28
Apr
2009

5 Signs the Chinese are Preparing Escape Route from US Dollar

USD and RMB

USD and RMB

I’ve been closely following the economic and financial relationship between the China and US.  As we all know, China is largest foreign holder of US dollar denominated debt.  While it is in their best interest not to create “a run on the bank,” there are five small “tells” that indicate they are slowly but surely looking for diversification from the U.S. Dollar and preparing an exit plan.  The five signs are:

  1. The public calling for a supra-national currency backed by the IMF,
  2. Funding IMF reserves in return for greater voting rights,
  3. Using the RMB as a medium of exchange with neighboring countries, to starting the use of the RMB as an Asian reserve currency,
  4. Using dollars to buy everything…commodities, and companies, and
  5. Increasing Gold reserves.

Implications for you and me?  Start worrying about your USD denominated savings & investments and start planning for a post-USD world.

Eric C. Anderson at Huffington Post highlighted many of these “tells” in his recent piece entitled “Beijing preparing for exodus from U.S. Treasury Notes.“  Because most Americans really couldn’t care less about China unless it affects them directly, he opens with the implications of this Chinese exodus:

The cost of borrowing money in the United States is going to increase. Not tomorrow, and likely not in the next six months, but in the foreseeable future it is going to become increasingly expensive to finance your car, home, and college education. I come to that conclusion in the wake of reports that China–our largest creditor–is now looking to significantly diversify her holdings.

So what are these signs?

1.  Zhou Xiaochuan calls for the establishment of an IMF-backed supra-national currency

On March 23, People’s Bank of China governor Zhou Xiaochuan (周小川) issued a call for an IMF-backed global currency.  The global crisis, according to Zhou, proves that the system of a national currency serving as a global reserve currency is fundamentally flawed. We posted on this here.

You could potentially dismiss this call for an IMF-backed global currency as a publicity stunt designed to force Geithner and Bernanke into protecting Chinese interests.  At first glance, the idea seems ridiculous doesn’t it? an IMF based currency?

According to a Morgan Stanley article on reserve currencies (excerpted in an earlier CNReviews post, and originally here), money has three purposes: (1) unit of account, (2) medium of exchange, (3) store of value.  On point (2), medium of exchange, the US Dollar has “first mover advantage” and will be difficult to dislodge.  According to a Wall St. Journal response to the Zhou proposal:

Large, deep, and highly traded markets involving a particular currency “don’t spring up spontaneously just because the Chinese central bank governor suggests this would be a good idea,” says Barry Eichengreen, an economist at the University of California at Berkeley.

Think of the US Dollar as “English” or “Microsoft Windows.”  Once you have set the standard, it’s difficult to switch off of it.  So is this just a negotiating tactic by Zhou?

2.  China bolsters the IMF by investing $1 trillion cash (inclusive of other BRIC countries) in return for more voting rights

One month later, China “antes up” with cash and shows its seriousness of supporting the IMF’s role…but, of course, with strings attached.  Back to Anderson’s Huffington Post piece:

Beijing wants greater IMF voting rights. As an economist for Deutsche Bank told the Journal, “China sees this as a good opportunity to increase [Beijing's] influence.” As it turns out, it China also sees the expanded IMF holdings as a means of escaping Beijing’s over-investment in American debt.

On 24 April, officials from Brazil, Russia, India and China (commonly referred to as the BRIC) met to discuss how they would contribute to the proposed $1 trillion fund. The response from IMF critics–this new fund could become competition for similar bond offerings from sovereign nations…like the United States. In order to continue drawing investors these sovereign debtors would either have to pay higher returns or curtail their deficit spending. I’m not sure the first option will work. Unlike U.S. Treasury notes, the IMF bonds have the additional allure of support from a deep-pocketed multi-national consortium. If I was a central banker in China my bet would be with the IMF bond–at this stage Washington appears intent on printing money until the dollar is worthless.

So perhaps China isn’t bluffing.  They really want to restructure to governance of the global reserve currency system via the IMF.

