The RMB as a Reserve Currency: Breaking Habits of Thought

The economic power and influence of China continues to grow. In September, 2009, I wrote the following:

The last line of reasoning I considered appears to be the most probable. It is simply that China's wealth is indeed denominated in the $US, and they are just doing enough to hold the $US from free fall. The reason is that this allows them time to use the $US, which they are still accumulating in large quantities, to prepare themselves for the post-$US world. Returning to the speculative post in which I imagined what I might do if I were China, I suggested that they would also diversify their holdings into commodities (in particular gold), other currencies, and would continue and accelerate their purchase and control of commodity/resource companies.

Some quotes from a recent article from AFP:

Chinese firms have become more active in mergers and acquisitions since the global financial crisis that began in 2008, as economic distress has thrown up bargains around the world.

[and]

Between 2005 and 2011, the number of China's overseas acquisitions tripled to 177 and jumped five-fold by value to $63 billion, according to law firm Squire Sanders and intelligence service Mergermarket.

[and]

But academics said more was at work than commerce, as China seeks growing stature and competes with other countries for resources.

If you can cast your mind back to 2007, how did you think of China? The AFP reports on the unease being felt by China's growing influence. If jumping back in time to 2007, if somebody had suggested that China would be this influential, would you have taken them seriously? Whilst China was seen as important, the idea that China would be causing this kind of unease would have been dismissed as fanciful. Another point that I long ago made, at about the same time as discussing China's potential shopping spree, was that China would seek to displace the $US as a reserve currency, and develop the RMB as a potential replacement. This from April 2009:

I have a very curious sense at the moment of the world moving in slow motion. I had thought that the economic crisis would create dramatic moments, but in some respects it appears to be moving through a gradual shift.

One of the predictions that I have made, on two occasions, is the collapse of the $US and the end of the reserve status of the $US. However, it appears that the end of reserve status is being achieved with little drama, as it is apparent that the RMB is slowly but surely being positioned as a replacement of the $US as the reserve currency. We have this latest news from the China Daily:

Five major trading cities have got the nod from the central government to use the yuan in overseas trade settlement - seen as one more step in China's recent moves to expand the use of its currency globally.

From these modest beginnings, the process of moving the RMB to reserve status has continued, and I have occasionally given examples in my posts. This is recent development:

Cracks are beginning to appear; the latest sign is that China and South Korea have come to an agreement in which banks from either country are able to borrow funds from a swap line that makes loans available to companies for deals in local currencies. (Source: “China, South Korea to Boost use of Local Currencies in Trade,” Bloomberg, December 4, 2012.)

This is analysis from Reuters:

Fed up with what it sees as Washington's malign neglect of the dollar, China is busily promoting the cross-border use of its own currency, the yuan, also known as the renminbi, in trade and investment.
The aim is both narrowly commercial - to reduce transaction costs for Chinese exporters and importers - and sweepingly strategic.

Displacing the dollar, Beijing says, will reduce volatility in oil and commodity prices and belatedly erode the ‘exorbitant privilege' the United States enjoys as the issuer of the reserve currency at the heart of a post-war international financial architecture it now sees as hopelessly outmoded.

Zha Xiaogang, a researcher at the Shanghai Institutes for International Studies, said Beijing wants to see a better-balanced international monetary system consisting of at least the dollar, euro and yuan and perhaps other currencies such as the yen and the Indian rupee.

However, I would not want to give a false impression that everyone thinks that the RMB as a reserve currency is likely. For example, this rather curious article from Forbes gives a consideration of the many ways in which the RMB's status is accelerating before then oddly concluding:

Does all this mean China is about to overtake the dollar as the world’s reserve currency? Not anytime soon. A reserve currency, in our view, requires deep and credible government bond markets, an open capital account and critical mass in global financial systems. China’s central bank has laid out a 10-year plan for “internationalization” of its currency. China’s FX bands are widening, but in an incredibly cautious way. Dollar holders need not panic.

Indeed, most articles, including the Reuters one quoted earlier, give caveats, express doubts etc. It is all rather odd, as the expansion of the international role of the RMB is an actuality. Indeed, as long as I have been tracking this steady expansion, the same things are said with each new step, and always that reserve status is something for the distant future. There is a growing conflict between what is taking place, and the analysis of what is taking place. This is a habit of thought and I made the point in an article for Trade and Forfaiting Review in November 2009:

Imagine a world in which there was no international reserve currency, but that an organisation was proposing that the US dollar ought to be the future reserve currency. Would you take such a proposal seriously?

Your response might be that the US dollar sits atop mountains of debt, a shrinking economy and you would point out that the US monetary authorities are printing money to fund record government borrowing. You might actually laugh at such a prospect.

On the other hand, how would you view the Chinese renminbi? You might point out that China holds large reserves of other currencies, the renminbi rests on top of a massive current-account surplus, China’s economy is growing and that the prospects for future growth are all positive. Furthermore, China is a country of savers, with a small fiscal deficit and is an export machine selling goods around the world, ensuring an ongoing utility for the currency in trade.

I do not have a copy of the full article to hand, but recall that I argued something along the lines of the $US as a reserve currency was a habit of thought, rather than a rational assessment. Time has moved along since I wrote the TFR article, and time has supported my case, and still there is a sense that it just isn't possible, even though the step-by-step expansion of the RMB into a reserve currency progresses forwards.

However, at this stage, I am not so certain that the RMB will be the major reserve currency, but not for the reasons that are generally given (e.g. deep bond markets). As regular readers will be aware, I am increasingly cautious about the overall position of the Chinese economy. I am not entirely convinced that China can sustain its economic miracle and, as ever, see political risk in any major slowdown in the growth of the Chinese economy.

Nevertheless, if China does manage to continue its growth, then the indications are that it will continue to chip away at the reserve status of the $US. Returning to the start of the post, the influence of China continues to expand, as the Chinese state encourages firms to seek out and purchase access to resources, and also expand internationally. It is but one example of the astonishing growth in China's economic heft. That influence is being felt throughout the world, and the influence just further enhances China's credibility as a 'major player', and that, in turn, enhances the credibility of the RMB as a reserve currency. Set against this, the economic policy of the US can only continue to erode the influence of the $US. The following is a commentary on the $US and the challenge of the RMB:

Rome in its day held the reserve currency of the world, and how the mighty have fallen. Unless real changes are made, we might be witnessing the beginning of such a shift here. The rising U.S. debt levels are raising questions by many countries around the world as to the legitimacy and viability of the U.S. dollar as the reserve currency.

Politicians in Washington must wake up to the realization that the U.S. dollar’s status as a reserve currency is not written in stone. The financial markets are currently more dynamic and fluid than ever before. It takes only the click of a mouse to move money around the world.

Unless America gets its fiscal house in order, I believe we will see more agreements, such as this one with China and South Korea, which will avoid the U.S. dollar and increase the continuing questions about the viability of its reserve currency status.

The author has a point. After all, if the $US was not already the reserve currency, would you pick it out as a new reserve currency? I think that this unlikely, but perhaps you would disagree?

China's Progression to Reserve Currency Status

When I first suggested in April 2009 that the RMB might develop into a reserve currency that displaced the $US, I recall that the comments ranged from surprise, through to 'don't be silly' (or words to that effect). Fast forwarding to the present, and the idea is now firmly in the mainstream, albeit without the part about displacing the $US. This is from Reuters:

China's yuan could become a reserve currency in future if the country undertakes further economic reform, International Monetary Fund managing director, Christine Lagarde, said in a speech on Sunday.

The IMF chief, speaking to a gathering of leading Chinese policymakers and global business leaders, added that China needed a roadmap for a stronger, more flexible exchange rate system.

China operates a closed capital account system and its yuan currency is tightly controlled, although Beijing has said it wants to increase the international use of the yuan to settle cross border trade and has undertaken a series of reforms in recent years to that end.

Following a pattern that China long ago established, this is another piece of news from Reuters:

Japan will buy 65 billion yuan ($10.3 billion) of Chinese government debt, the country's finance minister said on Tuesday, giving China a mark of approval in the credibility of the yuan as an international currency.

