The chief focus of strategic rivalry between the US and China in the economic sphere has so far been the trade war waged by Donald Trump against the challenger superpower snapping at America’s heels. There has been little comparable friction in financial markets. Indeed, as more Chinese stocks are incorporated into global indices, US investors have been pouring capital into China via their investment in index-tracking funds.
Yet that is unlikely to last, according to Michael Howell, a former research director of investment bank Salomon Brothers who now runs his own boutique. In Capital Wars he points out that the swap lines extended by the US Federal Reserve to other central banks after the 2008 financial crisis — an exercise repeated since coronavirus struck — have been extended to friendly nations, while China has been pointedly excluded. So the Fed’s role as a global lender of last resort has been both partial and politicised.
At a fundamental level, the nature of the relationship between these two powers is unbalanced. Despite its declining share of global output, the US is the main provider of the dominant reserve currency to world markets. Its economy is marked by low productivity growth along with highly developed financial markets.
China has enjoyed high productivity growth as it catches up, but has under-developed financial markets. Persistent trade surpluses have contributed to a huge accumulation of foreign exchange reserves: the majority is in dollar assets. It’s a fractious interdependence.
China’s economic rise has coincided with a long period of liberalisation in international financial markets. A central theme of the book is the ballooning of global liquidity — gross flows of credit, savings and international capital that facilitate debt, investment and cross-border capital flows. In 2019 this footloose pool of funds was estimated at $130tn, two-thirds larger than world gross domestic product. China’s contribution was close to $36tn.
This financial system is light years away from the postwar model, where banks borrowed from retail depositors and lent to individuals and companies. Today, wholesale markets predominate; the main providers of funds are financial institutions and large companies such as Apple or Toyota. Users range from companies and banks to hedge funds and governments.
The chief source of funds is not deposits but repurchase agreements or repos, a form of borrowing that has to be backed by collateral in the form of “safe” assets such as government bonds. One of the chief sources of instability in the modern financial system has been a shortage of such safe assets.
Before the 2008 financial crisis, investment bankers tried to solve that problem by inventing new safe assets such as collateralised mortgage obligations. They proved — at the risk of understatement — not to be safe at all. Soon after the crisis, government austerity programmes restricted the supply of government IOUs, thereby increasing market volatility and financial fragility.
This may now be easing thanks to governments spewing out safe assets to finance the fiscal policy response to the pandemic. Yet that seems unlikely to change the book’s assertion that financial flows and the risk-taking behaviour of investors increasingly drive the real economy and asset prices, not vice versa.
And the geopolitical tensions remain. Howell asks whether a digital renminbi might become the 21st-century’s pre-eminent safe asset. That requires a leap of the imagination. But certainly plausible is his immediate conclusion that regionalism will replace globalisation as capital rivalry limits cross-border trade, technology transfer and the free flow of risk capital.
There is much that is enjoyably controversial here. As a description of the workings of the modern global financial system and the interrelationship of finance and the real economy, it has no current rival. Not for beginners, but essential reading for market practitioners.
John Plender is an FT columnist
Capital Wars: The Rise of Global Liquidity, by Michael Howell, Palgrave Macmillan, £44.99, 304pp