Russell Napier: "Trade War Is The Beginning Of A New Global Monetary System"

Submitted by Russell Napier of ERIC

A Country Matures, An Exchange Rate Declines

After two weeks on the road visiting clients your analyst returns with a better view of the consensus outlook. There is, though, much in the consensus to disagree with. In particular it seems peculiar that the consensus believes the democratically elected government of Italy, with policies entirely contrary to EU membership, will be put through the bureaucratic meat grinder in Rome and Brussels and turned into EU sausage, in a similar process that minced the political representatives of Greece.

While this might well be the case, it is hard to understand that the grinding destruction of this democracy, even if it is only moderate compared to the Greek experience, can be anything but bad for growth and asset prices in the EU. Disciplining these politicians to abandon their manifesto promises and follow the ways of the EU is highly unlikely to be a painless experience, either for Italy or the rest of the EU. Nonetheless, investors are content to believe that a painless disciplining of Italy’s elected representatives is all but inevitable. We shall see.

Perhaps the most prevailing consensus view is that the recent weakness of the RMB represents a Chinese counter-punch in the trade war with the US. Coming when it does, it is easy to see the accelerated decline of the RMB as a tactical and not a strategic move. Comments by the PBOC on July 3rd have probably reassured many investors that the managed exchange rate regime is not at risk and that the RMB will continue to be managed against a basket of currencies. Your analyst does not agree.

Readers of the Q2 2018 report (When Monetary Systems Fail - A Guide For The Cautious) will know why the decline of the RMB exchange rate is part of a larger change in the global monetary system. It is a change that is initially deflationary and accompanied by a likely credit crisis. Of course, such a breakdown has been close three times post-GFC with first the European debt crisis (2011-2012), the taper tantrum (2013) and in the commodity price collapse that ended with the so-called Shanghai Accord in Q1 2016. So it is not surprising that market participants believe that, once again, central bankers stand ready to stick their fingers in the dike that holds back the market forces of deflation associated with the end of the current global monetary system. The recent movements in the RMB show that Jay Powell’s refusal to join the shoring-up party has prompted a fundamental shift in Chinese monetary policy.

Investors need to prepare for a formal widening of the trading bands for the RMB relative to its basket and the problems such a move will create for all emerging markets. That first move in the RMB is inherently deflationary. This is no counter-punch in a trade war; it is the beginning of the creation of a new global monetary system.

While many investors now concede that an emerging market debt crisis is likely, few are prepared to concede that China will be caught up in it. China is always seen as different and of course, in many ways, it is. It may well manage its exchange rate against a basket of currencies, dominated by the USD, but it has tools to manage this relationship that most countries do not.

Its exchange controls allow it to manufacture a capital account surplus, although those controls are not a perfect dam for capital outflows. By creating a larger capital account surplus than would otherwise occur, China maintains the total external surplus that leads to rising foreign exchange reserves and hence growing domestic commercial bank reserves. It thus extends the period of growth. Also, the state owns the commercial banking system and so can force it to keep lending, thus continuing to create RMB, when the growth in commercial bank reserves would dictate more moderate credit growth in a truly private banking system. While these tools allow China to extend the business expansion within the managed exchange rate regime, they do not permit it to abolish the business cycle. If it were so, everyone would be adopting similar policies.

At least since the time of David Hume (died 1776) and probably since Richard Cantillon (died 1734), we have understood how the downtrend in the business cycle is enforced in an exchange rate management regime. It is inevitable, in such a regime, that the enforced excess creation of money leads to a deterioration of the external accounts, an end to money creation and slower growth, often accompanied by deflation. There are natural forces at work within a managed exchange rate that cannot be resisted. Nobody yet has found a way to obviate that cycle, though many have extended it. China’s ability to use its capital controls and commercial banks’ balance sheets to temporarily override those natural forces has now come to an end.

The ability of China to extend the cycle has come to an end as the current account surplus has all but evaporated - a natural consequence of extending the growth cycle by keeping money too loose when the external account deterioration dictated that it should be kept tight. It has come to an end as the capital account is at best in balance rather than surplus. It has come to an end because the RMB is primarily linked to a strong currency in the form of the USD. It has come to an end because the Fed is both raising interest rates and destroying high-powered money to the tune of USD360bn a year. It has also come to an end because Jay Powell has warned China, and other emerging markets, that he will not alter the course of US monetary policy to assist with any credit disturbances outside his own jurisdiction.