Other countries are investing in China through state agencies, but Japan's investment is by far the biggest in the yuan. As a currency with limited convertibility, such bets are symbolic of the shift in global power towards China as the world's fastest-growing major economy.

And later in the article:

Japanese purchases of Chinese bonds would also be a sign of credibility in Beijing's long-term efforts to elevate the yuan's status as an international currency. That effort so far has involved China's promotion of the yuan to settle trade.

Beijing has struck agreements with several nations from Malaysia to Belarus and Argentina on the use of the yuan in trade and other transactions. It has expanded a pilot programme started in 2009 into a nationwide one allowing firms to settle their trade in yuan.

In order to understand why the RMB is gaining ground, I would point to an article that I wrote for TFR magazine. The argument is simple:

Imagine a world in which there was no international reserve currency, but that an organisation was proposing that the US dollar ought to be the future reserve currency. Would you take such a proposal seriously?

Your response might be that the US dollar sits atop mountains of debt, a shrinking economy and you would point out that the US monetary authorities are printing money to fund record government borrowing. You might actually laugh at such a prospect.

On the other hand, how would you view the Chinese renminbi? You might point out that China holds large reserves of other currencies, the renminbi rests on top of a massive current-account surplus, China’s economy is growing and that the prospects for future growth are all positive. Furthermore, China is a country of savers, with a small fiscal deficit and is an export machine selling goods around the world, ensuring an ongoing utility for the currency in trade.

We have all simply become so used to the $US as a reserve currency, that it is difficult to imagine the world any other way. This is why I used the idea of imagining a world in which the $US was not already the reserve currency. In a world where the $US was not a habit of mind, it looks like an absurd prospect. Nevertheless, the currency still retains a reserve status, and the diversification out of the dollar is a symptom of the shift in the habit of mind that is all that retains the dollar's status.

Another way to look at the rise of the RMB versus the $US is in terms of the utility of the currencies. At present, the dollar retains utility in trade, as the US still remains a very, very large economy. However, it must be remembered that the US runs an ongoing current account deficit, such that the utility also includes funding the US current account deficit.The US is a major exporter of goods and services, but still consumes more than it produces. And China is one of the countries that is responsible for the deficit in goods and services, and therefore an element of that utility is financing a current account deficit to fund the purchase of Chinese goods and services.

Although still a very important player in trade, the US gained reserve status for its currency due its former dominant position in world trade. As I hope the previous paragraph suggests, the dominance in trade is diminishing, albeit it is still important. Despite the reducing importance of the US in trade, large amounts of trade are settled in $US, and this is an economic structure that reflected the former position of the US in global trade. It is obvious that China has understood that the road to reserve status is rooted in the utility of a currency in settling trade, and they are using their growing trade strength in order to piecemeal displace the $US. The problem for the US is that it is apparent that, with regards to trade, the RMB has the potential to have greater utility in trade settlement.

The simple point is this. A currency only has underlying utility in its potential to buy goods and services. To use an economist's expression, all other things being equal, the country that produces the goods and services subject to the greatest overall demand should be the natural reserve currency.The currency's value is rooted in demand for its use to purchase goods and services. However, we do not live in the economist's world of all other things being equal; we live in a world in which the way that currencies are managed and the economic policy of the issuer impacts upon the underlying value of the currency. It is here that I return to the point made in the TFR article. Honestly, which currency would win in a world with no history of a reserve currency?

As I long ago argued, the key turning point for the RMB will be the use of the currency as the benchmark for trading in oil. This is what I wrote about the RMB in April 2009:

However, the real key to reserve status is when trade is more broadly conducted in the RMB, such as move to trading oil in RMB. Perhaps Venezuela will offer such an opportunity? An article here suggests that Venezuela may need to turn to China for financial support, and this may well present an opportunity for China to start this process:

In Latin America, the external funding situation remains relatively stable but in the case of further deterioration of capital flows, the solid economies would be able to tap the IMF or the Inter-American Development Bank (IADB) for non-conditional lines of credit, while the economies with less sound macroeconomic frameworks such as Ecuador, Argentina and Venezuela would most likely only be able to obtain funds through more formal conditionality or by turning to lenders like China.

Returning to the question of whether it is possible, I see no reason to prevent the RMB from taking on this role. There has been talk about the RMB not being 'liquid' enough, the lack of depth of their financial markets. However, I take a fairly simplistic view, which is to ask whether a currency has the underlying strength of being able to be used to purchase goods and services. The answer to this question is, of course, 'yes'.

In short, I argued that pricing and trading in oil in the RMB will be the signal that the RMB has really become a de facto reserve currency. This from Reuters:

HONG KONG, March 1 (Reuters) - After the impressive success of the offshore yuan trading in Hong Kong, China has now zeroed in on a new hub for its overseas renminbi trading - the Middle East.   

The three-year dream run of the offshore yuan trade settlement plan has given Beijing confidence to look beyond the region and boost the renminbi's muscle power in a big area: oil.

Industry sources told Reuters last Thursday that the Dubai International Financial Centre (DIFC), the United Arab Emirates' financial hub, may permit transactions in Chinese yuan from this year.  

"The internationalization strategy should move westward to find a supplementary region to the existing Asian region," said Cao Tong, senior vice president at CITIC Bank, adding that the oil-rich Middle East, Central Asia and Russia would be a good breakthrough.

The amount of trade settled in yuan jumped sharply to 2.08 trillion yuan ($330 billion), grabbing a 10 percent share of the total trade volume in the currency, compared with only 2 percent a year ago.

The same Reuters article later says:

What is more important is that if yuan is accepted and used by these oil producing countries, it will significantly enhance the currency's status in the global currency system.

In fact, the dollar's status as a global reserve currency is to some extent also because oil contracts are priced and settled in that currency.

China has already started accelerating its opening up of capital account by allowing yuan FDI and ODI recently, together with an ambitious outline of making Shanghai a global renminbi products innovation, trading and clearing center by 2015.

The timing could not have been better as the yuan is steadily appreciating which makes it more attractive, while the main currency-issuing countries are printing notes to solve their debt woes.

On this final quote I close my case on why the RMB will likely displace the $US, albeit nothing is certain or cannot be derailed (e.g. a major crisis in the Chinese economy). The surprising part is that it was so evident that this would be the path so long ago, but habit of mind prevented  so many from seeing what was right in front of them.

Special Drawing Rights - What are they?

I have had a very interesting contribution to the blog regarding IMF Special Drawing Rights (SDRs) in a comment, with the commentator also sending some additional information by email. The point made by the commentator is that it appears that there is the development of quantitative easing (printing money) at the world level through the issuance of SDRs. As such, I thought I would examine SDRs more closely, which has proved to be a somewhat challenging task.

This is the explanation of SDRs from the IMF website:

The SDR is an international reserve asset, created by the IMF in 1969 to supplement its member countries’ official reserves. Its value is based on a basket of four key international currencies, and SDRs can be exchanged for freely usable currencies. With a general SDR allocation taking effect on August 28 and a special allocation on September 9, 2009, the amount of SDRs will increase from SDR 21.4 billion to SDR 204.1 billion (currently equivalent to about $317 billion).

The SDR is based on a basket of currencies including the £GB, $US, Japanese Yen and Euro, but is also potentially a claim upon the currency of any IMF member. The status as a reserve asset "derives from the commitments of members to hold, accept, and honor obligations denominated in SDR." In other words, it is a form of money. Perhaps the most interesting aspect of the SDR is the following (from the IMF):

"The IMF has the authority under its Articles of Agreement to create unconditional liquidity through "general allocations" of SDRs to participants in its SDR Department (currently, all members of the IMF) in proportion to their quotas in the IMF."

What this means is that the IMF has no limit on the amount of money that it is able to create, and that is the creation of money in addition to the central banks of the basket currencies. The IMF is able to create money at will. To give a sense of the value of the SDRs, the exchange rate for SDRs is $US 0.634, £GB 1.048 as of 10 September (figures will change as the page is updated), and the SDRs also pay interest according to a calculation based upon the bond yields of the currency basket members (currently 0.26%):

SDR allocations provide each member with a costless asset. If a member’s SDR holdings rise above its allocation (for example, if it purchases SDRs from another member), it earns interest on the excess; on the other hand, if it holds fewer SDRs than allocated, it pays interest on the shortfall at the official SDR interest rate.

