Thursday, May 28, 2009

Why The Yuan Will Become The New Global Currency

Should we be worried that China's yuan will overtake the dollar as the new default global currency? Investment Director of Money Morning, Keith Fitz-Gerald thinks it's not a matter of if but when. In the following article, Fitz-Gerald, makes the argument on why he thinks that the yuan will eventually become the dominant global currency.

China has taken yet another step to transform the yuan into the dominant global currency, a long-term initiative that could ultimately dethrone the dollar as the world’s top unit of exchange.

In the last four months alone, China has signed currency swap agreements worth more than $95 billion (650 billion yuan) with an array of nations - including: Argentina, Brazil, South Korea, Indonesia, Malaysia, Belarus and Hong Kong - that are only too glad to move away from the increasingly shaky U.S. dollar.

For Westerners who are struggling to come to terms with the notion of a disarrayed dollar, the thought of oil, gold or other commodities being priced in yuan instead of dollars has to seem about as likely as having another country put a man on the moon.

But the Chinese yuan is already well on its way to becoming that globally accepted standard unit of exchange and the proverbial genie, as they say, is out of the bottle. In fact, I’d even go so far as to say the dollar’s days of dominance are numbered and with each new round of bailout chicanery, the clock is winding down ever faster.

Asia’s Long-Term View

In such Asian markets as Japan, Hong Kong and Mainland China, the long-term planning that’s an anathema to Corporate America is actually standard fare. During the height of Japan’s dominance in the 1980s, the Western business press - with a touch of derision - wrote about how some Japanese companies routinely formulated business plans with durations of 100 years or more (while working in Asia early in my career, I actually even contributed to several such plans … but that’s another story for another time).

That’s neither here nor there to most people who note smugly that Japan is getting its comeuppance. But what they don’t understand is that Japan is not alone. In fact, many people I talk with are shocked to learn that at a time when the West is still busy handing out Band-Aids in an attempt to deal with the greatest financial crisis on record, China has been quietly and shrewdly reinventing itself with the same kind of long-term vision.

Take commodities, for example. While companies in the United States, Great Britain and Europe are being forced to shed promising assets in order to compensate for massive losses or to pay down debt, cash-rich China has been able to operate as a buyer in a buyer’s market. While the rest of the world has interpreted this as a sign that China’s interested in buying the things it needs to grow, what they have not understood is that China’s also interested in using physical assets as a source of “currency” that offsets an increasingly eviscerated U.S. dollar.

This is actually a double-whammy of sorts, for while the rest of the world has been grappling with the global slowdown, China has been locking up supplies of commodities that are only going to become more scarce (and more valuable) as global demand escalates.

In fact, as I’ve suggested for months, now, China isn’t just going to consume those assets; it’s going to use them as part of the same long-term vision it’s been staking out with regard to its own currency, the yuan, which it fully intends to boost in status to the point where it becomes an internationally accepted currency.

The Once-Dominant Dollar


That’s quite a turn of events.

Even now, despite the travails of the U.S. economy, the dollar remains the world’s most widely held reserve currency and, as such, is the standard unit of exchange in most international transactions. In fact, many non-U.S. firms (such as Airbus SAS) actually price their manufactured products in dollars. And the dollar is the de facto unit of pricing for such commodities as oil (hence the term “petrodollar“). Several countries even use it as their “official” currency.
But the global financial crisis is threatening that dominance.

The United States has already “injected” into the world economy trillions of dollars that are collectively worth more than 60% of this country’s entire gross domestic product (GDP). And the prospect of still more injections for California, GMAC LLC and other “national” interests is extremely worrisome - and not just to millions of Americans, either. If Washington stays on this path, the result will be a currency crisis the likes of which few are capable of imagining and a near-complete devaluation of the once-almighty U.S. dollar.

Ironically, both events will only further embolden China, speeding up its efforts to boost the yuan’s international acceptance.

The “New” Yuan


While some experts may question Beijing’s motives, it’s hard to question China’s long-term strategic vision, since the country is actually being forced to take these steps that ensure its own survival. Unfortunately, our leaders in Washington don’t seem to understand this, so they’re only making matters worse - when they instead could be actively working with China and the world community on this instead of summarily ignoring the fact that the yuan may well be the world’s next reserve currency.

