The dismal decade (Part 2: Adversarial monetary policies)

The dismal decade (Part 2: Adversarial monetary policies)

Phuah Eng Chye (27 January 2024)

Throughout its hegemonic reign, the USD faced off currency challengers such as sterling, yen and euro which were unable to maintain their economic rankings. With the rise of China, for the first time the US faces a challenger with a population size several times larger, an ideological rival outside its sphere of influence, and a developing economy that overtook the US as the world’s largest economy in PPP terms.

The potential loss of its currency hegemony could undermine the US’s leading role in setting global monetary policy. As the Confucian saying goes, “there cannot be two suns in the sky, nor two emperors on the earth.” China’s rise is upsetting the global monetary order. China is now leading the de-dollarisation charge and setting an independent monetary policy. The conflict will intensify as the powerful rivals craft monetary policies to reshape international ecosystems around their currencies.

Monetary policy is usually analysed within the framework of the impossible trinity or trilemma. The trilemma refers to the hypothesis that countries cannot pursue an independent monetary policy (of the US), maintain a fixed exchange rate and allow the free flow of capital at the same time. This theory has been proven in a hegemonic currency setting. But it is unclear how it would work in a multipolar currency setting. The corollary of the trilemma is the N-1 country obligations where the reserve currency issuer (the US) has to run a current account deficit to support exports by other countries and for the export-surplus countries to reciprocate by buying USD debt. This explains the Goldilocks economic regime where the US sustained current accounts deficits which was financed by PBOC accumulating USD debt as forex reserves.

In this context, when the world’s two largest economies are cooperative, they can synchronise policies to extend mutual support. Japan’s monetary and fiscal policies helped the US recover quickly from its 1980 Volcker recession and its 1987 Black Monday stockmarket crash. In the 1990s, for as much as they blamed each other for the global savings glut – China blaming US fiscal profligacy and US blaming China’s currency manipulation – nonetheless there appears to be an “understanding” that Chinese exports and US consumption were creating favourable conditions for global economic growth. During the 2008 global financial crisis, China’s large-scale fiscal and monetary stimulus supported the US and European economic recovery.

The global monetary landscape is changing as the relationship between US and China becomes adversarial. With decoupling, the US is clamping down on China’s exports. PBOC has been selling down its USD forex reserves. China is now directly challenging USD hegemony by accelerating de-dollarisation via promoting the internationalisation of yuan and other substitutes. De-dollarisation makes it difficult for the US to leverage its currency outside its sphere and therefore USD liquidity will tend to congest within its currency area. Deliberately or otherwise, monetary policies will be designed to neutralise or curb each other’s influence. The tug-of-war with the two largest economies pulling monetary policy in opposite directions is likely to have negative effects on the global economy; possibly deteriorating to the level of beggar-thy-neighbour policies of the 1930s great depression.

Global Times highlights “how unusual it is to see such a consumer price divergence that has formed over time between the world’s two largest economies, which could bring the global economy to uncharted waters. Some thought one or two years ago that the divergence was due to the two countries’ different monetary policy choices, but as time goes by, there are growing signs that the increasing decoupling of the two economies may be the real cause of the inflation divergence. In the era of globalization, there was a time when the Chinese and US economies were closely intertwined…things changed after the US started promoting the decoupling push, and the complementary relationship has been sabotaged…Yet, the impact of decoupling on both economies is complicated and full of variables. So far, the only thing for sure is that both economies are facing challenges that were uncommon in the past decades. China needs to find enough markets for its massive production capacity, while the US needs to restructure its supply chain to rein in inflation, debt and interest payments. With no return to the original track, both countries will undergo a long-term structural adjustment amid the decoupling process, which will be a test for their economic resilience and endurance. For China, the economic decoupling, which is starting to have an impact on everything from exports and inflation to US investment in China, is almost certain to be a severe test for its economy in the coming decades”.

It should be noted diverging inflation-deflation experiences are not unusual. In the 1980s, Japan experienced inflation even as US and Europe underwent recession. In the 1990s, the situation reversed for Japan which experienced a lengthy period of deflation even as the US and Europe experienced an economic rebound. Today, US and Europe face inflationary pressures while China is experiencing deflation. Thus, monetary policy divergence is not surprising in itself.

Nonetheless, monetary policy divergence has a noticeable impact on markets. Nicholas Spiro points out “the overriding factor in the sharp falls in asset prices in Asia is the divergence in global monetary policies. The rapid rise in yields on benchmark US Treasury bonds is driving up the US dollar and sucking capital out of riskier assets such as emerging markets…Asia is more exposed than other developing economies because interest rates tend to be lower here. According to JPMorgan, the average interest rate gap between Asia’s emerging markets and the United States is negative for the first time in more than two decades, depriving the region of an adequate yield buffer to withstand the spike in Treasury yields. Even though the declines in core inflation across Asia should be bringing closer the start of central bank [interest rate] easing cycles rather than pushing them further away…improving domestic fundamentals are being trumped by the aggressive repricing in US debt markets”. “Asia’s economic fundamentals are much stronger than they were a decade ago, when India and Indonesia were part of the fragile five group of vulnerable emerging markets. Balance of payments positions have improved, central banks have amassed large foreign reserves and policy reforms have increased the appeal of the region – especially India – among global investors. And foreign fund flows into Asian equity markets outside Japan this year are still in positive territory…Moreover, the blame for the abrupt deterioration in sentiment towards Asia lies squarely with mounting stresses in US bond markets. If something is in danger of breaking, it is the US economy, which is in a much more perilous position than it was a few months ago”.

Today, capital no longer flows freely in search of the best returns. The new patterns are dictated by geopolitical loyalties reinforced by sanctions, controls, suasion and public and political pressure. Currency and monetary policies are unfortunately part of the soft power tools being weaponised in “whole-of-society” asymmetric warfare. The conflicts are deepening and we are likely to witness the emergence of separate currency areas; reinforced by adversarial monetary policies.

US monetary conditions and policy challenges

America’s recent monetary history begins with Paul A. Volcker’s decisively raising the federal funds rate from an average of 11.2% in 1979 to a peak of 20% in June 1981[1]. The Volcker shock is admired for its effectiveness in crushing inflation; which fell from its peak of 14.8% in March 1980 to below 3% by 1983. The consequence was the 1980–1982 recession with unemployment above 10%. It should be emphasised that in assessing monetary policy, the yardstick is not whether tight policy works in stopping inflation but whether the economy can subsequently recover from the recession. The 1980 recession was short-lived but it should be taken into account the US benefited from events such as the Plaza Accord agreement of 1985 to devalue the USD; financial product innovation, the emergence of Silicon Valley, the break-up of Soviet Union and the consolidation of American global financial leadership following mishaps suffered by European and Japanese banks.

Adam Tooze notes “in the aftermath of the GFC, America’s financial system – ground zero for the crisis – recovered fast and hard. Assisted by state intervention led by both the Treasury and the Fed and expansive monetary policy, JP Morgan emerged as the financial titan of the Western world and Blackrock became the world’s leading fund manager. By contrast, Europe’s financial interests suffered a shock from which they have still not recovered”. “Faced with the shocks of the Ukraine war and inflation, Europe’s banks have sharply curtailed lending and hedged against rising losses on loans…despite this retrenchment, serious concerns about financial stability remain” in relation to European bank exposure to commercial real estate loans and to nonbank financial actors.

