The Sovereign Debt Complex

Economics, Geopolitical, Premium POM42 Comments

How China and America Are Waging a Quiet War over Sovereign Debt Restructuring

By JC Collins

Note:  This large article of 2300 words is one of the most important pieces I’ve written on the multilateral transition, as it ties much of the previous material together to present the reader with a conclusive and realistic analysis of what is happening internationally, both economically and geopolitically.

The most pressing issuing facing the international monetary order today is the threat of sovereign debt defaults and the loss of confidence in sovereign bonds.  The sovereign debt crisis is growing at a brisk pace with most of the attention on Greece.  But many other countries could quickly slide into the limelight and steal the show.  Some of these countries are Spain, Italy, Ireland, and even the United States.

America could find itself in a situation where the world is no longer willing to finance its large account deficits and leave the reserve role of the USD without any international support.  There are many reasons why this would not happen, none more so than to avoid the loss of value on foreign assets which countries like China are heavily invested in.

Being the number one challenge facing the global financial framework, the determination can be made that all other issues, such as RMB internationalization and SDR composition, are sublets which will be required in order to facilitate an orderly and sustainable sovereign debt restructuring process.

The reform of international institutions, such as the IMF, are also a necessary component of addressing the treat of a sovereign debt crisis.  Governance reforms, such as the 2010 IMF Quota and Governance Reforms (2010QGR), are meant to more broadly recognize the emergence of developing countries, such as China and India.  The purpose is to give them a more balanced representation within the International Monetary Fund, leading to a sustainable process of sovereign debt restructuring.

There are two much discussed methods of sovereign debt restructuring.  One is called Collective Action Clauses (CAC), which is a more market oriented solution desired by private investors and some sovereigns, such as the United States and Japan.  The US would seek a market oriented solution such as CAC’s because of the market dominance of the dollar.  Emerging markets, like China, are concerned about the negative market effects of a CAC, based on increased costs and further currency debasement.

The other is the Sovereign Debt Restructuring Mechanism (SDRM), of the International Monetary Fund.  The SDRM, or a modified version of the SDRM, is a structural (non-market) solution to sovereign debt, which is desired by China, and other emerging economies. The obvious nature of the non-market structural changes involved with the SDRM process does not give the largest debtor nation, America, the ability to leverage the process against the needs of the developing countries which largely hold US debt, such as China.

With the United States supporting a market oriented CAC solution to sovereign debt, and China supporting a structural SDRM solution, the delays continue and the world is pushed closer to an all-out sovereign debt crisis with large economies getting closer to defaulting, such as Greece.

Both nations account for the largest borrower and lender sovereigns in the international monetary system.  China is on the extreme lender spectrum, while America is on the extreme borrow spectrum.  Borrower and lender nations are equally responsible for the level of sovereign debt in the world, and all should share the burden in seeking sustainable resolutions.

America, and select investors in USD denominated assets, are the main detractors to an SDRM structural solution.  The reasons have as much to do with value retention of dollar securities as they do with the loss of monetary sovereignty to an international institution such as the IMF.  For other countries, they have lost value on domestic currency and assets, while also giving up monetary sovereignty to the United States.

This diametric foretells the demand and need for a multilateral framework, as an ever increasing deficit of the US cannot be sustained indefinitely.  The American debt ceiling and deficit will again be debated in Congress this October.  The function of raising the debt ceiling will be directly related to the United States ability to get the rest of the world to continue sustaining the role of the dollar.

The International Monetary Fund is being pulled in both directions of CAC and SDRM, as America and China use political leverage and economic interdependency in attempts to push the solution.  The IMF will ultimately seek the sustainability of 2010QGR and SDRM, which is supported by the funds official statements surrounding reforms and the addition of the RMB to the Special Drawing Rights composition this October.

