China Must Prepare for New Global Financial System

The U.S. dollar cannot continue as reserve currency in the current system. This is year 11 of a global depression because the U.S. dollar can no longer function as the global reserve currency. If by some luck the system revives as currently constructed, the U.S. will need to run trade deficits well over $1 trillion every year and possibly $2 trillion or higher. As the election of President Trump revealed, U.S. voters will not go along with this even if it was economically possible.

President Trump's renegotiation of trade is a backwards renegotiation of the global financial system. If the U.S. wasn't under the control of Imperial DC and Avaricious NY, it would have proposed reforming the global financial system and reserve currency as the first step because that solves most of its economic problems. The U.S. runs a massive trade deficit because global trade is financed in U.S. dollars and to back a U.S. dollar system, nations buy the safest U.S. dollar asset: U.S. treasuries. This inflates the value of the U.S. dollar, making U.S. manufacturing and labor less competitive. It also short-circuits natural forces in the global economy. Trade deficits used to cause currency depreciation versus the neutral reserve asset, and that would in turn reverse the trade deficit before it grew out of control. Under the current system, trade deficits can theoretically grow to infinity because the U.S. dollar keeps expanding as much as the global economy needs. Or at least, it used to.

Monetary reform is near impossible because DC continues to wield the dollar as a financial weapon and Wall Street is more than happy to go along since its gets first bite at the big inflationary apple. President Trump isn't the best option, but he's the only option given the establishment's refusal to change. Blowing up the global trading system is a means to resetting the global financial system. An editorial in the 21st Century Herald says China must prepare for this eventuality.

21st Century: 社论丨中国要为“后布雷顿森林体系2”时代做好准备
Editorial: China to Prepare for Post-Bretton Woods System 2 Era

U.S. efforts to revive manufacturing and reduce the current account deficit may change the current global financial system with the U.S. dollar as the main currency. China should be prepared for this possible change.

Translation: if the U.S. government has an economic policy that favors Americans, the global financial system blows up. The American voters spoke in 2016: blow it up.

After the end of the Cold War, the "Bretton Woods System 2" was formed between the United States and emerging markets. That is, the United States consumed commodities from economies such as Japan and South Korea in East Asia and oil from energy exporting countries such as Saudi Arabia through current account deficits. These emerging market countries used their trade surpluses to purchase safe assets such as US debt, while the United States used these funds for global investment, forming a new cycle. After 2000, China joined this cycle and became the largest holder of U.S. debt.

The next sentence should be: and China almost blew it all up because the U.S. cannot finance an economy of China's size with domestic debt creation.

However, since the trump administration took office, the U.S. economic strategy will eventually destroy "Bretton woods system 2." This is because the United States first lifted the ban on oil exports. The United States is more dependent on crude oil produced in its own country and Canada. OPEC accounts for only about one third of the crude oil imported by the United States. The United States has become an oil exporter while China is the largest oil importer. Secondly, the U.S. government is trying to revive its manufacturing industry and realize import substitution through domestic tax cuts and tariff increases, thus reducing the trade deficit and improving the current account deficit. To this end, the United States launched tariff war against China, the European Union, Japan and other countries and regions.

Leaving aside that tariffs wouldn't be necessary if the monetary system was reformed, other countries also wouldn't care as much if the dollar wasn't the global reserve currency. The U.S. cannot act like a "normal" country because it is not a normal country, it is financing global trade through its trade deficits and budget deficits. If the U.S. started behaving responsibly under the current arrangement, the global economy will implode.

China has been the largest source of U.S. deficit for more than ten years, which is determined by the global division of labor. U.S. companies have gained the largest proportion of profits in this division of labor, and U.S. consumers also enjoy the benefits of low-priced goods. However, the increase in tariffs imposed by the U.S. government on Chinese goods will continue to reduce the scale of China's exports to the United States. As of April this year, the proportion of Sino-U.S. trade volume in China's total foreign trade volume has reached a new low of 11.18%. This means that China's trade surplus between the two countries will be reduced, and China must consume a large amount of foreign exchange to import oil. Therefore, China will lack the ability to continue to purchase US debt and may even be forced to reduce its US dollar holdings.