At the very least, China’s currency is likely to be granted a global status on par with the current major currency trading pairs for purposes of settling international transactions, whether the West wants that to happen or not.

I’ve outlined this scenario many times in recent years and, quite frankly, too often received blank stares in return. Most folks here in the West just aren’t prepared to deal with the idea that the U.S. dollar could be finished and that another currency could replace it after more than 60 years of global dominance. But they better get used to the idea - and in a hurry.

China is acutely aware that not having international currency convertibility hampers both its development and - thanks to the ongoing financial crisis - its potential survival. Not only has China been forced to accept huge reserves built upon previous trade growth (its $2 trillion in reserves is an all-time record), but its own policies have contributed to its relative inability to flex its capital-market muscles. That’s especially true in transactions involving U.S. dollar/yuan exchange rates.

What for us sounds quite theoretical in nature represents a very real problem for businessmen such as Dong Xianbin, the chairman of the Guangxi Sanhuan Enterprise Group Holding Co. Ltd. He estimates that he’s lost more than 150 million yuan (about $22 million at current exchange rates) on international trade in the past three years alone because of exchange rate changes between the dollar and the yuan. So he’s keen to see yuan-based transactions that will reduce exchange-rate risks, or eliminate them entirely. And he’s not alone. Thousands of Chinese companies are chomping at the bit for the same reasons.

As a nation, not having a universally accepted currency is a huge issue. China’s record reserves are now at risk thanks to the U.S. government’s bailout boondoggle, because each new greenback printed debases the value of every other dollar out there, including the ones China holds.

Historically, Beijing sought to mitigate that risk by diversifying its holdings into other currencies most notably the European euro and the Swiss franc, for instance. But now China’s facing the kinds of problems that massive mutual funds closer to home must deal with when they hold a disproportionately large amount of money: China’s reserve fund is so massive that there’s literally no other single currency that can absorb all that liquidity. So even if China wanted to diversify more aggressively, it’s going to be hard pressed to do so.

Incidentally, this is precisely why China’s so-called “nuclear option” will never become more than a theory bandied about by conspiracy buffs. Under such a scenario, China will either “dump” its dollars, and/or stop buying them, causing the value of the greenback to plummet. China might start selling, but there literally is not another currency on the planet that could absorb a wholesale liquidation.

Therefore, the reality is that China needs to have the U.S. boost the value of the dollar - even as the United States needs to have China do all it can to maintain the dollar’s value.

Shopping for Commodities

At this point in time, China essentially has two alternatives:
  • It can seek out other stores of value, such as natural resources, which are highly liquid and reasonably “deep” in global markets, but which can also be very volatile from a pricing standpoint.
  • Or it can elevate the credibility of its own currency in the international financial markets and effectively remove the exchange rate risks associated with its own partially blocked yuan.
Never one to leave anything to chance, China is pursuing both strategies. For instance, China’s been buying gold like there’s no tomorrow - and is looking to add to its holdings. Since 2003, China has boosted its holdings of gold by 73% to an estimated 1,054 metric tons, with an approximate value of $31.3 billion. This makes China the fifth-largest holder of gold on the planet, followed by the United States, Greater Europe, and Switzerland.

China’s also gone global in its hunt for oil - which, of course, is the only other global “currency” truly in international demand.

While there’s a real benefit to having locked up supplies of commodities, they aren’t an ideal store of value. And that suggests that what China really needs to do is elevate the global prominence of its own currency at the same time, whether U.S. leaders aid the process or not.

History shows that strong economies tend to have strong currencies. And the actions that I’ve reported on recently from China - the cross-Straits agreements reached between China and Taiwan, the Hong Kong yuan-trade agreements and the “yuan carry trade,” to name a few - only reinforce the effort China is putting forth to achieve this goal.

Speaking of goals … there are obviously plenty of Doubting Thomases on this issue - but they were around years ago before China announced that it wants to put a man on the moon by 2020.

This article has been reposted from Money Morning. You can view the article on Money Morning's investment news website here.

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