China Takes a Big Step Forward

John Browne
Posted Dec 13, 2015

On November 30th the International Monetary Fund (IMF) announced that it would admit China's Renminbi currency, commonly known as the Yuan, to the select basket of reserve currencies that make up its Special Drawing Rights (SDR's). Having been stalled by U.S. influence for many years, the long-awaited IMF decision acknowledges the massive transfer of financial power from the old West to the new East. The move heralds an era of potentially great change with global implications for politics, economics and investments.

At the end of WWII, the U.S. and British governments persuaded the participants of the Breton Woods Agreement to accept the U.S. dollar as the world's international reserve currency and to simultaneously create the World Bank and the IMF. The aim was to establish a stable, global financial system and to encourage the recovery of international trade. In particular, the role of the IMF was to ensure a smooth flow of foreign exchange and to lend money, when needed, to sovereign nations experiencing temporary balance of payments problems.

For much of the postwar years, the structure succeeded. In the first decades following the War, the value of world trade grew so fast that the demand for currency threatened to outstrip the available amounts of gold and U.S. dollars. The IMF responded in 1969 by creating the Strategic Drawing Rights (SDR) as a supplementary international reserve asset for central banks. Each SDR was valued at 0.888671 grams of fine gold equivalent to one U.S. dollar. (Fact Sheet, SDR, IMF 11/30/15)

When the fixed exchange rate system established by Bretton Woods collapsed in the early 1970s and currencies were exchanged at floating rates, gold was dropped from the SDR's backing and replaced by a combination of the most widely-traded currencies, which became known as the 'SDR basket'.

Most recently, the basket was comprised of five international reserve currencies, including 41.90 percent U.S. dollars, 37.4 percent euros, 11.3 percent pound sterling and 9.4 percent yen. (Fact Sheet, SDR, IMF 11/30/15)

For much of the past ten years, China has sought to gain international recognition commensurate with her growing economic and political power. China lobbied hard for the inclusion of its Renminbi currency in the prestigious SDR basket. However, the U.S. used its 17 percent vote, along with its political influence among allies, to block China on the grounds that its reserves remained undisclosed and its currency was not freely convertible.

In response, China began to liberalize trading in its currency to allow foreign central banks to trade in its government bonds and to begin disclosing its hidden reserves. This was a major political step for the secretive Communist government and a crucial test of President Xi Jinping's efforts to transform the Chinese economy.

These moves were sufficient to gain allies for China in the IMF and admittance to the SDR basket. Referring to China's inclusion, Christine Lagarde, Managing Director of the IMF, has stated, "...It is also a recognition of the progress that the Chinese authorities have made in the past years in reforming China's monetary and financial systems...The continuation and deepening of these efforts will bring about a more robust international monetary and financial system, which, in turn will support the growth and stability of China and the global economy." (IMFSurvey Magazine, 12/1/15)

The new SDR basket will comprise 41.73 percent U.S. dollars, 30.93 percent euros, 10.92 percent Renminbi, 8.33 percent yen and 8.09 percent sterling (Fact Sheet, SDR, IMF 11/30/15). The percentages reflect just an initial recognition of the financial power accumulated in the new East.
Furthermore, China's Renminbi is the first currency of a non-U.S. ally to be admitted to the SDR basket. That alone heralds a new era for monetary affairs. On a parallel track, China has recently succeeded in launching the Asian Infrastructure Investment Bank, a Chinese led multi-billion dollar investment bank that would finance roads, bridges, and other infrastructure projects in the poorer regions of Asia. The bank was widely viewed as a means to counter America's influence in Asia. And while Washington opposed the project, Beijing managed to line up the support of 57 countries, including such key U.S. allies as Britain, Germany, Australia, and South Korea.

It is no secret that China wishes to become first among equals as a superpower. As part of this strategy, it is not unrealistic to assume that China's endgame will be to knock the U.S. dollar off its perch as the International Reserve Currency.

If successful, this could prove a devastating blow to the U.S. As the International Reserve Currency, almost all global commodities are traded in dollars. This confers upon the Federal Reserve the unique privileges of setting the stage for major international interest rates to suit U.S. economic cycles and of creating seemingly unlimited amounts of fiat money from thin air. Rather than yielding meekly to U.S. wishes, China can be expected gradually, but inexorably, to challenge the dollar's Reserve status and today's omnipotent influence of the Federal Reserve. It could herald also a revival of the role of precious metals in the global monetary system.

Even now, with its potential inclusion in the SDR basket, central banks and corporate treasurers will be considering further currency diversification into the Chinese Renminbi. Most likely, this rebalancing will involve selling of U.S. dollars and euros to buy Renminbi. This will be done both to balance risk and because, as China's economic might grows and the dollar's Reserve status is challenged, it is increasingly likely that more commodities will be priced in Renminbi.

It is unlikely that China will wish to upset international trade, and its own export machine, at a time of looming recession. However, over the long term, China may be expected to use its new found financial influence to erode the power of the U.S. dollar. As the world's largest producer, and rumored already to be the world's largest holder of gold, China may push progressively for the reintroduction of a gold link for the SDR, and eventually for its Renminbi, to boost international support for its acceptance as an increasingly credible substitute for the dollar as the world's International Reserve.

Should this happen, perhaps the most important floor supporting the dollar would evaporate, rendering the Federal Reserve unable to continue creating money at will and catapulting U.S. interest rates to levels that potentially could threaten a massive debt and even a currency crisis. Given the unprecedented $18.8 trillion level of U.S. Treasury debt and estimated $100 trillion-plus level of unfunded U.S. Government obligations, according to usdebtclock.org, this would be extremely damaging for the dollar and potentially to the U.S. economy.

The risks of devastation to world trade make it likely that this strategy will take considerable time to become manifest. In the meantime, China may be expected to use the implied threat judiciously to twist the arms of powerful nations.

Despite potentially serious domestic political problems and massive internal debt levels of some $28 trillion, according to McKinsey & Co., China has gained its place in the SDR basket. Only time will tell precisely how China will use this new-found influence. But it could spell the beginning of the end for America's monetary and even military dominance. Such developments could result in a revival of precious metals in monetary affairs. As debt then would become revalued rather than devalued by inflation, such a move could have considerable economic and political implications for national and private debtors in the U.S., Europe and the entire world.

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Dec 10, 2015
John Browne
Senior Market Strategist
Euro Pacific Capital, Inc.
1 800-727-7922