In contrast, Adam Tooze notes “America’s megabanks have established a dominant position for themselves in investment banking, including in European investment banking services. Ranked in order by overall investment banking earnings, the top five firms in Europe, Middle East and Africa are JPMorgan, Goldman Sachs, Bank of America, Citi and Morgan Stanley”. Reflecting the benefit of its global investment banking leadership, the US navigated safely through several financial crises such as the Black Monday crash of 1987, the tech bubble in 2000 and the Global Financial Crisis of 2008. They were aided undoubtably by the US-China “cooperation” that created the Goldilocks low interest rate and inflation environment that fostered the global economic buoyancy that lifted many boats. The puzzle remains as to why Japan was the exception and instead had to endure its deflationary lost decades.

I am revisiting history because of recent comparisons of US monetary policies with the Volcker commitment to fighting inflation. Though interest rates have risen sharply from near-zero to between 4%-5% in a relatively short period of time, they are far from the Volcker levels. The financial landscape is also very different as evident from an analysis of domestic monetary conditions.

  • US fiscal budget, public debt and debt servicing costs[2]. Wolf Richter notes “US government debt in the 1970s was around 35% of GDP; today it is about 125% with corporate debt at almost 80%, household debt at 75% – US total debt stands at more than 275% of GDP”. For year ending September 2023, the US fiscal deficit was $1.7 trillion, $320 billion higher than the prior year’s deficit. As a percentage of GDP, the deficit was 6.3%, an increase from 5.4% in FY 2022. Despite higher taxes, fiscal revenues fell 9.3% to $4.4 trillion. US public debt rose by about $2 trillion to $33.6 trillion. In relation to this, there is concern over the speed at which public debt is compounding and the consequences of higher interest rates on future interest servicing costs. Interest payments in FY23 amounted to $879 billion based on an average interest rate below 3%. With interest rates hovering between 4%-5% and the prospect of the national debt exceeding $40 trillion, interest payments could potentially rise to $2 trillion annually.
  • Quantitative Tightening (QT). The Federal Reserve started QT in September 2022 to wring excess post-pandemic liquidity out of its system. This is a prudent move giving the Fed space to manoeuvre if it chooses to resume QE. Wolf Richter notes “since peak-QE in April 2022, the Fed has shed $1.284 trillion” of total assets. Its holdings of Treasury securities have fallen $1.02 trillion from its peak in June 2022 to $4.75 trillion in December 2023. The Fed’s share of Treasury securities has fallen to 17.6%, down from over 24% at the peak”.
  • Money supply. The big surprise is despite the interest rate hikes, the much-ballyhooed recession has yet to appear. This is because QT haven’t completed mopping up excess liquidity while the risk of higher interest rates falls more on investors, financiers and Fed as house buyers and corporations are protected by fixed rate loans made at lower interest rates.

Ryan McMaken is concerned “money supply has now fallen by $2.8 trillion (or 13.1 percent to $18.9 trillion) since the peak in April 2022. Proportionally, the drop in money supply since 2022 is the largest fall…since the Depression…money supply fell by 12 percent from its peak of $73 billion in mid-1929 to $64 billion at the end of 1932”. However, this should take into account “the trend in money-supply remains well above what existed during the twenty-year period from 1989 to 2009. To return to this trend, the money supply would have to drop at least another $3 trillion or so – or 15 percent – down to a total below $15 trillion…Since 2009, $12.2 trillion of the current money supply has been created. In other words, nearly two-thirds of the total existing money supply have been created just in the past thirteen years. With these kinds of totals, a ten-percent drop only puts a small dent in the huge edifice of newly created money. The US economy still faces a very large monetary overhang from the past several years, and this is partly why after eighteen months of slowing money-supply growth, we are only now starting to see a slowdown in the labor market. The inflationary boom has not yet ended”.

Daniel Lacalle provides an alternate perspective. “The amount of money in the system is not declining, and it is basically soaring to keep the troubled banking system alive. So monetary aggregates are declining fast, credit for families and businesses is dropping, and the cost of debt is rising at alarming rates, but the Fed’s liquidity injections into banks and lenders are at new record levels. That is why inflation is not falling as it should. Yes, money printing goes on, but the productive sector is not seeing any of it. In fact, the private sector is bearing the entire burden of monetary contraction…it does not matter if the Fed cuts rates or not. The Fed is likely going to continue to ignore the weakness of the private sector, poor investment, and debt-driven consumption and accept a gross domestic product figure bloated by debt, while unemployment may remain low but with negative real wage growth…If inflation remains persistent, the Fed will not cut rates, and the deterioration of the productive private sector will be worse because all the contraction in monetary aggregates will come from families and businesses. However, if the Fed decides to cut rates, it will be because they see a significant decrease in aggregate demand. Thus, as government spending is not dropping, the slump in demand will be fully generated by the private sector, and rate cuts will not make families and businesses take more credit because they are already living on borrowed time. With these conditions, it is almost impossible to create a solid and positive credit impulse from rate cuts when the economy loses the placebo effect of debt accumulation. It is difficult to believe that the productive sector is going to react to rate cuts in the middle of an earnings and wage recession in real terms. Rate cuts will only come from a slump in aggregate demand, and this can only be the consequence of a collapse in the private sector. By the time the Fed decides to cut rates, the negative impact on earnings and margins is unlikely to drive markets higher, as many expect. Fed rate cuts as the drivers of multiple expansions and bullish markets may be the ultimate mirage. If the Fed does cut rates, it is because it failed to achieve a soft landing, and by then, the risk accumulation in debt and Fed borrowing will be hard to manage”. He adds “we have not seen a recession yet despite the collapse in base money supply. We are witnessing the stealth nationalization of the economy…when an agent like the state, which weighs 40 to 60 percent of GDP in most economies, continues to consume wealth and spend, gross domestic product does not show a recession even though consumption and private investment in real terms is declining. Bloated government spending is disguising a private sector recession and the decline in real disposable income, real wages, and margins of SMEs (small and medium enterprises)…Large corporations have no significant problem with higher rates, as they can access credit without any problem…and most are swimming in cash after years of prudent balance sheet management”. It also explains why inflation is not reacting faster to rate hikes. “With the current slump in money supply, inflation should be half what it is now…However, money velocity is not declining because state consumption of newly created currency units is rising despite poor real private consumption and investment. If we think of the quantitative theory of money, this may be the first private-only recession because money supply declines and money velocity growth coming from the public sector offsets it…The money supply slump and rate hike path so far are destroying the backbone of the economy, families, and small businesses. Normalization of monetary policy without normalization of government spending and deficits is the recipe for stagnation”.

  • Who is bearing the costs of higher interest rates. One of the dangers of a long period of near-zero (and negative) interest rates is that it gets deeply embedded into the financial system. When interest rates rise, there are potential systemic risks from massive revaluation losses. But it takes time for these risks to manifest. Michael Lebowtiz points out “despite surging interest rates, there are few signs they are impeding economic activity or causing distress amongst borrowers” This is due to the lag effect or “the time it takes for the new debt issuance to bear enough weight on the economy to slow it down”. For example, only new issuance rather than the total amount of $32 trillion of Treasury debt outstanding is affected. Surprisingly, “in aggregate, higher interest rates are currently helping corporate borrowers…net interest payments for U.S. corporations have fallen while Fed Funds have risen significantly”. This is because “many companies borrowed heavily in 2020-2021 at very low-interest rates, and the proceeds remain in deposit accounts earning more than the interest on the debt. Consequently, net interest is reduced”. In addition, “most companies spread out their debt, so only a small amount matures in any year. Therefore, it can take time until more expensive debt replaces cheaper maturing debt”. However, he notes “a wall of maturing debt is approaching quickly…corporate interest expenses will triple”. For individuals, while current “mortgage rates are well over 7%, about 4% higher than the lowest mortgage rates set in early 2022…the weighted average rate has barely ticked up”. “When contemplating how corporations and individuals have thus far insulated themselves from higher interest rates, consider that when interest rates are held low for long periods, the weighted average rate for every type of loan is lowered”.

