Silicon Valley Bank collapsed as its start-up depositor clients withdrew money because of an interest rate hike by the U.S. Federal Reserve. Signature Bank collapsed as its depositors went for panic withdrawal seeing the collapse of Silicon Valley Bank. Silvergate Bank had heavily invested in cryptocurrency whose recent depreciation caused the collapse of the bank. After this news, there is a huge global backlash against US Dollar.
Saudi Arabia & Iraq have started to trade with China in Yuan instead of US dollars. In Russia, Yuan has become the most traded currency in 2023. In Iran, Yuan has passed ahead of Euro as the second most important foreign currency. The UAE sold LNG to China in Yuan for the first time last month. Brazil has decided to use Yuan and its domestic currency in global trade. India and ASEAN countries too sought to reduce dependence on the U.S. dollar, Euro and increase the use of domestic currency. Yuan now exceeds Euro in Global Trade Invoicing.
Why Different From the 2008 Crisis
The Great Financial Crisis of 2008 was triggered by the collapse of Lehman Brothers. The crisis of 2008 happened due to bad quality of credit resulting from the low-interest rate of the U.S. Federal Reserve that allowed the financing of many bad projects with a bad quality mortgage. So the 2008 crisis happened due to an excess supply of funds. The 2023 bank crisis happened due to a shortage of funds for financing businesses because of an interest rate hike by the U.S. Federal Reserve.
The US Economy and the Global Economy
To understand this journey of U.S. capitalism from low-interest rates to the high-interest rate we have to see the US economy as a part of the global economy. From the 1970s to 2008 the U.S. economy was the demand center for the global economy. The U.S. became a net importer of goods, services, and capital in this period. The U.S. used to finance this import through the extension of the U.S. Fed balance sheets which entailed low-interest rates. This low-interest rate was possible because of the flow of cheap goods and services created by the cheap yet productive labor of the Third World especially China.
The cheap productive labor of China kept inflation of the U.S. economy low which allowed the U.S. Federal Reserve to keep the interest rates low giving rise to a lot of innovative ventures and asset trading activities. But after the 2008 crisis, China felt that it cannot rely on the US market as the main driver of demand for its huge manufacturing base. China started making huge demand-generating infrastructure projects first inside and later throughout the world. The wage rate in China also grew 5 times in the last 40 years and by the end of 2023 China will enter the bracket of High-Income Countries (US $ 13,589 Gross National Income Per Capita by Atlas Method).
As Chinese cheap productive labor dried up, the US economy started facing a high inflation rate which forced US Fed to raise the interest rates. US-led Trade war and Technology war with China, the expansion of the Fed’s balance sheet during COVID-19, and geopolitical clashes in Ukraine further worsened the inflation situation. As the Chinese wage rate keeps rising, capital’s bargaining power with workers of other countries especially First World is falling. The US wage rate has started rising since 2016 and this has added to inflation as well. All these resulted in a shortage of funds for new projects resulting in lower growth.
The US can solve this problem in two ways:
Find a new alternative to cheap productive labor in Third World. There are still a lot of poor countries in the Third World but it is difficult to find an alternative to China. This is because the quantity and quality of Chinese workers and infrastructure have not matched in the entire Third World.
Devalue the US Dollar with respect to the Chinese Yuan. This can be done in two ways:
a) Reduce the role of the US Dollar in the global market. This will devalue US Dollar against other currencies like the Chinese Yuan which will make US goods cheaper and hence US economy can get relief from high inflation and high-interest rate.
b) Without reducing the role of the US Dollar in the global market appreciate the Chinese Yuan against US Dollar by opening China’s capital account and making the Chinese Yuan freely convertible.
On the one hand, the USA is trying to prop up new centers of cheap productive labor to replace China e.g. India (similar population size to China), Mexico (nearest to the US market), Vietnam (nearest to China and hence Chinese supply chain), Bangladesh (showing good growth for years). On the other hand high-interest rate in the US is creating a shortage of US dollars in the global foreign exchange market forcing many countries to seek alternatives to the US Dollar in global transactions.
Why the U.S. Cannot Find an Alternative To China?
The Chinese population is aging and its workforce is falling. Indian, South-East Asian, and African population is still young and their workforce is rising. But the number of young workers is not the only factor in an economy’s development. Any country’s total output grows because of factors like the number of workers, the productivity of the workers, capital, and Total Factor Productivity (TFP) which includes innovative measures, economies of scale, etc.
In the heydays of China’s GDP growth (1980-2020), labor accounted for a mere 6.1% while capital accounted for 64.2% as the sources of this growth. TFP accounted for the rest 29.7%. During the same time period sources of GDP growth in the 30 largest Middle & Low-Income countries are 62% from capital formation or investment, 30% from labor, and 9% from TFP. Sources of GDP growth in the 30 largest High-Income countries are 74% from capital formation or investment, 24% from labor, and 2% from TFP. So it is clear that in all types of economies, the most important source of GDP growth is capital formation. It is economically wrong to think to a fall in the workforce will reduce China’s GDP growth rate significantly if its saving percentage of GDP and net fixed capital formation continue to be significantly higher than the rest of the world.
