The China Trigger
The Day of Reckoning for Dollar is Fast Approaching
by Michael Hampton. November 9, 2006
An imaginary official, Mr. Dai Mingdao ("major leader" in Mandarin) is a paramount leader of today's China.
Will Mr. Dai shrink from making an Important Decision, which will have a huge impact upon his country and the entire global financial system?
Sometimes putting oneself in the other man's (or other woman's) place can give great insight into the decisions that others are facing. In this imaginary exercise, try to put yourself in the position of one of nine members of China's powerful Standing Committee of the Politburo. These nine leaders meet regularly to discuss the policies that will govern China. As this internal dialogue starts, Mr. Dai is leaving the Beijing airport on his way to one of those Committee meetings. He believes that an important decision will be need to be made at the meeting, and the issues surrounding that decision are already swirling around in his brain.
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The car arrived on time, and the driver was alert and lively, almost as if he somehow knew that an important decision would be made later that day. Though tired from the long flight, and running behind schedule, Mr. Dai nodded at the driver, and asked him to drive quickly, so he would not be too late to hear the opening discussion at the meeting. Dai had just returned on a long flight from his home province, where he was visiting to participate in a ceremony to sweep his ancestors' graves. The visit had left him in the contemplative mood, and was thinking deeply about the legacy that he will leave for his own children and grandchildren.
Mr. Dai saw a recent report in the newspaper that his country's foreign exchange reserves had just surpassed $1 Trillion. The article said that was 20% of the world's forex reserves. It was a huge step forward from the $200 billion level of only six years ago. Dai laughed to himself as he recalled that just a few years prior to the millennium, during the so-called "Asia crisis", the Western media was full of articles worrying about whether or not China was headed towards bankruptcy. His Chinese countrymen are certainly hard-working, he thought, but they need good leadership to keep them on track.
He recalled that 70% of those reserves, a huge $700 billion, was tied up in us dollar securities. That's over 5 trillion renminbi, he thought, a sum so large that it is impossible to contemplate. That money is needed to keep building China, and to maintain a strong economy in a future where China's demographics are likely to be unhealthy, thanks to the decades-old "one child policy." Over the past year, he had watched those reserves grow by 30%, while the country's growth rate was maintained at about 11%. High enough, it seemed, but some economists had told him privately that the real figure was even higher. Sometimes he wanted to pat himself and his colleagues on the back for having allowed those dollar reserves to grow, because the recycling of all those dollars earned in foreign trade had encouraged a virtuous cycle. Returning dollars back to the US, through the purchase of treasury bonds and mortgage-backed securities had given the average American continued access to cheap debt. Just as the Committee's economic advisers had predicted, Americans continued to refinance the mortgages on their homes, taking out more money if they could afford it. And they went out and spent the money. A fair share of that spending went into Chinese products, and helped to create new jobs in China. Not a prudent decision for the borrowers perhaps. But this relentless spending allowed a few hundred thousand more of those Chinese trapped in the countryside to come to the cities, and find jobs in factories. There still remained hundreds of millions under-employed in China's over manned agricultural sector, and only if they saw the prospect of a brighter future, would their grumbling be contained. The violence and riots that sometimes erupted could be kept under control.
Dai Mingdao thought of his two old parents in the last years before they died. They were bent over with age, from all the hard work that they had endured. Dai could still recall the wrinkles on his mother's old face as she used to speak with pride about how her son had done so well, and was busy building a better China. Mr. Dai did not want to see any of his grandchildren return to such a life. The best assurance of that was to give the masses a pathway out of poverty. That required jobs and more jobs. This way, those who were willing to work hard, would have a way out of poverty. Otherwise, these same people were energetic enough to cause trouble…
Uneven growth, with riches growing only in the giant cities on the East Coast, was something that Dai, and the other top leaders worried about every day. Without those jobs, and the taxes that they helped to generate, there would not be enough money to build the schools and hospitals needed to the cities and the rural areas. Education, and opportunities were the key thing. Without them, the agitated tensions will boil over into chaos throughout the country. Despite the recent decades of rapid growth, China remained vulnerable to trouble from its still-impoverished peasants.
