Currency Wars: The Making of the Next Global Crisis

by James Rickards

  Consideration of such military doctrine suggests that the future of geopolitics might not be the benign multilateral ethos of Davos Man but a rather more dark and dystopian world of resource scarcity, infrastructure collapse, mercantilism and default. China’s call to replace the U.S. dollar as the global reserve currency, routinely dismissed by bien-pensant global elites, might be taken more seriously if they were as familiar with Chinese financial warfare strategy as with Keynesian theory.

  China’s main link with the global financial system is the U.S. government bond market. China may be history’s oldest civilization and a rising superpower, but on Wall Street it is more likely to be viewed as the best customer in the world. When China needs to buy or sell U.S. Treasury bonds for its reserves, it does so through the network of primary dealers. Large customers like China prefer to trade with primary dealers because their privileged relationship with the Fed gives them the best information about market conditions. Relationships are the key to knowing what is really going on in markets, and China taps into those relationships.

  When China calls a bank dealer, the call never goes to voice mail. Direct lines are installed from China’s central bank and sovereign wealth funds to arena-sized trading floors at UBS, J. P. Morgan, Goldman Sachs and other major banks. A salesperson knows China is on the line before she picks up the phone. Code names are used so the salesperson and trader can engage in market-making conversations safe from eavesdropping. When China wants to trade U.S. bonds, it typically calls several dealers at once and makes dealers compete for the business. China expects—and gets—the best bids on its bond sales in exchange for the massive volume of business it provides.

  Figures on China’s purchases of U.S. Treasury bonds are difficult to ascertain because China is nontransparent about its holdings. Not every dollar-denominated bond is issued by the U.S. government and not every government security is issued by the Treasury. Many U.S. government securities are issued by Fannie Mae, Freddie Mac and other agencies, and China holds some dollar-denominated bonds issued by banks and others not part of the U.S. government. There is no doubt, however, that the vast majority of China’s dollar holdings are in U.S. Treasury bonds, notes and bills. Official U.S. figures put Chinese holdings of Treasury securities in excess of one trillion dollars, but when government agency securities from Fannie Mae and Freddie Mac are taken into account, the dollar-denominated government securities total is much higher.

  China’s great fear is that the United States will devalue its currency through inflation and destroy the value of these Chinese holdings of U.S. debt. There has been much speculation that China, in retaliation for U.S. inflation, could dump its one trillion dollars of U.S. Treasury securities in a highly visible fire sale that would cause U.S. interest rates to skyrocket and the dollar to collapse on foreign exchange markets. This would result in higher mortgage costs and lower home prices in the United States, as well as other major financial dislocations. The fear is also that China could use this financial leverage to sway U.S. policy in areas from Taiwan to North Korea to quantitative easing.

  These fears are dismissed by most observers. They say that China would never dump its Treasury securities because it has far too many of them. The Treasury market is deep, but not that deep, and the price of Treasuries would collapse long before more than a small fraction of China’s bonds could be sold. Many of the resulting losses would fall on the Chinese themselves. In effect, dumping Treasuries would mean economic suicide for the Chinese.

  This easy logic ignores other things the Chinese can do that are just as damaging to the United States and far less costly to the Chinese. Treasury securities are sold in many maturities, ranging from thirty days to thirty years. The Chinese could shift the mix of their Treasury holdings from longer to shorter maturities without selling a single bond and without reducing their total holdings. As each long-term note matures, China could reinvest in three-month instruments without reducing its total investment in Treasuries. These shorter maturities are less volatile, meaning the Chinese would be less vulnerable to market shocks. This shift would also make the Chinese portfolio more liquid, vastly facilitating a full Chinese exit from Treasury securities. The Chinese would not have to dump anything but merely wait the six months or so it takes the new notes to mature. The effect is like shortening the time on a detonator.

  In addition, the Chinese are aggressively diversifying their cash reserve positions away from dollar-denominated instruments of any kind. Again, this does not involve dumping and reinvesting by China, but simply deploying its new reserves in new directions. The Chinese earn several hundred billion dollars each year from their trade surplus. This is a massive amount of new money that needs to be invested alongside the reserves they already have. While existing reserves may remain mostly in U.S. Treasury debt, new reserves can be used in any way that makes sense to the Chinese.

  Investment options in other currencies are limited. The Chinese can buy bonds in yen, euros and sterling issued by governments and banks outside the United States, but the choices are few—there simply aren’t enough of them. None of those other markets has the depth and quality of the U.S. Treasury market. But China’s choices are not limited to bonds. The other leading investment—and the one the Chinese now favor—is commodities.

  Commodities include not only obvious things like gold, oil and copper, but also the stocks of mining companies that own commodities—an indirect way of owning the commodity itself—and agricultural land that can be used to grow commodities such as wheat, corn, sugar and coffee. Also included is the most valuable commodity of all—water. Special funds are being organized to buy exclusive rights to freshwater from deep lakes and glaciers in Patagonia. The Chinese can invest in those funds or buy freshwater sources outright.