However, SDRs are unusual in that they can only be held and traded by governments and 'prescribed holders' such as the BIS. What we seem to have here is a currency which can be issued at will, with no restraints, and which can then be used by governments to pay their debts to each other. It is therefore interesting to note that the IMF has just completed a record allocation of SDRs to the tune of $US 250 billion:

The Board of Governors of the International Monetary Fund (IMF) has approved on August 7, 2009 a general allocation of Special Drawing Rights (SDRs) equivalent to US$250 billion to provide liquidity to the global economic system by supplementing Fund’s member countries’ foreign exchange reserves.

In order to support the finance of the IMF and SDRs, the following countries have chipped in:

• As of end-July 2009, three bilateral borrowing agreements, designed to temporarily bolster the Fund's capacity to provide timely and effective balance of payments support to member countries during the current crisis, are effective: Japan ($100 billion), Norway ($4.5 billion), and Canada ($10 billion).

• In addition, European Union members have pledged loans worth €75 billion ($100 billion). Switzerland has pledged about $10 billion. China, Brazil and Russia have indicated their willingness to invest in notes issued by the IMF.

• In sum, substantial progress toward the G-20 goal of $250 billion in immediate resource additions has already been made and the Fund is continuing to work with members to supplement its resources.

In broader terms, this is the IMF description of the source of the organisation's financing:

The IMF's resources come mainly from the quotas that countries deposit when they join the IMF. Quotas broadly reflect the size of each member's economy: the larger a country's economy in terms of output, and the larger and more variable its trade, the larger its quota tends to be. For example, the United States, the world's largest economy, has the largest quota in the IMF. Quotas are reviewed periodically and can be increased when deemed necessary by the Board of Governors.

Countries deposit 25 percent of their quota subscriptions in Special Drawing Rights or major currencies, such as U.S. dollars or Japanese yen. The IMF can call on the remainder, payable in the member's own currency, to be made available for lending as needed.

Perhaps the most interesting point here is that many of the countries that are the major contributors to the IMF are countries with large and growing government debt, with the US as an obvious example. As such, there is a situation in which, for example, the US is funding lending despite having a high level of net debt. The money that they are lending is borrowed money. The creditor is a debtor, and the real creditors are therefore the lender of the money to the US, with China as one of the major lenders. This from Forbes:

He [Liu Guagxi, director general of the Capital Account Management unit of its forex reserve body -- the State Administration of Foreign Exchange (SAFE)] said Beijing was encouraging overseas direct investments and the yuan would be growingly recognized as a global currency.

'Renminbi (yuan) will be more and more widely recognised worldwide and more and more in use in trades and capital transactions. This is irreversible,' he said.

China wants the yuan to be added to the basket of currencies that make up the International Monetary Fund's Special Drawing Right (SDR) virtual currency.

It is apparent that China has recognised that, in reality, a large proportion of the funding of the IMF is actually rooted in Chinese credit. In addition to the US contribution being rooted in borrowed money from China, China is also lending money directly to the IMF with the purchase of SDRs.

An IMF official, speaking on condition they not be named, said the board initially considered limiting the bond sales to $150 billion, based on the level of interest from member states. Board members decided against such a cap because IMF needs will evolve over time, the official said.

China’s government has said it will buy $50 billion in notes. Russia and Brazil last month said they would each buy $10 billion of bonds from the IMF. India has also indicated it would contribute to an IMF bond program. The four nations make up the so-called BRICs.

“This is a victory for the BRICs, particularly China,” said Claudio Loser, the former director of the IMF’s Western Hemisphere department. “Because they will be investing in the fund they will have, directly or indirectly, some say in the governance of the fund that goes beyond their quota.”

The IMF’s “quota” system allocates voting rights to member states based on their financial contributions.

The note sales probably would not reach the $500 billion in new funding that the lender is seeking, Lipsky said.

The more that the idea of SDRs is examined, the more curious the whole scheme becomes. On the one hand there is an organisation which has no economy of its own, issuing a currency that is rooted in the economies of debtor countries. It then disburses created currency over and above its own holdings of assets, including to the countries that are funding the organisation. This is the IMF on access to financing:

Access to financing. The amount of financing a member can obtain from the IMF (its access limit) is based on its quota. Currently, under Stand-By and Extended Arrangements, a member can borrow up to 100 percent of its quota annually and 300 percent cumulatively. However, access may be higher in exceptional circumstances.

....but the financing of the IMF does not actually come from the countries that are providing the quota, but instead coming from countries like China, who are lending the funds to countries like the US to provide the quota.

Quite simply the SDR is a currency, a form of money, that is rooted in the lending of the major creditor economies such as China. As such, the idea that the currency is rooted in a basket of currencies from debtor countries is, to say the least puzzling. It is no wonder that China is seeking to have the basket include the RMB, as the RMB is the real funder of a large proportion of the SDRs.

In effect, what a country like the US can do, is borrow money from China, lend the same money into IMF funding, and as a result can multiply access to even greater credit. Furthermore, the more money the US lends, the greater the control that the US has in the disbursement of money, as voting rights are tied to the amount of funding that is provided. One of my recent posts was published in Seeking Alpha, and the post discussed the rise of the RMB as a world reserve currency. I pointed out at the time that China's support for SDRs was a red herring, and that China was seeking to replace the $US with the RMB as the world reserve currency. There were several comments that were critical of the post, suggesting that the RMB as the next world currency were a fantasy.

When we actually look at the funding of the SDRs and the IMF, it becomes apparent that one of the China is one of (if not the most) important underlying creditor. Despite this, up to now, their influence in the IMF is disproportionately small. The idea that they might genuinely support SDRs as a new international reserve currency under current arrangements is therefore highly improbable. As I have suggested in previous posts, the SDR is simply a stalking horse for the replacement of the $US with the RMB.

China, in purchasing the SDRs is simply making explicit the reality that the RMB is now the most important currency in the world system, as it is the primary currency of international credit. Whilst China will, in the short term, seek to support the SDR system, they will only continue as a creditor in the long term if Chinese influence in the IMF becomes more proportional to their real role as a major creditor. To a lesser extent, the same might be said of the other underlying lenders, but I have concentrated on China as the major creditor to the US, and therefore the major creditor to the IMF.

In the meantime, the IMF is enacting a policy of quantitative easing (money printing) in which they are issuing currency which is based in economies that are already themselves undertaking quantitative easing. This IMF printed money is being issued internationally, and represents further calls on the output of the countries that constitute the basket of currencies. The problem arises is that countries like the UK and US are currently incapable of supporting their own level of consumption with their output, so it is not clear how such issuance might actually be underwritten without a further underwriting by creditor countries. In other words, the SDRs are entirely contingent for their value on the willingness of countries like China to continue to support countries like the UK or US with credit.

What we are actually seeing in the issuance of SDRs is an illusion. There is, in reality, very little that might support them going forward, at least as long as their value resides in currencies that are being debased by their own central banks, as well as by the issuance of the SDRs themselves. Quite simply, they present the same problems as the fiat currencies in which they are based, and simply serve to add to the problems of those currencies. Alongside this, we can see that the whole system remains beholden primarily to the ongoing support of China, both directly and indirectly.

As a conclusion to this post, I will admit that I find the whole issue of SDRs to be inherently confusing (not something I like to admit), and that my analysis of this issue is therefore open to question. My reading for the post included a wide variety of sources, such as an IMF Working Paper (e.g. 'International Liquidity and the Role of SDR in the International Monetary system', 2002, Clark and Polak). Despite such reading, I find myself struggling to see the SDRs as anything but a fantasy whose value is built upon foundations of sand. I therefore welcome other interpretations, analysis, or explanation and critiques.