LOOKING IN THE MIRROR
Dai caught a glimpse of himself in the window. He saw experience, and some traces of aging in his face. Like all his colleagues on the Standing Committee, he was male, and in his sixties. Gone were all the old workers, and theologians that used to be on the old Committees. And gone with them were all those old visionary, but dangerous schemes, that had ruined China for decades. Since Deng's time, they had gradually been retired, and new and more pragmatic leadership had taken over. The political analysts were calling those elected at the 16th Congress, a "fourth generation" of Chinese leaders. Like Dai, many of the others were educated as engineers, so they sought a real understanding of how things work, rather than getting carried away with the pure rhetoric. Dai took a particular interest in economic subjects, and had worked hard to understand the subject. Some members of the Politburo had joked with him, and said that he should have become an investment banker instead of a party official. They would quietly consult him on their personal investments.
The whole standing Committee, and even the 24-person Politburo who elected them, had been inspired by the steady hand and the "balanced growth" policies of Hu Jintao, who took over as party leader in the 16th party Congress of 2002, and later became China's President. Dai Mingdao thought it ironic that Western countries often critised China's lack of a fully democratic process in electing its leaders. But the Chinese system had served up leaders with longer term vision, while the American four-year Presidential election cycle had produced a leader who believed in cowboy diplomacy and thought that global bullying, relying mainly on the powerful American military were a sensible way to fight a complex problem like the terrorist threat. America's short-term-ism had cost the country dearly, and the leaders of China were keen to avoid the trap of seeking easy short term benefits at the expense of future disasters.
US leaders, like Senator Charles Schumer, had been critising China for allowing its trade balance with the US to become so lopsided. In recent months, the US trade deficit with China had zoomed past $20 billion per month. Senator Schumer, and his Washington colleagues, had been threatening to impose an import tax of 27% on Chinese goods, in order to limit the ongoing damage to US manufacturers. The Senator's rationale was that the Chinese currency was too weak, and if it strengthened markedly, the US would have better terms of trade. A stronger renminbi, meant the US would find Chinese products expensive and would import less from China. And at the same time, the US might export more dollar-priced products to its Asian trading partner. Chinese economic advisers had continually disagreed with this approach, saying that the real problem was in America: US consumption was out of control, Americans were spending like there was no need to save for tomorrow. A bad situation, thought Dai, but at least that excess consumption was helping to feed orders into Chinese factories.
A FRIENDLY FACE
Fortunately, the recent visit of the intelligent new Secretary of Treasury, Henry Paulson, had eased the pressure. Paulson knew and understood China. During his days as head of Goldman Sachs, he had regularly jetted to China, where Goldman had sought to take stakes in Chinese banks, as a prelude to their IPO's. He was a welcome change from his predecessor, John Snow, who seemed a relic from some forgotten past. Paulson had told Chinese leaders that he could keep Schumer at bay, so long as China made continuous progress in easing its capital controls on the export of currency, and in strengthening its currency. The renminbi had already appreciated by 3% against the dollar in the past year. That's not enough, said Paulson, who wanted to keep the trend intact, but at least the currency is moving in the right direction.
Paulson agreed with the Chinese economic advisers that China should continue to restructure its banking system. In fact, some said that Goldman had helped to develop the strategy to reinvigorate the troubled Chinese banks. And that strategy had brought a dramatic improvement. Dai was secretly proud to see the recent IPO by the huge International Commercial Bank of China, ICBC. He had even purchased some banks shares in Hong Kong, with the help of his son-in-law. The issue had brought in record subscriptions in China and especially in Hong Kong. The buying frenzy had resulted in a total fund-raising of $22 billion, the largest IPO ever seen, anywhere on the planet. And only two years ago that bank was considered virtually bust. The rescue had happened to two stages. First, government institutions took billions of troubled loans onto the books of the state, leaving "only" $19 billion of non-performing loans with ICBC. Then the bank went out and raised enough through its huge IPO so it would remain be solvent, even if all of those bad loans had to be written off. Along the way, the bank rebuilt its internal credit procedures, getting help from foreign lending institutions. This was meant to insure that future lending would be prudent. Now ICBC was preparing for its new mission. It would lend more to China's own consumers. And so would those other Chinese banks that had done big IPO's just before it (Bank of China, China Construction Bank, and China Merchants.). Moreover, there was now a long list of foreign banks, who were eager to find a way into the Chinese market; keen to lend to China's newly emerging consumers. A brilliant strategy, and if Goldman had helped concoct it, perhaps they deserved the $4 billion profit they they were now sitting on, as a result of the banking investments that Paulson had approved. A clever man, who deserved a return favor, which was why China had delayed introducing changes in the management of its Forex reserves. China held off until after the election, so that it would keep its agreement with Paulson. They did not want to be seen to be tampering with the election result. But now the election was over, and it was time to think again.
