“Already, China dominates world trade. Her own economy is already significantly larger than that of the US on the PPP estimates. While being the largest consumer of raw materials, China also exports more finished goods by value than any other country.”…

In last week’s Insight article, America’s Financial War Strategy, I described how the Chinese government viewed the geopolitical scene. It is clear from earlier remarks by the Peoples Liberation Army’s senior strategist, Major-General Qiao Liang, that the view in Beijing is that America perpetuates her empire through the financial benefits to America from America’s actions against other nations, friend or foe. These actions can be either military or financial, or even both. This week, similar views were expressed in Moscow by Sergey Glazyev, a senior advisor to President Putin.ⁱ

There are many questions that arise from last week’s analysis that I chose not to address, in the interest of focusing on the main theme. It concentrated on geopolitics and economics as the Chinese see them, financial and currency issues mentioned in passing. This article addresses perhaps the most important subsidiary issue, and that is how China visualizes the future, in terms of monetary policy.

China’s eventual objective

If nothing else, the Chinese have a sense of history and destiny. They have had a glorious past, stretching back millennia, and once controlled most of the Asian heartland in the days of Genghis and Kublai Khan. But even then, China was essentially inward-looking, protecting her own cultural values. Trade with Europeans in the centuries following Marco Polo’s visit was mostly at the behest of European travelers, not the Chinese. She exported her art and culture to visitors, and did not import European values.

This was a mistake, implicitly recognized by China’s current leadership. This time, China has embraced Western thinking and technology to further her own progress. The development of the Shanghai Cooperation Organization in recent years is the platform for China in partnership with Russia to embrace the Asian continent through peaceful trade, improving the lives of all the citizens of the many nations who are and will become members. The SCO promises a revolution in the wealth and living standards of over 40% of the world’s population, and associated benefits for its supplier-nations on the other continents.

China’s approach is fundamentally different from that of America, which under President Trump appears to be envious of the success of non-Americans producing goods and services for the American consumer. Autarkic America has a GDP of $19 trillion. Eventually, China will have free trade agreements with the rest of the world, excluding for now the EU. On a purchasing power parity basis, this is a market with a GDP of about $70 trillion, out of a world total of about $125 trillion.ⁱⁱ

Already, China dominates world trade. Her own economy is already significantly larger than that of the US on the PPP estimates. While being the largest consumer of raw materials, China also exports more finished goods by value than any other country. As the Asian powerhouse, she has lifted the economies of all the countries on the Western side of the Pacific Ocean, which including her own between them have a GDP of $50 trillion. Her exports into Asia now exceed her exports to the US. Yet despite this dominance, most of China’s trade is conducted in US dollars, something China is bound to change, if she is to contain external economic risk and replace America as the dominant global empire. Both objectives can only be achieved by China replacing the dollar as a medium of exchange.

Why gold is central to China’s future trade settlement policy

China’s challenge is the yuan as a purely fiat currency will take decades to replace the dollar, possibly never. And that assumes that China follows more stable monetary policies than the US. This has not been the case since the Lehman crisis, with China’s M2 broad money quantity expanding rapidly, accounting for much of the world’s monetary growth in recent years. The rate of monetary expansion is criticised as a dangerous credit bubble by western analysts, who are quick to condone monetary expansion in their own developed nations, but turn into hard-core monetarist critics over China. No, China will never replace the dollar with her own currency without a golden guarantee.

Therefore, China needs to deploy gold to displace the dollar. This might be done in one of two ways, one encouraging markets to evolve away from dollars towards gold, or alternatively by the state forcing the pace.

China provides the facility to convert yuan into physical gold in the Shanghai market through the Shanghai Futures Exchange. This gives an exporter of raw materials to China a sound-money option instead of being paid only in yuan or dollars. It does not require China to use state-owned gold, the physical gold being sourced through the market. In time, liquidity in the yuan futures contracts should improve, and Shanghai is already the largest physical gold market. Note that only last month it was announced that Russia’s central bank has opened an office in Beijing, and is tasked with resolving the technical aspects of gold deliveries from Russia into China. The importance of the Shanghai Gold Exchange will increase further through this link to Moscow. Using the Chinese market for physical gold delivery over time should impart some stability to the yuan relative to the dollar, particularly if American banks trading on Comex continue to discourage taking delivery of physical bullion.

That might take for ever. Alternatively, China could announce plans to make her currency convertible into gold at a fixed rate, but it would have to be at a far higher exchange rate than the current CNY8,700 to the ounce. If this course is followed, US Treasuries are bound to be displaced as the zero-risk bond standard, potentially creating chaos in western financial markets. China would also need to reveal her true holdings of gold bullion, transferring them into the currency reserves account, to give the foreign exchanges confidence over the scale of gold backing for the yuan.

So far, China’s policy has been to pursue the least disruptive route, preferring not to dislocate global trade, partly because she needs to co-exist with the rest of the world politically, and partly because it would affect her own trade adversely. It has also been very convenient to be able to direct the Chinese economy through the expansion of bank credit. The least disruptive route is still the default assumption.

China will also want to reduce her reserve exposure to the dollar and US Treasuries in an orderly fashion. The pace of selling, the degree to which dollar reserves are to be reduced, and the rate of accumulation of industrial materials and energy all determine the length of time to complete a currency reset. This course has been expected by informed observers to lead to a gradual decline in the use of the dollar as its role in global trade diminishes. The alternative, with China announcing its true gold reserves and a rate of exchange with its own currency was always viewed as an extreme option, only to be resorted to upon severe provocation.

North Korea might become the trigger for that event, but so would a domestic financial crisis in America, insofar as it might be expected to affect America’s foreign policy. Remember that the Chinese believe America periodically engineers a foreign crisis to fund its own economy, by encouraging dollars to buy US Treasuries, in preference to more risky employment. For this reason, China will be watching the US economy closely for signs that might impact on the dollar’s value.

After a long period of subdued growth, there are now signs that the US economy is suffering from overall debt fatigue. Bank lending is stalling, as the chart below of US M2 minus M1 money supply shows……More Here