  These commodity investment programs are well under way. Most prominently, between 2004 and 2009 China secretly doubled its official holdings of gold. China used one of its sovereign wealth funds, the State Administration of Foreign Exchange (SAFE), to purchase gold covertly from dealers around the world. Since SAFE is not the same as the Chinese central bank, these purchases were off the books from the central bank’s perspective. In a single transaction in 2009, SAFE transferred its entire position of five hundred metric tons of gold to the central bank in a bookkeeping entry, after which it was announced to the world. China argues that the secrecy was needed to avoid running up the price of gold due to the adverse market impact that arises when there is a single large buyer in the market. This is a common problem. Nations usually deal with it by announcing long-term buying programs and giving themselves flexibility as to timing, so the market cannot take undue advantage of one buyer. In this case, China went beyond flexible timing and conducted a clandestine operation.

  What other financial operations are being pursued in secret today? While the Chinese proceed on numerous fronts, the United States continues to take its dollar hegemony for granted. China’s posture toward the U.S. dollar is likely to become more aggressive as its reserve diversification becomes more advanced. China’s hard asset endgame is one more ticking time bomb for the dollar.

  Collapse

  After this Cook’s Tour of financial hot spots, it is daunting to consider what may be the greatest risk of all—correlation. As applied to global financial warfare scenarios, correlation refers to two or more threats originating abroad that might produce adverse shocks at the same time, either because of coordination or because one acts as a catalyst for the others. If Russia wanted to launch a natural resources attack on the West through a cutoff of natural gas supplies, it might make good sense for the Chinese to accelerate their efforts to diversify away from paper assets into hard assets because of the expected price spikes produced by Russia’s move. Conversely, if China were ready to announce an alternative reserve currency backed by commodities, it might make good sense for Russia to announce that it would no longer accept dollars in payment for oil and natural gas exports, except at a greatly devalued exchange
rate to the new currency.

  At a more malign level, China and Russia might find it beneficial to secretly coordinate the timing of their commodity and currency assaults so as to be self-reinforcing. They could accumulate large positions in advance of their actions using leverage and derivatives. This not only would be a financial attack but would involve advance insider trading to profit from their own misdeeds. Iranians with access to Dubai banks observing these developments might decide to trigger a war with Saudi Arabia or a terrorist attack, not because they were necessarily communicating with the Russians or Chinese, but because the financial force multiplier from an attack would be that much greater.

  Throwing a Russian resources assault, a Chinese currency assault and an Iranian military assault at United States interests in a near simultaneous affront would produce predictable effects in the hair-trigger world of capital markets. Markets would experience the financial equivalent of a stroke. They would not just collapse; they might cease to function entirely.

  The foregoing threats are fast arriving. They are not extreme worst-case scenarios, but the culmination of events happening today. Consider the following:• October 28, 2008: Interfax reports that Vladimir Putin, prime minister of Russia, advised Wen Jiabao, premier of China, to abandon the U.S. dollar as a transaction and reserve currency.

  • November 15, 2008: The Associated Press reports that Iran has converted its financial reserves into gold.

  • November 19, 2008: Dow Jones reports that China is considering a target of four thousand metric tons for its official gold reserves to diversify against the risks of holding U.S. dollars.

  • February 9, 2009: The Financial Times reports that transactions in gold bullion have reached an all-time record.

  • March 18, 2009: Reuters reports that the United Nations supports calls for the abandonment of the U.S. dollar as the global reserve currency.

  • March 30, 2009: Agence France Presse reports that Russia and China are cooperating on the creation of a new global currency.

  • March 31, 2009: The Financial Times reports that China and Argentina have entered into a currency swap, which would allow Argentina to use Chinese yuan in lieu of dollars.

  • April 26, 2009: Agence France Presse reports that China is calling for the reform of the world monetary system and replacement of the U.S. dollar as the leading reserve currency.

  • May 18, 2009: The Financial Times reports Brazil and China have agreed to explore conducting bilateral trade without using dollars.

  • June 16, 2009: Reuters reports that Brazil, Russia, India and China, at a BRIC summit, call for a more “diversified, stable and predictable currency system.”

  • November 3, 2009: Bloomberg reports that India has purchased $6.7 billion worth of IMF gold to diversify assets away from the weaker dollar.

  • November 7, 2010: World Bank president Robert Zoellick states that the G20 should “consider employing gold as an international reference point of market expectations about inflation, deflation and future currency values.”

  • December 13, 2010: French president Nicolas Sarkozy calls for the consideration of a wider role for SDRs in the international monetary system.

  • December 15, 2010: BusinessWeek reports that China and Russia have jointly called for the dollar’s role in world trade to be diminished and are launching a yuan-ruble trade currency settlement mechanism.