In the US, the bulk of the interest rate revaluation losses are mostly borne by long-term investors (e.g. insurance companies, pension funds), the banking industry (mostly the small and mid-size banks) and the Fed. The Fed is absorbing a portion of revaluation losses by subsidising investors, depositors and intermediaries. In 2023, the Fed booked an income loss of $116.4 billion and reported $1.3 trillion in cumulative unrealized losses on Treasury securities and MBS in Q3 2023[3]. The Fed’s negative equity is not a concern as central banks can be easily re-capitalised by governments. In my view though, negative equity matters because it signifies central banks, as market-makers of last resort, are facing insolvency pressures due to their large inventories and mark-to-market losses. This would crimp their ability to bail out the financial system.

  • Financial stability vulnerabilities. Viral V Acharya, Rahul S Chauhan, Raghuram Rajan and Sascha Steffen point out “the starting point for QT today is different. The Fed does over 2 trillion dollars in reverse repo transactions with the non-banks (typically money market funds)…To the extent that the initial shrinkage of reserves reduces these reverse repo transactions, it should have little consequence for bank-level liquidity mismatches. However, this will reduce the aggregate availability of reserves relative to claims on liquidity. More problematic will be when the aggregate reserve shrinkage starts reducing the reserve holdings of individual banks. If banks do not reduce the claims they have written on liquidity commensurately…the system could become more prone to liquidity stress. Another difference today is that the Fed introduced the Standing Repo Facility (SRF) in 2021 (partly in response to previous episodes of liquidity stress). This allows primary dealers, among others, to borrow more reserves from the Fed against high-quality collateral. While the SRF will help alleviate individual liquidity stress at primary dealers, it is not universally available…the real problem could emanate if some banks/dealers with access to liquidity hoard liquidity in times of stress. The Fed will then have no option but to intervene once again and lend widely as it did in September 2019 and March 2020. Such repeated intervention may not just go against the Fed’s monetary policy stance, but may also engender less liquidity-prudent behavior in the private sector”. They note “evidence suggests banks in aggregate do not seem to be taking advantage of the compression in term spreads. Instead, they have been shortening the maturity of their liabilities, even within deposits, over the period of QE, making it harder for them to finance long-term loans”. “We have documented an important phenomenon of liquidity dependence that has implications for monetary policy and financial stability. As the Federal Reserve increased its balance sheet through successive waves of quantitative easing, commercial banks issued claims on liquidity such as demand deposits and lines of credit. This certainly meant that liquidity was never as plentiful as suggested by the simple increase in reserves. Indeed, claims on liquidity may not only render the banking sector vulnerable to liquidity stress…but bank actions may also have limited the working of monetary policy”.

Ayelen Banegas and Phillip Monin point out “hedge funds have become among the most active participants in U.S. Treasury (UST) markets over the past decade. As a result, the financial stability vulnerabilities associated with their leveraged Treasury market exposures, which are facilitated by low or zero haircuts on their Treasury repo borrowing, have become more prominent…UST and repo exposures are concentrated in a small group of highly leveraged funds, with the 50 funds with the largest Treasury exposure accounting for 83 percent of qualifying hedge funds’ (QHFs) UST exposure and 89 percent of repo borrowing at the end of 2022. Also, we find that hedge funds face low haircuts on their repo financing transactions, with about 74 percent of total repo borrowing volume transacted at zero or negative haircuts. Furthermore, we document that average balance sheet leverage of funds transacting at zero or negative haircuts is significantly higher than that of the average QHF…We estimate that hedge funds had $553 billion in repo borrowing collateralized by UST securities as of December 2022, supported by $9.9 billion in hedge fund capital. Our empirical estimation shows that if haircuts on UST repo borrowing were subject to a hypothetical 200 basis points floor, funds in the aggregate would likely need an additional $12.4 billion in capital to support their existing repo borrowing levels, which most funds could cover with their unencumbered cash. We also show that this higher capital requirement reduces the effective leverage funds have in UST repo from 56x to 25x, negatively impacting hedge funds’ return on equity on their relative value trades financed by UST repo. As a result, pricing spreads in hedge fund trades would have to about double to remain at their current profitability levels”.

Melissa Davies notes “the Fed has already started down the path to resuming quantitative easing. The question is whether they do so before, or after, upending the highly-leverage hedge fund basis trade that has been supporting the Treasury market…QT has been complicated by the presence of large amounts of money market fund cash sitting in the Fed’s Overnight Reverse Repurchase Facility, or ON RRP…the ON RRP may have been playing an altogether riskier role in bond markets – financing the proliferation of the so-called hedge fund ‘basis trade’, whereby hedge funds borrow to buy Treasuries and sell Treasury futures to make a tiny return, leveraged up multiple times. This trade has caught the attention of regulators on both sides of the Atlantic.  The problem is that the basis trade is financed in the private repo markets, and it is money market funds – drawing down their ON RRP cash – that are financing this trade…This has created the possibility of a worrying chain reaction – from the Fed’s balance sheet, via the money market funds and the private repo market, through the basis trade and on to the demand for Treasuries, at a time when the US government is coming to market with massive amounts of issuance. Instead of scarce bank reserves creating liquidity problems and forcing the Fed to stop QT, it may well be the exhaustion of the ON RRP and the upending of the hedge fund basis trade that causes problems in 2024. The worrying difference now is that there is no Fed backstop for hedge funds and the high degree of leverage used in the trade could lead to liquidity problems proliferating even more quickly through the financial system.

The fragility of the US financial system arises from keeping interest rates too low for too long and the vulnerabilities (over-leverage and funding mismatches) is being exposed by rising interest rates and volatility amid diminishing market liquidity. The Fed has to manage new concentration risks and extend liquidity support, albeit reluctantly, to new players. Product proliferation and channel expansion make it difficult to monitor to keep track of risks. As a large player, the Fed cannot avoid being a significant counter-party to these risks in one role or another.

This creates a policy quandary. How much longer can the Fed persist with QT and high interest rates as they are taking its toll on the domestic economy. On the one hand, markets are getting impatient and moving ahead of the Fed; signalling they want the pivot to QE and lower interest rates to start sooner rather than later. The Fed appears reluctant as neither inflation rates nor aggregate demand have softened sufficiently and they did not wish to be seen as complacent on the fight against inflation.

The divergence in interests is pitting markets against central banks. Central banks are resisting having to succumb to market demands to prematurely exercising the “put” option. But markets need to be careful what they wish for. Pivoting to QE and lower interest rates may boost investment returns temporarily but they will compound the longer-term challenge of finding sufficient buyers for US government debt. In this situation, the Fed will have to absorb more government debt; i.e. run QE at a faster pace. At any point that the Fed pivots to QE and lower interest rates, it would trigger a rapid depreciation of the USD. This could re-ignite inflationary pressures. The most likely scenario is a pause on interest rates and gradual deceleration of QT. If the Fed decides to lower rates, the floor is likely to be between 3%-4% as the Fed needs to keep interest rates higher than other countries to attract foreign capital.