And if that were not enough, it has come to an end because the US runs small current account deficits, by its own historical standards, and the President of the USA seems determined to make them even smaller. Investors now need to ask a bigger question when considering the future for Chinese, and thus emerging market, monetary policy. Why would anybody want to link their currency to the USD?

As a graduate of the University of Cambridge, your analyst can attest that things often done for the soundest of reasons can continue to be done long after they cease to make any sense. Such behaviour is the social habit we often proudly call tradition, or as Henry Ford put it more eloquently -

‘History is more or less bunk. It’s tradition’’

In the field of monetary policy, following tradition is both dangerous and unsustainable and doing it one way because we have always done it that way is not an option. Investors need to think not about the long tradition of the RMB link to the USD, but whether today such a policy makes sense. Indeed, one thing we can all forecast, with a very high degree of probability of being right, is that one day China will have an independent monetary policy as one of the world’s largest economies.

It is of course a big call to say that the tradition of linking to the USD is ending now and a new independent monetary policy is in the process of being created, but that time has come. Japan, the Eurozone, the UK, Canada and Australia are just some countries that manage their monetary affairs free of any de facto or de jure link to the USD. China is now joining the club, and other emerging markets will either have to decide to move to a free float or, believing that China is now capable of running major current account deficits, move to linking their currencies to the RMB.

So why is it now that China is maturing into a country with an independent monetary policy? It is a combination of a change in the Chinese economy and also a change in the nature of the US economy, and what the US wants to be to the world economy. The US is a country where the current account deficit relative to GDP has been less than 2.5% since 2012 - compared to a deficit of almost 6.0% of GDP at the peak of the last business cycle. President Trump appears determined to reduce even this moderate deficit.

If the US is not to run ever-bigger deficits, how can those linked to the USD run ever larger surpluses? Such surpluses force a rise in foreign exchange reserves and the creation of domestic base money thus facilitating higher economic growth. This tightening of monetary policy through smaller US current account deficits can be somewhat offset, if US interest rates are declining, with positive impacts for capital flows to those managing their currency relative to the USD. However, as it happens, interest rates are rising and as readers of The Solid Ground Q1 2018 report will know, the contraction in the Fed’s balance sheet exacerbates the problem.

To add to the problems for those linking to the USD comes the statement by Jay Powell in Zurich on May 8th that he bears no responsibility for the consequences of his monetary policy on emerging markets. In short, it is a system where the de facto lender of last resort has absolved himself of liability. China and other emerging markets will know why they started their managed link to the USD but they will be hard pressed to work out why they continue with it.

At this stage nobody can really move onto a new monetary system until China moves on. If any form of managed exchange rate is to form part of EM monetary policy, then the most important thing to establish is who will run the world’s largest current account deficit. China has been a mercantilist since the death of Mao, and Japan and Germany/Eurozone are all bent on running current account surpluses. While President Trump’s policies may be contradictory in terms of what they will achieve, his resort to non-market mechanisms in terms of tariffs show it would be too dangerous to believe that he will ultimately fail to generate his desired US current account surplus.

So, who can run the current account deficits necessary to make their currency an attractive anchor for smaller countries seeking to run current account surpluses?

It seems well nigh impossible to believe, following almost 40 years of mercantilism, that China would opt to become a country running large current account deficits. Such a change in the mindset may seem revolutionary, but it is just another necessary shift in the long game in the attempt to make China the pre-eminent global economy. Already the move to a more consumption orientated economy has all but eradicated the country’s current account surplus.

Yet this is a country still with a long way to go in reducing its reliance on investment as a component of its economy. It is a country with a level of debt to GDP that is growing more rapidly than any other country in the world. It is, in short, a country that needs to further accelerate consumption and generate sufficient growth in broad money to inflate away its excessive debt level. It is very difficult to see how those key goals can be achieved without running a material current account deficit associated with much higher nominal GDP growth. This country needs an independent monetary policy.

That independence can only come from abandoning the exchange rate policy and generating the level of high nominal GDP growth, in a world of low nominal GDP growth, that will produce a major decline in the exchange rate. As argued above, structurally and cyclically it is time for China to move on and to take its full place with those independent nations that do not rely upon others to ultimately determine the price and quantity of money of their domestic currency.

The initial shift to a more flexible Chinese exchange rate is deflationary and dangerous. The USD selling price of Chinese exports will likely fall, putting pressure on all those who compete with China - EMs but also Japan. The USD will rise, putting pressure on all those, particularly EMs, who have borrowed USD without having USD cash flows to service those debts. With world debt-to-GDP at a record high, such a major deflationary dislocation can easily trigger another credit crisis and The Solid Ground has previously focused on where such credit events are likely.

