Dec 1, 2022 • 24M

Episode 28: Is the current monetary cycle accelerating bifurcation between China and the West?

How US monetary policy may be boosting Chinese influence

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Sam Olsen
Meyrick Chapman
Understanding what China wants with the world. Total domination, or just to rub along?
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Hello and welcome to Episode 28 of What China Wants.

Is the US Federal Reserve unwittingly increasing Chinese influence around the world? Source

Stewart and Sam are joined today by Meyrick Chapman, a 40 year veteran of macro-investing and formerly of Elliott Management. Meyrick’s research of monetary policy has shown up an interesting and potentially vital impact on China’s relationship with the world. Basically, US monetary policy is driving the bifurcation of the world economy, and actually giving China the opportunity to increase its economic influence. Assuming this is true, then the structural impact of this on political international relations will be significant.

Some highlights from our discussion:

  • Even though the US Federal Reserve has raised US interest rates at the fastest rates for a long time (400 basis points), the impact on the US economy has been slight, according to US Federal Reserve Governor Christopher Waller.

  • However, the US Federal Reserve serves to promote the US economy, not the world economy. And the UN thinks that US monetary tightening is causing negative economic consequences around the world.

  • One major consequence is that China is decreasing its dollar balance sheets, partly because of US monetary policy, but also because of political decisions.

  • Most Chinese loans have been made in dollars, so as their hold on dollars decreases, China is swapping debt for equity in many projects around the world. This gives China more control over these assets.

  • Thus, US monetary policy is pushing decoupling from China, and at the same time strengthening Beijing’s international influence.

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Many thanks for listening.


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Here is the transcript:

Sam Olsen: Hello, and welcome back to What China Wants with me, Sam Olsen, and, as always, Stewart Paterson. Amidst the current financial turmoil, it is easy to think that the only country affected is the one that you yourself live in. That, however, would be wrong. The financial world seems to be in a state of flux not known for quite some time, wherever you are.

To discuss this, Stewart and I are fortunate to be joined today by someone who was described to me as "one of the smartest guys in the market", Meyrick Chapman. Meyrick, formerly of Elliott Management, is now the principal at Hedge Analytics, and an investment industry professional with 40 years of experience of macro-investing. Welcome.

Meyrick Chapman: Thank you. Thank you, Sam and Stewart, it is great to be here.

SO: And so today, the specific title of the podcast is "Is the current monetary cycle accelerating bifurcation between China and the West?" I suppose, to kick things off, it would be great if you could give our listeners a quick overview of the extent of that current economic turmoil in the world and some of the factors that are causing it?

MC: Yes, I will have a go. The Fed has raised interest rates at an amazing rate, almost 400 basis points in seven months, which, I think it is fair to say in my lifetime, is unprecedented at that speed, especially coming from effectively zero interest rates, and also a huge monetary stimulus in the form of QE. So there has been a monetary shock, which is reflected in stock markets down a lot, bond markets down a lot, presumably housing markets down a lot, and the dollar is up a lot. But it really depends on who you speak to as to whether this is turmoil or not.

Certainly, if you are holding crypto, it feels like turmoil. But the Fed itself does not describe it that way, and certainly it does not look like they are finished tightening yet. So, Fed Governor Christopher Waller this week said "I've been just amazed to watch rates go up for the seven or eight months, and the markets haven't collapsed. We don't have a financial crisis or anything along those lines, we've got to have a good level of rates." I assume he means "we have got it there fast, and we did not break anything. We are certainly not breaking anything in the labour markets, in terms of unemployment, households are in good shape and household balance sheets are in very good shape." So he sounds like everything is fine.

But I think if you look elsewhere, outside America, and do not forget that the Fed, as it says in their mandate, works to promote the health of the US economy. They are not there to promote the health of the world economy, and that is kind of what we're seeing. UNCTAD, a division of the United Nations, recently got very worried in its 2022 report that the Fed tightening in particular was going to lead to a slowdown, a global recession, and a vicious economic cycle in the developing world. So it depends where you stand really.

Stewart Paterson: Meyrick, that's brilliant analysis, and we will talk about the rest of the world shortly, because of course, a lot of our listeners will remember the early 1980s cycle and the impact that had on Latin America, the subsequent need for Brady bonds, and the criticism that the US monetary authorities came under then from what we now call the Global South. But can we just firstly turn to the United States itself. In simple terms for non-economists, can you explain to us how quantitative easing, the size of the Fed's balance sheet, and the behaviour of the commercial banks in the United States, how those factors interacted with each other, when quantitative easing was a thing? And how now that monetary policy has reversed and is tightening, what we can expect and what might be the ramifications for the United States of that?