The United States is resisting both 2010QGR and the RMB’s inclusion into the SDR basket.  There are many reasons for this.  When the RMB is added to the SDR, the internationalization of the Chinese currency will increase dramatically as the renminbi liquidity market explodes.  This increase in RMB market liquidity will be measured along a decrease in USD market liquidity. Eventually both markets will balance with one another.  Parallel currencies as it were.

This decrease in USD market liquidity will make the function of a CAC sovereign debt solution less likely, as the CAC process being promoted by USD interests will lose the dollar liquidity which makes a CAC process beneficial for them in the first place.

So, the addition of the RMB to the SDR this October, which comes into effect on January 1, 2016, will expand Chinese currency market liquidity while decreasing American currency market liquidity. This will in turn make a CAC sovereign debt solution unworkable, which will leave a version of SDRM solution as the only viable alternative.  This alternative will also include the use of substitution accounts, which we have widely reviewed here on POM in many previous articles.  These accounts will ensure that no loss of asset value will occur during the transition from USD denominated assets to RMB and SDR denominated assets.

On the geopolitical front, the world is witnessing a wide array of regional and international crisis which all have the United States at the center.  The reasons for this are partially understood by the logic and information presented above.

To expand on that, it is important to understand that the United States uses political, diplomatic, and military means to secure lending from other countries, and ensuring that USD dominance is maintained as a means to continue the deficit spending at home.  In addition, in cases where America is the creditor nation, it uses domestic laws to maximize its interests and create undue hardship and leverage on the borrower nations.  This hardship will usually take the form of resource allocation and deposit development by Western corporations.

The fixed and semi-fixed exchange rates which the dollar has with the currencies of Asian countries like China, Vietnam, and others, has also allowed the United States to finance its large account deficits.  It is probable that if the RMB is included in the SDR, China may end the managed peg with the dollar, which would cause an instant and dramatic effect on America’s ability to raise the debt ceiling in October and continue its policy of deficit spending.

Recently the tension in the South China Sea has picked up as the United States is attempting to intimidate and stop China from projecting its influence in the region.  China is obviously building stationary and fixed equivalents to American air craft carrier groups in the disputed islands area.  These “carrier groups” cannot be sunk and will give China a tremendous naval advantage.

China Man Made Island

If China can successfully cut the United States out of the South China Sea, then it would put immense pressure on Japan, another larger holder of US debt, to support the SDRM solution to sovereign debt restructuring.  Japan, a country on the verge of its own sovereign debt crisis, much like Greece, cannot hold out much longer before a solution will need to be implemented.  Both Japan and Greece will take the world with it, including China and the United States.

Let’s take a closer look at the process of addressing the sovereign debt situation.

China, as a major international creditor, and now largest economy on Earth, needs to be directly involved in any sovereign debt restructuring mechanism, whether it is the market oriented CAC or structural reforms of an SDRM.

Chinese policy makers are supportive of reforms to the international monetary institutions, such as the IMF and 2010QGR, and the SDRM process. Along with structural sovereign debt solutions, China encourages a reduction in excessive borrowing and lending to support the management of sustainable debt in the future.

Along with that, China’s other main concern is to maintain the value of its foreign assets, such as USD denominated bonds. Use of the SDRM and substitution accounts will be an important aspect of this wealth retention for China.

So, China will support an SDRM process which is based on a balanced representation and governance within the IMF which takes into account the importance of the emerging markets.  It is these markets which have carried the bulk of US debt and deficit spending.

The SDRM process will require RMB market liquidity and the implementation of 2010QGR, or a version which is similar.  The inclusion of the RMB in the SDR composition will also be required.  But could the RMB be included in the SDR while still maintaining the managed peg to the USD?  This would allow for an increase in RMB market liquidity and still give the USD the dominant position internationally.  America could be negotiating exactly this position as it faces the inevitability of an expansion of RMB market liquidity.

The internationalization of the renminbi began in 2002 when Hong Kong asset managers were given permission to begin buying and selling RMB denominated exchange-traded securities in China. Since that time the internationalization picked up pace and is now somewhat substantial based on the diversity of Bi-Lateral Swap Agreements (BSA) which the People’s Bank of China has established with central banks all around the world, and the establishment of the BRICS Development Bank and Asian Infrastructure Investment Bank.