Capital formation or investment in an economy depends on its savings as a percentage of GDP. Let us look at the savings rate of different economies between 2011 and 2021: China has a savings rate of almost 45%, and for India, it was a mere 30.21%. So China is not only five times the size of Indian GDP, but its savings rate is also 50% higher than India’s. So despite having a huge number of young workers India has little chance to emulate the Chinese growth if the savings rate is not raised significantly. Bangladesh has a savings rate of 36%, Vietnam has 32% and Mexico has 23%. Given the size of the labor force and savings rate surely they are no match for China.
Naturally gross fixed capital formation as a percentage of GDP is 42% in China, 29% in India, 31% in Bangladesh, 32% in Vietnam, and 20% in Mexico. On average in the last 20 years, China is ahead of others by 10% in gross capital formation. So it can be said without doubt that no country can come even close to China in the near future.
Past Policies Of the US To Destroy Competitors
History tells that the USA out-competed West Germany (Blessing Letter, 1967) and Japan (Plaza Accord, 1985) by enforcing upon them the devaluation of the US Dollar against their respective currencies. A higher value of domestic currency makes the value of domestic goods, services, and assets dearer. Thus there is less demand for its domestically made goods and services but more demand for its assets. Thus the country’s production sector becomes uncompetitive and fewer funds are available for production. While the country’s asset market becomes lucrative for buying assets cheap and selling dear type non-primary transactions (in other words, speculation).
When Plaza Accord made Yen dear against US Dollar, it means demand for Japanese goods and services will fall while the demand for Japanese assets will rise. Trade in Yen will rise or fall if demand for Japanese goods services and assets rises or fall respectively. So higher value of Yen means more use of Yen if the rise of Yen usage in the asset market is more than the fall in the goods-services market. The deeper the asset market is relative to the goods-service market, the more increase in the use of a currency is expected when its value appreciates. So, whether a higher valuation of a currency can result in more use of the same depends on the asset market depth compared to the size of the goods-service market.
But the size of a country’s asset market is always determined by the size of that country’s GDP. If a country’s GDP is 4 times more than another country then the latter’s asset market needs to be 4 times more than its own GDP if the latter’s currency has to match the use of the former one. But for major economies, stock market capitalization as a percentage of GDP ranges between 80% to 200%. Moreover, the USA with the highest GDP and highest stock market capitalization (193%) among all major economies. So mere appreciation of Japanese and German currencies cannot make their currencies match the power of the US Dollar and had only resulted in a fall in capital formation within their respective economies. Thus enforcing appreciation of Japanese and West German currencies helped the USA to checkmate the former competitors.
A similar case happened in 2015 in the Chinese stock market. The appreciation of the Yuan led to a huge inflow of funds in the Chinese stock market which burst after creating a boom. This is because a small base of the goods-service market could not sustain an asset boom much longer. This boom though a short period reduced the gross capital formation rate of China as a percentage of GDP by 3% (from 45% in 2013 to 42% in 2015).
Can the Chinese Yuan Challenge US Dollar?
Yes, it can. This is because the size of the Chinese GDP is similar to US GDP and the former’s potential GDP is three times the latter. In 1950, the US share of global GDP was 45%. Today’s high use of the US Dollar in global transactions comes from this 1950s reality. But the global economy has changed a lot since the 1950s. Chinese share in global GDP grew from 2% in 1980 to 19% in 2022 and the USA fell from 45% to 24% between 1950 and 2022. But, the Chinese asset market is less than one-third of the USA (The stock market capitalization rate is 83% for China).
So many Western economists argue that Yuan is no match for Dollar as long as the Chinese asset market is not far deeper and the Chinese Yuan is not freely convertible. But now we can see that shortage of US dollars is already forcing many countries to use Yuan for trade in goods and services as China is the largest bilateral trading partner for most countries in the world. In this way, many countries hope to avoid a shortage of necessary imports in the absence of the US Dollar. Thus without making the asset market deeper and Yuan freely convertible, Yuan has been able to gradually establish itself as a global currency using China’s status as the largest bilateral trading partner of most countries and the present shortage of the US Dollar due to high-interest rate in the USA resulting from high inflation inside the US economy.
The U.S. GDP’s global share has fallen so much that the present share of U.S. dollar usage in global transactions cannot be sustained. As Chinese labor becomes costly, workers across the globe especially those of the First World have gained greater bargaining power vis-à-vis capital as capital has no more cheap productive labor option to go to. This is creating high inflation in the U.S. market which is resulting in high-interest rates and a shortage of the U.S. dollar in the global market. Thus most countries are searching for one or more alternative global currencies. Only the Chinese Yuan can gain from the loss of share of the U.S. dollar in the long run as only the Chinese GDP size is similar to that of the US GDP. Even without opening the capital account and deepening the asset market, the Chinese Yuan can play a significant role in global transactions especially in Trade Invoicing since China is the largest bilateral trading partner of most countries. The U.S. dollar will remain an important global currency for many years to come but its monopoly power in global transactions will end soon.
DISCLAIMER: The views and opinions expressed in this article are those of the author and do not necessarily reflect the official policy and position of Regional Rapport.
• By 2025, we can have several Global Reserve Currencies with US Dollar having a 53% share, Euro having a 20% share, and the Chinese Yuan having a 5% share.
• By 2030: USD, Euro & Yuan respectively may have 45%, 15% & 15% shares.
• By 2035: USD, Euro & Yuan respectively may have 35%, 10% & 35% shares.
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