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China’s Monetary Policy Must Change

Author & Head of Research @ Goldmoney
November 2, 2018

The next credit crisis poses a major challenge to China’s manufacturing-based economy, because higher global and yuan interest rates are bound to have a devastating effect on Chinese business models and foreign consumer demand. Dealing with it is likely to be the biggest challenge faced by the Chinese Government since the ending of the Maoist era. However, China does have an escape route by stabilising both interest rates and the yuan by linking it to gold.

But will the Chinese have the gumption to take it? This article examines the challenges and the possible solution. It concludes there is a reasonable chance China will embrace sound money, because it is in a position to do so and the dangers of not doing so could destroy the State.

Are the Chinese Keynesian?

We can be reasonably certain that Chinese government officials approaching middle age have been heavily westernised through their education. Nowhere is this likely to matter more than in the fields of finance and economics. In these disciplines there is perhaps a division between them and the old guard, exemplified and fronted by President Xi. The grey-beards who guide the National Peoples Congress are aging, and the brightest and best of their successors understand economic analysis differently, having been tutored in Western universities.

It has not yet been a noticeable problem in the current, relatively stable economic and financial environment. Quiet evolution is rarely disruptive of the status quo, and so long as it reflects the changes in society generally, the machinery of government will chug on. But when (it is never “if”) the next global credit crisis develops, China’s ability to handle it could be badly compromised.

This article thinks through the next credit crisis from China’s point of view. Given early signals from the state of the credit cycle in America and from growing instability in global financial markets, the timing could be suddenly relevant. China must embrace sound money as her escape route from a disintegrating global fiat-money system, but to do so she will have to discard the neo-Keynesian economics of the West, which she has adopted as the mainspring of her own economic advancement.

With Western-educated economists imbedded in China’s administration, has China retained the collective nous to understand the flaws, limitations and dangers of the West’s fiat money system? Can she build on the benefits of the sound-money approach which led her to accumulate gold, and to encourage her citizens to do so as well?

China’s economic advisors will have to display the courage to drop the misguided economic policies and faux statistics by which she will continue to be judged by her Western peers. If she faces up to the challenge, China should emerge from the next credit crisis in a significantly stronger position than the West, for which such a radical change in economic thinking undertaken willingly is impossible to imagine.

Post-Mao financial and monetary strategy

Following Mao Zedong’s death in 1976, the Chinese leadership faced a primal decision over her destiny. With Mao’s demise, the icon that forcibly united over forty ethnic groups was gone. It was the end of an era of Chinese history, and she had to embrace the future with a new approach. Failure to do so risked the fragmentation of the state through civil disobedience and would probably have ended in a multi-ethnic civil war.

Wise heads, which had observed the remarkable successes of Hong Kong and Singapore being driven by Chinese diasporas, prevailed. It was clear that in order to survive, the Communist Party would have to embrace capitalism while retaining political control. Mao’s nominated successor, Hua Gofeng, lasted no more than a year, being promoted upstairs out of harm’s way. It was his successor, Deng Xiaoping, who reinvented China. In the late-1970s, Deng, hating the Soviets for their involvement in Vietnam, reaffirmed the USSR as China’s main adversary. At this crucial point in China’s pupation she secured a strategic relationship with America by sharing a common enemy.

The seeds for the relationship with America had already been sown by Nixon’s first visit to China in 1972, so the Americans were prepared to help ease China into their world. Through the 1980s, the relationship opened China up to inward investment by American and other Western corporations, and there was a rush to establish new factories, taking advantage of a cheap diligent labour force and the lack of restrictive regulations and planning laws.

By 1983 it was clear that China’s central bank, the Peoples Bank (PBOC), had a growing currency problem on its hands, because it bought all the foreign exchange against which it issued yuan for domestic circulation. Inward capital flows were added to by the policy of managing the yuan exchange rate lower in order to stimulate economic development. Accordingly, as well as foreign currency management the PBOC was tasked with the sole responsibility of the state’s gold and silver purchases as a policy offset. The public was still banned from owning both metals.

In those days, China’s gold objective was simply to diversify her reserves. The leadership grasped the difference between gold and fiat money, just as the Arabs had in the 1970s, and the Germans had in the 1950s. It was prudent to hold some physical gold. Furthermore, Marxist economic theory taught in the state universities impressed on students that western capitalism was certain to fail, and that being the case, their fiat currencies would become worthless as well.