Regardless of whether it turns out to be a soft or hard landing (in the case of QT) or stagflation-recession (in the case of QE), the ultimate long-term objective of monetary policy must be to create conditions favourable for a private sector recovery; otherwise all the effort and sacrifices would be wasted. Richard C. Koo hypothesis that it was the government’s failure, despite QE, to overcome private sector balance sheet retrenchment as the main cause of Japan’s lost decade remains valid. In this environment, QE would be “pushing on a string” in a liquidity trap as domestic liquidity supply will be in excess of domestic credit demand. However, the solution is not endless fiscal deficits either. At some point, the US government must plan to taper its fiscal deficit while creating room for a  revival of the private sector. The key to staging a private sector-led recovery is global rather than domestic monetary policy. Without a buoyant global economy and international expansion of its private sector, reindustrialisation will sputter and US technology leadership will be stunted; and without its intermediaries expanding internationally, cross-border re-leverage of USD will be inhibited.

Circling the Western monetary wagons

Monetary policy is set primarily on domestic concerns and objectives. Nonetheless,  geopolitical concerns loom large as the US-China relationship becomes more adversarial. The biggest threat is de-dollarisation which not only affects the US but also its allies as it is aimed at permanently reducing the use of Western currencies. This, in turn, would diminish the role of their intermediaries and venues in international finance. In this context, the Fed, BOJ and ECB are in a position to circle their monetary wagons to defend against the threat to USD hegemony and, more importantly, to extend mutual support to strengthen resilience against external threats. There are similarities among the major three economies.

First, the three governments run large fiscal deficits and seem incapable of cutting fiscal spending. Japan’s[4] central government debt to GDP ratios at 214% (2022) is much higher than the US at 110% while the EU[5] at 90% is not far behind. Other European countries such as Greece, Italy, Scandinavia, Switzerland and France also have high public or private debt levels and are vulnerable to rising interest rates. While collectively Europe is a major economic force, its share of the global economy and currency markets is being eroded.

Second, the Fed, ECB and BOJ own roughly around 20%, 30% and 50% of their own government debt respectively. The large government ownership is problematic as it gives rise to captive markets with few outside participants. Captive markets tend to be illiquid and large trades can trigger volatile price movements while domestic investors may flee abroad in search of yield and liquidity. Large government ownerships limit prospects for future monetisation of government debts and hampers the ability of BOJ and ECB to further purchase US debt assets.

Third, the growing disproportion between central bank balance sheets and the economy reflects the growing impotence of monetary policy. In 2023[6], the ratio of central bank assets relative to GDP for the BOJ (at 128.1%) and ECB (at 49.5%) are more bloated than that for the Fed (23.6%). [As a matter of comparison, PBOC’s ratio stands at 35.6%]. The higher the ratio, the less the economic impact from QE.

These central banks are approaching a cross-road with stark policy choices ahead. Inflation is on a downward trajectory in US and Europe but it is yet to be extinguished. Despite what their buoyant equity and bond markets may suggest, their economies are on the brink of  recession and private sector balance sheets are contracting. The risks of financial crisis and contagion are rising. The economic pain could be more excruciating in the next phase when governments and central banks face up to financing the huge fiscal deficits; a problem compounded by revenue shortfalls and rising debt service costs. The alternative is to tighten fiscal spending and maintain tight monetary policies but that will certainly send markets and the economy into a tailspin. The quandary for central banks is that if they hold onto QT and higher interest rates for too long, they could be blamed for causing markets and the economy to crater. On the other hand, if they restart QE, ease interest rates and inflation resurges, they would lose credibility for being weak on inflation and caving in to markets. In either scenario, an unhappy electorate may vote to change the government at the next election.

The need for coordinated actions arise because if one of the legs of the tripod collapses, then the financial stability of the USD currency area would be placed in jeopardy. Since mid-2022, Western central banks have synchronised their transition from post-pandemic QE towards normalising their balance sheets by raising interest rates and QT. Wolf Richter notes the ECB shed €1.94 trillion  or 21.9% of total assets since its peak in June 2022. The pandemic loans are almost completely unwound (-€1.79 trillion) while bond holdings have fallen by €262 billion. For BOJ, “since peak-balance sheet in April 2022, total assets have plunged by ¥54 trillion, or by 7.3%, or by $371 billion…It unwound roughly one-third of the pandemic-era QE: Total assets on the BOJ’s balance sheet fell to ¥684.9 trillion at the end of September 2022”.

The coordinated balance sheet normalisation reflects attempts by the central banks to create policy space for the next phase of financing fiscal deficits. Among the three, the weakest link is perhaps the over-extended BOJ. Despite the minor share of the yen in global currency markets, BOJ has a critical role as the world’s largest holder of  US government debt and, as Wolf Richter points out, “the world’s largest net creditor…with a net international investment position (NIIP) of almost $3.5 trillion”. However, BOJ’s balance sheet appears over-extended. Apart from owning more than 50% of JGBs, BOJ owns an assortment of domestic ETFs, corporate bonds, commercial paper and J-REITs. As Wolf Richter notes, these assets accounted for just 7% of the BOJ’s total assets but from another perspective, Taiki Murai and Gunther Schnabl notes “as of June 2023, it held about 57 trillion yen (37 trillion yen in book value) in ETFs. This equated to 81% of all Japanese ETFs”. As at January 2022, Japan held over $1.3 trillion of US Treasury debt, $286 billion of agency bonds, $310 billion of corporate bonds, and $861 million in stocks.

The key issue for Japan is whether after several unsuccessful attempts BOJ can finally “exit the QE trap”. But the policy options appear unattractive. Japan finds it difficult to give up yield curve control (YCC) and to allow interest rates to rise, domestic holders of government debt (including BOJ) would suffer substantial losses. The financing costs for its fiscal deficit would rise substantial. Yet the option to cut fiscal spending is not on the table as this would cause the economy contract.

There are global spillover effects. BOJ, along with PBOC, can be regarded as the two major sources of global USD liquidity over the past 3 decades. Through QE and sterilisation, Japan emerged as a major exporter of capital. At the moment, the yen is under pressure because of the wide differentials between the US and Japanese interest rates. William Pesek notes “the plunge and gyrations of the yen started in September 2021, when the Fed communicated that it would begin tightening in reaction to inflation that had begun to rage. Until then, the yen traded at around ¥110 to the USD, and had been in that range for years. By October 2022, as the yen was plunging chaotically toward the ¥150 range and threatened to blow through it…An exchange rate of ¥151 to $1 means that consumers and businesses in Japan have lost roughly 27% of their purchasing power since 2021 with regards to imports, including foods and energy products, and with regards to foreign acquisitions and foreign travels. So Japanese consumers and businesses are going to shift spending back to Japan, and they’re paying a whole lot more for imports”. If the BOJ abandons YCC and allows interest rates to rise, this would trigger an unwinding of yen carry trades and cause the yen to appreciate. The unwinding of the yen carry trade could inadvertently drain global liquidity and this could potentially trigger a financial crisis elsewhere and contagion. It isn’t too difficult for BOJ to staunch any pressure on the yen by selling down its massive USD FX reserves. But it is constrained by the impact USD sales have on Fed’s tight money policies and the potential de-stabilising effects on global markets.