The RMB as a reserve currency - an update

I have been discussing the steady progress of China in setting up the RMB as the reserve currency for a long while, and have proposed that it is fast moving towards success (though success is not guaranteed). Economists like Nouriel Roubini have suggested that this is going to be a long term process:

This decline of the dollar might take more than a decade, but it could happen even sooner if we do not get our financial house in order. The United States must rein in spending and borrowing, and pursue growth that is not based on asset and credit bubbles. For the last two decades America has been spending more than its income, increasing its foreign liabilities and amassing debts that have become unsustainable. A system where the dollar was the major global currency allowed us to prolong reckless borrowing.

Roubini is seeing a long term decline in the $US, and sees the RMB as being unready to take the place of the $US. In an update to his article, he has this to say:

So the process that will lead - in the medium-long term - to a challenge of the US dollar as the major global reserve currency has started. The US creditors - the BRICs, the Gulf states and others - are becoming increasingly alarmed that the US will deal with its unsustainable fiscal path via inflation and debasement of the value of the dollar via depreciation. So they will not sit idly waiting for this to happen: they are already diversifying into gold, into resources (as China purchases mines and energy, mineral and commodity resources all over the world) and into shorter term maturity US Treasuries that have less market risk than longer term Treasuries. With two-thirds of US Treasuries, being held by non-residents and the average maturity of such government debt down to 4.5 years, the risk of a refinancing crisis and disorderly fall in the dollar will increase over time unless the US presents a credible plan for medium term fiscal consolidation.

Even the Chinese are approaching the issue of the shift in reserve currency with some considerable caution, so Roubini's view is mirrored by the official view of the $US replacement in China:

Yet even Chinese officials pour cold water on the idea that this might happen fast. China Vice Foreign Minister He Yafei, who is traveling with China President Hu Jintao this week to attend the G8 meeting, said Sunday night in Rome that the creation of a supranational reserve currency has been discussed “among academic circles” but that any proposal outlined “is not the position of the Chinese government,” according to China’s state-run Xinhua news agency (in Chinese here). And, at the Global Think Tank Summit in Beijing on Saturday, Li Yang, a former adviser to the PBOC and a prominent academic, said that the transition to a multi-reserve currency system could take 20-30 years or longer.

In some respects I have no argument with Roubini. I have long argued that the US deficits will eventually see the $US decline in value. However, I would argue that his implication of an orderly decline is far too optimistic. The fragility of the $US is becoming increasingly evident as each day passes. Just one example can be found in a recent article from Reuters on 26th June:

NEW YORK (Reuters) - The U.S. dollar fell broadly on Friday after China renewed its call for a super-sovereign reserve currency and as improving appetite for risk dented the greenback's safe-haven allure.

China's central bank on Friday did not mention the dollar by name but said it was a serious defect in the international monetary system that one currency should dominate.

Whilst such negative news dents confidence, it is still not enough to finally pull the rug out from under treasuries, as more recent news reports a rally in the face of poor stock market performance:

Treasuries rose, with the 10-year yield touching the lowest in more than a month, as investors speculated the worst recession in 50 years has further to run, tempering concern record U.S. borrowing may outstrip demand. U.S. debt gained as the U.S. sold $35 billion of three-year notes at the lowest yield since May. The auction is the second of a record four this week totaling $73 billion and stocks fell.

What we are seeing in these two reports is a process that I described in a recent article in the TFR magazine, which is that fear is driving markets, and that there is an oscillation from one place of risk to another place of risk. The problem is that there is no safety in any of the traditional safe havens. As each day passes, the underlying reality of the weakness of the $US is gaining traction, as ever more analysts are coming to realise that the current fiscal policy can no longer be sustained. An interesting example can be found in the Telegraph, which reports the analysis from the Federal Reserve's senior economist:

He added: “Similarly, a percentage point increase in the projected debt-to-GDP ratio raises future interest rates by about 4 to 5 basis points.” Economists are predicting a wide range of ratios but Mr Congdon said it was “not unreasonable” to assume debt doubling to 140pc. At that level, Mr Laubach’s calculations would see long-term rates rise by 3.5 percentage points.

The study is damning because Mr Laubach was the Fed’s economist at the time, going on to become its senior economist between 2005 and 2008, when he stepped down. As a result, the doubling in rates is the US central bank’s own prediction.

In the meantime, in the face of increasing uncertainties, one of the few remaining props for the $US is the purchase of treasuries by the Federal Reserve:

TOKYO, June 29 (Reuters) - U.S. Treasuries edged down in Asia on Monday as traders took profits after a rally pushed benchmark yields to their lowest in nearly four weeks, while the prospect of the Federal Reserve buying bonds this week underpinned prices.

It is clear that the process of printing money to purchase bonds can not continue forever. Whilst the process is currently supporting the bond market, the process of itself weakens the bond market, as it generates inflationary expectations. As such, having started the process, the Federal Reserve is now locked into the process. The more bonds that they buy, the less confidence in the $US, and the less confidence in the $US, the more bonds the Fed must buy. They are now locked into a cycle that must eventually end with the destruction of the value of the $US.

Whilst all of this is taking place, the Chinese continue to promote the idea of SDRs as a replacement for the $US:

The Special Drawing Right (SDR), a unit of account used by the International Monetary Fund, presents a viable alternative to the dollar as a global reserve currency, said Li Ruogu, chairman of the Export-Import Bank of China, a major state-run bank.

"It is a feasible plan to reform the present SDR and make it into a real settlement currency, a universally accepted 'currency basket' that would replace the dollar at the heart of the monetary system," Li was cited as saying in Financial News, a newspaper published by the central bank.

I have long argued that China is using the idea of an SDR reserve currency as a stalking horse. I positioning the SDR as the replacement for the $US, China can engage the support of other countries like Russia, India and Brazil, who might blanch at the prospect of the RMB as the reserve currency (e.g. see here for discussion of support for the SDR in relation to India and Russia).

The underlying reality behind the challenge for reserve supremacy is that China is increasingly the linchpin in the global financial system. Whatever China does with its massive reserves quite literally shapes the world financial system. China quite literally has the power to make or break any asset or any market, as can be seen in the attention paid to every utterance from China regarding the $US. When a country has such economic firepower, it is puzzling that anyone might suggest that it is not ready to take on the role of a reserve currency. I can only assume that many analysts are taking the SDR stalking horse seriously, and are not considering the vacuum that will be left when the $US finally collapses under the weight of quantitative easing and fiscal profligacy.

One argument I have read (sorry, I forget where) is that China would not want the RMB to become a reserve currency, as it would mean that the RMB would strengthen. There is some merit to this argument, as the fall of the $US against the RMB would make a serious dent in China's trade. However, the problem that underpins the current fragility is that China is currently subsidising US consumption at the expense of Chinese people.

At present, China is funding the US deficits and consumption in return for treasuries. Those treasuries are a promise of payment in $US, and yet the issuance of $US is massively expanding even as output is falling in the US. With each $US a representation of the output of the US economy, such issuance of $US currency and debt means that each currency unit is representing a smaller amount of output (I explain this in more detail here). As such, one way or another, China must eventually shift its reliance on a large US export market, and start to gain the full value of their economic output. They can not continue to literally give away a proportion of their output to the US, which is what the purchase of treasuries represents.

The only question marks that remains over the RMB as a reserve currency are largely to do with whether China can continue the present economic momentum, and the timing and nature of the collapse of the $US. When I first wrote about China for the blog in July 2008, I highlighted the risks for China, but concluded that on balance I favoured the view that China would emerge in the ascendant in the economic crisis. Whilst still issuing a note of caution, the developments since that time are even more favourable for China. With regards to the collapse of the $US, it is quite astounding that it has defied gravity this long.

As the current situation stands, the RMB is looking very much like the new reserve currency, and it is not going to become the reserve currency in ten or twenty years time, but in the near future. It may be that SDRs will be implemented as a reserve on a temporary basis during the transition, for long enough for China to satisfy the aspirations of the other supporters of the SDR. However, unless China's ascent is halted (e.g. through civil unrest), it is almost certainly going to succeed in the ambitions for the RMB.

Note 1: I have recently seen an article which agrees with my view that the SDR is a stalking horse, though he is using the expression 'smoke screen'.