China’s secret accumulation of gold in the 1980s was also an insurance against future economic instability, which is why it was spread round the institutions that were fundamental to the state, such as the Peoples Liberation Army, the Communist Party and the Communist Youth League. Only a relatively small portion was declared as monetary reserves.

In the 1990s, inward capital flows were beginning to be supplemented by exports, and a new wealthy Chinese class was emerging. The PBOC still had an embarrassment of dollars. Fortunately, gold was unloved in Western markets, and bullion was readily available at declining prices. The PBOC was able to accumulate gold secretly on behalf of the state’s institutions in large quantities. But there was a new strategic reason emerging for buying gold, following the collapse of the USSR.

The end of the USSR in 1989 meant it was no longer America’s and China’s common enemy, altering the strategic relationship between the two. This led to a gradual change in China’s foreign relationships, with America becoming increasingly concerned at China’s emergence as a super-power, threatening her own global dominance.

These shifting relationships changed China’s gold policy from one where gold acted as a sort of general insurance policy against monetary unknowns, to its accumulation as a strategic asset.

Bullion was freely available, partly because Western central banks were selling it in a falling market. The notorious sale of the bulk of Britain’s gold by Gordon Brown at the bottom of the market was the public face of Western central banks’ general disaffection with gold. China was on the other side of the deal. Between 1983 and 2002, mine supply added 42,460 tonnes to above-ground stocks, when the West were net sellers.

The evidence of China’s all-out gold policy is plain to see. She invested heavily in gold mining and is now the largest national miner of gold by far. Chinese government refiners were also importing gold and silver doré to process and keep, and they set a new four-nines standard for one kilo bars. Today, China has a tightening grip on the entire global bullion market.

A decision was taken in 2002 by China to allow the public to buy gold, and the benefits of ownership were widely promoted by state media. We can be certain this decision was taken only after the State had accumulated sufficient bullion for its supposed needs.

China’s public has accumulated approximately 15,000 tonnes to date, net of scrap recycling, based on deliveries out of the Shanghai Gold Exchange’s vaults. Given the public is still banned from owning foreign currency, gold ownership should continue to be popular as an alternative store of value to the yuan, and currently between 150-200 tonnes are being delivered from SGE vaults every month.

Other than declared reserves, it is not known how much gold the state owns. But assessing capital flows from 1983 and allowing for the availability of physical bullion through mining supply and the impact of the 1980-2002 bear market, the PBOC could have accumulated as much as 15,000-20,000 tonnes before the public were permitted to buy gold. If so, it would represent approximately 10% of those capital flows at contemporary gold prices.

The truth is unknown, but we can be sure gold has become a strategic asset for China and its people. China must have always had an expectation that in the long-term gold will become money again, presumably as backing for the yuan. Otherwise, why go to such lengths to monopolise the global bullion market?

But there is a problem. As time goes on and a newer, western-educated generation of leaders emerges, will they still fully recognise the value of gold beyond being simply a strategic asset, and will they recognise the real reasons behind the West’s economic failures, given they have successfully embraced its economic and monetary policies?

These remain fundamental questions. But before teasing out answers to China’s current dilemma, we must dissect China’s current economic, monetary and geostrategic policies.

Working with the West’s monetary standards

The Chinese have embraced fractional reserve banking as the means of financing economic expansion. There are, however, significant differences compared with the West in the way this credit is dispersed. In the US, the commercial banks are all independent entities, nominally controlled through regulation. In China, roughly two-thirds of all bank assets are in state-owned banks. This structure permits the Chinese government to directly control overall bank lending strategy.

By controlling lending strategy, the state can ensure financing is provided for its strategic objectives. But importantly, the state also uses its nationalised banks to influence private sector capital flows and to ensure a cap is put on speculative excesses. Most recently, this has been seen in the deliberate reduction of shadow banking. Before that, the state jumped on speculation in commodities, and in 2015, the stock market bubble was pricked (though there were other influences at work – see below).

A point rarely recognised by Western analysts is that while the expansion of China’s bank credit has been more rapid than in the US, there is less money tied up in speculative activities. And it is excessive speculation that unseats markets.

