The China Puzzle

Economics, Premium POM10 Comments

Internationalizing the RMB and Prepping for End of the Dollar Peg

A new burger place opened just down the street and to be honest I can’t get it out of my mind. At some point I’m going to run over there and order a big juicy burger with bacon and cheese. Of course this would murder my intended diet and has absolutely nothing to do with this article, but it needed to be said. So there.

Momentum for the internationalization of the Chinese renminbi is hotter than a fast fry grill. The RMB, commonly referenced as the yuan, is being transformed to serve alongside the US dollar in the international monetary system. It will not replace the dollar. It will not become the new international currency. It is simply being expanded to help develop the multi-currency framework which will assist in the creation of an SDR infrastructure.

Most POM readers will have a working understanding of this process and be able to functionally explain the broad strokes. We should all feel encouraged that the real-world implementation of this strategy is unfolding as expected. Our patience and perseverance are beginning to pay off. It would appear that we all deserve a tasty burger.

A recent article from The Global Times confirms the complex Chinese puzzle which which has been defined in the POM thesis. It covers everything from an increase in trade services, to the internationalization of the renminbi, and of course the SDR and infrastructure projects across the Belt and Road Initiative:

“There are several points of view I’d like to share with regard to China’s trade and its monetary system.”

“First, in terms of dollar-denominated value, China’s total goods trade was $20 billion less than that of the US in 2016. But if the yuan’s depreciation against the dollar last year is factored in, China remained the largest goods trading nation. As such, when China’s trade volume reaches a certain level, the internationalization of the Chinese currency will be gradually achieved.”

“Second, China’s services trade has increased rapidly. In 2015, Chinese travellers made 120 million outbound trips, with outbound consumption totalling about 2 trillion yuan ($294 billion), including overseas Chinese students and various cultural cooperation activities. Against such a backdrop, I believe the yuan will naturally become internationally accepted, which should be in line with the laws of the market instead of being pushed by too much pressure.”

“Third, with the development of financial technology, including IT and mobile payment, there have been a lot of new business patterns and forms.”

“Fourth, the yuan’s inclusion in the IMF’s Special Drawing Rights basket requires further development of China’s financial market. In China’s financial market, the indirect financing sector, or the banking system, is too large. By the end of 2016, China’s banking sector was worth 145 trillion yuan, accounting for 70 percent of China’s financial system. China needs to strengthen its financial market construction to adapt to the internationalization of the yuan.”

“Chinese President Xi Jinping announced at the opening ceremony of the Belt and Road Forum on May 14 that China will step up financial support for the B&R initiative, including efforts from the China Development Bank (CDB) to set up a special lending plan worth 250 billion yuan to support B&R cooperation. It is through these projects that the CDB will promote cooperation between China and the rest of the world, also boosting exports of the yuan at the same time. For instance, during the Belt and Road Forum, the CDB granted a loan of $4.5 billion to a consortium of Indonesian and Chinese companies for building Indonesia’s first high-speed railway connecting Jakarta and Bandung, and this is also expected to facilitate the yuan’s internationalization to a certain extent. From the perspective of the CDB, we always adhere to promoting China in the world arena through an international approach.”

Cool, right!?

One of the major concerns for the monetary authorities in Beijing is the possibility of Western interests orchestrating some form of exchange rate attack on the RMB. The appreciation of the yuan can only happen when China completely ends the peg it maintains with the dollar. This peg is defined as the central parity rate between the USD and the RMB. This would need to end so the renminbi could free-float and realize upward valuation based on the rate of internationalization and stabilization.

It would not be against Western interests to encourage RMB internationalization while strategizing a method to keep the valuation down or cause a credit crisis in China. As such, China just implemented a fail-safe mechanism which will prevent or discourage “herd behaviour in the forex market”.

The mechanism is best explained in this article from the Asian Business news site East Day:

“China plans to change a formula for forming the yuan-US dollar central parity rate, a move to ensure stable exchange rates at a time when global financial markets remain beset by instability.”