RMB denominated gold funds through the Shanghai Gold Exchange is another method which China is expanding RMB market liquidity. This gold fund will help China manage a sustainable capital account liberalization which will be difficult to manipulate from external foreign sources.  This SGE RMB gold fund does not support the thesis of some analysts which suggest China is overthrowing the western banking system by starting a central bank for gold. This article alone should strongly support the errors in such alarmist conclusions.

The full internationalization of the RMB will be achieved when it is functioning as an international unit of account, means of payment, and store of value.  This status of internationalization will require a deep and liquid financial market, which is being realized by the implementation of such functions as the SGE and BSA’s.  This will foster off-shore financial centers to support RMB denominated transactions.

The forthcoming Asian trade agreement, AEC, will also further broaden RMB market liquidity.  The AEC comes into effect on January 1, 2016, the same date as the updated SDR composition.

For all of this, RMB capital account liberalization and internationalization needs to be accelerated if the sovereign debt crisis is to be averted.  But caution needs to be considered as an acceleration of RMB internationalization could potentially expose the international financial system to greater risk if not handled in a methodical manner and through agreements with all countries, including the United States.

If the RMB is not included in the SDR, and IMF 2010QGR is not implemented when Chinese financial markets are fully liberalized, leading to the opening of the capital account of the balance of payments, the risk to the international financial system could exceed the risks which exist today.  The sovereign debt crisis would not have been effectively addressed and no agreed upon multilateral solution would have been implemented.

Removing the remaining restrictions on the use of RMB for international transactions, which the SDR and 2010QGR would achieve, will also force Chinese policy makers to implement a more flexible exchange rate in order to accommodate the larger volumes of RMB financial flows.

This is likely why the United States is leveraging to agree on structural reforms but not allow the RMB to become a part of the SDR composition.  If both reforms and SDR inclusion are achieved, it will all but ensure that the managed peg to the dollar will have to end.  Which in turn will prevent America from continuing its current level of deficit spending.

Vietnam has also made it clear that they could potentially end the fixed peg to the USD and peg to their largest trading partner China. In such a situation, and under the AEC trade agreement, other Asian countries will follow, leaving the USD with dramatically reduced market liquidity.

The United States is caught in a situation in which it requires the rest of the world to facilitate the orderly transition out of the global sovereign debt crisis.  Yet, in order to do so it must give up much of the financial and monetary power and leverage which it has wielded over the last 70 years.

The sovereign debt crisis, which is really a lack of confidence in sovereign bonds, will continue to affect all countries.  The threat of complete collapse of the bond markets should be enough to push both private investors and sovereign countries to agree on institutional reform and a restructuring method, such as the SDRM. The CAC market oriented solution which America favors will only continue the systemic imbalances which have been partially responsible for creating the situation in the first place.

If an agreement on these matters cannot be reached, the world could very well be heading for a sovereign debt implosion.  Let’s hope that cooler heads prevail and a new multilateral framework can be implemented for the benefit of all countries and people.  - JC

42 Comments on “The Sovereign Debt Complex”

  1. JC,

    American petrol-dollar is dying on the vine. China essentially owns much of the Fed as we know it. And most ports in the U.S.

    I see the AIIB playing a greater role in the near future. The IMF is a puppet, in my opinion, to what will transpire in the near future.

    They have no funds, unless printed by the Fed, ECB or other entities. All a part of the manipulation.

    The world is growing weary and is astute to the U.S. bully mentality.

    Curious how those meetings will bear fruit re: the elimination of cash.

    Interesting food for thought...

    Great piece, but as always time will tell...

    P.S. A tribute to those who have fallen under a false guise...

    http://youtu.be/iLmNz7OyvZo

  2. Hi JC
    I have been following your site for about a year now and this is my first post. I appreciate all your in-depth research that has allowed me to understand this complex adjustment to multilateral framework at this historic time in humanity. It is riveting. The following excerpt is from the Article IV staff memo from the IMF China review dated May 26, 2015.