In recent months, there appears to be internationally coordinated efforts to assist BOJ out of its dilemma and to strengthen the resilience of the USD currency area mainly by re-directing capital flows from China into Japan. Taiki Murai and Gunther Schnabl notes “since January 2023, the Nikkei 225 index has risen by around 30% – by far outperforming US and European stocks. The boom is driven by foreign investors, with Berkshire Hathaway CEO Warren Buffet’s Japan visit seen as a stamp of approval for investing in Japan. The boom is surprising because since early 2023 the corporate sector has had no positive news concerning innovations that would boost the international competitiveness of Japanese products… With US and European interest rates rising high relative to Japan, the Japanese yen has depreciated by 36.3% against the dollar since January 2021. This has made Japanese stocks cheap in terms of US dollars…Domestically, the yen’s depreciation boosted the revenues of large export-oriented Japanese enterprises. At the same time, depreciation made the acquisition of foreign assets more expensive and repurchases of Japanese stocks more attractive. In 2022, stock repurchases by Japanese corporations reached a historical peak of 9.2 trillion yen…the new stock market miracle seems driven by state intervention – as previously in the case of Abenomics”. It is plausible these inflows can help BOJ liquify its balance sheet by disposing their equity investments at a profit.

The QT undertaken by the central banks have created policy space for the resumption of QE. In this regard, none of their governments appear ready to curtail fiscal spending; particularly the US with presidential elections taking place in 2024. In this context, the crucial event for central banks to manage is the transition from QT-high interest rates-strong USD to QE-low interest rates-weak USD. This transition will begin at the point when economic growth suddenly decelerates or when the market finally revolts against financing fiscal debt. The earliest reaction will be a USD depreciation due to the unwinding of long-USD carry trades. The burden of absorbing the annual $2 trillion (ballpark) issuance of US government debt will fall on the Fed as it appears neither the BOJ and EU will be in a position to undertake large-scale sterilisation.

Raising US interest rates may have caused an economic slowdown but lowering US interest rates may not necessarily lead to an economic recovery. A recovery requires the private sector expansion of their balance sheets and their international operations. Otherwise, QE, low interest rates will combine with private sector retrenchment would give rise to liquidity trap conditions.

China’s monetary policy choices

China has charted its own monetary path based on its stage of development and its evolving policy objectives. China’s early economic growth was powered by the credit and investment-led model. However, the 1997 Asian financial crisis exposed its vulnerabilities. During this period, global regulators led initiatives to improve and harmonise financial regulations and standards. This proved a blessing to China and developing economies which mostly adopted international rules on governance, transparency and prudential controls.

China has also systematically addressed its financial vulnerabilities. Logan Wright relates “the deleveraging campaign that China’s leadership launched in 2016 to reduce systemic financial risks is the only logical starting point to explain how China’s structural economic slowdown began. By reducing the growth of the shadow or informal banking system, China’s financial authorities cut credit growth in half and made it far more difficult for Beijing to power the economy using its traditional tools of credit-fueled investment by state-owned enterprises and local governments. Over the course of the deleveraging campaign, property developers continued expanding their own borrowing, inflating an unprecedented real estate bubble even larger before it finally burst in late 2021, amplifying China’s current economic distress. The deleveraging campaign marked the end point of China’s unprecedented credit expansion after the global financial crisis. But the legacy of China’s deleveraging campaign is complex. Had Beijing not taken the forceful steps it did targeting shadow banks starting in 2016, China probably would have faced a financial crisis far earlier, as its system became increasingly difficult to regulate and was already resembling parts of the U.S. financial system ahead of the 2007–2008 global financial crisis. Acting preemptively to control risks in one area of the financial system ended up creating them in another. China had previously used its financial system as a shock absorber for political risks from a slowing economy, rolling over loans and extending credit to unproductive enterprises in order to avoid unemployment and bankruptcies. After the deleveraging campaign cut rates of credit growth almost in half, China’s financial system can no longer play this role, and more credit risks and political consequences are now materializing within the economy, from banks to property developers and local governments”.

Yi Gang explains China’s monetary policy emphasise on prudence and stability. Since 2019, “the PBOC’s balance sheet expanded only around 3 percent each year. Over the same period, China’s broad money supply (M2) and aggregate financing to the real economy have grown at an average annual rate of around 10 percent, basically in line with the average annual growth rate of nominal GDP, which stood at nearly 8 percent”. The PBOC favours “lowering the required reserve ratio (RRR), which increases the money multiplier, thus achieving reasonable growth of money and credit while keeping our central bank balance sheet basically stable”. PBOC kept open market operations (OMOs) rates stable even during the pandemic and refrained from following the “aggressive interest rate hikes of the major central banks in the world” in 2022. “It will not be good for economic growth, which is supposed to be steady and sustained, if the interest rate is too high or too low. Over the past two decades, China’s real interest rate has in general remained slightly below the potential economic growth rate, which is the golden rule level. Basically in line with the potential economic growth rate, it met the requirements of keeping prices basically stable and played an important guiding role in promoting macroeconomic balance and efficient allocation of resources. At the same time, China’s benchmark one-year deposit rate is 1.5 percent, and as commercial banks usually raise the rate to around 2 percent, the people get an appropriate return on their deposits”.

Yi Gang adds “domestic prices and the RMB exchange rate have remained basically stable thanks to the efforts at the national level to stabilize the prices of food and energy with their supplies secured…On the whole, our macro policies have achieved desired results. China’s consumer price index (CPI) went up by 2 percent year on year despite the soaring global inflation in 2022. Over the past five and ten years, China’s CPI has maintained an annual growth rate of 2 percent or so, and the fluctuation is relatively small. In the past five years, the volatility of the RMB exchange rate against the US dollar averaged around 4 percent, slightly higher than before but lower than that of major currencies under the floating exchange rate regime…In the past five years, the RMB exchange rate against the US dollar has been beyond 7 three times, in August 2019, in February 2020, and in September 2022, respectively. For the first two rounds, it took five months for the RMB to return to below 7, and for the third round last year, the process took three months…Over the past two decades…the real effective exchange rate of the RMB has appreciated by approximately 40 percent, with an average annual appreciation of about 2 percent, while the RMB exchange rate against the US dollar has appreciated by 20 percent, with an average annual appreciation of 1 percent. Thanks to the RMB appreciation, China’s total GDP and per capita GDP maintained steady growth even after conversion into other international currencies. In comparison, some countries were troubled by middle-income trap as their currencies experienced significant depreciation”. “We have taken a series of measures to contain financial risks and we have firmly defended the bottom line whereby no systemic risks will occur. We’ve steadily and properly defused the risks of key enterprise groups and financial institutions. The number of high-risk small and medium-sized financial institutions has fallen by half from the peak of over 600 to over 300. The aggregate scale of high-risk quasi-credit shadow banks has been slashed by about RMB30 trillion. Nearly 5,000 P2P online lenders have been shut down….We’ve advanced the construction of financial infrastructures, pushed for the formulation of the Law on Financial Stability, and established the Financial Stability Fund”.

PBOC Governor Pan Gongsheng[7], appointed in July 2023, outlined “the traditional model of relying heavily on infrastructure and real estate might generate higher growth, but it would also delay structural adjustment and undermine growth sustainability…the ongoing economic transformation will be a long and difficult journey. But it’s a journey we must take…China’s real estate sector is searching for a new equilibrium to achieve healthy and sustainable growth of the high-quality variety”. He admitted financially fragile regions in the west and north of the country may have “difficulties servicing local government debts.”

