How The Chinese Yuan Will Dethrone The U.S. Dollar [PowerShares DB US Dollar Index Bullish, Powershares Db Us $ Index]

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May 6, 2015 4:21pm NYSE:UDN NYSE:UUP

dollar etfJim Bach: The “Red Dragon” is awakening and the Chinese yuan has taken another swing at the U.S. dollar’s security as reserve currency.

The International Monetary Fund (IMF) has begun debating whether the Chinese yuan should be included in the IMF’s Special Drawing Rights (SDR) basket of currencies, the Financial Times reported.

The SDR is not a currency, but rather “a potential claim on the freely usable currencies of IMF members,” according to the IMF website. The current basket includes the dollar, the yen, the euro, and the British pound sterling.

If the Chinese yuan is confirmed as an SDR currency, it signifies a growing interest within the international community in the yuan as a reserve currency – a widely used asset to settle international transactions.

German and Australian finance ministers support the move, according to The Wall Street Journal. The fact that the IMF is even considering this action is as much an endorsement of China’s growing role on the global economic stage as it is an indictment of the U.S. dollar and other currencies.

China has long been vilified for a number of reasons and for many critics its emergence as a global economic powerhouse has been thought a farce.

Detractors have called China a currency manipulator. They say it has stifled wage growth and kept labor costs low to weaken the Chinese yuan and bolster its exports, all while exporting inflation to the rest of the world, but primarily the United States.

But China’s principal role as a “currency manipulating” exporter is changing. The middle class is growing and the Red Dragon is no longer content to sacrifice a higher standard of living at the altar of roaring export growth.

“They’ve had the largest economy for 18 out of the last 20 centuries. They will have periodic fits and starts just like we have,” Money Morning Chief Investment Strategist Keith Fitz-Gerald said. “The difference is, they’re driven by 1.3 billion people that want to live the way we do, an economic machine that is still very much in growth mode, a working population that is a prime age – 18 to 54 – and they’ve got $3.1 trillion in reserves. We’re $221 trillion in the hole.”

China skeptics have been emboldened in 2015 by reports of slowing growth. And they continue to refer back to the same problems again and again.

“Doom, gloom, debt, ghost cities, taxation – they can’t possibly survive,” Fitz-Gerald said.

There is a theme in all of this criticism.

“The only consistency to all of that is the fact that these same people that have been calling for the demise for the last 40 years have been wrong for the last 40 years,” Fitz-Gerald said.

Recently, China also opened up its domestic bonds to foreign investors. China’s SDR push is yet another step in a much larger endgame for China.

“They will be the world’s most sophisticated financial markets over the next ten years. They will absolutely supplant London and New York,” Fitz-Gerald said. “They are rapidly modernizing their financial system… they’ve got futures, they’ve now got derivatives, they’re beginning to bring their intellectual law up, their property law, their legal system – all the necessary implements for a true capitalist market are being put in place right now in China and they are not going to back down.”

This modernization is all happening as the China bears seize on the headlines trumpeting China’s slowing growth.

But they aren’t just ignoring China’s promising investment potential.

There is a much more worrying shift taking place – one that threatens to dethrone King Dollar and reassign the U.S.’s role from a global economic powerhouse to a second-tier currency issuer…

The Chinese Yuan’s Shift to Power

Chinese yuan chart

The dollar has been strong as of late. From its lows in 2008 to its highs in March, the U.S. Dollar Index – a measure of the dollar’s value against six other world currencies – has gained as much as 41.3%.

And what’s more, the 2015 first-quarter U.S. trade deficit was its highest in six-and-a-half years. By all measures, the dollar seems to be on top and its status as reserve currency unchallenged.

But the longer-term picture is a little different.

The majority of the dollar’s value right now is measured against the yen and the euro, two currencies that have been crashing as their central bankers place their feet firmly on the easy money accelerator.

The story behind the U.S. dollar and the Chinese yuan has been much different.

In 2008, the U.S.’s current account deficit, its exports less its imports, was $806.7 billion. In other words, the U.S. imported $806.7 million more than it exported, according to the World Bank. In 2014, that deficit had fallen to $400.3 billion.

