Brian Caplen blog 2016

Trade and tech wars are not the only flashpoint in the superpowers’ battle for supremacy. The battle over capital flows could be even more dramatic.

Banks will likely get caught in the cross fire if, as predicted by some experts, capital flows become the next battleground between the US and China. What’s at stake is the hegemony of the US dollar and whether China can successfully create a renminbi monetary sphere with the proposed digital renminbi playing a leading role.

The danger is that in trying to resist Beijing’s ambitions, western powers impose restrictions on the free flow of capital, causing disruption in financial markets and preventing banks from operating internationally.

Michael Howell, managing director at research firm CrossBorder Capital, is the author of a new book called Capital Wars: The Rise of Global Liquidity, that plots the massive expansion of money and credit since the early 2000s in which Chinese liquidity has played an increasingly large role.

The process is unbalanced in several ways, first, by the sheer scale of the liquidity which at $130trn is two thirds larger than world GDP; second, the scale of debt at three times GDP means there is a huge annual rollover to be financed; and, third, China, as the emerging nation, is exporting huge amounts of capital to the more affluent country, the US (in the form of treasury bond purchases) in a reversal of the more usual capital flow.

A major concern is that as China and the US wrestle over currency supremacy, stock and bond prices, as well as bank credit, get caught up in the turbulence.

In a world awash with liquidity, and with central banks responding to the Covid-19 crisis by pumping in even more, asset prices are artificially inflated and do not reflect fair value.

A major concern is that as China and the US wrestle over currency supremacy, stock and bond prices, as well as bank credit, get caught up in the turbulence. Mr Howell sees the Federal Reserve’s March expansion of dollar swap lines with a number of countries, but excluding China, as an attempt to contain China economically and as “the economic equivalent of NATO”.

In a Linkedin post he says: “…the yuan is unlikely to see a straight-line path to dominance because the existentialist threat it poses to the entire western financial system will stir-up countervailing geopolitical forces and likely spur attempts to halt the free flows of capital. This threat of ‘peak liquidity’ could limit the ability of our private sector financial institutions to expand their balance sheets. Alongside, fungibility could plunge and illiquidity risks rise, so heightening the odds of more financial turmoil.”

The Covid-19 crisis has exaggerated all these underlying tensions. They will not be disappearing even when the pandemic is brought under control.

Brian Caplen is the editor of The Banker. Follow him on Twitter @BrianCaplen

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