The car pulled off the fast toll road, and onto a slower, more crowded street. Dai looked up at the huge new hotels, office buildings, and shopping malls springing up everywhere, as developers and property investors fought for a piece of the future boom they saw coming to Beijing along with the 2008 Olympics. But not all of the city was so crowded. Beijing's historical legacy is its wide boulevards, particularly in the area near its heart, the Forbidden City, once the home of China's emperors. The critical institutions of modern China, were still scattered nearby, within walking distance of the palace. But few important people walked in Beijing, because the scale is too large. The open spaces and the imposing architecture, made pedestrians feel like ants. Having an official car was the only way to get around. Dai's limousine had picked up an official escort, so it could slide quickly through the traffic lights, following the escort car and its flashing lights.
Dai remembered the recent phone conversation when he was told that the meeting had been scheduled. He had received a call from President Hu's office, saying the Committee was being convened, and he was needed back in Beijing. He wanted to spend more time in his hometown with his relatives, so he asked what the quickly-scheduled meeting was about, thinking if it was unimportant one, he might skip it. Dai Mingdao was told in hushed tones that "Pulling the Trigger" was on the agenda. He had previously been carefully briefed on the issue, so he said, "Of course, I will be there. I will fly back immediately." Dai didn't want to be the only leader not to vote on such an important subject.
Dai was not totally surprised the meeting had been called. ICBC was a big bank, and there were not many more left to take public. The plan all along had been to fix the banks before pulling the trigger. The US election was over, the markets were up, and the psychology was right for the action that the Chinese had been discussing. The pre-election good feelings that Paulson and has team had engineered, might not last much longer. The recent fall in oil, and the rally in the US stock market had brought back confidence into global securities market. The politburo's advisers had shared their views about market conditions, and there was now enough liquidity around to make the move possible, provided it was taken quickly.
Mr. Dai knew how he would vote. He had been a key supporter of CNOOC's bid to buy the Far Eastern assets of Unocal, the US oil major. CNOOC had offered a fair price, in fact they were the highest bidder. But in July 2005, the US House of Representatives had passed a resolution urging President Bush to block the bid. If China was not to be allowed to use its dollar reserves to buy assets to protect its own economic security, what use were the dollars as a reserve currency? Dai and one or two others were ready to vote to unload the dollars at that time, as quick retaliation for the US interference. But Hu and his closest allies had urged a steady policy. China needed more time to rebuild its banks. Goldman and other has helped to suggest a way to do that, and a better time would be found later. Now that time may be at hand.
THERE AT LAST
As the car pulled up in front of the Committee's secret meeting place, Dai thought for a moment that it might be a close vote. Two committee members had phoned him already, asking how he was planning to vote. Both cited the same advisor's report, saying the move could prove catastrophic. The Asian Crisis had hit the region hard, and growth had gone negative in many Asian countries for one or two years. If things went wrong, this action was likely to have a larger and more long-lasting impact.