For China, it exported $420.5 billion more than it imported in 2008. By 2014, that current account surplus shrank to $182.8 billion.

Additionally, from 2008 to 2014, the U.S. dollar gained nearly 20% against the U.S. dollar index currencies, but collapsed almost 15% against the Chinese yuan.

Part of the reason the U.S. has been able to run up the national debt with impunity (despite a slowing of its growth) while also maintaining massive trade imbalances (the “twin deficits”) is because the U.S. dollar has reserve currency status.

As an illustration of what this has done for the U.S. dollar, here is how an international transaction works with China:

The U.S. will buy goods and services from China. Because of the dollar’s reserve status, it would be buying those goods with dollars. China would receive dollars and the U.S. would receive real assets for which to improve domestic standards of living.

China is then left with dollars. Instead of letting those sit in their reserves, China would buy up U.S. treasuries to get a return on those reserves. That’s essentially what the U.S.’s debt to China is – U.S. dollars that have been recycled through the system. This has all helped a massive debt-fueled expansion of standards of living in the United States. As long as the U.S. wants to spend more than it is making and China has massive dollar reserves, the expansion can continue.

That’s the power of the U.S. dollar. Since all its debts are denominated in dollars and the U.S. is the sole issuer of the dollar, there’s no question of solvency. The U.S. can print as much money as it needs and it can always honor its debt to China and its other creditors.

But let’s say the signals that we are seeing – the U.S. continuing to grow exports and the dollar continuing to weaken against the yuan – are not a fluke. That’s going to alter this paradigm and it’s going to shake the U.S.’s very ability to grow its economy over the long haul.

Too many people look at the U.S.’s current account deficit as $400 billion in lost GDP. But what that $400 billion really signifies is $400 billion that gets shipped abroad then recycled back through the U.S. financial system as foreigners buy U.S. assets with those dollars.

That in turn props up the financial system and helps the U.S. grow, expanding the economy with debt. This is how it has worked for decades, and it’s been a big driver of growth and wealth in the U.S.

But if the Chinese yuan – which, right now, looks like the only true challenge to dollar hegemony as the euro and yen are devalued – claims that role, it’s going to fundamentally change the way the U.S. works. And ultimately, stifle growth.

So, what happens if the dollar loses reserve currency status?

The world could soon be chasing Chinese yuan to settle their international transactions. The U.S. will no longer be able to find as many buyers of its debt, and it won’t be able to continue to run up its credit with no consequence.

This will also inhibit the U.S.’s ability buy goods abroad. The U.S. won’t buy them with dollars that they issue, but instead, they’ll have to convert those dollars into yuan.

And all that international money that was once flowing to Wall Street will instead flood to Shanghai and Shenzhen.

When that begins to happen, the days of debt-fueled expansion will be over, and the U.S. will be facing a long period of sustained, slow growth – upending the financial system as we know it here in the U.S.

The Bottom Line: For all the headlines touting the “slow growth” of China – which is still above 7% – there is a more terrifying shift undergirding it all. China has 1.3 billion people looking to raise their standard of living to the level we in the U.S. have been enjoying since the twin deficit era began in the 1970s. And the best way to do that is for China to unseat the dollar as reserve currency by doing what the U.S. has been doing – namely, buying goods abroad with yuan and having them recycled through the Chinese financial system. China is modernizing its financial system at a rapid pace, and is looking to oblige the demands of the Chinese trying to climb into the middle class. And with the U.S. and the rest of the globe looking to debase its own currency and bolster exports in a misguided currency war, the rest of the world looks all too willing to oblige as well.

Money MorningWritten By Jim Bach From Money Morning

We’re in the midst of the greatest investing boom in almost 60 years. And rest assured – this boom is not about to end anytime soon. You see, the flattening of the world continues to spawn new markets worth trillions of dollars; new customers that measure in the billions; an insatiable global demand for basic resources that’s growing exponentially; and a technological revolution even in the most distant markets on the planet.And Money Morning is here to help investors profit handsomely on this seismic shift in the global economy. In fact, we believe this is where the only real fortunes will be made in the months and years to come.

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