    "On the exchange rate system, we urge the authorities to make rapid progress toward greater exchange rate flexibility, a key requirement for a large economy like China’s that strives for market-based pricing and is integrating rapidly in global financial markets. Greater flexibility, with intervention limited to avoiding disorderly market conditions or excessive volatility, will also be key to prevent the exchange rate from moving away from equilibrium in the future. We believe that China should aim to achieve an effectively floating exchange rate within 2–3 years". http://www.imf.org/external/np/sec/pr/2015/pr15237.htm

    They also state that after their review the Yuan is not undervalued and that inclusion to the basket is when not if. What is the purpose of recommending a free floating currency 2-3 years from NOW when clearly they must unpeg when (if not before) the Yuan is included in the basket between now and the end of the year? Are they hinting/hoping that when the Yuan is included it maintains the USD peg for 2+ years as you indicated as a possible US dream scenario in your analysis above as stated here:
    "But could the RMB be included in the SDR while still maintaining the managed peg to the USD? This would allow for an increase in RMB market liquidity and still give the USD the dominant position internationally. America could be negotiating exactly this position as it faces the inevitability of an expansion of RMB market liquidity".

    I appreciate your thoughts, if any. Thanks for all your hard work.

    1. Great first post. You've touched on an important subject here. It is beginning to look like a settlement of sorts, involving the exchange rate pairing of USD/RMB, may have been reached. Lets see what comes out of the G7 meetings next week.

        1. And here's the best quote from that article:

          "Chinese government has made steps to introduce the infrastructure needed for the domestic currency to float freely on global capital markets."

          1. So, taking into consideration the analysis discussed here about potentially widening the RMB peg before completely ending it, when it does go full free float I am correct in assuming it will appreciate significantly? Could you please offer your perspective on this? From an investment perspective its (RMB/USD) looking more and more attractive as the pieces come together . . .

          2. I am expecting a higher valuation for the RMB. Whether it's suddenly or slow over a year or two is open to speculation.

  3. The Yuan, RMB is making its way through the SDR component to dismantle. Will be interesting to see the chess game play out w the bear n dragon vs US mentality.

    All about who holds the winning hand or gambles with lives along the way...

    We have witnessed enough of bloodshed, yet Man still has not learned.

    Always hope down the road...

    Best to All

    1. Funny how those stories keep changing to fit the emerging realities. First it was the SDR is dead. Then it was China will never join the SDR and is going to overthrow the IMF and the west. Now its, well, yes, the yuan is going to be in the SDR, and yes, China supports the IMF, but...wait for it...only because they are acting as a Trojan Horse. Its both laughable and sad.

      While other "analysts" keep changing their script, my conclusions stay the same and are getting validated week by week. I'll just keep on keepin on.

      Sorry friend, I can't agree with the analysis your referencing.

      1. Excellent post and analysis! There is a predetermined script playing out. The US (although the media narrative shows diametric opposition) in fact helped create the internationalization of the RMB via the fact that 2010QGR was written in the first place by an organization heavily steered by western interests. The US consumer and debt based model is unsustainable which would be known decades ago.

        Since global central bank policies such as Basil 3 regulations are created and dictated from the Bank of International Settlements (initially founded by the US and other western countries) along with the IMF which was also founded after World War 2 by the same western group, the mandates in place are to serve the groups and entities who own these institutions.

        Both sides of wars have had the same source of funding. This is not so much a matter of what a country wants or not, but rather how can countries be organized and utilized to make the most profit for internationally focused banking interests. At this level, there is no patriotic nationalistic ideologies. These players are the financiers who draw the pretend lines on maps we believe is our country. With national pride, we will fight wars and die for colours on a piece of fabric because our focus is directed towards a manufactured enemy when in reality it makes these international financiers money regardless.