“Under China’s market-based, managed floating exchange rate regime, the yuan can rise or fall by 2 percent against the dollar from the central parity rate each trading day.”

“The central parity rate is a weighted average of quotes from dealer banks, and follows a formula of the previous day’s closing rate and changes in a basket of currencies.”

“The new formula, announced last Friday by the China Foreign Exchange Trade System, will allow dealers to incorporate a “counter cyclical factor” into the existing formula.”

“In a statement, CFETS said China’s foreign exchange (forex) market was easily influenced by irrational expectations and “spurred by inertia, due to a certain level of “pro-cyclicality,” which distorts market demand and supply, and magnifies the risk of exchange rate over-correction.”

“The proposed adjustment aims to “appropriately hedge against the pro-cyclical fluctuation in market sentiment and alleviate the potential for herd behaviour in the forex market,” the statement said.”

“It added the “counter cyclical factor” would be adjusted in accordance to China’s economic performance, but it did not give further details about how and when the potential new formula would be used.”

“CICC analyst Chang Huili said the “counter cyclical factor” might be adjusted according to a number of economic indicators, particularly those concerning growth and inflation.”

“According to Commerzbank senior economist Asia Zhou Hao, “counter cyclical factor” could counteract the impact of the previous day’s excessive volatility by reducing the closing rate’s role in the next day’s central parity rate, and help to ensure the general stability of the yuan exchange rate.”
“CFETS noted on Friday that the yuan-dollar market exchange rates had recorded lower levels from the central parity rate, despite China’s improving economic fundamentals and a weakening US dollar.”

“According to CICC, the yuan has depreciated 2.7 percent this year against the CFETS basket, in contrast to the notable improvement in economic fundamentals this year.”

“The new formula will enable the yuan-dollar exchange rate movements to be more independent and better reflect the domestic economic fundamentals,” Chang Huili said.”

“The CICC analyst expects the yuan to be well supported by China’s economic fundamentals this year, saying a prolonged period of growth slowdown was unlikely.”

“The proposed formula change comes amid China’s efforts to push reform to the yuan’s exchange rate formation system to make the currency more market-oriented and internationally recognized.”

“Last October, the yuan joined the dollar, euro, pound and yen in the International Monetary Fund’s special drawing right (SDR) currency basket.”

“After joining the SDR basket, the yuan’s better reflection of domestic economic and financial performances has become an important precondition to help diversify global risk, and a solid foundation for the internationalization of the currency,” said Meng Xiangjuan, an analyst at Shenwan Hongyuan Securities.”

“Pan Gongsheng, deputy governor of the People’s Bank of China, said China’s efforts to seek a balance between making the yuan exchange rate more flexible and keeping it more stable is good for the global community, avoiding negative spillover effects from the yuan’s disorderly adjustment or competitive currency devaluations.”

Well, that’s certainly a mouthful of greasy burger. But once we decipher and understand what is being communicated above, we quickly see that both of the articles quoted are completely aligned with what we have been learning and reviewing now for years.

As an example, when it talks about making the yuan’s “exchange rate more flexible and keeping it stable”…which is “good for the global community”…we can interpret that to mean that the exchange rate arrangement with the USD will have to change and if managed correctly will help stabilize not just the Chinese currency itself, but will also help rebalance and stabilize and international monetary system.

The end goal is becoming more focused and multiple mandates are beginning to align across the financial and geopolitical battlegrounds. This transition will continue for years but at least we have an understanding of just what is going on.

The day will come when Trump, or someone in his administration, will shout the phrase Special Drawing Right. On that day we can all raise our burgers and allow the hot grease to run down the length of our arms. We will do this not because we agree with what is happening, but because we will know without doubt that the world can make sense if we just take the time and make the effort to understand it.

Once the puzzle is solved we eat! Did someone say double bacon cheese burger? – JC

This article is copyrighted by POM Media©2017. As Premium content permission is not given to be copied and re-posted.