Dai thought again about all the arguments that he had heard. If China "pulled the trigger" and started to unload dollars, there would be two immediate impacts: the dollar would plummet, and US long term rates would push higher, perhaps much higher, as fixed income investors worked out that a falling dollar would push up inflation in the US. Chinese imports would get more expensive, and so would the imports from any country with the stronger currency than the dollar. A plummeting dollar would mean that virtually every currency would be stronger than the buck - apart from those that retained a dollar link, and a few basket-cases, like Zimbabwe. And how would the Middle East react to a sharp fall in the dollar? They didn't like it when their income fell. The oil price drop that the US has engineered before the election had nearly run its course, and crude prices had begun to bottom out in recent weeks, because OPEC producers began to cut production to prop up the price. Surely, if the dollar was losing its value, the Middle East would want to see a higher dollar oil price, to maintain the spending power of those dollars. Advisers to the Politburo had forecast that if the dollar fell 30-40%, oil would rise to $150 per barrel, and maybe $200. This would mean pain and hardship to the US, which was still heavily dependent upon imported crude for over half of its oil needs. But other countries, like China with an appreciating currency will see much less change. This move would bring an important lesson to the US, which Dai believed had overstepped itself in the world community. Soon Americans would have to learn, through economic pain, how to use less oil. Dai Mingdao had always thought it unfair that the US used about 30 times as much oil per capita as China did. America had lost its claim to cheap oil, when it became the world's largest debtor nation.
TWO ADVISORS, TWO REPORTS
He recalled his conversations with the Doves from the Standing Committee. The report that his two colleagues had cited spoke about how the loss of orders from America market would harm the Chinese economy. Exports were about 30% of the Chinese economy, and the US was the second largest market fot Chinese products, after the EU, which had recently overtaken America. But there were other possible markets for Chinese products. Mr. Dai commissioned a report of his own, which he had shared with his more hawkish colleagues. He suspected that Hu Jintao secretly agreed with the conclusions in the report, although Hu had so far been careful to steer a neutral, delaying any action. Dai's special report said that the US consumer was about to stop buying anyway. The slide in US housing prices was turning into a rout, and within months, mortgage refinancings would virtually disappear. With the threat of job losses, US consumers would be spending less than their incomes, after years of spending more. If China pulled the trigger, their incomes would be strapped by higher energy prices, and higher mortgage interest costs. More strain, just when the banks (and the markets that absorbed the securities) were losing their appetites for mortgage loans.
In a way, Dai felt sorry for Fed Chairman Ben Bernanke, whom he had never met. He had been at a meeting once with his predecessor, Greenspan, and shook his hand. Greenspan had been hard to understand. When his speeches were translated into Chinese they came across as garbled. Dai had been told, that Greenspan's academic writings about topics like gold, suggested a man who understood the risks of inflating a paper-backed currency. But his actions were different. Every time a crisis hit, Greenspan's Fed had provided liquidity, and lots of it. Easy liquidity brought rates down, and allowed more borrowing, so the US consumer went on spending, and the demand stimulus bailed out a troubled economy. It was never acknowledged, except in the report that Dai's own adviser had put together, but this strategy would not have worked without the co-operation of foreign central banks. The Fed pumped, pushing short term rates down, and the foreigners helped by making big purchases of US bonds, keeping long term rates down too. China, along with Japanese were the most important purchasers of those bonds. Now, on Bernanke's watch, it would be different. At some stage, and perhaps in immediate future, China would stop buying bonds, and would turn seller instead. As the dollar sank, it was likely there would be another sort crisis, stagflation � inflation and economic stagnation at the same time. Fighting a slowdown would be tough. Bernanke would have problems cutting rates because the weak dollar would bring inflation into the US, with some prices driven up by the rising cost of imports, even though consumer demand was weak.
AN IMPOSSIBLE BIND
If Bernanke dared to cut short term rates in the face of inflation, it might accelerate the fall in the dollar and spur a faster rise in long term rates. The critical point, Dai grasped, was that market controlled long term rates, not the Fed. If holders of bonds panicked when they saw the Chinese selling their bonds, then long term rates would rise, no matter what the Fed was doing to the Fed funds rate. According to the report, Bernanke was in an impossible bind. Long term rates in the US were headed higher, and there was nothing the Fed chairman could do about it. Fixed mortgage rates were likely to soar, and this would drive housing prices back down, erasing the easy gains since 2000. That's what Dai's report said. But if prices went back to 2000 levels, American would remain saddled with all the extra debt they had added thanks to their spending orgy.
