Yuan Collapse: Trade War Prelude to Monetary Reform, Fiat System Implodes From Periphery to Core

It would be wonderful if there was global monetary reform, but unfortunately trade war and the resultant damage to international system looks like the best shot for rebooting the global financial system.

ZH: Russell Napier: "Trade War Is The Beginning Of A New Global Monetary System"

nvestors need to prepare for a formal widening of the trading bands for the RMB relative to its basket and the problems such a move will create for all emerging markets. That first move in the RMB is inherently deflationary. This is no counter-punch in a trade war; it is the beginning of the creation of a new global monetary system.

While many investors now concede that an emerging market debt crisis is likely, few are prepared to concede that China will be caught up in it. China is always seen as different and of course, in many ways, it is. It may well manage its exchange rate against a basket of currencies, dominated by the USD, but it has tools to manage this relationship that most countries do not.

Its exchange controls allow it to manufacture a capital account surplus, although those controls are not a perfect dam for capital outflows. By creating a larger capital account surplus than would otherwise occur, China maintains the total external surplus that leads to rising foreign exchange reserves and hence growing domestic commercial bank reserves. It thus extends the period of growth. Also, the state owns the commercial banking system and so can force it to keep lending, thus continuing to create RMB, when the growth in commercial bank reserves would dictate more moderate credit growth in a truly private banking system. While these tools allow China to extend the business expansion within the managed exchange rate regime, they do not permit it to abolish the business cycle. If it were so, everyone would be adopting similar policies.

At least since the time of David Hume (died 1776) and probably since Richard Cantillon (died 1734), we have understood how the downtrend in the business cycle is enforced in an exchange rate management regime. It is inevitable, in such a regime, that the enforced excess creation of money leads to a deterioration of the external accounts, an end to money creation and slower growth, often accompanied by deflation. There are natural forces at work within a managed exchange rate that cannot be resisted. Nobody yet has found a way to obviate that cycle, though many have extended it. China’s ability to use its capital controls and commercial banks’ balance sheets to temporarily override those natural forces has now come to an end.

...And if that were not enough, it has come to an end because the US runs small current account deficits, by its own historical standards, and the President of the USA seems determined to make them even smaller. Investors now need to ask a bigger question when considering the future for Chinese, and thus emerging market, monetary policy. Why would anybody want to link their currency to the USD?

The main complaint I have with many in the dollar bearish crowd is their Amero-centric analysis. Most nations have managed their currencies far worse than the U.S. dollar. Although the PBoC is a well-run central bank, it is not independent. The political leadership used the banking system to force lending into state-owned enterprises, creating a distorted economy over the past decade as money and credit growth soared. For an American domestic critic none of this matters, but from a global perch, the U.S. is far from the worst actor.

In the field of monetary policy, following tradition is both dangerous and unsustainable and doing it one way because we have always done it that way is not an option. Investors need to think not about the long tradition of the RMB link to the USD, but whether today such a policy makes sense. Indeed, one thing we can all forecast, with a very high degree of probability of being right, is that one day China will have an independent monetary policy as one of the world’s largest economies.

It is of course a big call to say that the tradition of linking to the USD is ending now and a new independent monetary policy is in the process of being created, but that time has come. Japan, the Eurozone, the UK, Canada and Australia are just some countries that manage their monetary affairs free of any de facto or de jure link to the USD. China is now joining the club, and other emerging markets will either have to decide to move to a free float or, believing that China is now capable of running major current account deficits, move to linking their currencies to the RMB.

The U.S. cannot finance the world:

So why is it now that China is maturing into a country with an independent monetary policy? It is a combination of a change in the Chinese economy and also a change in the nature of the US economy, and what the US wants to be to the world economy. The US is a country where the current account deficit relative to GDP has been less than 2.5% since 2012 - compared to a deficit of almost 6.0% of GDP at the peak of the last business cycle. President Trump appears determined to reduce even this moderate deficit.

If the US is not to run ever-bigger deficits, how can those linked to the USD run ever larger surpluses? Such surpluses force a rise in foreign exchange reserves and the creation of domestic base money thus facilitating higher economic growth.

The U.S. current account deficit is rising again.

But in terms of global trade, it has been shrinking since 2005.

This is similar to the U.S. current account as a share of U.S. GDP. As the U.S. economy shrinks relative to the global economy, it must run ever higher current account deficits if it is to remain the sole issuer of reserve currency. The next global growth cycle will break the dollar if the global financial system doesn't break first. The fact that the U.S. is unwilling (per the voters wishes in 2016) to run ever larger current account deficits and absorb the associated distortions (pain in flyover country) doesn't matter in the long-run. It only accelerates the time table.

In order to finance global trade and in the absence of a new global system running off SDRs or gold, someone (China) has to step in:

At this stage nobody can really move onto a new monetary system until China moves on. If any form of managed exchange rate is to form part of EM monetary policy, then the most important thing to establish is who will run the world’s largest current account deficit. China has been a mercantilist since the death of Mao, and Japan and Germany/Eurozone are all bent on running current account surpluses. While President Trump’s policies may be contradictory in terms of what they will achieve, his resort to non-market mechanisms in terms of tariffs show it would be too dangerous to believe that he will ultimately fail to generate his desired US current account surplus.

So, who can run the current account deficits necessary to make their currency an attractive anchor for smaller countries seeking to run current account surpluses?

The U.S. dollar system dies by deflation, conversely currency collapse in China:

That independence can only come from abandoning the exchange rate policy and generating the level of high nominal GDP growth, in a world of low nominal GDP growth, that will produce a major decline in the exchange rate. As argued above, structurally and cyclically it is time for China to move on and to take its full place with those independent nations that do not rely upon others to ultimately determine the price and quantity of money of their domestic currency.

The initial shift to a more flexible Chinese exchange rate is deflationary and dangerous. The USD selling price of Chinese exports will likely fall, putting pressure on all those who compete with China - EMs but also Japan. The USD will rise, putting pressure on all those, particularly EMs, who have borrowed USD without having USD cash flows to service those debts. With world debt-to-GDP at a record high, such a major deflationary dislocation can easily trigger another credit crisis and The Solid Ground has previously focused on where such credit events are likely.

As I wrote in 2015: The Dollar Dies By Deflation

The U.S. dollar will die as a reserve currency because other currencies will collapse in value. It will become more attractive to borrow in foreign currencies and with the attendant debt destruction, foreign assets will become more attractive as well. The last phase is a collapse in the value of the dollar, but the transition to a new monetary system involves the appreciation of the greenback, not its collapse, assuming there isn't a war that determines the outcome. If the dollar were to start depreciation now, it would extend the life of the U.S. dollar system, not shorten it.

In 2013 I wrote: Death of the U.S. dollar greatly exaggerated; Historic U.S. dollar rally still likely

The U.S. dollar is the core of the global financial system and global powers, including China, will seek to preserve it as long as possible. As each nation passes through hyperinflation, however, they become freed from the global financial system via devaluation. At that point, the cost of launching a new financial system have been paid up front. As each nation goes through hyperinflation, it puts the U.S. dollar in a more untenable situation and makes a nation more likely to defect to a new system. Since gold will likely be a part of a new financial order, even if there is deflation it is wise to obtain physical metal, but the ultimate denouement of the U.S. dollar may be years away.