Contrary to what many observers seem to realise, China’s financial system is more effective at financing production than that of the US. The US’s M2 may have doubled in the last ten years, but nominal GDP has increased by only 40%. China’s M2 has tripled, but China’s nominal GDP growth has almost matched it. In America, the balance of monetary expansion has gone into financial speculation and supports an economy dependent on continually increasing asset values as the basis of wealth creation.

China’s policy of ensuring that the expansion of bank credit is invested in production and not speculation may seem old-fashioned. But there is another reason she avoids the destabilising potential of speculative flows, and that is the likelihood America will use them to undermine China’s economy. Major-General Qiao Liang, the People’s Liberation Army strategist, in a speech to the Chinese Communist Party’s Central Committee (CCPCC) in April 2015 identified a cycle of dollar weakness against other currencies followed by strength, which first inflated debt in foreign countries and then bankrupted them. That then allowed US business interests to acquire assets at rock-bottom prices.

Qiao argued it was a deliberate American policy and would be used against China.

In his words, it was time for America to “harvest” China. Drawing on Chinese intelligence reports, in early 2014 he was made aware of American involvement in the “Occupy Central” movement in Hong Kong. After several delays, the Fed announced the end of QE the following September which drove the dollar higher, and “Occupy Central” protests broke out the following month.

It was obvious to Qiao that the two events were connected. By undermining the dollar/yuan rate, the Americans tried to disrupt the economy. Within six months, the focus of speculative excesses at that time, the Shanghai stock market, began to collapse with the SSE Composite Index falling from 5,160 to 3,050 between June and September 2015.

We cannot know for certain if Qiao’s suspicions are correct, but we can understand the Chinese leadership’s caution based on his analysis. It is extremely relevant to the situation today. A strong dollar is being driven by rising interest rates, “harvesting” Turkey, South Africa, and all the other states hooked on cheap dollars. It is also undermining the yuan exchange rate, threatening to harvest China as well. It seems likely, to the Chinese at least, that the current commentary about the disasters likely to befall China if the rate crosses Y7.000 to the dollar are down to whispers coming from the US Government.

For this and other reasons, the Chinese leadership is extremely wary of having dollar liabilities and the accumulation of unproductive, speculative money in the economy. It justifies to them their strict exchange control regime, whereby dollars are not permitted to circulate in China, and all inward capital flows are turned into yuan by the PBOC. However, the current exchange control regime also blocks the yuan from being widely circulated outside China, limiting its acceptance as an international currency.

That will have to change, if the yuan is to replace the dollar for China’s trade. Furthermore, a policy that leads to the mass accumulation of dollars has to be terminated at some point.

The answer is to back the yuan with gold

Major-General Qiao made it clear to the CCPCC that the dollar achieved global domination only after August 1971, when the link with gold was abandoned and replaced with oil. The link with oil was not through exchange values, as had been the case with gold, but through a payment monopoly. In Qiao’s words, “The most important thing in the 20th century was not World War 1, World War 2, or the disintegration of the USSR, but rather the August 15, 1971 disconnection between the US dollar and gold.”

Strong words, indeed. But if that’s the case, the Chinese will know that the most important event of this new century will be the destruction of the dollar’s hegemonic status. It requires careful consideration, and many unforeseen consequences may arise. The Chinese know they must not be blamed for the dollar’s demise.

So long as the world economy continues to grow without periodic credit dislocations, then China needs only to react to events, doing nothing overtly to undermine the dollar. She need never seek reserve currency status. No one can complain about that. But while central bankers may presume that they have banished credit crises, the reality is different. An independent, market-based view of the current credit cycle is that the onset of another credit crisis is becoming more likely by the day. That being the case, on current monetary policies China’s economy can be expected to crash, along with those of the West’s welfare states.

China’s manufacturing economy will be particularly hard hit by the rise in interest rates that normally triggers a credit crisis. Higher interest rates turn previous capital investments in the production of goods into malinvestments, because the profit calculations based on lower interest rates and lower input prices become invalid. This is a greater problem for China than for many other economies, because of her emphasis on the production of goods. In short, unless China finds a solution to the next credit crisis before it hits, she could find herself in greater difficulties than states where the production of goods is a minority occupation, purely from a production point of view.

