China | Monetary Paper Dragon
Economic Rival Juggernauts
The US and China, economic behemoths # 1 and # 2 respectively, are global rivals in every conceivable sector. The competition in international lending is just getting underway as China has rapidly doubled its market share. However, there are hard limits to China’s rapid lending growth.
To give you a visual and statistical perspective of how the US and China account for a combined 42% of the world’s GDP, the following chart entitled Global GDP 2021 provided by Visual Capitalist presents a comparative overview of each country’s total GDP organized by region in 2021 with the US and China the dominant economies by far.
The following chart entitled China’s Economy in 2021: GDP by Sector provided by Visual Capitalist presents a breakdown of the diverse sectors that power the Chinese economy. China’s diverse economy is critical in fulfilling the world’s demands for goods & services placing them in the enviable position of being able to offer their currency, the yuan, as an alternate payment method.
The following chart entitled China’s Exports in the 21st Century (2001-2022) provided by Visual Capitalist underscores the fact that China is the world’s export powerhouse. It debunks the notion that plans for Russia, Saudi Arabia and Brazil use of the yuan for transactions with China are at the cusp, or at least will somehow unseat the US dollar (USD) as the world’s reserve currency. In fact none of these countries are in the top 10 countries of Chinese exports and are unceremoniously lumped into the “rest of the world” category.
Plan B | Jurisdictional Borrowing Diversification
As with any good business practice, China’s new borrowing clients are smartly pre-positioning themselves, even if on a limited basis, by using China as an alternate line of credit primarily for short-term, stop-gap needs. This new option provides them with jurisdictional borrowing diversification and eliminates, or at least reduces, their dependency on western lending institutions as the sole source.
The yuan also serves as a monetary insurance policy and short-term cash flow relief should they themselves encounter, or are threatened with, sanctions either directly or indirectly in doing business with third parties under sanctions. Furthermore, with respect to risk, China’s often draconian and opaque terms & conditions is the cost of doing business.
China’s Hard Limits
On the other hand, it’s one thing to have the world’s second largest economy as measured by GDP and world’s leading manufacturing exporter and another to be a major monetary player on the world stage. China is well aware of these limitations as an international lender.
Nonetheless, the Chinese leadership is quite enthusiastic to promote the illusion that it’s international lending growth will seriously rival and perhaps supplant the USD as the world’s reserve currency, or at least, share the monetary hegemony.
This much publicized and touted “de-dollarisation” – low hanging fruit with respect to public relations scare tactics - serves to exploit niche markets with short-term financial bailouts in exchange for medium-to-long term political support.
The following chart entitled Understanding De-Dollarization provided by Visual Capitalist presents an historical timeline of the US dollar’s dominance.
Dollar Prominence & Dominance
The USD has been and will remain into the far future the world’s reserve currency, the economic “oil” so to speak, that keeps the world economic engine running. In other words, the demise of the US dollar has been greatly exaggerated for the following reasons:
Ø About 60% of the world’s reserves are held in USD.
Ø USD comprise 90% of global foreign exchange transactions.
Ø Global trade is 58% in USD. This figure has declined from 75% since the mid-2000s because of the greater use of the euro not Chinese yuan in international trade.
Ø About 95% of USD payments are made through the Society for Worldwide Interbank Financial Telecommunications (SWIFT).
The much discussion trade figure comparisons with respect to China doubling the use of the yuan in international trade is without context and thus misleading. Indeed, China’s market share in global trade has doubled, from 2% in February 2022 to 4.5% in February 2023, but it’s hardly an alarming threat to USD dominance. Meanwhile the USD declined from 86.8% in 2022 to 84.3% during this same period.
Countries are cleverly using the yuan and non-USD currencies to complete particular transactions to preserve their USD reserves.
From a political and psychological perspective, the USD is highly liquid and universally, unquestionably accepted and preferred by everyone, everywhere for all payments because of capital market transparency and political stability.
Ø The yuan is pegged to the USD so it does not float, and thus has no exposure to market forces.
Ø China’s capital accounts are closed to foreigners.
Ø The Chinese government actively manages the exchange rate which always favors an adjustment to increase Chinese exports.