Note 2: I have had some negative feedback on the new comments system. More feedback would be welcome, as I am starting to think that I need to revert to the old system (which might be a bit tricky to actually do, but I will work it out if necessary).

China, the RMB and the $US

For a long while I have been discussing the economic shift of power to the East, in particular the rise of China as the potential major economic power. I have been fairly confident of my analysis, and have posted several pieces on the subject, all of which have been pointing to a major shift in the shape of the world, and a commensurate shift in world power. The following are some posts that I have written on the subject of the shift of power towards China (both economic power and power in a very broad sense):

1. April 2009, China as the World Economic Power?
2. April 2009, The RMB as the Reserve Currency
3. March 2009, Economics and Power, the Loss of US Power
4. March 2009, China, Gold and the $US
5. February 2009, China's Pivotal Role in the Next Step for the World Economy
6. January 2009, The Myth of the Eternal Status of the $US as 'the' Reserve Currency
   

The last of these is a post which does not discuss the shift in economic power, but rather the underlying weakness of the $US as a reserve currency. The remainder directly discuss the shift in economic power to China, which is belatedly being recognised by the mainstream media and analysts. If you have time to review the articles, you will find a progressive argument that amounts to a simple conclusion; that China is positioning itself as the world economic power, and is seeking to displace the US from that position.

Even before these more recent articles, I have been reviewing China and the Chinese economy. In particular, I have highlighted the risks and the potential upside for China of the quasi-mercantilist strategy that has been pursued by the country.

1. January 2009, Free Trade 'Yes' - Mercantilism 'No' - Why China Should be Shut Out
2. August 2008, China Propping up the $US
3. July 2008, China - What Future?
   

The second set of articles only hint at the potential rise of China as a superpower, as can be found in this excerpt from the second article (emphasis added):

Each of the stories above, taken in isolation, would not cause undue alarm. However, when considering them all together, then there is a worrying pattern emerging. It should also be remembered that all of the above are just examples. What is very clear is that China, and the Chinese government, are actively pursuing a policy of unfair trade at home and abroad. Quite simply, they are using economics as a tool of power rather than just enrichment.

I have suggested in a previous post that the world trading system needs to get tough with China. I did not have the time to dig up the articles that I had read, which caused me so much concern, so have previously not outlined this point of view. However, on reading the latest attempt by the Chinese government to manipulate trade, it seemed a good point in time to outline this problem. I am at heart a free trade advocate, but I also believe that trade should be free and use reciprocal rules should be binding and enforced. It is very clear that China intends to rise economically by any means, fair or foul. The crazy part is that the foul is unnecessary, and one then becomes very suspicious of the underlying motives for such methods.

The point in linking to, and asking readers to review these articles, is to highlight the progressive nature of my argument, as well as giving readers an opportunity to review the considerable evidence for a deliberate bid for economic power by China. However, there is much else on the subject of China included in more general posts and too many to detail here.

As it is, it appears that the mainstream analysts are starting to understand what is actually taking place.

One example article can be found in the Business Spectator (I first saw the article in the FT). The thesis proposed in the article is that London and New York have a serious new competitor in the emergence of 'ShangKong', a concatenation of the names Shanghai and Hong Kong. The author points to the simple financial system in China as a virtue, before suggesting Shangkong as the new world financial centre:

How could China make a big, dramatic leap? It could begin by strengthening the links between Hong Kong and Shanghai, and transferring financial know-how from the former colony. The two cities are 750 miles apart, not an insurmountable distance in this age of rapid transit and internet communications. The connections are already being made: Beijing has just declared that Shanghai will be a major global financial centre in the next decade and co-operation between Hong Kong and Shanghai is growing, as shown by recent agreements to work together between key exchanges in both cities. Beijing could declare that Shanghai and Hong Kong will have a common set of regulations and recruit some of the world’s best financiers to bolster its regulatory structures – perhaps luring them with an advantageous tax regime no longer possible in the west.

Besides that, if China continues to raise questions about the dominance of the US dollar and the need for an alternative monetary system, other countries may have no choice but to listen – and gradually act. An eclipse of the dollar would be mirrored by a rise in the use of the renminbi. That would guarantee Shangkong’s prominence.

The author, Jeffrey Garton, is from the Yale School of management, which means that this is a perspective from an academic. As many readers will be aware, the academic community has had a very poor record in understanding the current crisis, with many acting as cheer leaders in the preceding boom. However, whilst not knowing much of Garton's record, another academic has been more successful in calling the real economic situation, and that is Nouriel Roubini. As for Garton, he sees a major shift occurring, and he is offering an analysis in which he confirms my views that the RMB will replace the $US as the reserve currency.

It is noteworthy that the Telegraph is alone among UK newspapers in picking up Roubini's thoughts, reflecting the Telegraph's role as the most intelligent (UK) paper on the subject of the economy. The original article was published in the New York Times and can be found here. Roubini points to the history of previous reserve currency shifts, for example from the £GB to the $US, pointing out that reserve currencies are held by creditors, not borrowers and that excessive borrowing by a reserve issuer undermines reserve status. His argument is quite persuasive, and I therefore recommend reading the complete article.

However, in a couple of respects I believe that Roubini is completely wrong. For example, he says the following:

We have reaped significant financial benefits from having the dollar as the reserve currency. In particular, the strong market for the dollar allows Americans to borrow at better rates. We have thus been able to finance larger deficits for longer and at lower interest rates, as foreign demand has kept Treasury yields low. We have been able to issue debt in our own currency rather than a foreign one, thus shifting the losses of a fall in the value of the dollar to our creditors. Having commodities priced in dollars has also meant that a fall in the dollar’s value doesn’t lead to a rise in the price of imports.

This is exactly the kind of wrong headed thinking that has led to the current situation. The ability to borrow huge sums of money is not a good thing, but a risk associated with being a reserve currency. The ability to raise more debt than can be repaid is a problem - not a benefit. It allows a government to act beyond the usual constraints of debt markets, allows large current account deficits, and mutes what would otherwise be powerful market signals. In other words, without the reserve status the $US would have slid long ago, and the US would have needed to have reformed before reaching the current crisis situation.

Another problem I have with Roubini's analysis is the question of timing. He has the following to say:

At the moment, though, the renminbi is far from ready to achieve reserve currency status. China would first have to ease restrictions on money entering and leaving the country, make its currency fully convertible for such transactions, continue its domestic financial reforms and make its bond markets more liquid. It would take a long time for the renminbi to become a reserve currency, but it could happen. China has already flexed its muscle by setting up currency swaps with several countries (including Argentina, Belarus and Indonesia) and by letting institutions in Hong Kong issue bonds denominated in renminbi, a first step toward creating a deep domestic and international market for its currency.

He goes on to suggest that it will take ten years for the shift to take place. This seems to contradict the rest of his argument, which highlights the underlying weakness in the $US and the underlying strength of the RMB. As he identifies at the start of the article, reserve currency status is linked to creditor status. In the case of the $US, there is a massive and expanding deficit, no prospect of a return to surplus, and a deliberate policy of massive currency issuance through quantitative easing policy (printing money). Why would it take ten years for the shift to take place?

Another point is that he is suggesting that China make its bond market 'more liquid'. I am not sure, in this context, what he means, but he may be implying that this might mean issuance of greater numbers of bonds. If China were to do so, this would simply replicate the problems that the US eventually suffered. Issuance of debt is not a requirement for reserve currencies, and it is the lack of debt that is one of the reasons for the inherent strength of the RMB. However, maybe I am misunderstanding his intended meaning. The point is that a reserve currency simply needs to have sufficient issuance to cover internal needs for a unit of exchange and sufficient to allow for the currency to be used for external trade.

The trick is to issue sufficient for these needs to prevent appreciation/depreciation of the currency. After all, a currency is a unit of exchange....and reserve status means that it is possible to issue greater quantity without implying that there is a full immediate redemption of the unit in goods or services (I discuss the underlying value of currency here, and the nature of reserve status here).

