Understanding the RMB and Transforming the Existing Exchange Arrangement
China needs to increase foreign RMB demand so it can begin to phase out the accumulation of US dollars and maintain stability in its own domestic economy.
China is trapped because its economic model is based on exporting cheap goods and receiving US dollars in return. Chinese business owners exchange these dollars for RMB through the People’s Bank of China. This forces China to expand the RMB market which keeps the valuation down because RMB demand predominantly exists within China. This is what China is attempting to change as it internationalizes the RMB and creates asset markets based on the RMB.
These excess US dollars which are accumulated by the PBoC are used to purchase US Treasuries and other foreign assets. A simple method of understanding this relationship can be viewed as China taking the dollars and investing them in US Treasuries with an expected maturity date and yield, or return on investment. The dollar bills go back into the Treasury and are subsequently re-distributed back into the American economy. This domestic re-distribution of dollars has contributed to upward valuations of the stock markets, real estate, and overall credit markets, as monetary planners find creative ways to prevent an oversaturation of the domestic dollar market.
This is compounded by Chinese efforts to take US dollars out of the mainland and invest in assets around the world. China is bursting at the seams with US dollars and can only send so many back through the official Treasury channel. Expanding Treasury holdings outside the fluctuating range which currently exists would work against the objective of reducing Treasuries. As such, Chinese business owners are allowed to move capital under the radar and inflate real estate markets around the world while purchasing Lamborghini’s to cruise around in Western cities.
The objective for China is to continue expanding the foreign RMB assets and markets so it can reduce the amount of US dollars it accumulates, and shift its economic model from a trade-exporting one to a trade-services one. The difference between both is that exporting is based on tangible products, while services would consist of RMB denominated financial assets, loans, and use in balancing trade with economic partners instead of dollars.
The more the RMB international capital market develops, the more China can export its own products for payment in renminbi. This means less USD accumulation and reduced need to purchase US Treasuries with those dollars. It also means a reduced amount of Chinese shadow-capital being invested in Western real estate markets.
As dollar accumulation decreases, and RMB denominated trade payments increase, the PBoC can begin to allow the currency to appreciate, which in turn will strengthen its monetary position internationally and energize the whole cycle for expansion. Less dollar accumulation means less Treasury purchases, and less Treasury purchases means incremental RMB appreciation.
This will also allow the USD to begin its depreciation cycle, which is something American monetary planners desperately need in order to increase exports and bring back domestic jobs for American workers. The Trump administrations scripting on China currency manipulation and trade practices are a direct assault upon the historical framework which has kept the USD appreciated against the RMB. These are attempts to shift the narrative and should not be considered a coincidence.
This existing monetary dynamic is the exact reason why China could never dump US dollars.
First, flooding America’s shores with trade dollars would increase the risk of speeding up inflation and causing the dollar to depreciate at a fast rate. This would also depreciate the investment China has made into US Treasuries and cause the RMB to appreciate at a rate that would slash its exports and cause havoc in the domestic economy. The civil unrest which would develop from this is something the Chinese government wants to avoid, especially with the upcoming 19th National Congress of the Communist Party of China.
Second, there isn’t a viable alternative to US Treasuries as other assets, such as the euro, are not as stable and cannot provide the liquid market which would be necessary to support and encourage global growth.
The overall Chinese debt-to-GDP ratio, including government, financial sector, personal household, and business, has now exceeded 300%. The world’s collective debt is around 324% of GDP. There’s obviously a problem here which is developing at a fast pace. Any attempt by either America or China to suddenly change the monetary dynamic which exists between them, without the agreement of the other, could topple the whole house of cards.
China’s domestic credit market is going to be facing enhanced pressure. The solution for this problem is for China to continue internationalizing the RMB and further open domestic on-shore financial markets to foreign investors. Beijing can no longer continue to expand domestic growth by enlarging credit markets. It needs to attract foreign capital and investment into RMB denominated financial instruments.
But there is the rub.
China is reluctant and skittish about opening their domestic markets in fear of manipulation and sabotage from outside influences. But if it doesn’t, its domestic credit market will implode. The patient strategy of incrementally internationalizing the RMB and opening capital markets at a match pace can no longer be allowed to continue. Things must be accelerated and transformation encouraged.
The pressure which the Trump administration is beginning to put on China regarding trade practices is meant to force this change. It’s in America’s interest for China to phase out USD accumulation and open its on-shore capital markets. This will cause the RMB to begin appreciating against the dollar and will be a huge step towards the multilateral restructuring which is needed.
As China is strengthening the exchange arrangement policies of the RMB, the domestic troubles which are developing in America, along with the “Trump is unstable” narrative, will contribute to the change in investor attitude towards the dollar. Demand will begin to decrease and international investors will seek opportunities elsewhere at exactly the time when China is opening its domestic capital markets and expanding the international role of the RMB.
This is not a coincidence.
Though there may be some liquidity “bleed-off” from markets as interest rates increase in America (which is another reason for China to shift away from Treasury accumulation, as it puts further pressure on the RMB), a large financial and economic crisis cannot be allowed to develop and take hold of the international investor mind.
The development of a trade war between China and America will serve as a catalyst for the broader transformation. Trump has the ability to end the exchange rate arrangement himself if need be, and in fact may do so as the answer to Chinese manipulation, but it would work much better if both sides agreed on timing and message before big forex shaking events were to be implemented. – JC
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JC Collins can be contacted at email@example.com