Saturday, June 28, 2014

China moves forward to "Globalize" the Yuan

China is clearly a major player now in the global financial system. We know that in July they will be a leader in the BRICs summit meeting which will establish a new reserve currency fund and publish details of the new BRIC's bank which would offer an alternative to the World Bank. China is clearly aligning with Russia in an effort to offset the US and EU and promote wider use of currencies other than the US dollar.

Even as China works to "globalize the yuan" as this article notes, some are questioning if China will suffer problems from its own massive debt and the possibility that Chinese banks may have a lot of troubled loans on their books. This week Bloomberg runs an article  explaining how China found billions in fraudulent loans where commodities like gold were sold multiple times to back loans. 

So what is the potential impact of all this on the global monetary system? 

China will obviously continue to work steadily to internationalize the yuan. This is described in the article linked above as a 5 step process. Here is a quote from the article:

"Analysts widely forecast five steps in yuan internationalization: 1) yuan used and circulated overseas, 2) yuan as a currency of account in trade, 3) yuan used in trade settlement,4) yuan as a currency for fundraising and investment
and 5) yuan as a global reserve currency."

We see here that establishing the yuan as a "global reserve currency" is one of the steps. But this process is described in this article by Chinese officials as a 10-15 year project. Not something they expect to happen soon. 

While that is ongoing, what are the problems China might have to deal with? The second article linked above notes that the path of Chinese debt is "unsustainable" just as the path of US debt is unsustainable. Here is that quote from the article:

"The buildup of total debt, unprecedented in recent history, is leading to mounting repayment pressures. The bank estimated that interest payments were equivalent to 13 percent of GDP in March, up from an average of 7 to 8 percent in recent years. This high ratio is eating up an increasing share of corporate profit and government revenues and crowding out new investment, which makes a pick-up in growth momentum in 2014 all the more difficult to achieve.   . . . . . . 

"While we do not believe a debt crisis is around the corner, partly because some of this debt is 'evergreenable', it is clearly dragging on investment and will continue to do so for the foreseeable future," the report said. "This trajectory is unsustainable. "
Then we have this article which explains how even the $4 Trillion in reserves China now holds might not be enough if there were a banking crisis in China. Here is this quote from the article:
"And $4 trillion simply might not be enough cash. Officially, Chinese commercial banks’ bad loans make up only 1% of total outstanding loans. That sounds very comforting, but it’s also risibly wrong. Chinese banks are notorious for rolling over loans and undercounting bad debt. Even if the PBoC could use dollars to recapitalize its banks, at 18% of China’s total outstanding debt, they very likely wouldn’t be enough."

Earlier this year Jim Rickards wrote this article titled "The China Bubble is Bursting" in which he says, "China is on the verge of a financial collapse of unprecendented magnitude". Rickards explains that many older Chinese are invested in something Chinese banks promote called "Wealth Management Products" because normal interest rates are so low. Rickards describes the problems with these investment products:

"These wealth management products are offered by banks but are not guaranteed by them. Investor assets are pooled into the products and then invested in commercial projects with the proceeds shared among the investors.
The banks promise high returns on these products, which resemble the notorious collateralized debt obligations popular in the U.S. before the Panic of 2008. Actual performance on the wealth management products is below the promised returns in many cases. Banks cover this up by selling new products and using the proceeds to pay off the old ones. This is exactly how a Ponzi scheme operates.
Eventually some event such as a project failure or admitted fraud will start a panic in which investors demand that the banks redeem their wealth management products all at once. The banks will be unable to do so and will suspend redemptions on the products. Investors will claim that the products were backed by the banks but the banks will deny this. A run on the banks will commence that only government intervention and bailouts can contain. The result will be a general collapse in Chinese asset values for real estate, stocks and bonds as investors hoard cash, buy gold and move to the sidelines."
How does all this potentially impact the global monetary system? As we see it, it means that even China with the largest surplus reserves in the world can easily become a source of global financial instability. Because of all the debt overhanging the world, the expansion of derivative products tied to that debt (now far in excess of total world GDP), and the interconnected nature of the global financial system, a crisis that starts anywhere could spread everywhere in a short time frame. That could lead to major change very rapidly once that chain of events is triggered.
Meanwhile, many analysts believe that as China loosens capital controls money will begin to flow out of China all over the world. If Chinese investors are concerned about the stability of their banking system, money could flow into a variety of global investments including gold and other tangible assets. It could also trigger much higher inflation in the West.
If you step back and look at the whole big picture what you see is a gigantic global fiat currency system that is unstable and everyone admits is "unsustainable". Even in China where they have a massive $4 Trillion in surplus reserves. Understanding all this, it is easy to see why China is accumulating massive quantities of gold now. And why the IMF continues to hold nearly 3,000 tons of gold. And why Central Banks all over the world hold tons and tons of gold in their reserves. 
They know that if and when the massive fiat system fails, hard assets like gold will be the last resort asset left standing. So even as they jockey for position within the current global fiat system, they want to hold some last resort assets in case the whole system implodes and a "reset" of the rules of the game is forced upon them. In that situation, the tangible assets of each nation will take over as the basis for the value of currencies and national wealth.

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