As it is, as I have pointed out in previous posts, China is slowly but surely maneuvering the RMB into a position where it does indeed become the reserve currency. In a recent post, several commentators have added to the evidence of this progressive process by linking to an article from a blogger here. A later commentator then linked to the possible source of the blogger's article (thanks for the link, Gina), which was an article in The China Post:

HONG KONG -- About 50 percent of Hong Kong's trade with China may be settled in yuan as exporters reduce their exposure to a weakening dollar, Industrial & Commercial Bank of China (Asia) Ltd. said.

The first settlements of international trade using China's currency will start with about 400 Chinese companies in five pilot cities, Stanley Wong, deputy general manager at the unit of China's biggest bank, said in an interview today in Hong Kong. The payments may expand to half of all trade when authorities extend the program nationwide as soon as 2010, he said.

“There has been a perception that the U.S. dollar will continue to weaken,” said Wong. “Definitely on an annual basis, the yuan will probably appreciate against the U.S. dollar around 3 percent to 5 percent. It makes sense for companies to avoid foreign-exchange risk.”

This is just a further addition to the many small moves (see the links to my earlier posts) that have been made by China to initiate the RMB as a currency for trade settlement. Whilst each move in isolation might not be meaningful, the overall pattern is clear. The only element lacking is any official acknowledgement of the process in China, which has instead been to focus attention on the weakness of the $US, and to create a red-herring of IMF SDR's as an alternative reserve. As I have pointed out previously, the Chinese government will rarely take an open position on such a subject, and instead use proxies and indirect methods to lay out their position. However, ignoring the official position and looking instead at actions, there is every reason to think that China is now on the way to an official policy of RMB reserve status.

In many of my early posts, I pointed to a fundamental shift in the underlying shape of the world economy (summarised here), and have explained that this is the underlying reason for the current economic crisis. The more I have looked at the part that China has played in this change, the more apparent that it has become that China has moved to the centre stage of the world economy. Having said this, I have often issued caveats to my analysis, in particular emphasising the risks that are inherent in the Chinese policies. I still hold to those caveats, but I am increasingly of the view that the actions of China are both farsighted and likely to prove effective in shifting economic power into their hands.

In the meantime, US policies appear to be perfectly formulated to encourage and support the shift in power. Their profligacy, and outright rejection of reform, are catalysts for the process, and will make the shift occur more quickly, and with greater effect.

If the US continues on the current path, it is quite possible to imagine the arguments of future historians. They will view the Bush and Obama years as the critical years in the loss of US power, and the decline of the US economy. They will point to the debt accumulation, government profligacy, populist policy, the irresponsibility of the Federal Reserve, and the failure to confront the mercantilist policies of China - the argument will be over which was the nail in the coffin of US power. From my point of view, the argument is that it is impossible to view any of these factors in isolation, but rather to view them as part of a single process.

The single process that unifies all of these elements is self-delusion. It is the belief that power is an inherent right, that wealth is an inherent right, and that underlying economic realities might be wished away. In short, the leaders, the analysts, and the people of the US forgot that power and success are rooted in real wealth creation, not the ersatz wealth of borrowing and printing money.

As yet, there is no guarantee of the shift in power towards China. There are many risks, and China is operating in a dynamic system, in which outcomes will always be uncertain. Having said this, their overall strategy appears to be bearing fruit and, with the help of US policy, they are now firmly on track for success.

Quite simply, I believe that they are winning, and others are starting to share this view.

Note 1:

Another interesting point that Roubini makes is in his discussion, which is on a different subject to the main article is as follows:

But what could replace it [the $US]? The British pound, the Japanese yen and the Swiss franc remain minor reserve currencies, as those countries are not major powers. Gold is still a barbaric relic whose value rises only when inflation is high. The euro is hobbled by concerns about the long-term viability of the European Monetary Union. That leaves the renminbi.

Regular readers will know that I have flirted with the idea of a gold standard in currencies, but eventually came to the idea of a currency of fixed issuance (the link is to a long article that approaches the subject is a fairly roundabout way). I am somewhat surprised to see an economist using emotive terms such as 'barbaric relic' in reference to a gold based currency. This is not an explanation of why gold is not a viable alternative, but an emotive argument. The reality is that, in the current situation, it is possible to see how easily governments and central banks can debase a fiat currency when there is no restraint on the issuance. Whilst no longer subscribing to a gold standard, I believe that some form of restraint on issuance of currency is better than the current situation of no restraint.

The very essence of Roubini's argument is that the unrestrained issuance of currency has created the current problems, and it is difficult to see how such issuance might be restrained without some kind of commodity backing. A 'barbaric' gold standard currency would have prevented this mess, as gold would have flowed out of the US with the massive deficits, and therefore the currency issuance would have been constrained.

If that is barbaric, then I am all in favour of barbaric.

Note 2:

I found a fascinating clip that illustrates how shockingly opaque the Federal Reserve actually is. This is, of itself, a subject of a post. The clip can be found here. You may be shocked.....

Note 3:

So much for the 'Green Shoots'. The US consumer has apparently been (as expected by anyone grounded in reality) pulling in their horns. Taylor, of the famous Taylor rule, is suggesting that US interest rates will need to rise in the near term, in an analysis that slams down much of the recent optimism and analysis of the situation. Meanwhile Freddie Mac is drawing on another $6 billion due to ongoing losses - but apparently the crisis is now over....??? and foreclosures continue at shocking levels...

More depressing, from the UK there is news of a lift in the numbers of first time house buyers. I feel sorry for these individuals, who are no doubt reading of recovery, and optimism, and are thinking to climb onto the housing ladder whilst there is still time....no doubt they will hear this story in the press, and from the mouths of the estate agents. They are, of course, buying long before the bottom has been reached. For example, the buy to let market looks dire, and signals more properties coming onto the market at discounted prices. As for the economy overall, the BoE has come in with a pretty gloomy picture in the latest inflation report, which can be found here....(the GDP projections might be seen as good material for black humour).

Note 4:

The idiocy of the US bailout schemes is highlighted in an article here, which also serves to confirm the 'clubiness' that I detailed in a recent article:

“The taxpayers ought to know that we are in effect receiving a subsidy. They put in 40pc of the money but get little of the equity upside,” said Mark Patterson, chairman of MatlinPatterson Advisers.

The comments are likely to infuriate Tim Geithner, the US Treasury Secretary, because MatlinPatterson took advantage of the TARP’s matching funds to buy Flagstar Bancorp in Michigan. His confession appears to validate concerns that the bail-out strategy is geared towards Wall Street.

Note 5:

Thanks, as ever for the comments. There was a little tension between two commentators, and I was glad to see the tension resolved in such a reasonable way. As ever, the standard of the comments and intelligence of the commentators is a pleasure to see.

Note 6:

Apologies for linking to so many old articles, but this appears the best way to highlight the overall picture of China. I hope that readers have the time to view these, as they do together paint (I believe) a compelling picture.

China as the World Economic Power?

When I first wrote a post on this blog devoted to China in July of last year, I emphasised how opaque China was as an economy. For example, I suggested that the housing construction boom might be a bubble (which proved to be the case), but could offer no solid backing for it. As such, my thoughts on the future of China were cautious:

The Chinese economy may, or may not be, at a point where internal growth within China has the potential to take up the slack. Has it yet reached that point? It is very difficult to say. It is a finely balanced point, but the economic growth of the coastal areas is now being replicated in the interior. Can the growth in the interior maintain the momentum of the coastal cities? The Chinese government has huge reserves to draw upon should the economy falter, and may seek to use those funds to further develop the interior of the country. There is also an ongoing and dramatic process of infrastructure investment which may help carry China through the bad times.

Furthermore, China has being making ever stronger inroads into markets such as Africa, and South America. Whilst these can not replace the US and European markets, they may serve to ameliorate the effects of a downturn.

As you will note, there are many question marks here. There are many 'experts' in China trying to wade through the piles of figures trying to see what will happen with China. The trouble is that many of the statistics are either opaque or suspect. In this situation, it is just as well to rely on intuition.

In a later post I emphasised the mercanilist approach of the Chinese government, and have followed that theme through many of my subsequent posts. However, the major question mark over the future of China has remained, and my posts have tried to balance the potential for huge economic success with the risks to the Chinese economy from the world economic crisis.

