The rise of a unified Germany in the late 19th century is now increasingly credited with the outbreak of the First World War, the outcome of which arguably also led to the Second World War. Chancellor Otto von Bismarck’s achievement of creating a unified Germany provoked a crisis of balance of power on the European continent. Bismarck managed to keep a lid on the resulting tensions through proactive diplomatic policies, which worked on creating a system of alliances that minimized chances of war. The Bismarck era closely resembled the Chinese policy of walking softly and creating economic interdependence between its economy and that of major established rivals such as the EU and the US. For decades, European and American companies thrived on establishing a presence on the fast-growing Chinese market. That was all fine and well until China declared its ambitions to become more than just a manufacturing superpower, by aiming to challenge the technological supremacy of much of the developed world, through its own state-supported companies. Its made in China 2025 policy threatens the economic supremacy of much of the developed world. Current US policy assumes that an economic war with China meant to prevent it from achieving technological supremacy can be easily won. The historical precedent of Germany, the emerging power that threatened the balance being defeated, may seem encouraging to those who think that history may repeat itself. I am not entirely certain that we should expect the same outcome this time around. We may be witnessing a turning point in global economic hegemony, and there are some serious economic implications associated with any attempts to stop it from happening.
China’s ability to counterstrike is greatly underestimated
China’s massive US dollar-denominated reserves were often thought of as its nuclear option in the event that trade frictions would arise. It was often thought that due to increased interdependence, with China needing the US market, while the US needed China to buy its debt, the US-China economic relationship might always remain amicable. China’s so-called nuclear option expired with the 2008 economic crisis when the US as well as much of the world entered a deflationary cycle, despite all the money printing.
Given that, since 2008, the US Federal Reserve dumped about $6 Trillion into the economy, and we are yet to see an inflationary effect, it is doubtful that China’s ability to dump over $1 Trillion in US bonds and other USD denominated assets on to the market would trigger much of anything at all.
Because China’s ability to push back has been perceived as being neutralized, more aggressive moves by the US government to counter China’s technological rise gained increasingly bipartisan political support. We are seeing it with America’s campaign to stop Huawei from dominating the 5G infrastructure buildup, as well as an effort to deny its mobile phone industry some crucial technological inputs. There is also the trade war and other measures meant to block China’s continued emergence as an economic superpower.
It goes without saying that China is not likely to just accept this state of affairs. It will push back. As I already pointed out in a previous article, companies like Boeing (NYSE:BA) may be targeted. If things get more severe and a vicious cycle of measures and countermeasures will develop, China will go after US tech companies, like Apple (NASDAQ:AAPL), Cisco (NASDAQ:CSCO), and so on, which supposedly are already on a counter-measures list. American counter-sanctions meant to take revenge on Chinese measures against US interests will lead to a vicious cycle that will only deepen a mutually painful economic war. China will initially seem like the loser, given that US tech continues to dominate the world, while the US dollar continues to enjoy global reserve currency hegemony.
It is the elimination of America’s role as the issuer of the world’s most important global reserve currency that China will most likely use as a new nuclear option if the economic war will deepen. Given its sheer size and importance in terms of global trade, it can now challenge US dollar hegemony in global trade and as a reserve currency.
As we can see, 80% of all trans-national trade transactions involve the use of the US dollar as an intermediary that facilitates it. It is the global economy’s heavy reliance on the US dollar that keeps the dollar as the main global reserve currency. 58% of all global FX reserves are currently held in USD form.
America’s currency dominance in this regard is arguably its greatest economic competitiveness asset. It allows the US to run perpetual trade and budget deficits, and the Federal Reserve can print money with little concern about destroying the value of the dollar. What this means is that America can over-consume at government, business, and consumer levels. We can spend more on things that make us more competitive like R&D, infrastructure, and so on without having to reduce consumption than it would be possible without this crucial advantage.
China’s new nuclear option is to reject all USD transactions
Perhaps 20 years ago, or even a decade ago, this would have been an unlikely scenario. A few things happened since then which makes this a possibility, especially if the economic confrontation between the US and China will continue to intensify. Given China’s weight in global trade and the size of its domestic market for most goods, ranging from cars to food, it could opt to simply reject all USD transactions, forcing its trading partners as well as firms that operate in China to agree to other forms of payment settlements. They could use currency swap agreements, such as the one that China and Russia are already implementing, or the one that China initiated with the ECB. These are all facilities that can be quickly expanded in order to bypass the US dollar.