        1. Also, many answers are found when asking who created the manufacturing model for China and why? Who funded the founding of the United States? Where does much of our tax money go? What are the three main cities dating back to ancient Rome and before? How do they govern themselves and use the legal system differently? What do they control? What is the symbol on their flags and what is the origin of that symbol? The China Vs. US dialectic is to distract from finding the hidden answers.

  4. As always,

    Time will tell.

    Wish we had a crystal ball...

    Still an interesting journey as we dwell in uncertainty.

    All changes day by day.

    Your insight is most inspiring...

    Best Brother

    P.S. Not about who is right or wrong in analysis, but what becomes the here n now.

    Food for thought...

  5. And Jennifer, I hope we hear more from you..your first post was so well thought out.

    And I too wonder who thinks up all these scenarios about China? Where is any facts that show this is their objective? The analysis has to have some facts to support it..there needs to be some dots to connect the analysis.:)

  6. JC, about the RMB to USD peg, isn't that peg a flexible peg? A peg within a specific bandwidth? As a I understood, that bandwidth could be also broadening....

    If that is the case there could also be a possibility that all the currencies withi the SDR basket will be tied to eachother by flexible pegs. This would bring even more stability a d would be a step closer to a true SDR currency, would it not?

    Just exploring an out of the box scenario here.... 🙂

    1. Yes, it is a managed peg within a range. I reviewed in a previous post how China could widen the peg further before completely ending it. You're scenario is possible. Much will depend on how the RMB is added to the SDR, and what the United States agrees on. Extremely interesting.

    1. The peg terminology can be somewhat confusing. There are fixed pegs, which is when two currency pairs are pegged at one rate and rise and fall with one another.

      There are semi-pegged, which we call managed peg. The USD/RMB pair are managed, meaning the RMB is allowed to float within a pre-determined band only. Think of it as a fixed peg with some stretch.

      There are free floating exchange rates which have no bands or management restrictions, or limitations established.

      There are various other methods of pegging currency pairs, but these are the main ones which we discuss here.

      Does this help Dottie?

  7. http://www.zerohedge.com/news/2015-05-30/russian-pivot-greece-will-probably-join-brics-bank-official-says

    J.C, Greece drama is going along as you did put forward in one of your earlier post, Russia taking on the savior role in the name of BRICS in this new paradigm, where old sources of liquidity is insufficient to resolve very high debt burdens. So, this trial method, very likely to materialize soon, could soon be the norm. Moreover, call me nuts, crazy and/or superficial but I'm fairly convinced that there is some British hand behind this Syriza policies from initiation. The whole process is supranational bankers dismantling the old system of IMF for it to rise again, like a phoenix, from its ashes as a SDR market making mechanism in addition to the worldwide standardisation of national data dissemination.

  8. Two materialist mentalities, the imperialist and the usurious, together threaten the physical existence of mankind. The collapsing economy incrementally reveals the underlying problem: physical and cultural genocide as Judeo-Anglo-Saxon state policy.

    1. Your assumption is that non-white (non-Judeo-Anglo-Saxon) governance authorities have not been responsible for genocide. History does not support that position. Imperialism is waning as all countries seek balance through multilateralism. Let's see how long it lasts.

  9. I didn't know exactly where to post this because comments were closed on the esoteric. I had not seen the beautiful photo of you and your bride JC. Absolutely beautiful. I can see in your eyes and hers the happiness found in finding that person to share a life with. Thank you for sharing that beautiful picture. It is so good to see you in your happy moments in life. Many years of joy and happiness to you both. So sorry for taking up this space on the economics, but I just had to tell you how moved I was with your story.:)

  10. Mr. Collins:

    It has been a few months since I last posted comments. For months I have been involved in extensive and numerous business travels all about the USA and internationally including lengthy travels about Ontario, Canada. The present global economy appears to me to be on the verge of a very deep depression. In addition, the tax rates that people are forces to pay about the globe are staggering. Banks are juiced up and historical wealth transfers have been and are rapidly occurring. “Sovereign debt default” is a politically correct phrase meaning, “irredeemably bankrupt”.

