World Reserve Currency: Is The Yuan A Real Challenger To The U.S. Dollar? (UUP, UDN, CYB, FXI)

Jack Crooks: Many commentators who follow the global markets were very excited on the recent announcement that China would “widen the trade band” for its currency.

The People’s Bank of China, China’s central bank, said it would allow the yuan to trade up to 1 percent on either side of a midpoint price it sets every trading day. Previously the currency was allowed to fluctuate 0.5 percent.

Some were so overwhelmed, they pronounced this must be proof positive China is not headed for a hard economic landing, and soon its currency will be replacing the dollar as global reserve currency. That is a bit of hyperbole, to say the least.

If the Chinese currency is going to lift the Chinese economy out of trouble, it will take a lot more than a 1 percent change in the trading band. The country requires a major restructuring of its growth model, to which its currency is only one component; albeit a very important one. The belief that this move is a reflection of the fact the yuan will displace the dollar in the near future seems farcical.

China’s Desire for World Status

I don’t think there is any doubt that China would someday love to attain world reserve currency status with the yuan. And indeed, they have taken some minor steps in the process of internationalizing their currency.

For example, China has established currency swap arrangements with some of its key trading partners, so both countries can bypass the U.S. dollar. It has also allowed a Chinese yuan Hong Kong deposit to be created; it trades freely in Hong Kong. And then there is the widened trading band, which I discussed at the beginning.

These actions, plus their general disgust with being locked into the U.S. dollar reserve system (the U.S. Treasury/Federal Reserve implicit weaker dollar policy means China must pay more for imported commodities as most currencies are priced in dollars), means China would jump at the chance to have an alternative.

Given the dismal status of the global monetary system, China isn’t the only one unhappy with the U.S. dollar as the global reserve currency. But if history is any guide, shifts in the global monetary system take much longer than we expect …

One reason is because they are haphazard. Changes in global monetary status morph, or at least it has been that way historically. All we have to do is watch the G-20 to see how difficult serious, multi-global planning can be …

The handoff from pound Sterling to the U.S. dollar was an unplanned evolving event that accelerated after WWI.

And there was no great planning when President Richard Nixon took us off the gold standard, which ushered in the error of floating rate currencies. The gold was draining out of Fort Knox, something had to be done. Game over. Dirty float for a couple of years, then no pretense whatsoever of anything backing the currencies of the world’s major powers. Just faith in governments to repay!

From that point onward it was clear to all that money was not a store of value, but simply a unit of exchange once it became de-linked from real value.

So it leaves us where we are: Stuck with a global system of money that can be created and destroyed at the whim of governments and central bankers with the U.S. dollar the core of the system.

It’s no wonder many are looking for something better.

But even if the Chinese yuan is something better (I don’t believe it is), let me explore the myth that …

The Chinese Currency Will Soon Replace the Buck

Rather than turn this into a LONG essay, I will break it down into seven bite-size chunks — the reasons why I think the Chinese yuan is a very long way from world reserve currency status.

Reason #1—Size isn’t everything

It is never as simple as “the world reserve currency goes to the country with the largest global GDP.” The U.S. surpassed the U.K. in terms of total GDP back in the 1870s. Yet pound Sterling remained the reserve currency for another 40 years or so.

Reason #2—Wrong growth model

Remember, the world reserve currency country is saddled with a consistent current account deficit. Thus, China must push out trillions of renminbi and renminbi-based assets into the world economy. Fine if your model is open and based on consumption. Not so good if it is driven primarily by exports, as China’s is. So we will need to see a big shift in China’s growth model. That will be a wrenching long-term process.

Reason #3—Lack of free market capitalism

The reserve currency country must open its market to allow foreign investors to hold local assets. This means China will have to make a complete change to its current political structure to allow much more freedoms for citizens (not only allow money to flow in, but allow its citizens money to flow out freely).

The system in place is not something that is likely to change anytime soon despite the window dressing. The communist party still maintains absolute power, even though comments from visitors claim there was free market capitalism during their trip to the Orwellian Hall of Mirrors. It shows just how well the central committee is doing its job.

The West in general is duped by the Chinese leadership. If you want a better insight into this issue, I strongly suggest you read, The Party: The Secret World of China’s Communist Rulers, by Richard McGregor.

The latest scandal regarding the powerful Bo Xiang and the death of a British businessman, highlights the fact the Chinese leadership is less than meets the eye.

Reason #4—The U.S. is becoming wealthier relative to China

Say what? All true. The fact is that the average Chinese citizen is more than $17,000 poorer relative to the average American than he was in 1991. Per capita income for relatively large states is the best single determinant of competitiveness long term. So until this trend changes, it is highly unlikely the U.S. will give up the mantle of currency reserve status.

Reason #5—Low projections

Even optimistic assumptions from those who should know, assuming China’s growth remains on track, suggest by 2035 up to 12 percent of global reserves may be held in yuan. Indeed, a far cry from world reserves status.

Reason #6—China’s debt bomb

Officially, all is good. But unofficially, China may be facing its own debt bomb that could dampen growth for years, not just one or two quarters. Never say never … it happened to Japan.

According to Reuters Breakingviews,

“The government’s official debt is only 15 percent of GDP, but it adds up quickly. Ratings agency Fitch estimates a bailout could cost 20 percent of GDP. Add the unpaid cost of the last bailout, debts at state-owned entities, local governments and pension liabilities, and a Breakingviews calculation suggests Beijing’s debt rises to roughly 130 percent of GDP.”

Reason #7—Offshore deposits may backfire!

The current attempts at internationalization of the yuan seem backwards. Normally a country opens its capital account and upgrades its domestic financial system before attempting to internationalize its currency. Instead China is offering bi-lateral exchange deals with some trade partners, and that gets a lot of press.

But that seems to be mere window dressing as countries are really taking up the credit China is offering. And the developing offshore yuan deposits in Hong Kong may actually backfire, as the unofficial yuan rate in Hong Kong (CNH) is fluctuating around the official rate in China (CNY). This may force China’s central bank to actually hold more dollars.

BUSTED!

China’s decision to widen the trading band on its currency is a step in the right direction. But it doesn’t mean the yuan will be a real challenger to the dollar anytime soon.

So as far as I’m concerned, the myth that the yuan will soon replace the dollar as the world’s reserve currency is clearly busted.

My advice: Don’t get caught up in the hype. It will be a long time before the Chinese currency is allowed to fluctuate much against the U.S. dollar. If you want action in the currency markets, the yuan is not the place to be.

Best wishes,

Related: PowerShares DB US Dollar Index Bullish ETF (NYSEARCA:UUP), PowerShares DB US Dollar Index Bearish ETF (NYSEARCA:UDN),  iShares FTSE China 25 Index Fund (NYSEARCA:FXI), WisdomTree Dreyfus Chinese Yuan (NYSEARCA:CYB).

Written By Jack Crooks From Money And Markets

Money and Markets (MaM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Nilus Mattive, Claus Vogt, Ron Rowland, Michael Larson. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance  returns cited are derived from our best estimates but must be considered  hypothetical in as much as we do not track the actual prices investors  pay or receive. Regular contributors and staff include Andrea Baumwald, John Burke, Marci Campbell,  Selene Ceballo, Amber Dakar, Maryellen Murphy, Jennifer Newman-Amos, Adam   Shafer, Julie Trudeau, Jill Umiker, Leslie Underwood and Michelle Zausnig.

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