  This is just a sample of the many reports indicating that China, Russia, Brazil and others are seeking an alternative to the dollar as a global reserve currency. A role for commodities as the basis for a new currency is another frequent refrain.

  These are daunting trends and pose difficult choices. Upholding U.S. national security interests cannot be done without knowing the dynamics of global capital markets. U.S. dependence on traditional rivals to finance its debt constrains not only fiscal policy but U.S. national security and military options. Geopolitical dominoes are already falling in places such as Pakistan, Somalia, Thailand, Iceland, Egypt, Libya, Tunisia and Jordan. Much larger dominoes are waiting to fall in Eastern Europe, Spain, Mexico, Iran and Saudi Arabia. Challenges to U.S. power grow stronger as the U.S. dollar grows weaker.

  Then there are the geopolitical big three—the United States, Russia and China. Of those, the United States is the most secure against foreign financial attack yet seems intent on undermining itself by debasing its dollar. Russia is visibly weak, yet its weakness can be its strength—it has a history of turning its back on the world and surviving in autarky. China appears resilient but, as shown throughout history, is the most fragile, having repeatedly fluctuated between centralized empires and fragmented warring states for five thousand years. It is hard to appreciate how much the Chinese leadership lives in dread of the least sign of unrest from the unemployed, the countryside, the Falun Gong, the Tibetans, the Uighurs, North Korean refugees or the many other centrifugal forces at play. A global economic crisis possessed by a complex dynamic could be a catalyst that undoes sixty years of Chinese Communist Party rule. Waiting in the wings is Iran, which sees U.S. economic weakness as the ultimate force multiplier, something that gives Iran more bang for the buck when it decides to strike its neighbors in the Middle East. We have begun a descent into the maelstrom. The nexus of unrestrained global capital and unstable geopolitics is a beast that has begun to show its claws.

  CHAPTER 9

  The Misuse of Economics

  “Human decisions affecting the future . . . cannot depend on strict mathematical expectation, since the basis for making such calculations does not exist; . . . it is our innate urge to activity which makes the wheels go round, our rational selves choosing . . . but often falling back for our motive on whim or sentiment or chance.”

  John Maynard Keynes, 1935

  In the late 1940s, economics divorced itself from its former allies in political science, philosophy and law and sought a new alliance with the hard sciences of applied mathematics and physics. It is ironic that economics aligned with the classic physics of causality at exactly the time physicists themselves were embracing uncertainty and complexity. The creation of the Nobel Memorial Prize in Economic Sciences in 1969, seventy-four years after the original Nobel Prize in physics, confirmed this academic metamorphosis. Economists were the new high priests of a large part of human activity—wealth creation, jobs, savings and investment—and came well equipped with the equations, models and computers needed to perform their priestly functions.

  There has never been a time since the rise of laissez-faire capitalism when economic systems were entirely free of turmoil. Bubbles, panics, crashes and depressions have come and gone with the regularity of floods and hurricanes. This is not surprising, because the underlying dynamics of economics, rooted in human nature, are always at work. Yet the new scientific economics promised better. Economists promised that through fine tuning fiscal and monetary policy, rebalancing terms of trade and spreading risk through derivatives, market fluctuations would be smoothed and the arc of growth extended beyond what had been possible in the past. Economists also promised that by casting off the gold standard they could provide money as needed to sustain growth, and that derivatives would put risk in the hands of those best able to bear it.

  However, the Panic of 2008 revealed that the economic emperors wore no clothes. Only massive government interventions involving bank capital, interbank lending, money market guarantees, mortgage guarantees, deposit insurance and many other expedients prevented the wholesale collapse of capital markets and the economy. With few exceptions, the leading macroeconomists, policy makers and risk managers failed to foresee the collapse and were powerless to stop it except with the blunt object of unlimited free money.

  To explain why, it is illuminating to take 1947, the year of publication of Paul Samuelson’s Foundations of Economic Analysis, as an arbitrary dividing line between the age of economics as social science and the new age of economics as natural science. That dividing line reveals similarities in market beh
avior before and after. The collapse of Long-Term Capital Management in 1998 bears comparison to the collapse of the Knickerbocker Trust and the Panic of 1907 in its contagion dynamics and private resolution by bank counterparts with the most to lose. The stock market crash of October 19, 1987, when the Dow Jones Industrial Average dropped 22.61 percent in a single day, is reminiscent of the two-day drop of 23.05 percent on October 28–29, 1929. Unemployment in 2011 is comparable to the levels of the Great Depression, when consistent methodologies for the treatment of discouraged workers are used for both periods. In short, there is nothing about the post-1947 period of so-called hard economic science to suggest that it has had any success in mitigating the classic problems of boom and bust. In fact, there is much evidence to suggest that the modern practice of economics has left society worse off when one considers government deficit spending, the debt overhang, rising income inequality and the armies of long-term unemployed.