William Pesek adds that given “President Xi Jinping’s new push to reduce debt risks plaguing local governments in order to increase economic dynamism around the nation”, initiatives are ongoing to optimize the debt structure of central and local governments to improve the quality of national growth. This “suggests the central government may take up more funding responsibilities and leverage up further while local governments de-leverage and de-risk by resolving implicit debt problems”.

Similar to Japan during its ascendency, China’s top banks rank among the largest in the world. Despite its lower GDP per capita, China’s finance industry contributes about 8%[8] of GDP; roughly the same as the US. China’s banking industry risks are largely plain vanilla type credit risks but it is elevated due to the lack of credit culture, opacity and weak debt resolution processes. In many ways, the strict capital controls and stringent regulations exist to compensate for these shortfalls. In contrast with the size of the banking system, China’s markets are under-developed with a total market cap over GDP ratio of about 50%[9] – partly reflecting bearish conditions – as compared with a US ratio of 170%[10] – partly reflecting bullish conditions. This implies market risks in China are relatively lower than in the Western economies. But Chinese investors could be exposed to Western product risks; as Western intermediaries are skilled at laying off risks to unsuspecting counter-parties as was the case with knock-out bonds during the 1997 Asian financial crisis. In other words, China is more exposed to contagion risks from a US fallout. The reverse is not true because China’s markets and foreign exposure to it are relatively small.

China has regularly clamped down on shadow banking industry – where the fallout continues – and reform of financial regulatory system[11] is ongoing with plans to “establish a long-term mechanism to handle local government debt risks, control new debt strictly and provide emergency liquidity to local governments with heavy debt burdens when necessary…improve mechanisms for financial risk prevention, warning and management[12]. Unlike Japan and the Asian tigers in earlier crises, China is better-positioned to withstand pressures from the Western financial community.

There is a noisy debate over China’s economic outlook and monetary policy choices. China faces headwinds from its property overhang, local government financing, supply chain relocation and deflationary pressures. Decoupling is deepening and spilling over into trade and investments. William Pesek notes “PBOC is caught between Federal Reserve rate hikes in Washington, Bank of Japan dovishness in Tokyo and credit market volatility everywhere else. Add in China’s economic downshift, capital fleeing Shanghai and Shenzhen stocks, and enduring investor concerns about regulatory uncertainty in Beijing…The PBOC’s balancing act at home is getting dicier, too. At the same time, the yuan is under downward pressure, PBOC officials are trying to limit stimulus so that progress in reducing leverage and unproductive lending isn’t squandered”.

Markets continue to clamour for bold stimulus as it would boost asset prices. William Pesek notes “the central bank spent the last few months expanding its balance sheet with aggressive lending to banks. The PBOC’s total assets jumped 8.6% year on year in October to 43.3 trillion yuan (US$6.1 trillion), the biggest increase since at least 2014”. However, he notes PBOC are not “talking explicitly about QE” but rather is working to “unblock the monetary policy transmission mechanism, enhance the stability of financial support for the real economy, promote a virtuous economic and financial cycle, and keep prices reasonably stable.”

Logan Wright thinks “Beijing faces difficult strategic choices ahead as it confronts the end of the credit and investment-led growth model that has powered China’s economy for the past two decades. Restructuring local government debt and the central-local fiscal relationship are near-term imperatives, along with the need to unlock additional spending power for Chinese households to ensure more sustainable growth. Interest rates will need to fall in order to manage debt levels, creating incentives for capital outflows and corresponding pressures on China’s exchange rate”.

China wants to avoid creating dependencies on stimulus; which it perceives to be a major problem with Western economies. Yet, it worries about the build-up in negative sentiment could snowball into a loss of confidence in China’s financial system. So far, China’s attempts at intervention have been perceived as half-hearted and its market-friendly pronouncements as insincere. In this context, we need to factor in the geopolitical aspects as they have a critical bearing on China’s monetary policy choices.

Monetary policy from a geopolitical perspective

China’s monetary policy choices have strategic geopolitical implications. Logan Wright points out “the deleveraging campaign’s success or failure also implicates global perceptions of China’s power and influence. One vision of China after deleveraging involves stable, technocratically oriented leadership capable of solving some of the most pressing challenges facing China’s economy while maintaining high rates of economic growth. This view suggests important advantages to China’s system of political organization with the CCP’s monopoly on political power. It also demonstrates China’s continued international influence and capacity to engage with its allies and aligned partners economically. Finally, this view suggests that challenges to China’s continued rise in global influence will not come from financial stress or the economy overall, given that Beijing effectively countered one of the most significant threats to China’s economic stability. An alternative narrative sees Beijing caught in an economic trap of its own making, unable to effectively reform its system or change course. As the deleveraging campaign and the collapse of the shadow banking system produced more and more defaults and credit risk in the financial system, lenders became far more risk averse, and Beijing was unable to control the volume of credit deployed in the economy. The property sector’s rapid decline dramatically weakened overall growth and eroded the wealth of the vast majority of Chinese households, whose primary assets were most often their homes. Moreover, many households owned multiple properties. This view suggests that the costs of China’s rapid pace of expansion over the previous decade were far higher, and that China’s leadership and technocrats could not successfully manage them. In short, economic gravity reasserted itself, and China reverted to the mean of other emerging markets where credit had expanded rapidly. Rather than serve as a model, China’s economic and political system was discredited in the eyes of the world, and China’s international influence correspondingly waned. Both of these are just narratives, of course, within oppositional views concerning the competition of political systems. But much is at stake within the question of how the world perceives China’s technocratic competence and the stability of its economic model overall”.

Logan Wright also notes “the rising risks within China’s economy and financial system also raise new policy questions for the United States in the context of rising systemic competition. Liberalization of China’s financial markets has been a long-held U.S. objective, but China’s limited convergence with global economic practices and norms has elevated political concerns about deeper linkages between China and global markets. The United States has a clear interest in regulating its own markets transparently, including Chinese firms’ participation in those markets, rather than attempting to influence or alter the calculations of risks and returns for investors in China’s financial markets. Beijing has plenty of challenges of its own attracting foreign investment given the headwinds China’s economy is now facing”.

China’s monetary policy choices has a significant impact on global liquidity. Simon White notes “since 2007, China’s M1 in dollar terms has hugely outpaced GDP-weighted M1 in the rest of the world. M1 in China is 67 trillion CNY, or $9.5 trillion, while M1 in the US, the country with the second largest stock of narrow money after China, is 30% lower, despite an economy that is a third bigger than China’s. That’s without including the demand deposits of households. They’re not part of M1 in China as they are in most other countries. Adding them in would enlarge China’s M1 by more than half again. Even without this adjustment, China has been pivotal for global money growth over the last 15 years…At no time was China’s global monetary significance more critical than in the aftermath of the GFC. While the US was hesitating in providing large-scale fiscal and monetary stimulus, China’s money growth exploded. Between 2008 and 2011, it was on average about twice the rate than in the rest of the world. In percentage terms, M1 in the rest of the world rose by 30% in 2008-11, while in China, adjusted for household deposits, it climbed by almost 110%. It’s no overstatement to say a deep recession could well have become a global depression if it were not for China’s largesse”.

This is changing. Simon White notes “since the pandemic, China has been faltering. For the first time since it entered the global financial system, China has been a persistent drag on global money growth. Its M1 growth has stalled as it imposed some of the most draconian lockdowns in the world, and since then it has resisted engaging in so-called flood-like stimulus to reflate its economy. Without China, global money supply is likely to remain depressed, especially as growth is unlikely to come from the US et al when they are in the midst of rate-hiking cycles and reducing the size of their central-banks’ balance sheets. The pressure is mounting on China to stimulate broadly to resuscitate its property market and avert a debt-deflation. But that doesn’t mean it will definitely happen, and happen in time. If resistance to such measures turns into outright recalcitrance, then it’s not just China that will face the consequences”.

