• September 28, 2022

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Here’s a bit of history that I knew, but didn’t really know, until I read James Fok’s excellent new book, Financial Cold War: A View of Sino-US Relations from the Financial Markets.

In 1958, China embarked on an all-consuming effort to transform itself into an industrial society. The goal was to massively increase production of steel, coal and electricity. There was land collectivization and a huge diversion of resources away from agriculture, leading to a collapse in food harvests. Despite this, China actually exported grain because local officials, too scared to report the truth, told central planners in Beijing that harvests were robust. The result was famine and starvation.

By the time this “Great Leap Forward” was discontinued in 1961, 40 million people had perished. That’s the same as the entire current population of California dying in a three-year period. China’s society had virtually disintegrated.

A Book With History, Not A History Book

Given the book’s title, I was initially surprised that history – both Chinese and American – plays such an important role in Fok’s narrative. Luckily, I had the chance to interview him on this Top Traders Unplugged podcast and hearing his personal story helped me understand. Fok leads us carefully through the past so that we can think constructively about the future.

Pausing to comprehend the Great Leap Forward helped me see how the Chinese government might have viewed the situation they faced in Tiananmen Square in 1989. Well within living memory the country had been torn apart by chaos. Although stability and progress had been restored, the fear of backsliding must have been all consuming. Fok also explains that the student demonstrators weren’t advocating for “democracy” in the way we think of it. Initially, they mainly wanted an end to the practice of being assigned jobs by the government after graduation.

Yes – I’m simplifying. And no, I am not justifying/condoning the killing of citizens by a state’s own army (something the U.S. itself did at Kent St. in 1970). My point, and Fok’s, is that both the U.S. and China have their own histories, interests and perspectives. They have reasons to be aggrieved, proud and ashamed. They will both prosper going forward if they can switch their gaze to the future and work together.

Time For A Change

Working together is where his book pivots to finance. Fok believes the costs to the U.S. of today’s dollar-based system now exceed its benefits and he’s got a surprising, and surprisingly-named, suggestion for a fix.

First, the issues. There is a constant demand for the dollar because it is the dominant currency for trade. That keeps its value elevated relative to other currencies and this elevated value reduces U.S. competitiveness. The resulting loss of jobs feeds into political tension.

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In addition, as the monopoly “manufacturer” of dollars, the U.S. has to supply the world with enough of them to support both physical and financial markets, which means issuing a lot of debt. If the U.S. economy grows fast enough, servicing this debt might not be a problem. But when growth slows like it has recently, the debt burden can become overwhelming. Eventually, there will be a temptation, or even a necessity, to use inflation to erode its value.

These issues were always there, but in the decades after World War II they were manageable because global markets were much smaller relative to the size of the U.S. economy. Now, with far deeper connections among many more markets, the dollar system is creaking.

China has steadily increased its financial sophistication with an eye toward increasing the importance of its currency. The fear exemplified in Fok’s title is that this evolves into a financial conflict between the two countries. He sees another way.

M.A.D. Isn’t Necessarily Mad

Borrowing a cold war phrase, Fok suggests a policy of financial “mutually assured destruction” (MAD). It sounds scary, even confrontational, but he sees it as a form of deeper cooperation and integration:

“Rather than engaging in a geo-economic ‘arms race’, a financial version of the MAD doctrine …would involve deepening interdependencies in a way that would make it unthinkable for either the U.S. or China to wield their financial arsenals against each other in capital markets, thereby enhancing safety for both”.

For example, western markets could accept Chinese government bonds as collateral for loans. This would ease the debt pressure on the U.S. as it wouldn’t need to issue as many bonds to lubricate global markets. And it would benefit China by creating demand for its own borrowing, which needs to rise to meet the social welfare demands of a rapidly ageing society. The bonds would be held in depository accounts in Hong Kong – a transparent financial market governed by rules the west understands, but also part of China.

Wait. Hong Kong is part of China, right? Couldn’t protections eroded? Yes. But remember China itself feels vulnerable to exactly this right now. Rule changes like the kind the U.S. applied to Russia could dramatically impact China’s ability to access its vast holdings of U.S. dollars. Exposing western investors to similar risks is the uncomfortable counterpart to make MAD work.

Fok suggests another potential win-win. China could allow its citizens to invest abroad if those securities were held in custody in Hong Kong. This would help Chinese savers earn better returns and take the air out of the various shadowy financial products in its own markets. Western companies would gain access to the capital of many small Chinese savers – a far more palatable source of money than direct investment from state-owned companies (or big companies that are suspected of state control) where technology transfer is a real concern.

When I spoke to him last month he was in the midst of a U.S. book tour that took him to see a number of senior U.S. economists and policy makers. He’s starting an important discussion. The histories of the U.S. and China are different but the futures are intertwined. Make trade, not war.

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