MC: Sure. So quantitative easing is the purchase by the Central Bank of assets, and particularly government bonds, but not only government bonds. So the effect of that according to Bernanke – that’s Ben Bernanke, the Fed Chair in days gone by – was to depress the yield curve, so to keep rates low. Not only did the Federal Reserve reduce short term interest rates - the federal funds rate - but quantitative easing was designed to force down yields across the whole yield curve. In terms of the effect, it succeeded to a large degree and interest rates went down for a very long time. It should be said it is not just quantitative easing that did this. It was also forward guidance with a central bank that basically promised that they were not going to raise interest rates for a very long time; that also helped yields down.

But the actual accumulation of assets had a couple of other effects. First of all, it forced through what is known as the portfolio effect. It forced natural investors in Treasury bonds and mortgage-backed securities out of those, because the Fed was buying them, large amounts of them. And so they had to be bought from somewhere, and those people who held them had to go and find somewhere else to park their money. So that was the portfolio effects. But the other effect it had was on the liability side, and we should not forget that the liabilities of central banks are, to most definitions, that is how you define the currency. So, the liabilities side of the balance sheet grew to match their asset side, obviously, because it is a balance sheet, and those liabilities were reserves. Reserves are used only by the financial system, only by the banks to interact with the Fed, and more recently, in some degree, the money market funds in the US, but not the general public.

So what has happened through QE has been an intensification of the financialization of the US economy. It is very much an insider's system now, and the Fed has played a large role in that. Those are a couple of the big effects. I should say also that the reserves are the primary settlement medium for financial markets nowadays. It used to be different before the global financial crisis, but it has changed a lot since then, and now reserves in the system - central bank reserves - are the major medium by which banks settle between themselves securities transactions. So that is not just bank transactions, that is anybody's transactions that require a transfer between banks. In a sense, the increase in reserves has also increased the liquidity in the settlement system, which in itself, helps transactions in securities markets. So there has been a number of effects from QE, all of which have helped get and keep yields down, and equities up, and that is now reversing.

SP: So now this is all reversing, what should we expect, or what are you seeing in US commercial banks, that gives you either cause for hope that there will be a soft landing despite these interest rate rises, or worries you that there won't be?

MC: Well, I think it is not completely clear either way. But certainly, in the case of the domestic US economy, there are some mitigating circumstances. First of all, they are all dollar-based, everybody in the US is dollar-based. And so they are not directly affected by the rise in the dollar that has been created by this change in Fed policy towards tightening. The other thing which is very evident is that as the Fed expanded its balance sheet, the other side of that, well, the commercial banks balance sheets. And as the commercial banks balance sheets, were forced by QE to take on more central bank reserves, that actually displaced loans from their balance sheet. So they swapped one set of assets, namely loans, the traditional asset of commercial banks, were forced out by the creation of reserves, which are used by the central bank to pay for QE. That is now reversing. So to some extent, the increase in loans is a mitigant for the public, because interest rates are going up, but actually so are loans.

SP: Is this not the ultimate irony that most people would think that rising interest rates dampen the demand for loans and supply of loans, and that is actually how monetary policy is meant to work? Whereas what you are describing here is the fact that actually, as commercial banks' reserves at the Central Bank fall through QT, they are actually expanding loans, which is not necessarily what the Fed wants, is it, or is it?


MC: Well, the Fed does not make loans directly itself to end users, so it is up to the banks to decide how they apportion their balance sheets. So yes, loans are going up. However, the actual size of commercial banks' balance sheets is shrinking, only for the last month and a half, two months, but that is a factor that the Fed has influenced, they are causing the shrinkage of balance sheets. But within those balance sheets, there is a compositional change and the compositional change has switched away from reserve assets and securities, towards loans, so yes.

I should say also that the higher interest rates means these loans are more expensive than they used to be, and in some cases, it might be the case that consumers and companies may be forced to take the loans simply to consume, or to stay afloat. So it is not necessarily totally joyful. This is not a total offset, but it is a mitigant for the Fed, tightening for domestic US borrowers, that is not generally available for non-US borrowers.