China’s efforts to produce its own state-backed cryptocurrency is seen as another way to bypass all USD and Western institutions when it comes to transactions. Firms operating in China as well as those involved in imports/exports could use the cryptocurrency as an intermediary by purchasing it with their own currency and then paying for their purchases with the cryptocurrency. When transactions are finalized, trading parties may opt to exchange the cryptocurrency back into their own local currency if they so wish. It would eliminate any need to rely on the USD, other foreign currencies, or SWIFT for trade.
The factor that makes it more likely for China to succeed if it chooses to go down this path is the fact that there are a large number of countries that are eager to reduce their US dollar dependence for their trading and other needs. The EU was always eager to gain equal status for its own euro currency with the US dollar. It already embraced Russia’s moves to demand non-dollar payments for its oil and gas exports. The EU is also heavily dependent on trade with China, especially when it comes to German exports. Countries like Kazakhstan, Turkmenistan, Mongolia that are stuck between China and Russia would have no choice but to comply, given their economic dependence on these two countries. Australia’s commodities exports to China also make it unlikely that it would not abide by China’s demands to remove the dollar as an intermediary of trade.
Looking at the increasingly complex economic connections between countries and keeping in mind just how massive of a trading and manufacturing power China has become, it is unlikely that many countries out there would be willing to give up on trading with China in response to it potentially cutting the dollar out of its transactions. China could do this if it chooses to in response to America’s attempts to keep China from cutting into the Western World’s technological advantage. It would not be the ideal solution by any means, because China’s own economy would take a hit as a result of temporary trade disruptions, but it would be an effective countermeasure if things were to escalate much beyond current levels of economic friction.
If we will ever reach the point where China will feel compelled to take such drastic measures, it will be the end of the current economic world order, established seventy-five years ago at the end of the Second World War. In effect, the way that the world has been doing business for many decades now would come to an abrupt end. The inevitable outcome would be yet another global economic shock, which is the last thing we need after what we experienced this year.
For the United States, losing the dollar’s main reserve currency status, as well as the dollar’s role in facilitating global trade would be a catastrophic outcome. Rebalancing would have to occur, where trade and budget deficits will have to be drastically reduced because the Federal Reserve will not be able to continue printing the money needed to cover those deficits. Interest rates would go up, making it harder for consumers to consume, for firms to invest and for the government to spend on infrastructure as well as the social safety net.
The overall stock market would suffer a huge setback, especially if we take into consideration the fact that much of the rally we have seen since the lows of 2009 is considered to be due to the Federal Reserve’s policies of increasing its balance sheet, as well as the low-interest rates.
Data source: Siblis Research
If we are to only look at the effect that low interest rates have had on the stock market, we can visualize to what extent the current state of things is dependent on America’s ability to print money. Assuming that the market would trade at an average P/E ratio of about 20, the low interest rates alone can be considered to be responsible for about $6 Trillion of that total market value, assuming that average corporate debt yields would be about 3% higher. Given about $10 Trillion in total corporate debt, yearly interest costs would be about $300 billion higher, meaning profits would be about $300 billion/year lower. An additional effect amounting to about half that can be attributed to the Trump tax cuts. We should keep in mind the fact that the US government can only run higher deficits because of the lower interest rate it pays on that debt. Lower interest rates can be considered to be directly responsible for about a quarter of the stock market’s current value when the above-mentioned factors are taken into consideration. If we consider the indirect effects, such as subdued consumer demand and perhaps less government spending, the impact on the total value of the US stock market would be higher still.
There are some people who are inclined to believe that, if President Trump will lose the November election, economic tensions with China will ease. I don’t believe this is the case. At this point, there is widespread consensus on a confrontational position towards China, given the emerging threat to America’s perceived global hegemony. This situation will persist no matter what the next electoral outcome will be. It may be temporarily softened, but any easing of tensions will be quickly reversed in response to China’s increasingly assertive economic and geopolitical positions. As was the case over a hundred years ago, when the geopolitical imbalance caused by an emerging power ended in an inevitable conflict, so is the case right now that the economic and geopolitical rise of China will lead to an inevitable clash with the current global hegemon. The final outcome of the clash may not be known, but it is naive in my view to believe that China will not hit the US at the core of its interests, including America’s arguably most important asset, namely its global currency status, and it may happen sooner than some might expect.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.