3.  The start of the use of RMB as regional trading currency

We first highlighted the use of RMB as a trade settlement currency via a 12/25/08 People’s Daily article.  In the same CNReviews post, we also highlighted the establishing of swap lines between China and Japan and Korea (source: Financial Times). Most recently, Bloomberg (4/2/09) reported that China is to Boost Yuan swaps:

China’s leaders, increasingly concerned about the nation’s $740 billion of U.S. Treasuries, are making it easier for trading partners and consumers to do business in yuan. The People’s Bank of China has agreed to provide 650 billion yuan ($95 billion) to Argentina, Belarus, Hong Kong, Indonesia, Malaysia and South Korea through so-called currency- swaps. More such arrangements are being planned so importers can avoid paying for Chinese goods with dollars, the central bank said.

Back on 12/25/08, the trade settlement pilot was with “eight neighboring countries, including Russia, Mongolia, Vietnam and Myanmar.”  Now currency-swaps enable more countries to pay for Chinese goods in yuan rather than use dollars as a medium of exchange.  You see where this is going?

4.  The use of dollars to buy everything…commodities and companies.

Time magazine highlighted the purchase of commodities in an article entitled “China goes on a smart spending spree“:

As economies across the world shrink, Chinese officials have told reporters in Beijing in recent weeks that they see a rare chance to expand its sources for primary commodities. “There are editorials in the Chinese press saying that this is a one-in-one hundred-year’s opportunity,” says Erika Downs, China energy fellow at the Brookings Institution in Washington. “There is a sense that this is a moment to be seized, that with competition lower they can get a good deal.

Another article, in Canada’s Financial Post, highlights that the Chinese government is pushing Chinese companies to go global, even if it is beyond their comfort zone.  From an article entitled “Chinese companies not keen on foreign purchases”:

The Chinese government has been urging its business sector to embark on an international spending spree, picking up offshore assets at bargain-basement prices. Beijing has even sent trade and investment delegations around the world to pave the way for the country’s state-owned and private companies to make inroads abroad.

But although there has been some increase in foreign investment by Chinese companies in recent months, the majority of Chinese executives fear they don’t have the expertise to invest in markets like Canada and the U.S., especially during an economic downturn.

There are probably better articles that outline China’s “Go Global” initiatives.  But this at least shows that the push goes beyond rational profit-maximization of individual companies…and perhaps is a sign of a “use it or lose it attitude” with respect to US dollars.

5.  An increase in Gold reserves

Financial Times reports that the Chinese government announced an increase in gold reserves.

Gold prices rose modestly on Friday after China said it had become the world’s fifth largest holder of bullion after secretly increasing its reserves by 75 per cent to 1,054 tonnes since 2003.

Gold added 0.9 per cent at $910.20 a troy ounce, taking its gain over the week to 4.9 per cent. There was talk that China’s announcement could prompt a broader reassessment of gold’s role as a reserve asset by other central banks.

I left this for last because when people think about a run on the US Dollar, they usually think about Gold.  But the magnitude of this increase is not that big.  Here is some context from HardAssetInvestor.com:

The latest commodities bull news came Friday, when China announced that it had increased its gold reserves to 1,054 metric tons after years of reporting no change. In fact, as recently as March, China reported that its gold reserves were just 600 metric tonnes. The surprise 76% increase means that China is now No. 5 on the list of top gold reserves by country, as reported by the World Gold Council. China narrowly edged out Switzerland, which holds 1040.1 tonnes.

Tonnes

% of FX Reserves

United States

8,133

78.90%

Germany

3,412

71.50%

France

2,487

72.60%

Italy

2,451

66.50%

China*

1,054

1.60%

*This is the new, updated number

Keep in mind that it is not just countries that hold a lot of gold. The International Monetary Fund holds 3,217 tonnes, and SPDR Gold Trusts hold 1,104.45 tonnes, while all ETFs combined hold just over 1,600 tonnes.

Taken alone, this move should not be too alarming. China could increase its Gold reserves substantially and still be well below most other countries. In fact, the leading Gold ETF (GLD) has more Gold in its reserves.  But based on the other signs above, I’d expect China to be acquiring more Gold (and all other commodities) in the future.