SP: So maybe that is a good opportunity to move on and talk a little bit about the rest of the world, and what this monetary cycle might mean for the relative standing of the United States and China around the world. Maybe as a starting point, we could just discuss briefly what (a) the strong dollar and (b) high US interest rates mean, for many countries in the Global South, who, during the period of easy US monetary policy - which let's face it has been most of the time, frankly, since the global financial crisis - have borrowed dollars. Do you see significant duress there? And what might this mean for their use of the dollar in financial transactions going forward and potentially even trade?

The USD has strengthened significantly agains the RMB this year. Source: Google Finance

MC: Yes, I think that is a really, absolutely central question. What you are raising here is truly both absolutely fascinating, and also really consequential. The dollar carry trade was massive. You can see it in numerous statistics, but a good one to look at is the BIS international debt securities issued in dollars, which is non-US issuance of dollar debt, what is often called euro bonds, so issued by non-US residents. That has gone from roughly 8% of global GDP, around the time of the GFC, (the global financial crisis) to a peak of about 14% of global GDP towards the end of 2020. And it is now down to 12%. But that is 12% of GDP, and a very large amount of that has gone to what you termed the Global South.

But a significant subset of that, in Asia in particular, has been intermediated by Chinese banks. And what we are seeing now is Chinese banks aggressively reducing their dollar balances on both sides of the balance sheet. At the same time, this deleveraging globally, is both helping the dollar rise, it has been caused by $1 rise, but effectively, this is a close of $1 short. You can think of the dollar carry trade as $1 short. Well, now that short everywhere has been closed. So that in itself is forcing the dollar higher. You can see it quite clearly that as the dollar balances in Chinese banks have gone down, effectively they really started in about February this year, coinciding with the invasion of Ukraine. Those dollar balances have gone down at the same time as the renminbi has also gone down against the dollar very sharply. Not only the renminbi but other currencies have also fallen. This factor has pervaded what you termed the Dollar South, and I can term it that as well. But it includes China as a sort of intermediary as well as a victim of this.

SO: Can I just ask from my position as someone more interested in the politics side? Just to be clear, do we see now, especially in 2022, countries, either getting more exposed to the dollar or countries getting less exposed to the dollar as a matter of political choice? Or is this just a normal function of economic cycles?

MC: I think it can be both. It is certainly part of the cycle, as interest rates in the US go up from effectively zero. This is partly an unwind from an extraordinarily low level of interest rates, which is what the carry trade was predicated on. So, it is certainly cyclical. It could also be structural, in the sense that there is a geopolitical tension. It is very clear that China does not want to be so reliant on the US, and it is very clear equally, that the US does not want to be so reliant on China. So, in a sense, there is a geopolitical imperative to split the globe or bifurcate the globe, and to some extent that is working hand in hand with what is happening monetarily, where the Fed policy is forcing holders of dollar shorts, namely debt, out of those holdings. I think those two things can go together, but it can also be it can be both cyclical and structural.

SP: I guess Meyrick, this is the first sort of US tightening cycle that we have seen in which China has been a major creditor to third countries, to the Global South in terms of its lending. The shape of its international assets has changed very dramatically from being almost exclusively in foreign exchange reserves, where it was a credit of the US government, to now a much more diversified set of assets, including a large amount of loans, largely intermediated by the big state-owned commercial banks and the development banks.

And so, China has not really had an any experience of an international lending cycle gone wrong. How do you think they will cope? And what do you think their reaction will be? Do you think that this will make them question their engagement with the Global South of which Belt and Road is a part, but it has largely been debt financed? Or do you think that they will look to capitalise on the financial straits, if you like, of some of their debtors to put more money onto them, but maybe on different terms and to accumulate equity? And sort of it will accelerate the engagement but make it more assertive? I mean, it could go either way perhaps, I do not know.

The China-Laos railway added massively to Laos’ debt. China is now swapping debt for equity in Laos and other countries. Source.

MC: Yes, so I think it is early days, I do not think we are yet finished with the Fed tightening cycle. And by the way, China, is monetarily easing, they are going in the opposite direction at the moment, so we have a real tension in monetary policy between the two, but a few salient points. I think, if you look at the balance sheets of the Chinese banking system, you look at the overseas loans, about 80% of them (of the loans made overseas) were made in dollars. And it is really clear that since February, if you translate those loans holdings into renminbi, the level actually has not changed much, what has changed a lot is the dollar denomination. So they are maintaining their level in renminbi terms at pretty much the same level, which to my mind this raises the question, "Well, is there some authority in China or some regulation, which is saying, 'Well, you must not lend more than X amount of your renminbi-based balance sheet overseas?' So I think that is an open question but we are definitely seeing disengagement from the dollar lending which was, for overseas loans, the dominant way in which China made its loans.

