Currencies | Jul 03 2009
By Greg Peel
It started last year and has continued into this year. Every other week some Chinese official, be they government or regulatory or central bank or whoever, comes out and suggests it is time to end the reign of the US dollar as reserve currency. The implication is that the US has failed, and the GFC is testament. China holds vast amounts of US denominated debt and is angered by the push by the US to issue more and more. There is a very real risk of a collapse in US bond prices, and the US dollar, which we see billions wiped off China’s foreign currency surplus.
And then the following week another official will come out and suggest: Don’t panic, of course we see the US dollar as reserve currency for a long time yet. We’re hardly going to shoot ourselves in the foot now, are we?
When first the to-ing and fro-ing began, US dollar traders were getting whiplash. But so frequently have the threats and counter-threats been made now that an air of “cry wolf” exists. Currency traders have learnt not to pay much attention to Chinese outbursts, nor those from Russia or Brazil, the Middle East, or anyone else. Parochial Americans still fall about laughing when anyone suggests there could be a reserve currency in the world other than the US dollar. But then pride always comes before a fall.
Let’s just settle this right here and now and say that the day will probably come when the US dollar is no longer the world’s reserve currency, or at least its sole reserve currency, but that day is a long way off. This assumption is acknowledged by the BRICs and other US creditor nations, but that does not mean they will throw up their hands and concede defeat to an immovable greenback. The BRICs have already begun the process of extracting themselves from the grip of the greenback, but only in a manner one might adopt in tip-toeing away from a crocodile. Any sudden movement could be fatal.
The truth is China has dug itself a very deep hole. As a mere observer of the Asian Currency Crisis of 1997, it resolved never to end up in the same boat, and thus chose to avoid boom-related runaway currency appreciation by pegging its currency within a range of the US dollar. It did this by constantly buying more and more US dollars, which it parked in US Treasuries and agency debt. What this meant is the Chinese effectively lent money to Americans to buy cheap Chinese goods, which were always cheap because of the currency peg. In the early twenty-first century, China began building a massive US dollar surplus and the US a massive deficit. Soon it was too late to go back.
At the height of the boom years, economists estimated that the renminbi was as much as 40% undervalued. There was a strong call to let the renminbi float, given the currency disparity was destroying the longstanding US manufacturing sector. But were the Chinese to do so, there boom would have immediately turned to bust. They were simply in too far. The symbiotic relationship had reached a point at which to separate would prove internecine.
So when the Chinese complain that the US is building more debt upon already excess debt, a trip into the Hall of Mirrors might be the prescription. But the fact remains that some 70% of all world trade is conducted in US dollars, that some 70% of all foreign currency reserves held by the world’s central banks is held is US dollars, that the US economy – GFC or no GFC – is still far and away individually the world’s largest, and the US has the biggest guns. It is no wonder Americans scoff when anything other than the mighty greenback is suggested as world currency. It matters not that the US has been a net debtor to the world since the seventies.
The fact remains China must keep buying US dollar debt. To pull out would be to see the US dollar collapse, and to thus see China’s foreign reserves collapse. But China is the master of the softly-softly approach. Of course China intends to be the dominant world power one day. And of course it sees the renminbi as one day being the global reserve currency, but patience is a virtue.
[I’ve made note of this before but I will reiterate: Readers may be confused that when speaking of China and its currency, some texts will refer to renminbi (RMB) and others to yuan (CNY). The truth is China’s currency is the renminbi. The Chinese word “yuan” is a more generic expression, loosely translated as “money”, or “cash”, or maybe even “bucks”. When a Chinaman says something costs “50 yuan” it’s a bit like us saying “50 bucks”. Thus FNArena prefers to stick with renminbi.]
This week the International Monetary Fund announced the window was open on the issue of its new, and first ever, IMF bonds. The underlying currency of the bond will be the IMF’s Special Drawing Rights – a basket of leading global currencies (which still includes the US dollar as highest proportion of 40%). The bonds will only be available to central banks and sovereign wealth funds, but to begin with will be available on request, rather than a finite amount being auctioned. The BRICs have already stuck their hands up for an allocation, but at this point the amounts are miniscule compared to the amount of US dollar bonds on issue.
This is merely a small step.
Last night China announced another small step. It introduced rules to allow the first tentative steps of cross-border renminbi flows. Again the warning bells rang out on this announcement. Is China trying to set up a reserve currency? China was forced to quell fears by suggesting no – the upcoming G8 will not be used as a forum for a push to drop the US dollar. (But note, nevertheless, that the G7 has suddenly become the G8. No prizes.)
It must always be remembered that China was a communist country, and in theory still is. It is now moving towards a capitalist system, but again, softly-softly. Obviously the currency of a communist state is of no use to anyone outside that communist state, but in its move towards capitalism the renminbi has indeed become quite valuable. In theory it is far more valuable than the US dollar, given it is backed by a surplus and not a deficit. But as China began making its first tenuous steps towards capitalism, it kept in place regulations limiting renminbi transactions (to prevent George Soros, for example, doing anything untoward). This has meant a disjointed form of embryonic capitalism, including the frustrating “A” share stock market for locals only, the “B” share market for foreigners, and the “H” share market in Hong Kong, which is somewhere in between.
Britain handed over Hong Kong in 1997. But rather than immediately re-absorbing international capital centre Hong Kong back into the Chinese communist fold, China began the move to turn the rest of China into Hong Kong – slowly. Hong Kong still uses Hong Kong dollars as a currency, which, until yesterday, were not directly exchangeable for renminbi as a means of trade. In the first (very) small step toward making the renminbi an international medium of exchange in cross-border transactions, China declared Hong Kong was now free to trade in renminbi. Macau, which was handed over by Portugal in 1999, and is China’s gambling Mecca, also got the nod.
It’s not open slather, nevertheless. There is only one bank in Hong Kong initially permitted to act as a renminbi clearing house and only certain banks on the mainland side, located in the various large cities, permitted to do the same. Call it the trial period. To get even this far, China had to painstakingly unravel decades of communist bureaucracy. Indeed, the launch of the new system is six months late. The plan is to next open up renminbi exchange to China’s ASEAN trading partners, at least the South East Asian ones, but not before the trial period offers some tweaking opportunities.
China will not be rushed. It has foreigners behind the scenes advising on how to turn a communist system of state-controlled bureaucracy (and corruption) into a capitalist system of liquid financial markets and government-issued instruments. The government will issue a handful of renminbi bonds as part of this new currency initiative, as there needs to be something in which foreign (which includes Hong Kong) renminbi holders can park their cash. China has been quietly making investments over the years as part of the learning curve, in foreign bonds and stocks and other instruments, and has subsequently had its hand bitten off more than once. The toddler had only risen to its feet when it wandered straight into the middle of the GFC.
And so China is not trying to rush anyone into abandoning the US dollar as reserve currency either. But it has certainly put the idea on the agenda, and is not getting a lot of disagreement from anyone other than Americans. Although even US Treasury Secretary Timothy Geithner conceded a move towards the IMF SRD as reserve currency one day was not such a bad idea, but no surprise Republicans called for his public hanging in response.
Mao led China on the long journey into communism in the forties, and now China is making the long, and slow, journey back out again.