Dai recalled the key question asked in his report: if the US consumer was going to disappear, why go on recycling China's trade surplus to America? Why give money to a customer when he had stopped buying? The hawkish report said that China would do best to recycle money to other customers with greater potential, and it had identified two, the same two that China had been buying time to develop.
THE AFRICA - CHINA SUMMIT
Hu's advisers had suggested years ago that China get closer to Africa. China had been established for decades as a reliable trading partner on the African continent, and the Africans needed China's money and technology to develop their economies. The old partners had recently marked their relationship by a huge summit in China last month. In an amazing show of unity, all 47 countries on the continent had sent representatives to Beijing. And in most cases, it was each country's chief executive who came. China spoke of helping develop Africa by building hospitals and schools. But the real agenda was economic, and for both sides. China was prepared to finance the development of African infrastructure, making loans, and providing technology, and capital goods. And those loans would in effect be backed by Africa's mineral and energy wealth. Best of all, by importing those commodities, China would get the energy and raw materials it needed to keep growing, and those purchases would simultaneously assure the cash flow to repay its loans.
At the Africa China Summit, it was apparent that Chin's strategy was working, a masterpiece of soft diplomacy. Every country wanted money and customers for its products. And soon the the time would be right for the next stage. The recycling program that had been perfected in the US would now be deployed in Africa. There was an important side benefit. African resources would pay for the development of its own infrastructure, and the growth there would make Africa a larger customer for China's products. This would demonstrate China's good intentions, and its new African friends would be more likely to support its initiatives in the United Nations.
The strategy would be modified for the Middle East. Most countries there did not need China's money, but they did buy its products in increasing numbers. Iran was a special case. It was eager for Chinese money, and closer ties. China needed the oil and gas, and was ready to help Iran expand its petroleum capacity. The report pointed out that US would not like to see China build a closer relationship in that country, but the two countries had such complimentary needs that a relationship was likely to develop with Iran as China's energy needs continue to grow, particularly if China found itself blocked by the US in other Gulf countries.
THE BEST CUSTOMERS
Finally, the report revealed a satisfying solution. The most important new customers were going to be inside China itself. For years, China had such an emphasis on exports, and it had almost neglected its domestic consumers. In the US, consumer debt was about 70% of GNP. In China, it was only slightly more than 10%, and that was against a rapidly growing GNP. Of course, it was almost impossible to lend to Chinese consumers when they were at a subsistence level, particularly using a banking system geared towards providing loans to a bloated State Owned Enterprises. But times were changing fast. Chinese banks were cleaning up their exposures to teetering SOEs and learning better how to assess risk in lending to consumers, who now had much more income, something like 15-20% more each year. Revitalised Chinese banks would now be turning to these consumers, to offer them mortgage loans and credit cards. Their spending, together with that from African countries, and a still-rising number of customers in the Middle East and India, would allow China to keep growing, even as it lost a big share of exports to America.
Dai smiled to himself, thinking the decision would be obvious. Surely his colleagues would agree that the time had come to start selling those excess dollar reserves, and reinvesting the money in commodities, something China could use. And the time to do it was before others countries and speculative players like hedge funds caught on and started buying, and pushed the price up. The recent drop in oil, and other commodities, engineered as a prelude to the US elections, had provided a wonderful buying opportunity. Now was the time to strike.
A FINAL TASK
The car had stopped. Dai was anxious to join the meeting, now underway. But first, he had one important task. He quickly phoned his son-in-law, who was working for a Hong Kong based hedge fund. "It's time to buy gold," he said. "And while you are at it, why not buy a few of those junior miners you have been talking about.
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Will this happen as I have described, within the time frame I have suggested? That is unlikely. But this scenario does show some of the pressures which are going to be driving decisions in China. If we see things from the perspective of our Chinese bankers, the danger to the American standard of living is apparent. Americans need to make our own future, rather than waiting for someone else to hand them a bleak scenario they may not like.
Michael Hampton is a private investor and former banker, who recently returned to Hong Kong after an absence of 22 years.
© 2006 Michael Hampton