crisis itself was the result of unsustainable and systemic current account imbalances between the major economies, as well as a failure of integrating the emerging economies into the global economy.  The commitment made at the G20 meeting involved rebalancing the international monetary system (IMS) by reducing account surpluses and limiting account deficits.

To fully understand how this can be accomplished, it is important to understand exactly what the IMS is, and how it functions. The IMS is the relationship between domestic economies at a macro level. There are three main components, or operating functions, of the IMS.  They are:

  1. Exchange Rate Arrangements
  2. Capital Flows
  3. Institutions, rules, and conventions which govern its operation.

The domestic policies of individual countries are superseded by the macro-prudential policies of the larger monetary framework.

The world has functioned under a unipolar USD based monetary framework for the last seven decades, which has caused the large account deficits developed by the United States, and the large account surplus developed by China, and to a lesser extent, other emerging economies.

Rebalancing the monetary system will require changes in the geographic distribution of economic and political power, as well as the global integration of goods and assets markets.  The power shifts, and transitions, which will, and have been taking place, are reflective of the overarching strategy of addressing the disequilibria which has developed in the international monetary system since the end of World War Two.

Integrating one third of humanity, being the emerging economies, such as BRICS, into the global economy would have strained the framework of the existing USD based system.  The adjustment mechanisms of this system would not have been able to cope with the overwhelming surpluses and deficits which would have continued to develop if the system could not be changed to a more multilateral framework.

The main components of addressing and correcting the imbalances is found in the limiting and reducing of account surpluses.  The recent moves by China to reduce their US Treasury holdings is nothing more than the real world application of what was decided back at the Fairmont in November of 2009.  Countries with trade account surpluses must reduce those surpluses through various methods.

Countries with trade account deficits must either deflate or reduce the accumulation of their currency as reserves elsewhere.  This is in fact what we are beginning to witness.

The other component of this rebalancing is found in the development and implementation of flexible exchange rates, which will help provide more symmetric adjustments to the disequilibria.  Nominal exchange rate movements will help restore external balances and lead to the development of a real world floating exchange rate arrangement.

Such a floating arrangement will create liquid foreign exchange markets, which will in turn reduce the need for countries to hold reserves in the first place.  This will minimize the account surpluses and deficits by forcing the required adjustments.

The recent moves by the US and China are building towards the realization of these multilateral adjustments.  A strengthening dollar will serve to shatter the existing exchange rate arrangements which are based on the USD.  The reduction of USD denominated reserves are moves to rebalance the IMS, and not the moves by China to punish the United States.  Such statements and conclusions are symptomatic of a lack of understanding about how the monetary system actually functions.

We are in the early stages of this rebalancing and multilateral transition.  The overall process itself will unlikely be televised or communicated to the masses.  Fortunately readers of POM will pick up on the transition points and have a much better understanding of what is happening.

This will take many years and there will be volatility.  At some point the IMS will pass the fulcrum and rebalancing will begin to cause stability as opposed to the initial instability.  Reserves which will be required at this point could very well be denominated in the supra-sovereign reserve asset which will be a product of changes to the SDR.

With every piece the picture becomes clearer.  – JC