US Dollar Missiles

US Dollar Missiles

Summary

During recent history, the RMB has been (basically) pegged to the USD and China has been pegged to the US economy.  The result of this was global imbalances contributing to the latest financial crisis, and China holding the largest foreign reserves in the world, with over $785 billion of US-dollar denominated assets.  Now, we are seeing small but portentious signs that China is looking for an exit.  They are doing it quietly because a “run on the bank” would hurt the value of their reserves and threaten the stability of their export-addicted economy.  But these five signs are unmistakable:

  1. The public calling for a supra-national currency backed by the IMF,
  2. Funding IMF reserves in return for greater voting rights,
  3. Using the RMB as a medium of exchange with neighboring countries, to begin the use of the RMB as an Asian reserve currency,
  4. Using dollars to buy everything…commodities, and companies, and
  5. Increasing Gold reserves.

Many of these signs are small, but taken together indicate moves that preshadow a change in US Dollar hegemony as we see it today.  The result: loss of the “exorbitant privilege” of reserve currency status and, for the US, higher borrowing costs and slower debt-fueled economic growth.

UPDATE 5/1

Yale Global Online just published an article called “China tries to wiggle out of the Dollar Trap” by Wenran Jiang that basically outlines a similar set of factors as our “5 signs.”  The article includes more details about China buying natural resources companies and assets globally, and quotes Caijing Magazine as characterizing this as a “grand concert without a conductor.”  Here’s a longish extract from that article:

Another effort by China to pull itself out of the dollar trap is to diversify its global investment from low-return T-bills and volatile securities to energy and resource assets around the world. There is no central government body in charge of such a strategy. But newly announced policy measures, such as the Adjustment and Renewed Plan for the Iron and Steel Industries, have encouraged, and simplified procedures for overseas acquisitions by the Chinese enterprises. The prestigious Caijing Magazine has called the new wave of Chinese overseas acquisitions as a “grand concert without a conductor.” But the current world economic crisis has also presented opportunities with falling commodity prices and declining stock prices of many energy and resource companies. While still somewhat hesitant, some major Chinese companies seem to be on the move to increase their worldwide foreign direct investment portfolios. Leading the way are large Chinese mining companies, and the targets are primarily Australia’s mining sector. In February, Aluminum Corp. of China invested $19.5 billion in Rio Tinto Group, now pending for Australian government approval. Canberra approved an A$1.3 billion investment by China’s Hunan Valin Iron & Steel Group in Fortescue Metals Group Ltd.

In the energy sector, China has entered a new wave of large deal-making with major global players: It just signed a $25 billion agreement with Russia, getting 15 million tons of crude annually for 20 years beginning in 2011 while providing the loans to Russian oil major Rosneft and the oil pipeline operator Transneft. Beijing has just concluded a $10 billion oil-for-loan deal with Kazakhstan. Another $10 billion agreement with Brazil’s Petrobras is under way. As the Deputy Minister of China’s National Energy Administration Sun Qin stated, China must utilize its $2 trillion reserve to seize the opportunities brought by the current financial crisis for more loans-in-exchange-for-energy-and-resources deals.

Update 5/5

China has canceled US credit card. Uh-oh.

Update 5/5

FT.com – Andy Xie – If China loses faith the dollar will collapse. His assessment:

China is aware that it must become independent from the dollar at some point. Its recent decision to turn Shanghai into a financial centre by 2020 reflects China’s anxiety over relying on the dollar system. The year 2020 seems remote, and the US will not pay attention to something so distant. However, if global stagflation takes hold, as I expect it to, it will force China to accelerate its reforms to float its currency and create a single, independent and market-based financial system. When that happens, the dollar will collapse.

Update 5/14

NYTimes  – Nouriel Roubini – The Almighty Renminbi?

Roubini writes of the potential for the RMB to become a new reserve currency because of China’s current conditions, similar to pre-World War II America:

Traditionally, empires that hold the global reserve currency are also net foreign creditors and net lenders. The British Empire declined — and the pound lost its status as the main global reserve currency — when Britain became a net debtor and a net borrower in World War II. Today, the United States is in a similar position. It is running huge budget and trade deficits, and is relying on the kindness of restless foreign creditors who are starting to feel uneasy about accumulating even more dollar assets….
China is a creditor country with large current account surpluses, a small budget deficit, much lower public debt as a share of G.D.P. than the United States, and solid growth. And it is already taking steps toward challenging the supremacy of the dollar.

