Friday, March 25, 2016

Why does China matter so much if US trade with it is barely 2 percent of GDP?

In an interview with CFA Institute, Gordon Chang, as ever, essentially argues that not only is China on the brink of collapse, but that it simply doesn't matter too much for the rest of the world.

We won't rehash Gordon's same old arguments here (based, as ever, on assuming that the most pessimistic unofficial estimates of Chinese economic figures are the right ones); instead, the question that concerns both the US and global economy is, Why does China matter so much if trade with it is barely 2 percent of US GDP? More specifically, just why would a large yuan devaluation - say, 15 to 30 percent, as some well-known hedge funds have recently wagered - have such an outsize impact on the rest of the world?

It all boils down to the simple fact that the present global economy has been built upon the growth of US dollar-denominated international trade and capital flows - an unprecedented expansion of which China has been the linchpin. It may be less than 2 percent of US GDP, but that 2 percent is absolutely critical not just for the two economic superpowers, but everyone and anyone else, as well.

Interestingly, China's importance only becomes apparent when you consider the entire global economy as essentially an integrated whole based on the US greenback as the universal medium of exchange. Destroy the value of the yuan, and China dramatically constricts the supply of such international dollar - or "Eurodollar" - liquidity worldwide. This is the crux of the renminbi's virtually existential threat to the global economy as we know it.

It's important to retrace just how we got here. At the end of World War II, the US was the undisputed global economic superpower. America's combination of roughly half the whole world's industrial output, massive capital account surplus, and vast stockpile of gold reserves which burgeoned during the war years owing to its safe-haven status, enabled Washington to establish the Bretton Woods monetary system by fixing the dollar at $35 per troy gold ounce (later $42). This was the basis for the free, capitalist world's commercial and economic livelihood, which Washington further underpinned with the Bretton Woods institutions of the World Bank and IMF.

From the get-go, however, the gold peg proved hard to resist tampering with. Demand for credit, especially from the market-making financial and corporate sectors, inexorably outstripped the supply of hard physical gold, and because Treasury bonds and other dollar-denominated debt were widely perceived as "gold with interest", both domestically and among US allies - which were effectively Washington's protectorates against the Soviet and communist bloc - by the 1960s the original gold link had loosened to such an extent that it needed just one big-enough impetus to all but disintegrate.

That catalyst, it turns out, was the US proxy war with the USSR and, more immediately, Mao's China, in the former French colony of Indochina: the Vietnam conflict drained Washington's finances so badly that by around 1968, when it became clear that no quick victory could be won over Hanoi without bringing Beijing (then wracked by the lunacy of Mao's Cultural Revolution) into the fray, America's Western allies (as well as Japan) famously began a concerted run on both the dollar and its residual physical gold backings within American vaults. By the time president Nixon officially ended the gold standard in 1971 and "free floated" it to counterattack US allies in their currency war, the debasement of the greenback was already a done deal, with his actual policy largely a formality.

However, America wasted no time not only retaining its control of global capitalism under a purely fiat currency regime, but actually enhancing it - arguably dramatically. Its allies quickly discovered that their complete dependence on Washington's military protection against a Soviet Union that had achieved strategic nuclear parity meant that they were even less autonomous in a solely credit-based monetary setup than under the traditional bullion one. Next, in the aftermath of the 1973 energy crisis, the US skilfully crafted, in the remainder of the decade, the infrastructure of the "petrodollar" - forging a strategic alliance with Saudi Arabia and the other oil-rich states of the Persian Gulf region whereby the greenback's erstwhile exchange peg to yellow gold was effectively replaced by a new, deliberately exclusive procurement arrangement with black gold (and hence other commodities) that gave it an even more practicable lever of regulating real international economic activity. In the meantime, the dollar's free float unleashed the floodgates of monetary and credit innovation and expansion in the vast domestic US market. This coincided, not incidentally, with the birth of the high-tech IT industry.

Though it took the US the remainder of the "staglation" era of the 1970s into the early 1980s to finally settle into a sustainable "new normal" of credit-based economic expansion, the rewards it reaped in doing so were astronomical. The much-touted "supply-side" theories touted by leading economists of the period were, in practice, the reflection of the rise of a truly global supply chain of unprecedented size and sophistication: Western technological and managerial know-how working in conjunction with the cheap hydrocarbons of the Mideast, the commodities of friendly Latin American and African countries, and the cost-effective labor of East Asia (led by Japan but followed by the "little dragons" of South Korea, Taiwan, Hong Kong, Singapore, and to a lesser extent Thailand and Malaysia).

