The 'Great Distortion' ends

China has fiddled its currency for decades, financing America's national debt in the process. But that looks set to change. So, who's going to pay for America?

What's the one indicator you should be watching all the time? Alan Greenspan admitted a few years ago (under pressure) that for him it is the gold price. But this week, CLSA macro guru Russell Napier suggested to me that, in the short term at least, it should be something else: the renminbi currency band.

Why? Because the fact that the Chinese currency has been undervalued for the last 18 years, and the efforts the Chinese authorities have made to keep it that way, have been among the biggest drivers of events over the last decade. And that might be about to change.

To see how, we need to go back to 1994. China's foreign currency reserves came to around $17bn and the renminbi was pegged one-to-one to the dollar. That worked fine for a while. Then several things changed. China was accepted into the World Trade Organisation and, in the wake of the Nasdaq crash, the US dollar started to weaken significantly. The result, initially, was great for China. Exports doubled and doubled again. The current and capital-account surpluses soared and the overseas sector became a major driver of growth.

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"By rights of economic principal", as Eclectica's Hugh Hendry puts it, the renminbi should have "appreciated considerably" as a result. That didn't happen. Why? Because the Chinese authorities wouldn't let it. They printed vast amounts of money and used it to buy US Treasuries hence pushing up demand for dollars and effectively shorting their own currency in the process. The result? What Napier calls "The Great Distortion".

China now holds $3.3trn in reserves. In accumulating those, it has done more than indulge in a mercantilist dream (keeping its currency weak to steal market share for its exporters). It has also almost single-handedly financed America's national debt.

Usually, the savers of a nation end up financing their country's debt one way or another. But for all of the bubble period we are just leaving, US debt has been financed not by American savers, or, indeed, by real money but, as Napier says, by "the creation of liabilities on the Bank of China's balance sheet".

America's leaders would probably like this to go on forever. But there's a problem. It appears to be ending. The growth in China's foreign reserves is falling fast and the percentage of the US Treasury market owned by foreign central banks is too.

Why? Because the renminbi isn't undervalued anymore. Instead, says Napier, it is around fair value. When it was cheap it tended to sit near the top of the range set for it against the dollar. Now it isn't always there. So we need to watch for it settling in the middle (which would suggest China is not buying Treasuries) or at the bottom (suggesting it might be selling them).

Then we need to wonder what happens next. If China isn't going to keep financing America, who is? And if it might end up being American savers, what does that mean for other asset classes?

Merryn Somerset Webb

Merryn Somerset Webb started her career in Tokyo at public broadcaster NHK before becoming a Japanese equity broker at what was then Warburgs. She went on to work at SBC and UBS without moving from her desk in Kamiyacho (it was the age of mergers).

After five years in Japan she returned to work in the UK at Paribas. This soon became BNP Paribas. Again, no desk move was required. On leaving the City, Merryn helped The Week magazine with its City pages before becoming the launch editor of MoneyWeek in 2000 and taking on columns first in the Sunday Times and then in 2009 in the Financial Times

Twenty years on, MoneyWeek is the best-selling financial magazine in the UK. Merryn was its Editor in Chief until 2022. She is now a senior columnist at Bloomberg and host of the Merryn Talks Money podcast -  but still writes for Moneyweek monthly. 

Merryn is also is a non executive director of two investment trusts – BlackRock Throgmorton, and the Murray Income Investment Trust.