Tuesday, July 21, 2009

Time: China's Plans for Replacing the Dollar

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As we all await Apple (AAPL) to tell us which way the market will gap tomorrow morning, an interesting financial piece in, of all places, Time. This is going to be an interesting dynamic to watch over the next decade - as the ill behavior of the country with the "reserve" currency has collected calls from various nations to find alternatives. The euro seemed the natural choice but with so many moving parts, and so many countries under 1 umbrella potentially wishing for different outcomes it had not come to bear. China's yuan is not yet a freely traded instrument, so for now there has been talk of some non sovereign IMF based special drawing rights product. What has also quietly been happening behind the scenes are bilateral agreements between China and country XYZ in which the currency of use is the yuan, thereby freezing out the dollar.

Again, I cannot stress how remarkable this period has been as it has to be the 1 case in history where the country with the nexus of the world's problems actually benefited from all the world rushing into its currency... rather than fleeing. [World Currencies Performance in the Recession] By this happening, many tough decisions that would of had to of been made, could be kicked down the road for another (however many) years.
  • China's swipes at the U.S. dollar have been spilling out of Beijing with almost mundane regularity. Every time there is an international economic summit, it seems that some Chinese mandarin reiterates the now familiar complaint that the greenback needs to be replaced as the world's de facto reserve currency.
  • China usually suggests some "supranational" currency as a dollar substitute, to protect it against instability that could arise from any one country's errant economic policies. A favorite suggestion is the use of Special Drawing Rights (SDRs), the unit of account at the International Monetary Fund.
  • But Beijing's leaders may also see China's own currency, the yuan (also known as the renminbi), as a possible alternative to the dollar. There are indications that China intends to make the yuan a greater factor in international trade and investment, a development that, if successful, would have major implications for the global financial system.
  • HSBC economist Qu Hongbin believes that the yuan could become one of the top three currencies in the world by 2012, with some $2 trillion in trade transacted in the Chinese currency each year. "The internationalization of the renminbi has become a leading item on the policy agenda" in Beijing, Qu concluded in a recent report.
  • To an extent, a global role for the yuan appears inevitable. How widely a currency is used around the world is usually a function of how important its home country is to the global economy.
  • During the 19th century, when the British Empire reigned supreme, the pound was the top international currency. Since World War II, that role has been played by the dollar, with the U.S. having by far the world's biggest economy. Now that China is rapidly charging up the list — it currently ranks third and could overtake Japan as No. 2 as soon as next year — there is good reason to believe the yuan could dash into the big league of global currencies.
  • Right now, however, the yuan is far from that league. In fact, it is practically nowhere to be found in world currency markets. The reason is Chinese policy. Government restrictions prevent the yuan from trading freely around the world or being fully convertible to other currencies in all financial transactions. The yuan's value is pegged to a basket of currencies likely dominated by the U.S. dollar and is permitted to change each day only within a narrow band. Under such limitations, China's dreams for the yuan cannot progress very far.
  • There are signs, though, that Beijing may be slowly changing its policy toward the yuan in ways that could, over time, lead to its greater use on a global scale. Most notably, China and Hong Kong launched a pilot program this month through which Hong Kong banks can begin settling cross-border trade transactions in yuan for selected Chinese companies. This step will likely increase the use of yuan in Hong Kong, one of the world's premier financial centers. (The program also solidifies Hong Kong's role as China's chief financial hub.)
And here are the "swap agreements" I mentioned at the top of the piece.
  • This step follows a series of "swap agreements" concluded with foreign countries that allow their central banks to acquire yuan for use in trade with China. So far this year, the Chinese central bank has inked six such agreements — with nations including Argentina, Malaysia and Indonesia — totaling 650 billion yuan ($95 billion).
...
  • China's motivations to boost the global standing of the yuan stem from the same concerns as its calls for a new reserve currency. Greater use of the yuan in trade would improve the competitiveness of Chinese exporters by reducing transaction costs and currency risks.
  • By internationalizing the yuan, says HSBC's Qu, China can also begin extricating itself from the "dollar trap," in which the country, through its trade, amasses giant surpluses of dollars, which forces it to invest in dollar assets. This is why China, which holds $805 billion in U.S. Treasury securities, is the U.S.'s largest creditor. But this dollar hoard makes China's national wealth vulnerable to the whims of Washington's economic management. One of the reasons Beijing has been urging a gradual reduction in dollar dependence is the massive losses China could suffer if the value of the greenback was to erode as a result of U.S. deficit spending.
So is this really feasible?
  • Yet some analysts say China is still far from ready to undertake the dramatic reforms necessary to allow the yuan to be a true international player.
  • Making the yuan a freely traded currency would mean losing control over its value and flows of capital in and out of the country. This is a step Beijing's economic policymakers remain fearful of taking, since they still feel the need to protect China's developing domestic financial sector from shifts in the global economy. China sees its controlled currency as a "dam surrounding a reservoir, and the government doesn't know what would happen if it blew up the dam," says David Li, an economist at Tsinghua University in Beijing. "Would water flood out because the level inside the dam is higher than outside or would the opposite happen? That's what they are afraid of, that uncertainty." Li believes it could take 15 years for China to make the yuan a fully convertible currency.
15 years... that should give the US powers that be (private and public) time to blow 2 more bubbles, with 2 more collapses (oligarchs profiting on both the up and downside of course) transferring the last vestiges of middle class saving into the hands of the upper 0.2%.... before our drug providers finally say "enough".

Then the fun begins.

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