As China's importance in the world economy has become ever more apparent, there has been growing interest in the state of the Chinese economy. I have recently seen some reports which consider the future of China and there are mixed views. For example the D&B Riskline report for April rates China as a 'slight risk' with the trend 'deteriorating'. with very little economic growth for this year and the next. By contrast, the Economist magazine is painting a picture of strong growth on the back of the Chinese government stimulus:

At first sight, the GDP figures published on April 16th were disappointing. China’s growth rate fell to 6.1% in the year to the first quarter, less than half its pace in mid-2007. On closer inspection, however, the economy is starting to perk up. Comparing the first quarter with the previous three months, GDP rose at an estimated annualised rate of around 6%, after nearly stalling in the fourth quarter (see chart). By March the economy was gaining more speed, with the year-on-year increase in industrial production rising to 8.3% from an average of 3.8% in the previous two months. Retail sales were 16% higher in real terms than a year ago, and fixed investment has soared by 30%, signalling that the government’s infrastructure-led stimulus is starting to work.

What we have here are two very different perspectives on the Chinese economy, which appears to be the norm for analysis of the Chinese economy. To give a perspective on the opacity of the Chinese economy, analysts often use proxy measures such as electricity output to try to understand what is really going on. Understanding the Chinese economy is no easy matter.

The problem that this presents is significant. There are two very different futures that might arise depending on the growth in the Chinese economy. One scenario is of a collapse into disorder, and the other is to increasing dominance in the world economy.

As I have mentioned in previous posts, there is a belief that China needs to maintain a growth rate of 6% in order to maintain social stability. This is needed to soak up the ever expanding labour force, and failure to do so is supposed to create significant risks. In particular, the legitimacy of the Communist government rests on the pillars of economic growth and nationalism, so that any major drop back in growth might see a significant rise in discontent. An earlier report in the Economist highlighted the problems that students are having in obtaining employment after graduation, and pointed out the risks in such a situation:

Campus stability has long been a worry to China’s government. Students took a leading role in several outbreaks of pro-democracy unrest in the 1980s, including the Tiananmen Square protests of 1989. Student demands for political change have been rare since then, thanks largely to an improvement in career prospects brought about by the economic take-off and the freeing of state controls. (In the 1980s, graduates had to accept the jobs they were assigned by government.)

On the one hand, therefore, we have a scenario in which, if the economy slows significantly, there is a major risk to the stability of China overall. On the other hand there is the possibility that China will continue to grow, and the consequences of such ongoing growth might lead to a very different outcome for China.

If we assume that the growth scenario is correct, the position of China in the world economy becomes ever more important. It appears that China is currently making the opening bids to establish the RMB as a reserve currency, and I have posted on this subject several times. For example, in a recent post, I pointed out the many moves that China is making to achieve this goal:

In other words, China is now actively positioning itself as (at the least) a major issuer of reserve currency, but is doing so in a way in which - if their attempt were to meet resistance or fail - they can step back and point out that it was never their intention. They can therefore proceed with an official position of support for SDR, whilst acting to develop the RMB as a reserve, whilst never risking losing face. It is a very effective way of operating.

The post details a series of actions by the Chinese government to establish the RMB as an international reserve currency, along with some consideration and speculation about the Chinese government's thinking. You may wish to read the post before continuing. In another post (again, you may wish to read it before continuing), I made an even more speculative consideration of what the Chinese government may be aiming to achieve, and how they might achieve it. In essence, I speculated on how China might take advantage of the economic crisis to become the world economic power.

Within the speculation, I suggested that China would discreetly start to dump treasuries, and would move their reserves into a broad based portfolio of assets. Whilst China has promoted the IMF SDRs as an alternative reserve currency, I proposed that this was a red herring which would allow China to undermine the $US without actually promoting the RMB as a replacement. However, the SDR approach is being taken seriously by some:

But in recent weeks, China has begun to address each of these dollar-forever arguments head-on, taking baby steps on the long road toward diversifying away from the U.S. dollar and moving instead toward the establishment of an alternative world reserve currency.

The signs began to emerge in mid-March, when Chinese Prime Minister Wen Jiabao publicly announced that he was "worried" about China's exposure to the dollar. Shortly thereafter, Zhou Xiaochuan, the governor of the Chinese central bank, released a policy paper suggesting the creation of a "super-sovereign reserve currency" to replace the dollar as a reserve currency over the long run. Specifically, he suggested the creation of a fund, managed by the International Monetary Fund, through which dollars could be exchanged for Special Drawing Rights (SDRs), an IMF-created international reserve asset whose value is fixed by a basket comprised 44 percent of U.S. dollar, 34 percent of euro, and 11 percent of each pound and yen.

However, it is now apparent that China has made significant moves towards gold, and this was one of the moves that I suggested in the post. This would help bolster the RMB as a reserve currency. We now have the following from the FT:

China revealed on Friday that it built up its gold reserves by three quarters since 2003, making it the world’s fifth largest holder of bullion.

[And]

Hou Huimin, vice general secretary of the China Gold Association, said China should build its reserves to 5,000 tonnes.

“It’s not a matter of a few hundred, or 1,000 tonnes. China should hold more because of its new international status, and because of the financial crisis,” he said. “The financial crisis means the US dollar’s value is changing fast, and it may retreat from being the international reserve currency. If that happens, whoever holds gold will be at an advantage.”

In addition to this, China is also building up stocks of other metals such as copper. In the D&B report, this is viewed as a move towards supporting government infrastructure investments. An alternative view comes from Ambrose Evans-Pritchard in the Telegraph:

China's State Reserves Bureau (SRB) has instead been buying copper and other industrial metals over recent months on a scale that appears to go beyond the usual rebuilding of stocks for commercial reasons.

[and]

The beauty of recycling China's surplus into metals instead of US bonds is that it kills so many birds with one stone: it stops the yuan rising, without provoking complaints of currency manipulation by Washington; metals are easily stored in warehouses, unlike oil; the holdings are likely to rise in value over time since the earth's crust is gradually depleting its accessible ores. Above all, such a policy safeguards China's industrial revolution, while the West may one day face a supply crisis.

Beijing may yet buy gold as well, although it has not done so yet. The gold share of reserves has fallen to 1pc, far below the historic norm in Asia. But if a metal-based currency ever emerges to end the reign of fiat paper, it is just as likely to be a "Copper Standard" as a "Gold Standard".

The moves of the Chinese government are increasingly fitting with my speculations on a move by China to rapidly achieve economic dominance. However, it is necessary to consider the other side of this coin, which is that China is also quite vulnerable to social unrest.

The key question that keeps nagging at me is which way will China go in the coming year? Will it be a slide into disorder, or a successful bid for economic dominance? Are there other middle paths, and what might they be? Are they really making a bid for economic dominance - to be the new economic power?

With such an opaque system, it is not possible to be sure of anything. However, all the indications appear to point to an ongoing strategy from the Chinese government of placing China at the centre of the world economy. Whilst all the recent moves of China might be coincidence - responses to changing circumstances - there does seem to be an emerging pattern in their actions. If it is more than coincidence, we may be witnessing one of the most dramatic peacetime shifts in power in modern history. It could well be that China is returning to its traditional position as the preeminent country in the world.

Only time will tell......

The RMB as the Reserve Currency

I have a very curious sense at the moment of the world moving in slow motion. I had thought that the economic crisis would create dramatic moments, but in some respects it appears to be moving through a gradual shift.

One of the predictions that I have made, on two occasions, is the collapse of the $US and the end of the reserve status of the $US. However, it appears that the end of reserve status is being achieved with little drama, as it is apparent that the RMB is slowly but surely being positioned as a replacement of the $US as the reserve currency. We have this latest news from the China Daily:

Five major trading cities have got the nod from the central government to use the yuan in overseas trade settlement - seen as one more step in China's recent moves to expand the use of its currency globally.