However, following the great dislocation, China will be free to reflate the world, for such will be the potency of the monetary policy of such a large economy relaxed about running a current account deficit.

Investors should not bet on this happy outcome. There will be deflationary pressures and a potential credit crisis to navigate first. At any time in this process very unpredictable political feedback could delay or prevent China’s move to its new role. So, prepare for the deflationary consequences of this shift in the global monetary system, and expect as well as hope that it too will end as China helps the world to inflate away its debts.


hxc Fri, 07/06/2018 - 20:36 Permalink

Monetarist/post-keynesian micromanagement pseudotechnical type of stuff, but i agree 100% with the sentiment, if that makes sense.

anarchitect dirty fingernails Sat, 07/07/2018 - 08:22 Permalink

It's a very tedious exposition of Triffin's Dilemma.  To put it briefly, if the yuan is to become a reserve currency, China must run a trade deficit so that others can accumulate yuan.  But the author is so blinkered by his establishment thinking that he doesn't discuss the alternative, which is that no one needs to--and indeed cannot--run a chronic trade deficit under a gold standard.  The reason is that trade imbalances are settled in gold, which ultimately caps the trade deficit.  But would China be willing to do this?  Politicians everywhere love the power to print in order to finance their schemes.  To think the Politburo is different is dubious.  So a gold standard is unlikely to return unless there is a serious economic crisis and enough players decide that they don't want to use constantly depreciating fiat currencies as reserves.

In reply to by dirty fingernails

MoreFreedom dirty fingernails Sat, 07/07/2018 - 13:39 Permalink

I agree with your analysis of the Napier's intent.  But I think he sees it incorrectly.  He asks "Why would anybody want to link their currency to the USD? "  where the obvious answer is the US dollar is a better fiat currency than the others, but a better question is "Why wouldn't countries link their currency to gold and/or silver?".  The obvious answer being so the establishment can print money and screw the citizens.  Napier misses the bigger picture of internal politics driven via crony crapitalism and protectionism.  Whereby politicians get rich and powerful by protecting their rich crony business owners from foreign and local competition at the expense of their citizens. 

Trump is attacking this protectionist racket world wide, which threatens establishment politicians and their rich friends.  Leaving politicians the choice of a) trying to stay in power under declining living standards or b) abandoning the protectionist racket that makes them rich and funds their campaigns, and moving towards free markets globally.  They are all attacking Trump for this, and that includes the corrupt (politicians and their cronies) in the US.  As for linking to the dollar, this action makes the dollar sounder.  But the fly in the ointment is that Congress controls spending and the budget, and isn't cooperating.  But since they've given the president such power (when they never expected a free market president would use it against them) Trump is doing just that.

Living standards will decline everywhere as a result of the trade war, but who will it hurt most and who will blink first?  I hope Trump did his homework and knows it will hurt the corrupt protectionist nations a lot more than the US, and they'll come to the table before Congress can do anything.

In reply to by dirty fingernails

rtb61 Pinto Currency Fri, 07/06/2018 - 23:54 Permalink

It is complex, which for some, well.

The new monetary system, the only thing of real worth on this planet, energy (you can in affect make everything else from energy ie burn enough energy and you can suck dissolved gold right out of the sea). The direct global exchange of energy (traded with a crypto currency so it can always be tracked yet still traded privately) and than purchasing that energy on local markets via local currency, with those local investment markets having access to global energy exchange, where you buy in energy to local markets by that markets energy or currency.

All delightfully trading complex (what type of energy will be worth how much in the future), yet pretty stable as far as the energy is concerned, local market currency not so stable. Sanctions broken for ever (the nature of the trade and the quick ability to exchange one energy for another at any time) and open direct market access to all the world's energy (energy released to the market that is, countries who can will hoard some and keep it off market to ensure local demands are fulfilled first).

US will either lead trying to use business method patents or be dragged along anyhow kicking and screaming all the way as it loses control, tick tock, tick tock.

In reply to by Pinto Currency

Winston Churchill hxc Fri, 07/06/2018 - 21:40 Permalink

They are going to a gold backed system.They didn't want to,no govt. does,but they will not dethrone the

USD without doing so.The US threatening that it would take it as an act of war several years ago kicked the can,

but war is coming anyway unless they do it quickly,before the boost in MIC spending gets any benefit however

marginal for the inflated bucks.Helsinki is the last chance for a peaceful resolution IMO.Kneecap the dollar

before the USA destroys the world.No good choices,just better ones from a bad bunch.

