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China’s Attack on the U.S. Dollar

April 8th, 2013

dollarThe greenback gets no respect these days. The latest “sky is falling” event for the U.S. dollar is a plan to make the Chinese yuan and Australian dollar freely convertible into each other. As of now, the Chinese currency is only convertible into the Japanese yen and U.S. dollars.

This Australia-China gambit makes sense, since China purchases nearly 30% of all Australian exports and is the fifth-biggest source of Chinese imports.

Pundits are crowing that this deal is yet another nail in the coffin in the U.S. dollar’s role as the world’s reserve currency. It seems to many only a matter of time before the Chinese currency reigns supreme.

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I am deeply skeptical of this view and believe the U.S. dollar will likely remain the world’s reserve currency through the first half of the twenty-first century.

Let’s begin by looking at what characteristics make a durable reserve currency:

  • Strong and stable, with ample liquidity – The country’s currency should demonstrate deep liquidity so investors can move in and out of it without sharp movements in price. It needs to be widely recognized as a reserve currency.
  • Financial and political stability – The fiscal discipline and political stability of the country needs to be unquestioned. Countries with large fiscal deficits are unable to be dependable safe havens. That’s because the path of least resistance is to devalue the currency to make debt loads more manageable.
  • Market-based, rules-driven, open economy – Investors and trading partners thrive best in a market-oriented economy where the rules are clear and transparent. Faith in the fairness of the judicial system and institutions is vitally important.

Looking at the above characteristics of a reserve currency report card, you’re probably thinking, “the U.S. dollar is cooked.” America scores well on liquidity (perhaps too well), political stability, and is certainly one of the most market-based, rules-driven, open economies in the world. Unfortunately, it is at best a D- on store of value and fiscal discipline issues.

Fortunately for America, this test is graded on a curve, and China is not even in the front row…

Problems Facing the Yuan

On the issue of liquidity, the Chinese yuan is a long way from being convertible across the board. Chinese exporters who receive U.S. dollars are forced to turn them over to the central bank. (This is how China built its $3 trillion in reserves.) Citizens can’t take it out of the country. The yuan is not accepted as legal tender anywhere outside of China.

Second, it will be a long, long time before China allows its currency to freely float, because its whole system is built on tightly controlling its value. If the yuan strengthened 10% in six months, millions of exporters already on razor-thin margins would go bust. It would also be a volatile currency because of the economies that are dependent on so many commodities.

In addition, China’s weaknesses as a global safe haven are glaringly obvious. Two examples should suffice:

  • All of its strategic industries are firmly in state hands.
  • Its judicial system is anything but independent.

Then there is significant political risk. China’s decision-making process is anything but transparent. In addition, its more aggressive posture on regarding territorial disputes with Japan and some Southeast Asian nations is also a bit disquieting.

The U.S. dollar will remain on top due to the flexibility, openness and resilience of our economic and political system. Our fiscal challenges are huge and won’t be solved overnight, but I sense movement in the right direction. This and a credible medium-term plan to bring spending under control is oftentimes all currency markets are looking for.

The big test is what happens to currencies when there is a financial or foreign policy crisis. The greenback always rises.

Currency diversification is always a smart idea, but to hedge your global portfolio against a dollar decline, I’d go with the CurrencyShares Swiss Franc Trust (NYSEARCA:FXF) over the Chinese yuan any day of the week.

As for Australia, I would recommend that – rather than brag about its dependency on Chinese markets – it should do everything it can to diversify export markets.

Why?

It could easily boomerang if China’s economy performs below the inflated expectations.

In fact, I caught this ironic news flash on Monday morning:

“The Australian dollar fell against other major currencies in the early Asian session on Monday after the release of weaker-than-expected China manufacturing PMI for March.”

Perfect timing.

Good investing,

 

by Carl Delfeld, Investment U Senior Analyst

 


NYSE:FXF


 

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