The most interesting thing about the article is that the newspaper is part of the state run media, and therefore is careful to toe the party line. It is the following section that grabbed my attention:

Analysts said the experimental use of the yuan in trade settlement also reflects policymakers' rising concern over the shaky prospects of the US currency, of which China has large reserves from previous trade growth, and their willingness to gradually expand the yuan's use globally.

"The trial is the latest move toward making the yuan an international currency," Huang Weiping, professor of economics at Renmin University of China, said. "The prospect of a weaker US dollar is making the transition more imperative for China."

The method here is typical of the way that the Chinese government works. They use another person to make explicit an implicit policy, and thereby leave the situation open to later government denial. However, the idea is now 'out there', and that is their intention. The article also mentions several of the deals that I have discussed in past posts, and therefore offers a good summary of the progressive establishment of the RMB as a reserve currency to challenge the $US:

The mainland is trying to promote the use of the yuan among trade partners and, in the past four months, has signed 650 billion yuan (US95 billion) worth of swap agreements with Argentina, Indonesia, South Korea, Malaysia, Belarus and the Hong Kong Special Administrative Region. The agreements allow them to use their yuan reserves to directly trade with the Chinese mainland within a set limit in volume.

All the while this is going on, there is still chatter in the mainstream media about IMF Special Drawing Rights (SDR) developing into a new global currency. For example, Edmund Conway of the Telegraph points to a paper from the Governor of the People's Bank of China, in which there is a strong backing for SDRs as a global currency.

In fact, perhaps inadvertently the Geithner, Darling, Brown and Obama initiative has dramatically increased the odds of this happening [SDR as a reserve currency]. It will have increased the appetite of the Chinese, the Russians and the others who would like to depose the dollar as the world's reserve currency. Moreover, it has cemented the likelihood that they push for the deposition by trying to get the SDRs installed as the dollar's replacement. Quite how this would work remains to be seen. There appear to be plenty of obstacles and it is dubious that the SDR could be transposed to become a general unit of exchange.

I strongly recommend a read of the paper from the Chinese central bank governor. However, if you read it carefully, it might also be seen as much as an anti-$US statement, as much as a statement in favour of SDRs.

The problem for many analysts is that they are more likely to take an official paper as policy, rather than an article in the newspaper. However, a reading of Chinese history shows that a newspaper article is often used as a method of floating a new policy, often in contradiction to official policy. For example, the battle lines of the Cultural Revolution were heralded with People's Daily articles on the (apparently) innocuous subject of a Ming dynasty official called Hai Rui. I will not delve into details here, but this seemingly unimportant matter was exactly the opposite, and was later to be the precursor to a massive shift in government policy (for a full discussion of this you can find a good outline in 'The Search for Modern China' by Jonathon Spence, chapter 22 - which is one of the better studies of modern Chinese history).

Although the Hai Rui debate dates back to a different period of Chinese history, the methods of using the press, using proxy spokesman, and many other features of the case, can still be seen in use today. A more recent example that I discussed in a post many months ago was the indirect threat reported in a Telegraph article in which the Chinese obliquely threatened to destroy the $US if the US pressed further on trade disputes. As in this case, the idea was floated in such a way that allowed for later denials of this being an official policy. For those who may doubt that China might operate in such a way, I would suggest a reading of my post in which I discussed Chinese quasi-mercantilist policy in some depth.

In other words, China is now actively positioning itself as (at the least) a major issuer of reserve currency, but is doing so in a way in which - if their attempt were to meet resistance or fail - they can step back and point out that it was never their intention. They can therefore proceed with an official position of support for SDR, whilst acting to develop the RMB as a reserve, whilst never risking losing face. It is a very effective way of operating.

The real question is whether they might succeed in this ambition. Can the RMB become the world reserve currency? As I have pointed out in previous posts, they are already using their financial power to bolster their position and influence in developing countries (e.g. a recent loan to Mauritius). At the same time, despite my predictions of the demise of the $US still not coming to fruition, the actions of the US government, the irresponsible fiscal and monetary policy, continue to erode faith in the $US. However, the real key to reserve status is when trade is more broadly conducted in the RMB, such as move to trading oil in RMB. Perhaps Venezuela will offer such an opportunity? An article here suggests that Venezuela may need to turn to China for financial support, and this may well present an opportunity for China to start this process:

In Latin America, the external funding situation remains relatively stable but in the case of further deterioration of capital flows, the solid economies would be able to tap the IMF or the Inter-American Development Bank (IADB) for non-conditional lines of credit, while the economies with less sound macroeconomic frameworks such as Ecuador, Argentina and Venezuela would most likely only be able to obtain funds through more formal conditionality or by turning to lenders like China.

Returning to the question of whether it is possible, I see no reason to prevent the RMB from taking on this role. There has been talk about the RMB not being 'liquid' enough, the lack of depth of their financial markets. However, I take a fairly simplistic view, which is to ask whether a currency has the underlying strength of being able to be used to purchase goods and services. The answer to this question is, of course, 'yes'.

The remaining question is whether the Chinese government would want to have the RMB as the reserve currency. If it were to become the reserve currency, then it would surely dampen their export led growth, would it not? The RMB would appreciate in value and that would hurt the Chinese economy? There is some logic in this argument. The greater demand for the RMB, the more that it will appreciate - in principle. However, they would be able to hold down the value by expanding supply of the currency, though avoiding the level of expansion that has been the case with the $US. They will have surely learnt the lesson of the $US, which has seen the abuse of reserve status to finance massive deficits in government spending. Provided that they increase supply to provide sufficient to meet demand for the currency for trading usage, they will avoid the problems of the $US.

This point is critical. If a currency expands as a unit of exchange, rather than as a method of financing borrowing, the supply might expand without negative impacts and the value of the currency might remain stable. A currency is, in the end, a unit which promises to be utilised for exchange of goods and services and therefore needs to have the backing of an economy capable of honouring that promise. When a currency becomes a reserve currency, it might exceed that capability from the issuing economy, but still remain a currency in which there is confidence. Provided that confidence remains, there is little likelihood of the promise being called in all at once. In this respect, it mirrors fractional reserve banking in which the assumption is that it is safe to loan depositor money on the basis that not all depositors will want their money at the same time.

In other words, provided the currency continues in circulation, without a sustained call on the promise of the currency to provide goods and services from the issuing economy, it can hold and store value. My prediction of the (not yet arrived?) demise of the $US is that the underlying weakness of the $US is resultant from the abuse of the reserve status to build up a debt mountain, and the use of the reserve status to finance that debt. It can only service that debt through new currency issuance. There is no reason to see why China might follow such a course as a major creditor nation, and this is why it is so well positioned as a reserve currency. They only need to expand the money supply such that they provide sufficient units for exchange, not to finance debt. This is the inherent strength in the RMB, and why it might replace the $US.

I am sure that some will suggest that this is a simplistic approach. There are many other factors that are involved, some of which are psychological, or concerned with 'belief'. Whilst I can acknowledge these factors, indeed have to acknowledge them when viewing the continuing position of the $US, I do not believe that the underlying reality can be avoided for ever. In the end, as the situation becomes increasingly transparent and plain before the eyes of people, the underlying reality will become self-evident. In this case, the RMB as a unit of exchange for real goods and services is solidly backed up with the capacity to service the implicit promise of the currency.

On the other hand, the $US is expanding in volume to finance yet more consumption, the output of the economy is in decline, and the units in circulation are expanding beyond what is needed for exchange - whether for internal use or for use as a medium of exchange outside the US. Where is the underlying ability to service the promise?

The big question in my mind is when belief will end, and when will reality reassert itself?

Note 1: A regular commentator on the blog, Lord Keynes (a pen name) will be contributing an article in the future. Lord Keynes is a critic of many of the ideas in this blog, but I believe in open debate, such that I believe this will be a positive contribution. MattinShanghai - I would welcome an article on CDSs, an area I am aware you have both a strong point of view, and have evidently researched in some depth.

Note 2: I have had another article published in the Trade and Forfaiting Review, and you may wish to read this here. The article discusses the Japanese experience of quantitative easing (printing money).

Note 3: There is an interesting article here that I did not manage to integrate into this post. It is an essay on savings by the Chinese central bank governor, and makes interesting reading.