In reply to by hxc

Cloud9.5 dark pools of soros Sat, 07/07/2018 - 05:20 Permalink

The Fed ends when the dollar dies and not one second before.   History is precise in the fact that all fiat currencies crash.  We understand this. The when and how is the conundrum.  There is a tremendous momentum behind the dollar.  Even street vendors in China prefer it.  I know this for a fact because I purchased trinkets with it in Shanghai two weeks ago.

In reply to by dark pools of soros

Yen Cross Fri, 07/06/2018 - 20:43 Permalink

 Rustle The Leaves~ Napier?

 This guy is a fucking clown, with an reactionary mind.

  When, if ever, have we studied one of Mr. Leafs overlays, pertaining to finance?

michigan independant Fri, 07/06/2018 - 20:50 Permalink

So doubling down with the Democrats debt has consequences like funding China .mil for decades to rebuild since we already lost the trade war to service onerous debt as the consumers run out of rope to service inflated services they cannot afford. Asking them nice to stop was like taking a leak on a burning city as you melt into the black top. Yes we read the SDR papers also as Neroabama was on Valery's leash.

jmack Fri, 07/06/2018 - 20:57 Permalink

This just shows you why all the countries with any sense are bringing back and hoarding gold.  Powell is going to try and get the dollar back to health. But he is going to do it  by using pain in monetary policy (higher interest rates) to create adherence in fiscal policy (they cant afford to borrow any more money), instead of using a more disciplined fiscal policy (pay as you go, either by cutting spending or raising taxes or a combo of both) to allow the current loose monetary policy to continue.  This means pain for everyone. And no one likes pain.  


    So if you are going to have to undergo pain, why not undergo that pain in such a way that leads to the best possible future outcome.... If you are going to go on a diet, why not actually do a healthy diet that leads to actual health improvements, instead of a fad diet that even if you adhere to it completely will lead to questionable health improvement outcomes.


So yea, a monetary paradigm shift is in the air.



jmack dirty fingernails Fri, 07/06/2018 - 21:08 Permalink

The US did do that. but Trump is obviously trying to renegotiate that deal, ignoring the world order developed by the last 4 administrations.   Whether he is just a bull in a china shop, or an actual intelligent change agent is up for debate, but change, at a fundamental level, is coming, of that we can be sure.  This is one reason that Trump is getting so much push back from the deep state/MIC.

In reply to by dirty fingernails

jmack dirty fingernails Fri, 07/06/2018 - 21:36 Permalink

possibly, and this is just conjecture, but he is trying to build a fighting force, and not the batch of ticket punchers and desk jockies and sjw types that currently control the MIC.  Obama purged all the fighters out of the military, at the mid to high levels, he transformed the military form a competent fighting force, to a force for social justice, which is the biggest unreported or discussed scandal in american history, but whatever.

In reply to by dirty fingernails

Consuelo dirty fingernails Fri, 07/06/2018 - 21:08 Permalink

That military is used to ensure compliance alright - from nations who have absolutely no chance of fighting back on their own.

I often think of this dynamic as the mirage scene of the giant bloodied ape in one of the Planet of the Apes series from the 70's.   It fooled and intimidated the apes on horseback for a while, until one of them punched through the mirage and found there to be no substance.

In reply to by dirty fingernails

the artist jmack Fri, 07/06/2018 - 21:27 Permalink

You have a sane measured approach...

The US is the cleanest dirty shirt. We will end up the overall relative winners as this plays out over the next decade. 

China is in horrible shape 1.3 B people dependent on ever expanding growth model just to tread water. 

The math is not that complicated. 10% growth = doubling time of 7 years. 7% growth = doubling every 10 years. 5% = 14 year doubling time and 3% = 23 years.

The last 15 years has seen and average growth of GDP of about 10% Does anyone believe that Chinas Economy will double in the next 7-10 years to stay on pace with the last ten? 

2011-2013 China poured more concrete than the USA did in its entire history as a country. similar stories for energy consumption, copper, steel etc. 

The idea that China will double that output  and then double it again is ludicrous. Not Going To Happen. 

Anyone who thinks China will achieve escape velocity and become immune to the math or somehow transform their economy into something that defies physics is huffing old fire extinguishers. 

