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.
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