Thus, from the very start of Nixon's opening to China in 1972, prescient US political and economic strategists understood that it would be the middle kingdom's eventual integration into the dollar-based global economy - as the great center of mass production and assembly - that promised to deliver the crowning triumph of global capitalism in its centuries-long ascent from Protestant Western Europe. Indeed, even the early tremors of this Chinese reorientation towards the free-market camp in Mao's waning years was enough to compel the Soviet Union to unwittingly hasten its own demise through the opening of détente.

As reform and opening took off under Deng Xiaoping in the 1980s, China positioned itself to become the pivotal member of the emerging global dollar hegemony - that decade being the twilight of the defunct and discredited Soviet model that Gorbachev would find impossible to rescue without breaking up the USSR itself in the process. After surviving the existential identity crisis of Tiananmen Square in 1989, Beijing arrived at a convenient accommodation with Washington: the latter found that the former's autocratic internals were only a minor irritant in light of the exploding profit margins and credit expansion that its vast pool of cost-minimizing labor could give its transnational supply chains; whilst the former recognized that its stubbornly Western-incompatible political values were ironically best protected and served by collusion in enriching that same West.

The rest has been history: the history of Chimerica. A mercantile relationship which blossomed in the Clinton years (1993-2001) would reach a maturity and stability unprecedented between such disparate great civilization-states in the Bush era (2001-09). The decade from 1995 to 2005 - with China's attainment of permanent trade status with the US (2000) and acceptance into the WTO (2001) in the middle - was not by chance the golden period of the "Eurodollar", i.e. the Wall Street and London-led "financialization" of the global economy via the explosion of derivatives-driven investment banking. China was the axis of this bubble-finance monetary regime: its sheer productive volumes and cost savings were the basis of the dollar-denominated corporate profits and trade surpluses which overwhelmingly fed (largely via the US Treasury markets) into the two successive waves of greenback asset boom-busts, namely the dot-com (1997-2002) and housing (2003-2007) tsunamis.

An inflection point of sorts was reached in the 2008-09 global financial crisis, whose sheer scale had its origins in the London Eurodollar operations of a company, AIG, that had been founded by Jewish-American expats in Shanghai around the May 4 movement (1919). It was this crisis which literally brought the Western financial system to its knees - in effect, a 500-year crash, not merely a 100-year crash - that effectively propelled China to the very forefront of the global economy, over half a millennium after the middle kingdom fatefully sealed itself off from the outside world. From 2009 to 2012, China's massive fiscal and monetary stimulus - with its unprecedented binge of commodity consumption to fuel an investment boom of monumental proportions - effectively rescued the global economy from a broad recession; though we now see that it did so at a high price.

It is this history of the Sino-US relationship - the single bilateral relationship that drives the entire global agenda - that China cannot now fall without also scuppering. To understand the turmoil of 2015 and early 2016, one need look no further than this stunning fact: China is on the verge of crashing in US dollar terms.

By extension, that means the world as a whole - the entire Eurodollar system - is on the verge of a sharp contraction. The RMB is the last line of defense. Its feeder commodity partners (and hence currencies) - from fellow BRICS Brazil, Russia and South Africa, to OECD members Canada and Australia, to Mideast petro-states like Saudi Arabia and various other mineral-rich South American and African economies - have all suffered various degrees of dollar-measured decline or collapse since 2013. Since oil prices crashed in mid-2014, thanks largely to the last great Eurodollar play in the West - the US shale revolution - the yuan has stubbornly clung for dear life against the dollar even as the euro, yen, and pound sterling fell more liberally into 2015.

Against this backdrop, it's easy to see why global financial markets have responded so poorly to even 2 to 3 percent falls of the yuan: if it's possibly just a harbinger for a 20 or 30 percent (or, at least theoretically, unlimited) devaluation, there goes the global Eurodollar standard. We'll have a "strong dollar" alright - just less and less of them sloshing around anywhere. For the S&P 500, given how richly valued it tends to be thanks to foreign capital inflows, 1,400 could be the new 2,000.

But don't take my word for it: maybe Gordon Chang's right that this will only be a minor development after all. It's an adjustment that, while painful, is largely necessary to fix the severe inequities and imbalances on both sides of the Pacific - and hence worldwide. In the long run, Chinese growth should come less from trade just as US growth should depend less on foreign capital inflows; in the long run, neither country even needs growth per se as badly as fairness in its distribution.

And in the end, we'll all be one big happy family - if only because the alternative isn't just unthinkable, it's downright ludicrous.

No comments:

Post a Comment