In China's case, governments at various levels and corporations have a couple trillion dollars of debt denominated in USD, giving the powers-that-be a serious conundrum: devaluing the yuan gives their export economy a pricing advantage (and a tool to counter tariffs) but makes purchasing the dollars needed to pay the interest on that debt more expensive. This is something we've been harping on for the last six or seven year.*
First up, from GeoVest Advisors:
What is wanted is not the will to believe, but the will to find out, which is the exact opposite
– Bertrand Russell
I would like to know how many dollars are in China’s Reserve Account but the number is a state secret. For a nation that has been as successful as China in employing mercantilist strategies, you’d expect them to advertise this success. Yet we do know some things which makes it possible for us to infer with some degree of confidence that China is running out of dollars. I consider this variable to be the single biggest risk to the global financial system and it’s hardly on anyone’s radar.
It helps to first understand the economics of banking and money supply. When all debt instruments – loans and bonds – pay interest and principal as they are supposed to, money supply grows. When some of those debt instruments go bad, the amount that gets written off reduces money supply. It’s the definition of deflation; disinflation is when the general price level declines. The distinction is critical to understand.
My thesis is that China has made so many bad dollar-denominated loans that their true net holdings of dollars is either negative or close to going negative. And based on watching how China operates for 30 years, I believe they may be supplementing their currency reserve account with yuan, which has technically been a reserve currency since 2016.
For starters, we know that the yuan became a supplementary reserve currency in October 2016, at a time when China’s holdings of dollars, euros, and yen was rapidly declining. I believe the timing of this change is critical for accepting my thesis. Technically, this change made it possible for China to hold yuan in their measurement of foreign exchange reserves.
Appearances are more important than the truth in China and the Chinese Communist Party has proven that duplicity is acceptable as long as you can sell it to the broader community.
We know that the US dollar represented 79% of the reserve account in 2005 and that dollar holdings fell to 58% of the reserve account by 2014. 2014 was the high-water mark for China’s foreign currency reserves which declined by $1 trillion from late 2014 until the start of 2017. Over the past seven years, reserves have stabilized around $3.2 trillion.
We also know that trade with the US has NOT grown since 2014 indicating that China has had limited opportunities to re-build their dollar positions. Here’s a chart of China’s trade surplus with the US. Keep in mind that China needs to generate significant dollar levels in trade to pay for imports of food (20%+), energy (80%), and high-end technology that they can’t produce domestically. Apart from Russia and Iran, these markets don’t accept yuan.
Over the past two years, trade with the US and Europe has weakened while trade with Russia has doubled. The Russians don’t pay in US dollars, nor does Iran.
Don’t Forget the Debt!Debt is one person’s liability, but another person’s asset
– Paul KrugmanFifteen years ago, when the Fed’s quantitative easing program was in full swing, the only smart bet seemed to be shorting the dollar in the form of dollar-denominated debt. Today that bet doesn’t look smart at all....
And from Reuters, March 24:
Exclusive: Some European officials weigh if they can rely on Fed for dollars under Trump
Some European central banking and supervisory officials are questioning whether they can still rely on the U.S. Federal Reserve to provide dollar funding in times of market stress, six people familiar with the matter said, casting some doubt over what has been a bedrock of financial stability.
The sources told Reuters they consider it highly unlikely the Fed would not honour its funding backstops — and the U.S. central bank itself has given no signals to suggest that.But the European officials have held informal discussions about this possibility - which Reuters is reporting for the first time - because their trust in the United States government has been shaken by some of the Trump administration's policies.
President Donald Trump has made a sharp break from long-standing U.S. policy in several areas, such as appearing to endorse Russia's position on Ukraine, raising questions about U.S. commitment to European security and imposing tariffs on its allies.In some European forums where participants assess potential risks to the financial system, these officials have discussed scenarios under which the U.S. government might pressure the Fed to suspend the dollar backstops, two of the sources said.Some officials have been gaming out whether they can find alternatives to the U.S. central bank, the two sources said. In times of market stress, the Fed has provided the European Central Bank and other major counterparts with access to dollar funding.The takeaway from these discussions: there is no good substitute to the Fed, said the six sources, who include senior ECB and European Union banking supervisory staff with first-hand knowledge of the conversations.....
Back to China, some homely (literally) examples including the Hungarians and Poles who were enticed to take out mortgages in Swiss francs because the interest rates were so low. Previously on borrowing in a foreign currency:
June 2019's "One Of The Most Dangerous Situations In Finance: Dollar Denominated Emerging Market Corporate Debt" had many of these links:
Our Dec. 2014 post: Evans-Pritchard: "Dollar surge endangers global debt edifice, warns BIS":
Two quick points*:Reprised in "'Russian ruble's fall: A classic 'currency collapse' and Why It's Such a Big Deal".
1) This is the second BIS warning in under six months.
2) It is very dangerous to borrow in a currency other than the one in which you earn your income.
True at retail, true at wholesale....
We've said ad nauseum*:...
Remember When the BIS Was Warning That A Strong Dollar Would Wreck Everything?