Read that again if you think China will dump treasuries. That paragraph explains the reality of the situation: if China exports less to the USA, it obtains fewer U.S. dollars, but it needs foreign currency to import natural resources such as oil. China's dollar holdings will fall if trade is rebalanced. China has extremely tight capital controls because it has very little excess reserves backing its currency. If trade rebalances, China may "run out" of dollars, forcing a devaluation of the yuan to bring it in line with reserves.

The US trade deficit is the inevitable result of the US dollar's status as an international reserve currency. However, there is triffin dilemma: the accumulation of global reserves against US dollar requires the US to accumulate a current account deficit. As the world's reserve needs increase, the increase in US dollar reserves will not increase US foreign debt in a sustainable way. At this time, either the United States will stop increasing or eliminating its current account deficit, resulting in insufficient global reserves. Either, US debt will rise indefinitely with the growth of global nominal GDP, eventually destroying the US dollar and its value as a reserve currency.

Just as the Bretton Woods system was forced to decouple because of the dollar and gold, the "Bretton Woods System 2" also has some kind of decoupling critical point, which may lead to system collapse. No one knows when and why, but the current series of policies of the U.S. government are creating such risks.

There is no threat in this editorial, only plain spoken reality that has been discussed here and elsewhere for years on end. The U.S. dollar as global reserve currency is an unhealthy system that punishes American labor and manufacturing, and is mathematically unsustainable. That which cannot continue, will not continue.

One of the possible reasons that triggered the above-mentioned collapse of the system is that when the United States uses the low-cost capital of these emerging market countries to finance (borrow), the income from its outward direct investment is getting lower and lower, which is not enough to pay the interest rate that is attractive enough for these debts. Then, the system will become unstable and people will begin to suspect and withdraw.

However, a bigger possibility is that the U.S. debt continues to expand rigidly, but the world is beginning to have insufficient funds to take over the offer. This kind of risk is just around the corner. In the past three years, the U.S. fiscal deficit has continued to increase. However, due to the tariff war launched by the U.S. government, the world has begun to doubt the future of the U.S. dollar as a global currency, and many trading countries are unable to continue to purchase U.S. debt, resulting in a "break". One of the results may be that the Federal Reserve has to print more money to fill the deficit and is forced to monetize the national debt, eventually causing the dollar to depreciate and even losing its status as the world's reserve currency.

The opposite is happening. The U.S. dollar is rising because foreign countries, particularly emerging markets such as China, are inflating at far higher rates. As I've said before, the U.S. dollar system breaks from the outside in, emerging market fiat currencies devalue first, then possible the yen and euro, and last will be the U.S. dollar because escaping the U.S. dollar system is similar to breaking the link with gold. Only if the United States suffers a crisis or voluntarily moves first will it devalue first, but if that happens, then nearly all currencies will devalue simultaneously along with the dollar.

On last Wednesday, investors bid 2.17 times for the 27 billion U.S. dollar 10-year U.S. debt, the lowest since March 2008, meaning that investors' demand for the 10-year U.S. debt has weakened. At this auction, the proportion of US debt subscribed by foreign investors led by China and Japan has gradually decreased, increasing the pressure on domestic investors to subscribe to US debt, while the Federal Reserve is in the process of scale-down.

As China has more than 2 trillion US dollars in assets and foreign investors have lost interest in US debt or are unable to continue buying US dollars, the security risks of US dollar assets will gradually emerge. This is a huge visible risk to the global financial system brought by the US government through sanctions against other countries. Although it is unlikely that China will sell U.S. debt to hit the U.S. financial market, the challenge of how to ensure the safety of foreign exchange reserves is already ahead in view of the immediate risks and atmosphere.

China isn't going to put out an editorial warning of a collapse in the Chinese yuan, but that is what is coming as the global financial system begins breaking down. The editorial also doesn't say the end of Bretton Woods 2 was inevitable and forecast long ago. China should have been preparing for years, but instead of economic reform and opening the capital account, it went in the opposite direction. China's current predicament is based on their failure to reform and presumably their assumption that the United States would continue its slow suicide for another 10 to 15 years, that a Trump figure would never come along to disrupt and accelerate the process.

Ultimately, it doesn't matter if you agree on the order of events because unless you're speculating on relative movements in fiat currencies, the outcome of any reset will be global currency devaluation. What really matters is the timing, and whether you own enough gold and real assets before the reset hits.