Sure we will have some pain but we will secure a place at the table for the next transformation that is staging as we speak. 

China will not. Heads will roll as their society is forced a leg down. 



In reply to by jmack

MaxThrust the artist Fri, 07/06/2018 - 22:24 Permalink

"Anyone who thinks China will achieve escape velocity and become immune to the math or somehow transform their economy into something that defies physics is huffing old fire extinguishers. "

 I have agreed with this line of thinking for 7 years and still the Chinese government have manage through all sorts of smoke and mirrors to delay the day of reckoning. I believe the Chinese are waiting on a cause which they can blame for the crash of their economy. A cause they can attribute to others or external forces.

In reply to by the artist

OpenThePodBayDoorHAL the artist Sat, 07/07/2018 - 05:45 Permalink

Everybody misses one key difference: China has a sovereign currency. The USD is issued by commercial banks, not the US Gov. The USD is not a sovereign currency. The RMB by contrast is issued by Chinese banks, which are owned by the State. 

And people also forget: They're Communists. If a bank or other big SOE gets into trouble there, later that day they can just announce they did a debt for equity swap. By contrast, on the day we gifted Citi $174 B in free money we could have bought 100% of the Citi Class A Common for $4B and cleaned house. So instead of a festering sore, today we would have a (relatively) healthy bank.

Ditto the entire Eurozone banks, they never recapped them and if anything they're even uglier than the U.S. ones.

In reply to by the artist

el buitre jmack Sat, 07/07/2018 - 00:02 Permalink

One hand giveth and the other taketh away.

You have the Fed with its "quantitative tightening" ( do they hire morons to come up with these terms or just economists?) which of course is very deflationary and you have the Exchange Stabilization Fund with its trillions of funny money buying up all the dumped treasuries and sticking them in the sub-basement of the Treasury Building.  By keeping the 10 year yield under 3% when it should be 10% based on fundamentals, they are forcing money into the stock market, propping it up.

In reply to by jmack

Consuelo Fri, 07/06/2018 - 21:04 Permalink

Funny, in all that high-mindedness, not one mention of gold or the role it may and perhaps will play in this transition.   It sorta can't be denied the amount of gold China has accumulated over the past 10 years, at least.   Nor can it be denied that they're not accumulating it to adorn the Forbidden City, or high-maintenance wives...    All that is left in this scenario when it really gets rolling good, is how much gold China actually has, and how they intend to deploy it.

dirty fingernails Consuelo Fri, 07/06/2018 - 21:09 Permalink

Yep. I don't know how they'll use it, but they can see that they will need to use it to make their currency valuable while the US prints ever moar. However they do it, I'm sure it'll be asymmetric. Russia is clearly on a similar path as well as the other nations repatriating their gold (what they can get anyway, right Germany?)

In reply to by Consuelo

HRH of Aquitaine 2.0 Consuelo Fri, 07/06/2018 - 21:14 Permalink

There is also a massive amount of debt and leverage in the Chinese market. And the ever-present Mandate of Heaven.

I don't view the Chinese as omnipotent and all powerful. They have their weaknesses just as the west has ours. But we are allowed to think and be creative. You cannot teach that and the west has been breeding for that for several hundred years. Unlike China which breeds for compliance.

Rather than harness the energy of their people the Chinese stifle it. This is their Achilles heel. FFS why would anyone waste time making a fake egg and try and pass that off for real? What level of corruption does that take when people are reduced to such scams? I think this type of thinking is wide spread in China. Search for the fake egg video in China on YouTube. Another ZHer posted it here a few years ago. Worth watching. So much wasted energy in that type of scam.

In reply to by Consuelo

the artist Consuelo Fri, 07/06/2018 - 21:31 Permalink

One scenario is war, a culling of their population and a deployment of the gold after the dust has settled by the oligarchs to secure their own future in a drastically scaled down it New-China. 

You didn't think they were going to spend that gold on their citizens!?

The Arithmetic of Population and Energy is playing out. Chess pieces are being arranged and the game is about to begin. Lehman was the signal that the music would soon stop. 

In reply to by Consuelo

IDESofMARCH Fri, 07/06/2018 - 21:07 Permalink

US companies have gone all around the world to get CHEAP labour, China India, Bengladesh and suddenly Trump wants US workers to sew, shirts, pants, socks, silk flowers, minial assembly tasks for food and shelter. Where in the US are you going to find these hardworking unemployed that want these jobs.