From what we know of their strategic analysis of money and credit, the Chinese should be aware of the cyclical risk to production. If the yuan and the dollar go head-to-head as purely fiat currencies, the yuan will be the loser every time. It would mean the yuan would inevitably sink faster than the dollar in the run-up to the credit crisis, which appears to be happening now. As Qiao puts it, China is already being harvested by America. At some stage, China must act to protect herself from this harvesting. And that’s where her gold comes into play.

Stabilising the currency and the economy with gold

China originally accumulated undeclared reserves of gold as a prudent diversification from holding nothing but other governments’ liabilities. This then turned into a quasi-strategic policy, through encouraging her citizens to accumulate gold as well, while continuing to ban them from owning foreign currencies. We know roughly how much gold her own citizens have, but we can only guess at the state’s holding. It will soon be time for China to declare it.

The reasoning is straightforward. At this late stage in the global credit cycle, and so long as the yuan is unbacked, yuan interest rates will rise to the point where Chinese business models will be destroyed. The only way that can be stopped is to link the yuan to gold, so that interest rates align with that of gold, not the rising rates of an unbacked yuan weakening against the dollar whose interest rates are rising as well.

China will be taking a major step by putting an end to the dollar era that has existed since August 1971, when gold as the ultimate money was driven out of the monetary system. She must be ready to do this urgently, despite the opinions of Western-educated economists within her own administration. Some Western central banks may face acute embarrassment, having sold and leased their gold reserves, so that they are no longer in possession. China must move soon to avoid further rises in dollar interest rates undermining the yuan even more.

That time must be approaching. China must resist the temptation to defer such an important decision, allowing the yuan to fall much further. The neo-Keynesians in Beijing will argue that a lower yuan will compensate exporters facing American tariffs. But all that does is drive up domestic prices, and increase the cost of commodities required for China’s infrastructure plans. No, the decision to move must be sooner rather than later.

Assuming China has significant undeclared gold reserves, this could be done very simply through the issuance of a perpetual jumbo bond, paying coupons in gold or yuan at the holder’s option. This financial model, without the gold convertibility feature, is based on Britain’s Consolidated Loan Stock, first issued in 1751 and finally redeemed in 2015. Being undated, there was no capital drain on the exchequer, except at the exchequer’s option.

The broad advantages to this approach will become self-evident, and what follows is an outline proposal showing how monetary stability and the removal of systemic risk can be achieved. To give the markets time to adjust the gold price for China’s remonetisation, these proposals should be announced in advance of the bond’s introduction, together with full disclosure of China’s true gold reserves. The bond would impart a basic yield to gold, allowing for an additional portion of the yield to reflect China’s credit risk. It will be priced to ensure holding the bond is attractive to savers and investors, making it a credible alternative to owning physical bullion. Because the bond need never be paid off, it should benefit China’s credit standing in the markets and underwrite international demand for the yuan itself.

Further currency issues by the PBOC would then have to be backed by gold, as was the case with the Bank of England’s note issuance under the Bank Charter Act of 1844. Banks would be given a limited timescale to separate their deposit-taking functions from their loan books, which would substitute bond issues as the main instrument for funding loan business.

Bank deposits would earn nothing, and perhaps even face administrative costs. Depositors and savers would therefore channel their savings into the new bank bonds or the new jumbo bond. The banks and the banking system would no longer present a systemic risk.

This would mean that monetary expansion in China would only occur through gold imports, mine supplies, and scrap recycling of jewellery. Given China’s annual mine output of over 400 tonnes, and assuming the state already owns significant undeclared reserves, there should be sufficient gold backing to put the yuan on a gold standard by these means. A one-trillion-yuan bond issue with a 3% gold coupon, assuming a gold price of Y15,000 ($2,150 at current exchange rates) would require a maximum of only 62 tonnes of gold to pay the annual coupon, assuming all holders opt for interest paid in gold. In practice, most interest is likely to be drawn in yuan.

The cost of borrowing for production would then be realigned with the general price level in China, reinstating Gibson’s paradox as the producer’s price-to-funding cost relationship. Export businesses would be saved from higher interest rates on their borrowings but would have to adjust to a sound currency environment. Switzerland manages with a relatively strong currency, and in pre-euro days, so did Germany. Foreign-owned factories, whose owners are only there for a declining yuan exchange rate, will face wide-spread closures. But that releases workers for other functions more relevant to China’s future.