    Relative to the economy of the USA, there is a plethora of compelling evidence that the $USD is about to collapse. In fact, the $USD has been on artificial life support for decades and it is readily apparent to the astute and knowledgeable that the supportive means can no longer sustain a dead currency, a corrupt and criminal banking system, and felonious politicians.

    Blessings to you,

    Ozymandias

    1. Welcome back. I agree with you on the fundamentals of a USD collapse, at least based on the retiring monetary architecture. The emerging architecture will have a different affect on currencies, as we've been reviewing. Let's hope the dollar doesn't collapse. That will be the biggest of all wealth transfers.

  11. I use to actually pay attention to a lot of the doomsters. Of course I never got into the hoarding and prepping. I found that to be really extreme. I mean, really stocking up on non perishable foods and getting your guns and ammunition ready just wasn't on my list. I started to do a little research on my own and started asking questions. Then I discovered POM. I can't even remember how I came to find POM; I was just researching and it popped up and I started reading. It was so different and so unique. I would look at other market analysts and not find any real answers to what the heck was going on and what was going to happen. Then reading POM it started to click and my mouth just literally opened and said, WOW.. this guy is really on to something. Everything he said just seem to add up. So having said all this.. I would just say anyone who really wants to know how things are being engineered needs to read POM and most definitely, Reengineering the Dollar. I am waiting and anticipating for number two in JC's e pub.. If it were true that the dollar was going to collapse i would think you would have to prepare for the whole global economy to collapse because wouldn't that be a domino effect? This is why the IMF is doing what it is doing and why the SDR is entering the global world at least imo. I have to go back and read what JC has written prior in order to understand what is happening, but he has proved to be spot on.

    This is a Forbes article and I usually do not follow them, but found some of this to be funny, because how long have they been predicting the collapse of the dollar? This is the year..I tried finding the year this actually started, but could not find the exact timing, but it was not long after 2008.

    http://www.forbes.com/sites/investor/2013/04/29/why-doomsters-who-predict-the-collpase-of-money-are-wrong/

  12. I am intrigued by your statement that, "These 'alternative' accounts will ensure that no loss of asset value will occur during the transition from USD denominated assets to RMB and SDR denominated assets." Unless each and every currency is reset simultaneously while at the same time there is an unprecedented ‘debt forgiveness” (aka; write off), then I cannot envision how the $USD can avoid a massive devaluation and the US economy can avoid hyper inflation.

    Can you elaborate or enlightenment me on the subject.

    Thank you in advance.
    Ozymandias

    1. Sure, just about everything written on this site should suffice to enlighten you. Additional, the substitution accounts are meant to protect the value for sovereigns, like the US bonds China holds. And I've stated repeatedly that the USD will be devalued. The framing of your question is such that it makes a thorough answer too long for the comments section. Perhaps rereading the important posts will help you.

  13. So, your meaning is that "These ‘alternative’ accounts will ensure that no loss of asset value...." does not imply the protection of US assets held by the US citizenry, only other sovereigns and others who are not US citizens.

    1. The article was about sovereign (public) debt, not private or personal debt. Substitution accounts are for sovereign debt. And just to keep the reference point in clear focus, here is what the article stated:

      "So, the addition of the RMB to the SDR this October, which comes into effect on January 1, 2016, will expand Chinese currency market liquidity while decreasing American currency market liquidity. This will in turn make a CAC sovereign debt solution unworkable, which will leave a version of SDRM solution as the only viable alternative. This alternative will also include the use of substitution accounts, which we have widely reviewed here on POM in many previous articles. These accounts will ensure that no loss of asset value will occur during the transition from USD denominated assets to RMB and SDR denominated assets."

      Domestic held debt by Americans is a domestic issue which will require domestic solutions. The framing of this position has been made very clear. Attempting to re-frame the position which was made in the article will not lead to adequate comprehension of the material.

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