He goes on to say that the RMB is not ready and that the process could take a decade or more (which to me seems like a short timeframe). However, China’s first step would be to escape the orbit of the dollar. The implications of losing the dollar’s “exorbitant privilege” is concerning:

If China and other countries were to diversify their reserve holdings away from the dollar — and they eventually will — the United States would suffer. 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.
Now, imagine a world in which China could borrow and lend internationally in its own currency. The renminbi, rather than the dollar, could eventually become a means of payment in trade and a unit of account in pricing imports and exports, as well as a store of value for wealth by international investors. Americans would pay the price. We would have to shell out more for imported goods, and interest rates on both private and public debt would rise. The higher private cost of borrowing could lead to weaker consumption and investment, and slower growth.
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.

I personally think the prospects of a new reserve currency is less troubling than the period of transition where it is unclear what is a secure store of value and medium of common exchange. If this transition is happening in the next decade, it could be another drag on the prospects of recovery for the US economy.

Update 5/22

FT.com: China has a long way to go to dislodge dollar

This week’s initiative involves trade. China and Brazil are to begin talks on a scheme for bilateral trade to be settled in the renminbi and the real, rather than the dollar. Beijing has found a willing partner in the Brazilian government, which mixes conservatism in economic policy at home with developing worldist flourishes abroad.

Yet the curious thing about China’s attacks on the dominance of the dollar is just how much they are motivated by short-term, domestic politics. And in the process, the really important questions about China’s growth model and its future role are being pushed to one side.

If China wants a bigger international role for its currency, it will have to make other difficult shifts. For a start, the renminbi is not yet fully convertible and there are still a battery of restrictions on bringing funds in and out of the country. Why would a Brazilian exporter to China choose to be paid in renminbi, when the dollar is so much easier to trade and hedge against?
China’s international leverage would also be enhanced if it could lend money overseas in its own currency– to the US, for instance. But until China has a deep and open bond market where interest rates are set by the market and not the government, there will be only limited takers for such renminbi assets.

Elliott here:  Interesting point about the domestic politics influence on this US dollar attack.  Maybe this is a way for policy makers to cover their but should the US dollar take a fall.  But key barriers remain, namely:  full convertibility, deep pools of liquid markets, deep and open RMB denominated bond market.

Update 6/9

ChinaStakes posts on two items.  First, the post highlights China’s support for the IMF via support for a $50 billion bond issuance:

The IMF will discuss a financing scheme through bond issues at the coming director’s meeting. China says it is ready to buy up to $50 billion of such an issue. China has long urged IMF to raise more funds through market financing instead of through a political process.

Second, the post highlights the importance of bilateral trade currency agreements with Southeast Asia in particular:

Although many countries, including Russia and Brazil, are willing to settle bilateral trade with China in local currencies instead of USD, China is most interested in RMB settlement in trade with its Southeast Asian neighbors. Border trade with countries such as Vietnam is very active. China is promoting the establishment of a free trade zone, which will develop into a currency zone.

Recently, Malaysian Prime Minster Najib Tun Razak told Premier Wen Jiabao that his government might provide convenience to the bilateral trade by settlement of local currencies. The two sides may soon settle bilateral trade with their own currencies.

The People’s Bank of China (PBoC) and Malaysia’s central bank signed a currency swap agreement involving 80 billion yuan on February 8. PBoC has signed six currency swap agreements with monetary authorities of other countries totaling 650 billion yuan. According to these agreements, PBoC will receive other countries’ currencies and inject them into China’s financial system, so Chinese firms will be able to borrow those currencies to pay for imported goods, avoiding exchange rate risk and cutting exchange expenses.

Read the original ChinaStakes post here.

China Digital Times also highlights an interesting development – Russia’s support for Chinese Yuan as an alternative reserve currency:

“I think the shortest route would be if China liberalised its economy and allowed the convertibility of the yuan,” said Finance Minister Alexei Kudrin, a close ally of Prime Minister Vladimir Putin.

“This could take 10 years but after that the yuan would be in demand and it is the shortest route to the creation of a new world reserve currency and I think China needs to think about this,” Kudrin said at a panel discussion at the St Petersburg International Economic Forum.

China and Russia, the world’s No. 1 and No. 3 biggest holders of foreign exchange reserves, have expressed unease about the volatility of the U.S. dollar and called for discussions on ways to create rival reserve currencies.

Source is originally from Reuters.

More to come.

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