Thursday, May 4, 2023
Economic Rival Juggernauts
The US and China, economic behemoths # 1 and # 2respectively, are global rivals in every conceivable sector. The competition ininternational lending is just getting underway as China has rapidly doubled itsmarket share. However, there are hard limits to China’s rapid lending growth.
To give you a visual and statistical perspective of how theUS and China account for a combined 42% of the world’s GDP, the following chartentitled Global GDP 2021 provided by Visual Capitalist presentsa comparative overview of each country’s total GDP organized by region in 2021with the US and China the dominant economies by far.
Thefollowing chart entitled China’s Economy in2021: GDP by Sectorprovided by VisualCapitalist presents a breakdown of the diverse sectors that power the Chineseeconomy. China’s diverse economy is critical in fulfilling the world’s demandsfor goods & services placing them in the enviable position of being able tooffer their currency, the yuan, as an alternate payment method.
The following chart entitled China’sExports in the 21st Century (2001-2022) provided by VisualCapitalist underscores the fact that China is the world’s export powerhouse. Itdebunks the notion that plans for Russia, Saudi Arabia and Brazil use of the yuanfor transactions with China are at the cusp, or at least will somehow unseatthe US dollar (USD) as the world’s reserve currency. In fact none of thesecountries are in the top 10 countries of Chinese exports and are unceremoniouslylumped into the “rest of the world” category.
Plan B | Jurisdictional Borrowing Diversification
As with any good business practice, China’s new borrowing clientsare smartly pre-positioning themselves, even if on a limited basis, by usingChina as an alternate line of credit primarily for short-term, stop-gap needs.This new option provides them with jurisdictional borrowing diversification andeliminates, or at least reduces, their dependency on western lendinginstitutions as the sole source.
The yuan also serves as a monetary insurance policy andshort-term cash flow relief should they themselves encounter, or are threatenedwith, sanctions either directly or indirectly in doing business with thirdparties under sanctions. Furthermore, with respect to risk, China’s oftendraconian and opaque terms & conditions is the cost of doing business.
China’sHard Limits
On the other hand, it’s one thing to have the world’ssecond largest economy as measured by GDP and world’s leading manufacturingexporter and another to be a major monetary player on the world stage. China iswell aware of these limitations as an international lender.
Nonetheless,the Chinese leadership is quite enthusiastic to promote the illusion that it’sinternational lending growth will seriously rival and perhaps supplant the USD asthe world’s reserve currency, or at least, share the monetary hegemony.
Thismuch publicized and touted “de-dollarisation” – low hanging fruit with respectto public relations scare tactics - serves to exploit niche markets withshort-term financial bailouts in exchange for medium-to-long term politicalsupport.
The following chart entitled Understanding De-Dollarization provided by Visual Capitalistpresents an historical timeline of the US dollar’s dominance.
Dollar Prominence & Dominance
The USD has been and will remain into the far future theworld’s reserve currency, the economic “oil” so to speak, that keeps the worldeconomic engine running. In other words, the demise of the US dollar has beengreatly exaggerated for the following reasons:
Ø About 60% of the world’s reserves areheld in USD.
Ø USD comprise 90% of global foreignexchange transactions.
Ø Global trade is 58% in USD. Thisfigure has declined from 75% since the mid-2000s because of the greater use ofthe euro not Chinese yuan in international trade.
Ø About 95% of USD payments are madethrough the Society for Worldwide Interbank Financial TelecommunicationsSWIFT).
The much discussion trade figure comparisons with respectto China doubling the use of the yuan in international trade is without contextand thus misleading. Indeed, China’s market share in global trade has doubled, from2% in February 2022 to 4.5% in February 2023, but it’s hardly an alarming threatto USD dominance. Meanwhile the USD declined from 86.8% in 2022 to 84.3% duringthis same period.
Countries are cleverly using the yuan and non-USDcurrencies to complete particular transactions to preserve their USD reserves.
From a political and psychological perspective, the USD ishighly liquid and universally, unquestionably accepted and preferred byeveryone, everywhere for all payments because of capital market transparencyand political stability.
China’s Limitations
Ø The yuan is pegged to the USD so itdoes not float, and thus has no exposure to market forces.
Ø China’s capital accounts are closed toforeigners.
Ø The Chinese government activelymanages the exchange rate which always favors an adjustment to increase Chineseexports.
Ø Commodities are priced and invoiced inUSD. If payment is in yuan or another currency, the USD has by defaultestablished the exchange rate to complete the transaction.