JC Collins can be contacted at jcollins@philosophyofmetrics.com

10 Comments on “The China Puzzle”

  1. Thank you for providing the info I was looking for. Historic Times.

    “…a big juicy burger with bacon and cheese…has absolutely nothing to do with this article…”

    I beg to differ. You weaved it in to the article very nicely.

  2. An IMF working paper.

    “A Tie That Binds : Revisiting the Trilemma in Emerging Market Economies”

    “This paper examines the claim that exchange rate regimes are of little salience in the transmission of global financial conditions to domestic financial and macroeconomic conditions by focusing on a sample of about 40 emerging market countries over 1986–2013. Our findings show that exchange rate regimes do matter. Countries with fixed exchange rate regimes are more likely to experience financial vulnerabilities—faster domestic credit and house price growth, and increases in bank leverage—than those with relatively flexible regimes. The transmission of global financial shocks is likewise magnified under fixed exchange rate regimes relative to more flexible (though not necessarily fully flexible) regimes. We attribute this to both reduced monetary policy autonomy and a greater sensitivity of capital flows to changes in global conditions under fixed rate regimes.”

    http://www.imf.org/en/Publications/WP/Issues/2017/06/08/A-Tie-That-Binds-Revisiting-the-Trilemma-in-Emerging-Market-Economies-44942

  3. Really JC, really Dane, people talk like that and it makes sense to them?? Well of course it does. Not pickin on You Dane, but if I just took the first sentence out of your post, ‘The tie that binds.’ And spoke it aloud to 99% of people looking for a burger, they couldn’t make the proper change. That does not make you, JC or the people above your post short for their change. What I’m asking is, Huh??

    My best teacher instructed me, never get in the way, do not expect culture to slow down for you or you slow down the culture. You got to let that shit go, catch up where you can. Work, work, work, improve yourself, do not fear or shy away from ‘things’ you do not fully understand. Hang around them, some of that shit will begin to make sense to you if you do.

    So, where do you think China sat at the Bilderberg table this last week? It is my understanding they spoke last. One might interpret that to mean they were low man on the totem pole, Or they choose to speak last because they had the last word.

    JC, Dane, Carpi Diem, and all others on the fascinating site, why can’t they get the books to balance?? Is it because balanced books is the last thing they want? Is it because the struggle for balance is the ???
    PTM

    1. Hahaha. Your too funny Peter. I don’t hold a candlestick to JC and Carpe Diem but I thank you for…picking on me…lmao.

      I take “The tie that binds” to mean a pegged exchange rate to a single reserve currency. Maybe the bind could be the Triffin Paradox.

      And this part “Countries with fixed exchange rate regimes are more likely to experience financial vulnerabilities—faster domestic credit and house price growth, and increases in bank leverage—than those with relatively flexible regimes. The transmission of global financial shocks is likewise magnified under fixed exchange rate regimes relative to more flexible (though not necessarily fully flexible) regimes.” kind of echos what JC is saying in that it expresses the need to depeg and be more flexible for stability.

      This working paper focusses on the effects of the market fluxuations effects on emerging market economies.

      I get them sent to me by email and its kind of funny some times the subject matter reflects what JC writes about and they come in soon after he posts them.

      Can’t help you with the balance question. Hell, I walk around in circles all day :). Maybe the problem is they just don’t try. It’s always about balancing the budget not balancing the books. Management of debt as opposed to paying it down.

    2. Hi Pieter, Hi dane,

      I don’t know what this candlestick business is all about 🙂

      I am as always struggling with understanding anything to do with the economy, balancing books etc. To me, this is not too far from black magic and please consider me a confused student who fails at every exam on this subject.

      All I am left with is the POM and you guys as my mentors, please write more comments and share your thoughts and concerns. Thank you Pieter, and thank you dane for expanding on things.

  4. Thanks Dane, believe in or not your further explanation actually did help me see what the “The tie that binds” article is about. Also your last two sentences budget v books was very helpful. Thanks again!
    PTM

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