There are mutual benefits from a cooperative relationship. Following the 1981 Volcker shocks, US, Japan, Germany and China coordinated monetary policies to ward off threats to financial stability and to engineer a global economic recovery. However, geopolitical relationships have turned adversarial since decoupling and the financial sanctions on Russia. China increasingly follows its own monetary policy path. China is working with Global South countries to accelerate de-dollarisation and to establish a multipolar currency regime. This directly clashes with the US objectives to maintain USD primacy and ensure sufficient global capital inflows to finance its fiscal deficits.

Towards this end, there is suspicion the coordinated monetary tightening in the West is intended to contain China and to counter de-dollarisation. Tight monetary policy triggers financial stress in Global South economies, in particular weakening countries aligned with China by causing their currencies to depreciate, raising external debt servicing costs and imported inflation, dampening domestic demand and triggering capital flight. China is responding by easing domestic monetary conditions. By defying rather than following the tight US monetary policies, it is countering the shortages of global USD by offering yuan liquidity to its Global South “allies”. In theory, these policies are complementary; in practice they are in conflict because the liquidity is increasingly segmented in different currencies.

By the end of this decade, we may see the emergence of two distinct currency areas ruled by competing monetary policies. The lead countries, US and China, needs to run deficits to anchor trade expansion, needs allies to finance its deficits by purchasing its debt and needs to organise mutually supportive arrangements to maintain economic and financial stability. New global tensions may emerge as China competes with US to be the world’s biggest consumer and importer of resources. One distinction between the two currency areas is that cross-border yuan use is largely limited to bilateral commerce, infrastructure finance and direct investments. Cross-border use of yuan for investment purposes is hobbled by capital controls. This creates a dilemma for China in that in as much as it can boost bilateral trade with Global South countries, unless its bilateral counterparties are willing to hold onto their yuan, this will create a source of downward pressure on the yuan exchange rate. This implies the yuan currency area will be handicapped by its inability to leverage. At the same time, two-tier markets may appear with wide differentials between China and US prices.

The advantages of USD hegemony are beginning to shine. The well-established USD offers numerous advantages over the yuan in investments. The sophistication of its intermediaries, strength of financial regulation and support from its allies provides a base for low friction costs, high liquidity and enhances the ability to leverage. With decoupling and de-dollarisation, Western capital is exiting China and this is accentuating the deleveraging of China’s markets. This also means USD liquidity is congesting and being re-leveraged in Western markets. This explains the contrasting performances between Western markets, which are hovering around all-time highs, and the China-Hong Kong markets which have slumped badly. Due to geopolitical concerns, it does not look likely Western capital will return to China in force any time soon. It will be challenging for China to reflate asset prices or increase international leverage in the yuan currency area without relaxing foreign ownership restrictions and capital controls. The question is whether Chinese asset prices are near basement levels or whether there is further downside in a bottomless pit.

The market turmoil has finally attracted the attention of China’s policy-makers that has so far adhered to achieving stability goals through maintaining steady exchange and interest rates. In this regard, there is a heated debate on the long-term outlook for the yuan. Logan Wright argues “on balance, China’s exchange rate should depreciate in the long term…the case for a weaker exchange rate is based on the necessity of longer-term declines in interest rates in China, which will both encourage capital outflows from China’s world-leading money supply as well as reduce incentives for capital inflows into a low-interest-rate, low-growth economy. The potential use of the central bank’s balance sheet to stabilize financial conditions concerning local government debt will further incentivize capital outflows. The limited level of diversification of China’s domestic savings into foreign assets (around 98 percent of China’s deposits are held in renminbi rather than foreign currencies) offers fuel for many years of high levels of capital outflows. While the central bank had $3.13 trillion in foreign exchange reserves as of December 2022, this was only around 8 percent of China’s money supply, the lowest level in at least three decades and lower than levels even during the 1997 Asian financial crisis. As a result, the PBOC will likely be selective in choosing when to intervene to support the currency, particularly if the economy is slowing and exporters could benefit from some currency depreciation”.

I have a different view. I think China has already shifted from a competitive yuan to support export-led growth to a strong yuan policy in line with its “dual circulation” strategy to use domestic consumption to drive its external relationships, to emphasise innovation and quality and to support the international expansion of its firms. Monetary policy will thus be built around a  stable yuan, inflation and interest rates to aid the cause of de-dollarisation and enhance global perceptions of China as an economic power.

We are approaching an important inflection point. The US tight monetary policies are putting pressure on the West and Chinese economies alike. But the US cannot tighten fiscal spending in a US presidential election year while the voting population is becoming dissatisfied as they are getting squeezed by higher prices and slowing economic growth. The signs are that the Fed is getting ready to pivot to QE in Q2 2024 and possibly begin easing interest rates. At the moment USD is strong but the exchange rate could whipsaw as the long USD carry trades needs to be quickly unwound. The disadvantage of a weak USD is that it would relieve pressure on China and it carries the risk that a black swan event could turn an orderly reversal into a rout.

China not only needs to defend against from the pressure from a strong USD but needs to be on guard also from a weak USD in the event of tight-loose monetary policy oscillation.

Monetary policies thus play a key role in the re-setting of global relationships in production, consumption and investments. For exchange rates, based on the existing trade imbalances, the long-term trend seems to favour a strong yuan–weak USD regime. However, if both countries choose to adopt strong currency policies, then this will  set US and China monetary policies on a collision course with both countries competing to dictate the global level of interest rates.

As the currency areas take shape, it should be noted that they are no longer being built on optimising economic efficiency within a region but is being repurposed to support geopolitical alliances. Thus, the modern currency areas will be built around an information ecosystem of floating currencies benchmarking a lead currency. Russia is an early indication. Russia would look towards the yuan as a reference exchange rate because the USD has become irrelevant for them. It is natural for monetary policies to diverge in the different currency areas. For example, Western economies focus on combating inflation while China is facing deflationary pressures. In situations where monetary policies are at odds with each other, the pressure is for monetary policies to align within a sphere and for policies to diverge between spheres.

Monetary fragmentation will accompany economic fragmentation. Based on economic strength, the USD-yuan should be the most important exchange rate in the world. Yet, it is often sidelined and there is a wide differential between the onshore and the offshore rate. This will be aggregated by the deepening in financial decoupling that is accompanying the deepening in industrial decoupling. This will definitely impair financial connectivity, liquidity and efficiency between the two currency areas.

How are conflicting monetary trends to be reconciled? We already know price trends can diverge for long periods of time. What about interest rate differentials? At the moment, the US interest rate is higher than Chinese interest rates and this is one reason for the capital outflow. At the moment, self-interested investors have been calling for a lowering of interest rates to boost both equity markets. The greater likelihood is for US interest rates to converge towards the Chinese interest rate. This would them stem capital outflows from China but it is not clear whether Western capital would return to China in a major way. Two other scenarios should not be discounted. (1) The US could decide to raise interest rates higher – due to a resurgence in inflation. (2) China could raise interest rates higher as a move to squeeze speculators. Either way, the upside surprise could trigger more price volatility.