Ø Commodities are priced and invoiced in USD. If payment is in yuan or another currency, the USD has by default established the exchange rate to complete the transaction.
China’s alternative to SWIFT is Cross-Border Interbank Payment System (CIPS) which became fully operations in March 2018. It’s a clearinghouse that Russia does not yet have access to.
China holds $867 billion in USD denominated securities. A tumultuous drop in the US dollar would result in huge investment losses. For this reason, China realizes that it’s not in their best interest to “push the envelope” and challenge the USD to the point that it triggers a plunge in the USD and perhaps a rash, illogical domino-effect to de-dollarization.
As economist Brad Setser stated in Foreign Affairs magazine (May/June 2023), “The US ultimately holds the high cards here, the Fed is the one actor in the world that can buy more Treasuries than China could ever sell.”
The following chart entitled Foreign Holders of US Debt provided by Visual Capitalist provides a comprehensive breakdown of countries holding US debt such as Treasuries.
China has been an emergency lender to many developing countries to resolve cash flow or liquidity problems including Russia for various reasons. Although China’s market share of international lending is dwarfed by global organizations like the IMF and the World Bank, for some China has become a Plan B with few restrictions to capital access such as human rights issues.
A notable borrower is Russia who has been under increasingly tougher US sanctions since 2015, 7 years before the war in Ukraine. China provided Russia substantial economic assistance through the People’s Bank of China (PBOC) swaps in 2015-2016 when oil prices plummeted and the west imposed sanctions. Russia preferred to use the yuan instead of scarce USD in their foreign reserves for critical imports.
The following chart entitled The Countries Bailed Out by China provided by AidData, a research lab at William & Mary, presents an overview of China’s lending portfolio by country.
The Debt Figures
Lending institutions perform a risk assessment but inevitably end up with bad loans on their books, hopefully a low portfolio 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 totaling an estimated $240 billion to 20 distressed countries between 2000-2021 according to economists at Harvard University Carmen Reinhart.
Although no official figures are available several prominent organizations have placed an estimate on China’s outstanding bad loans worldwide. According to the Rhodium Group, a NYC-based research organization, during the past 3 years it estimates that $78 billion for infrastructure projects were renegotiated or written off between 2020 and 4Q2022.
Furthermore, it is estimated by several organizations which includes the World Bank and Harvard Kennedy School that China provided $104 billion to prevent sovereign defaults among 150 countries who signed up to the BRI. Menacingly lurking under the surface are other potential loans at the brink of default because of rising interest rates and overall global economic slowdown.
The Global Debt Game Explained
The IMF and World Bank are classified as “super senior creditors” and are exempt from debt restructuring. China prefers to rollover debts (issue new loans) rather than restructure them.
Ø Restructuring is a change of terms & conditions.
Ø Rescheduling the terms & conditions remain unchanged, rather the loan’s duration is extended with smaller monthly payments yet at higher interest rates.
Under China’s standard practice of lending terms & conditions, the outstanding loan is rolled over resulting in an estimated total average term of 3½ years. This means that although many countries can continue to access swap lines, this results significantly higher external debt.
On the other hand, with respect to western international lending institutions a swap is a short-term loan, usually 12 months or less, by which time the loan is paid back. If not, the outstanding amount is classified as external debt.
Conclusion & Takeaways
As a global economic capitalistic behemoth, China is fulfilling an 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 is textbook public relations fodder which has gained traction in US government circles.
However, particularly under a one-man dictatorship echo chamber, China risks lending over-reach if the loans become too big to manage or contain especially if there’s another global crisis. Even a short-term mild crisis or scare will provide a real-world stress test and expose the yuan’s limitations and test how the Chinese leadership will handle it.
Such a crisis will prove the yuan’s limitation, expose its flaws, inflexibility, inefficiencies, lack of transparency and ultimately hit the hard ceiling of market share in the international lending sector.
During earlier crisis, the real-life stress tests, the USD bent but never broke. Under similar or even lessor circumstances, the yuan will prove to be nothing more than a monetary paper dragon unable to support its client base. For this reason, it will take decades to dethrone the USD’s prominence and dominance as the world’ reserve currency.
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