But there are a couple of interesting other wrinkles to this, which are relevant to your question about how this is going to unfold in terms of the relationship with the destination of these loans. At the same time as lending is going down, and the actual part of the balance sheet, which is called 'portfolio investment', who knows what is in there, but basically, we can call it as 'equity' - that is equity stakes in in securities and other holdings - that is going up. And in dollar terms, that is going up as well. So even though their dollar balances in general are going down, their holdings of portfolio investment in dollar terms is going up. Now, I cannot tell from looking at the data, what is going on there. But one thing that does strike me is that perhaps we can ask the question of whether the loans are being foreclosed, and in return, the equity that is behind, that those loans supported, is perhaps been accumulated by these Chinese banks.

So there could be some form of debt-for-equity swap. That would make sense to me, we all know that some of the Belt and Road lending was particularly opaque, that some of the conditions could have been onerous, and that in some cases, already Chinese banks and Chinese entities, not just the banks, have laid claim to assets in foreign countries. So there is evidence to support that. Whether it is actually what is happening or not, is open for discussion, but certainly that is what the data may suggest. There is a relationship, which is definitely changing, I think.

SO: To be clear, just to make sure that I understand what you are saying, US monetary policy is tightening, and China is easing its monetary policy. A consequence of both those things is that China is disengaging from the dollar, but at the same time is changing its debtor relationship with other countries, because a lot of the debts were originally produced in dollar and therefore, what we are seeing - the ultimate consequence is that if this debt for equity move is correct, China is strengthening its hold in terms of influence over countries that it has done debt deals with in the past. Is that correct?

MC: Yes, it is, and that kind of makes sense. It fits what you think would be happening. There is just one thing, one point I would make, is that when you do a debt-for-equity swap, you do not normally make the debtor happy, you make the debtor unhappy. This may not be a an improved relationship that we are beginning to see between China and the rest of the Global South. It may, in fact, be the beginning of quite a difficult relationship, which we referred to earlier in terms of previous debt cycles in South America where the Yankee comes in and ask for his dollar back, well, now perhaps something similar is happening between Chinese banks and their recipient debtor countries outside China.

SP: Perhaps we can just finish with a slight diversion, but I think it is very relevant. That is to talk just a little bit about China's central bank digital currency, which obviously has been trialled. Initially, if we had this conversation prior to COVID, people would have said, "well, the most likely way that the central bank digital currency is going to spread internationally, at least initially, is through outbound Chinese tourism in destinations in Thailand, or Cambodia, where lots of Chinese tourists go. They will use telephone, wallet, smartphone wallets, to spread the currency into these countries." Obviously, COVID has disrupted that route of internationalisation because there are not any outbound tourists anymore. But do you see the central bank digital currency as being a serious threat to dollar hegemony in at least Southeast Asia if not the world?

MC: I think I would bracket it along with whether foreigners willingly want to hold renminbi either as reserves or as any other store of value. My impression is that the answer is no, they do not. They can be coerced into holding renminbi because the Chinese state says we will not trade with you unless you do. But most international countries, traders, banks would be much happier, accepting recompense or payment in dollars, because dollars are readily transferable and although political interference is not completely absent from US dollar, it is a lot more absent than it is with renminbi, whether that is now or in the future. And I think underpinning the dollar, something which does not get enough airplay, is the legal institutional framework behind the dollar. So, if you have a dispute in dollars, usually you can appeal to some court, which you generally think is going to give you a fair hearing. I do not think that is the case in renminbi, and I put the digital currency in the same bracket.

SP: Yes I could not agree more in the sense that the one thing you know about the US dollar is that the price you pay for it has been derived by market conditions, and everyone who has a US dollar has been free to sell it at any point in the last well, at least the last 40 years anyway. Whereas with the RMB, almost everyone who holds it is not allowed to sell it. Therefore, you actually have no idea what a market clearing price for the RMB would be. Meyrick, thank you very much indeed for joining us. We must have you back on when we get to the other side of the hump in the US interest rate cycle to assess how the global bifurcation has, indeed either accelerated or not as a result of the interest rate cycle.

MC: Well, thank you very much. On that basis. I shall probably be speaking to you in about nine months' time.

SP: Now there is a controversial call.

MC: I look forward to it.

SO: Thank you so much.

MC: Thank you.