The emergence of two currency areas also means a realignment of global consumption and investments is around the corner. In this regard, the question is how independent can China’s monetary policy be if it cannot wean itself off Western consumption and if it cannot find sufficient non-traditional “safe” or alternative assets. China would also need to work on developing a strategy to compete with USD currency area. The challenge for the US is that if it cuts imports from adversarial economies, does it mean that it is cutting imports overall or that it has succeeded in substituting it with products, albeit at a higher cost or lower quality, from within the West. But if adversarial countries refuse to purchase US debt, this will likely diminish the global influence of US monetary policy and increase the difficulty for the West to finance their fiscal deficits. If the West persists with its flawed ostracization[13] strategies, they would be shooting themselves in the foot. This is because they are restraining the expansion and competitiveness of the Western financial industry and creating space to nurture the growth of non-Western intermediaries and venues.


Adversarial monetary policies are destabilising the global monetary order and weakening international cooperation as the last line of defence against a future global financial crisis. For example, China is being left to deal with its financial crisis on its own. And if the West faces a rerun of the 2008 crisis, it is unlikely China would come to their rescue. John Connally’s 1971 remarks that “the dollar is our currency, but it’s your problem” is being turned on its head. Yet economies operate on the same global economic boat. A crisis in a large economy would certainly have spillover effects. The lack of global cooperation raises questions as to how the long-term contractionary effects from the withdrawal of fiscal stimulus and debt forbearance, illiquidity, market instability, balance sheet impairment and economic crises will be dealt with in the future. Once isolated within Japan, there are fears that liquidity trap conditions could spread to US, Europe and China if the private sector never fully recovers confidence and, if despite QE, liquidity is unable to flow to where it is needed to stimulate growth. This would amplify the forces of contraction and hasten a return to depression economics. Is there scope for cooperation or will the economic race between the economic superpowers mark a return to beggar-thy neighbour competition.


Adam Tooze (20 Jan 2024) “Chartbook 261 A failed project of state-capitalist relations? The Eurozone at 25 (part 2)”.

Ayelen Banegas, Phillip Monin (8 September 2023) “Hedge fund treasury exposures, repo, and margining”. Federal Reserve.

Daniel Lacalle (27 June 2023) “Money supply slump spells private sector recession”.

Daniel Lacalle (24 October 2023) “The United States deficit road to ruin”. Zero Hedge.

Daniel Lacalle (14 November 2023) “Fed rate-cuts will not save the economy”. Zero Hedge.

Global Times (10 August 2023) “GT Voice: Gap in Chinese, US inflation rates shows decoupling risk”.

Global Times (3 December 2023) “PBC to guard against systemic financial risks, further defuse risks of outstanding local government debt: Governor”.

Logan Wright (10 April 2023) “Grasping shadows: The politics of China’s deleveraging campaign”. Center for Strategic and International Studies (CSIS).

Martin Chorzempa, Nicolas Véron (March 2023) “Will China’s impending overhaul of its financial regulatory system make a difference?” Petersen Institute for International Economics (PIIE).

Melissa Davies (12 January 2024) “Too late – The Fed’s QE-comeback could be dangerous”. Zero Hedge.

Michael Lebowtiz (13 September 2023) “The lag effect unveiled”.

Nicholas Spiro (26 October 2023) “Asia’s market turmoil has the US’ fingerprints all over it”. South China Morning Post (SCMP).

Phuah Eng Chye (2015) Policy paradigms for the anorexic and financialised economy: Managing the transition to an information society.

Phuah Eng Chye (19 June 2021) “Global reset – Monetary decoupling (Part 1: Sterilisation and QE)”.

Phuah Eng Chye (3 July 2021) “Global reset – Monetary decoupling (Part 2: Economics of large central bank balance sheets)”.

Phuah Eng Chye (17 July 2021) “Global reset – Monetary decoupling (Part 3: Consequences of diverging policies)”.

Phuah Eng Chye (31 July 2021) “Global reset – Monetary decoupling (Part 4: Lessons from Plaza Accord)”.

Phuah Eng Chye (20 November 2021) “Global reset – Monetary decoupling (Part 12: Role of intermediaries – Disintermediation and fintech regulation)”.

Phuah Eng Chye (4 December 2021) “Global reset – Monetary decoupling (Part 13: Intermediaries in the era of globalisation and decoupling)”.

Phuah Eng Chye (27 August 2022) “The Great Economic War (GEW) (Part 3: The financial nuclear bomb)”.

Phuah Eng Chye (10 September 2022) “The Great Economic War (GEW) (Part 4: Battles reshaping the global monetary order)”.

Phuah Eng Chye (24 September 2022) “The Great Economic War (GEW) (Part 5: Global economic breakdown and monetary disorder)”.

Phuah Eng Chye (8 October 2022) “The Great Economic War (GEW) (Part 6: Geopolitics, monetary policy challenges and the collapsing tripod)”.

Phuah Eng Chye (9 December 2023) “The dismal decade (Part 1: De-dollarisation and currency landscape in 2030)”.

Ryan McMaken (7 December 2023) “The money supply continues its biggest collapse since the Great Depression”. The Mises Institute.

Sarah Bell, Michael Chui, Tamara Gomes, Paul Moser-Boehm, Albert Pierres Tejada (7 February 2023) “Why are central banks reporting losses? Does it matter?” Bank of International Settlement (BIS).

Simon White (6 September 2023) “The biggest threat to global liquidity is China”. Zero Hedge.

Taiki Murai, Gunther Schnabl (18 August 2023) “Japan stock market miracle more mirage than reality”. Asia Times.

Viral Acharya, Rahul Chauhan, Raghuram Rajan, Sascha Steffen (21 March 2023) “Demandable claims on bank liquidity complicate the unwinding of central bank balance sheets”. Voxeu.

William Pesek (30 November 2023) “PBOC’s Pan telling hard, uncomfortable truths”. Asia Times.

Wolf Richter (7 October 2022) “Shock & awe balance sheet reduction at the Bank of Japan: Assets drop 7.3% from peak”. Wolf Street.

Wolf Richter (13 November 2023) “Yen gyrates lower as Japan goes for weak yen, higher government bond yields, but moves must be orderly”. Wolf Street.

Wolf Richter (28 December 2023) “ECB balance sheet QT: -€1.94 trillion from peak, down to €6.9 trillion. Shed 47% of pandemic QE assets”. Wolf Street.

Wolf Richter (4 January 2024) “Fed balance sheet QT: -$1.28 trillion from peak, to $7.66 trillion, lowest since March 2021. Banks got an arbitrage opportunity when yields dropped”. Wolf Street.

Wolf Richter (12 January 2024) “Fed reports operating loss of $114 billion for 2023, as interest expense blows out”. Wolf Street.

Yi Gang (4 April 2023) “Building a modern central banking system to contribute to Chinese modernization”. Speech at conference organised by China Society for Finance & Banking/China Financial Forum.

Zhou Xin (24 October 2023) “Why a downsized central bank reflects major shifts in China’s financial governance strategy”. South China Morning Post (SCMP).


[2] See reports by Daniel Lacalle and Wolf Richter.

[3] Wolf Richter. See also Sarah Bell, Michael Chui, Tamara Gomes, Paul Moser-Boehm and Albert Pierres Tejada for discussions on central bank losses and negative equity.




[7] See William Pesek.




[11] See Martin Chorzempa and Nicolas Véron; and Zhou Xin.

[12] Global Times.

[13] For analysis on ostracization, see “Theories on war and diplomacy (Part 3: The information realm)”.