Remember Japan of the 1970s & 1980s? They were all set to conquer the world with their great multinationals, their long term thinking & their smarts. Japanese manufacturing was the envy of the world and in 1989 they bought iconic American properties like Rockefeller Center in New York and Pebble Beach Golf Resort in California. They were unstoppable and the world knew it.
Of course now we know that 1989 was indeed the top of Japan. For 26 years Japanese economy & Japanese financial power have been on the skids. That shows that, despite a reputation for being smart, Japanese society & establishment were dumb. They made three big mistakes, mistakes that resulted in the 26 year decline.
- Japan followed a mercantile trade policy that succeeded first only to fail big later. The examples of Germany in 1930s, Soviet Union in 1950s & 1960s, and Brazil in the 1960s & 1970s should have warned them of the danger. These policies work in the first decade or two and that success makes these policies hardwired into economic & domestic policy. These policies require an excessively high domestic savings rate. They require forcing some degree of monetary sacrifice or repression on their own citizens including lower interest rates & lower currency. That is unsustainable in the longer term.
- The success of a top down or government established policy creates a coterie or cadre of “best & brightest” who are educated in the established policy and are hardwired to maintain it. Such “best & brightest” always end up destroying their own system and Japan’s “best & brightest” proved no exception. They became so arrogant about their own intelligence that they refused to learn from the history of Germany, Soviet Union & Brazil.
- Most importantly, Japan never realized that they were playing America’s monetary game and that they didn’t really understand it. Japanese “best & brightest” thought that they were so intelligent that they had figured out a smart way of defeating America in America’s monetary-finance game and that Americans were too stupid to understand the uniquely Japanese strategy.
Who is dumb now, eh? But why is this relevant today?
1.China the “new” Japan?
China is turning into Japan before our eyes. Look at the three factors above and see how China has virtually mimicked Japan’s successes and mistakes over the past 13 years.
Since China joined the WTO in 2002, launched its mercantile trading policy based on inexpensive Chinese labor, and pegged its currency to the US Dollar, China has been on a tear. China came to be hailed as the new superpower and America was downgraded to a country in decline. China seemed unstoppable with its mastery of low cost manufacturing prowess, the boundless growth of its economy and the sheer intelligence of the Chinese leadership.
Capital flowed into China from all over the world both into direct investments in factories in China and into the Chinese currency. The expectation was that, despite the massive efforts of Chinese authorities to the contrary, the Chinese Yuan would rise against the Dollar.
The stunning success of Chinese policies inevitably created a centralization of power in the cadre of “best & brightest” technocrats who considered themselves more intelligent than dumb Americans. The 2008 financial crisis in America was the final proof to them of how excellent their system was, how smart they were and how dumb Americans were. They understood that the status of the US Dollar was the reason for US financial dominance and they wanted it. They worked hard to get the Yuan included in IMF’s basket of reserve currencies. They got that status in November 2015.
2.Come into my parlor?
Come into my parlor, said the spider to the fly. Like their Japanese counterparts in late 1980s, the Chinese “best & brightest” never understood they were playing America’s game. They never realized that America created this monetary policy game over a hundred years ago and they were sheer novices. The Chinese celebrated their entry into global reserve status just two months ago. Now look at them.
Capital is now running out of China much faster than it came in a few years ago. According to the estimates by the Institute of International Finance, Chinese individuals & companies sent out about $550 billion out of China. And the outflows are accelerating. Look at the chart below from RBS and tremble.
What opened the floodgates? To be included in IMF’s basket of global reserve currencies, China had to make its currency, the Yuan, “freely usable”. To do so, they had to remove some currency barriers. That opened the floodgates.
Now Chinese authorities are trying desperately to stem the tide. They tried to prop up the stock market and that created a selling panic. This past week, they tried burn the currency speculators by buying large sums of offshore Yuan in Hong Kong. Guess what happened? The borrowing rate on offshore Yuan exploded up to 66% on January 12. That is 10 times the normal rate.
China has a much bigger problem, a problem Japan didn’t have. China is still an autocratic system run from the top. And financial markets are free wheeling and work in waves. This is a fight between the irresistible force of free capital flows and the immovable object of Chinese leadership. And the force is winning. So what can China do from their top down command orientation?
Devalue the Yuan fast and big. This should not be a slow step by step devaluation because the first step would lead to much bigger outflows from China in fear of future devaluations. That is why RBS & many others recommend a brutal 20% devaluation of the Chinese Yuan.
3. Global Trade War?
It is not easy for China to officially devalue its currency by so much and in such a public fashion. That is a declaration that the Chinese leadership has failed. And that’s never done in autocratic regimes. A big devaluation will make Chinese savings far less valuable, create food inflation and damage consumer confidence in China.
The impact on the rest of the world could be huge. China would be exporting its problems to the rest of the world via trade. Chinese products, already cheap, would be so much cheaper that they could force draconian adjustments on companies in US, Europe, India and in any country that has a trade deficit with China. There is very little tolerance for that in today’s world. Chinese leadership gets this & they don’t want to ignite a global trade war.
4. So back to the past?
You can’t have your cake and eat it too. The financial flows equivalent is that a country with a reasonably free capital flows CANNOT control both its currency and interest rates. And Chinese leadership is totally unwilling to accept defeat against free markets the way Bank of England did in 1992 against George Soros and the currency speculators.
The only solution then is to slap controls on capital flows. That might stabilize the Yuan and decrease the rampant fear in Chinese currency & stock markets. That might also push a restructuring of the Chinese economy into the future. That is what Japan did in 1990s and the Chinese problem is much, much, bigger than Japan’s.
The bottom line is that Global Financial Markets & the Monetary policy that drives them is America’s game. And beating America at its own game is nearly impossible unless you create a bigger America with bigger financial markets with deeper liquidity and mass participation. But that requires a commitment to make your people richer & more powerful rather than build “best & brightest” teams that centralize decision making power.
Nobody else has done that yet.
Send your feedback to firstname.lastname@example.org Or @MacroViewpoints on Twitter