China’s alternative to SWIFT is Cross-Border InterbankPayment System (CIPS) which became fully operations in March 2018. It’s aclearinghouse that Russia does not yet have access to.
China holds $867 billion in USD denominated securities. Atumultuous drop in the US dollar would result in huge investment losses. Forthis reason, China realizes that it’s not in their best interest to “push theenvelope” and challenge the USD to the point that it triggers a plunge in theUSD and perhaps a rash, illogical domino-effect to de-dollarization.
As economist Brad Setser stated in Foreign Affairs magazineMay/June 2023), “The US ultimately holds the high cards here, the Fed is theone actor in the world that can buy more Treasuries than China could eversell.”
The following chart entitled Foreign Holders of US Debt provided by Visual Capitalistprovides a comprehensive breakdown of countries holding US debt such asTreasuries.
Economic Pot Holes on The Belt & Road (BRI)
China has been an emergency lender to many developingcountries to resolve cash flow or liquidity problems including Russia forvarious reasons. Although China’s market share of international lending isdwarfed by global organizations like the IMF and the World Bank, for some Chinahas become a Plan B with few restrictions to capital access such as humanrights issues.
A notable borrower is Russia who has been underincreasingly tougher US sanctions since 2015, 7 years before the war inUkraine. China provided Russia substantial economic assistance through thePeople’s Bank of China (PBOC) swaps in 2015-2016 when oil prices plummeted andthe west imposed sanctions. Russia preferred to use the yuan instead of scarceUSD in their foreign reserves for critical imports.
The following chart entitled The Countries Bailed Out by China provided by AidData, a research labat William & Mary, presents an overview of China’s lending portfolio bycountry.
The Debt Figures
Lending institutions perform a riskassessment but inevitably end up with bad loans on their books, hopefully a lowportfolio failure percentage. According to AidData, a think-tank at William& Mary’s, they estimate Chinas provided a total of $843 billion in loans.
China had 128 bailout loans totalingan estimated $240 billion to 20 distressed countries between 2000-2021according to economists at Harvard University Carmen Reinhart.
Although no official figures are available severalprominent organizations have placed an estimate on China’s outstanding badloans worldwide. According to the Rhodium Group, a NYC-based researchorganization, during the past 3 years it estimates that $78 billion forinfrastructure projects were renegotiated or written off between 2020 and4Q2022.
Furthermore, it is estimated by several organizations whichincludes the World Bank and Harvard Kennedy School that China provided $104billion to prevent sovereign defaults among 150 countries who signed up to theBRI. Menacingly lurking under the surface are other potential loans at thebrink of default because of rising interest rates and overall global economicslowdown.
The Global Debt Game Explained
The IMF and World Bank are classifiedas “super senior creditors” and are exempt from debt restructuring. Chinaprefers to rollover debts (issue new loans) rather than restructure them.
Ø Restructuring is a change of terms &conditions.
Ø Rescheduling the terms & conditions remainunchanged, rather the loan’s duration is extended with smaller monthly paymentsyet at higher interest rates.
Under China’s standard practice of lending terms & conditions,the outstanding loan is rolled over resulting in an estimated total averageterm of 3½ years. This means that although many countries can continue toaccess swap lines, this results significantly higher external debt.
On the other hand, with respect to western internationallending institutions a swap is a short-term loan, usually 12 months or less, bywhich time the loan is paid back. If not, the outstanding amount is classifiedas external debt.
Conclusion & Takeaways
As a global economic capitalistic behemoth, China is fulfillingan under-served niche market irrespective of its foreign and domestic policy practices.Their rhetoric about the demise of the USD through their clients and proxies istextbook public relations fodder which has gained traction in US governmentcircles.
However, particularly under a one-man dictatorship echochamber, China risks lending over-reach if the loans become too big to manageor contain especially if there’s another global crisis. Even a short-term mildcrisis or scare will provide a real-world stress test and expose the yuan’slimitations and test how the Chinese leadership will handle it.
Such a crisis will prove the yuan’s limitation, expose itsflaws, inflexibility, inefficiencies, lack of transparency and ultimately hitthe hard ceiling of market share in the international lending sector.
During earlier crisis, the real-life stress tests, the USDbent but never broke. Under similar or even lessor circumstances, the yuan willprove to be nothing more than a monetary paper dragon unable to support itsclient base. For this reason, it will take decades to dethrone the USD’s prominenceand dominance as the world’ reserve currency.
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