Therefore, disruption of legacy export industries is unavoidable, even necessary. The drift away from them is already embedded in economic policy. The Chinese always knew that relying on exports was only a stepping-stone to her own self-sufficiency. For the long-term, we may presume she knows sound money provides a more stable business environment than fiat money, especially when she is the world’s largest consumer of industrial materials priced in dollars.

It was gold-backed sterling that made tiny Britain the greatest nation on earth in the second half of the nineteenth century. Sound money works for a savings-driven economy, and with the Chinese saving a substantial part of their net income, that is China’s defining characteristic.

Protecting citizens’ wealth and savings is the leadership’s underlying priority. The value of the accumulated wealth of China’s savers relative to those in other nations with declining fiat currencies would be both secured and enhanced. Doubtless, the purchasing power of gold would continue to rise compared with that of unbacked fiat currencies, encouraging foreign demand for China’s new undated jumbo bond. The rise in its market value measured in foreign currencies would not only ensure continuing demand for the bond but create capital gains for existing owners of it along the way.

Making the yuan convertible into gold would allow China to end exchange controls and for the currency to be freely available and desired for trade. The PBOC would wind down its foreign currency reserves and take no further part in foreign exchange markets.

However, it would amount to a fatal attack on the federal dollar’s status, unless, as seems unlikely, the American Treasury swiftly follows it by reintroducing a credible form of convertibility into gold that avoids the flaws of the Bretton Woods system. The US Treasury states that it holds 8,133 tonnes of gold, which could be used for this purpose.

At current prices, the UST’s gold is valued at $325bn, and at a likely price after China’s announcement, perhaps $600bn. If the Treasury’s gold actually exists, China should be delighted to buy it if the US tries to sell some of it to suppress the gold price. After all, China has both dollars and Treasury bonds to sell in return for gold in far larger quantities. And America would be foolish to obstruct settlement of Chinese sales of Treasuries as some commentators have suggested, because that would simply undermine global confidence in both the dollar and dollar bond markets.

It is hard to see how the US can match a sound-money plan from China. Furthermore, the US Government’s finances are already in very poor shape and a return to sound money would require a reduction in government spending that all observers can agree is politically impossible. This is not a problem the Chinese government faces, and the purpose of a gold-linked jumbo bond is not so much to raise funds; rather it is to seal a price relationship between the yuan and gold.

Whether China implements the plan suggested herein or not, one thing is for sure: the next credit crisis will happen, and it will have a major impact on all nations operating with fiat money systems. The interest rate question, because of the mountains of debt owed by governments and consumers, will have to be addressed, with nearly all Western economies irretrievably ensnared in a debt trap. The hurdles faced in moving to a sound monetary policy appear to be simply too daunting to be addressed.

Ultimately, a return to sound money is a solution that will do less damage than fiat currencies losing their purchasing power at an accelerating pace. Think Venezuela, and how sound money would solve her problems. But that path is blocked by a sink-hole that threatens to swallow up whole governments. Trying to buy time by throwing yet more money at an economy suffering a credit crisis will only destroy the currency. The tactic worked during the Lehman crisis, but it was a close-run thing. It is unlikely to work again.

Because China’s economy has had its debt expansion of the last ten years mostly aimed at production, if she fails to act soon she faces an old-fashioned slump with industries going bust and unemployment rocketing. China offers very limited welfare, and without Maoist-style suppression, faces the prospect of not only the state’s plans going awry, but discontent and rebellion developing among the masses.

For China, a gold-exchange yuan standard is now the only way out. She will also need to firmly deny what Western universities have been teaching her brightest students. But if she acts early and decisively, China will be the one left standing when the dust settles, and the rest of us in our fiat-financed welfare states will left chewing the dirt of our unsound currencies.

Alasdair Macleod


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Alasdair became a stockbroker in 1970 and a Member of the London Stock Exchange in 1974. His experience encompasses equity and bond markets, fund management, corporate finance and investment strategy. After 27 years in the City, Alasdair moved to Guernsey. He worked as a consultant at many offshore institutions and was an Executive Director at an offshore bank in Guernsey and Jersey.

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