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Monday, October 13, 2014 1:38 PM

End of U.S. Dollar Hegemony - Not

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Is the end of US dollar hegemony at hand?

Inquiring minds may be asking that question given China’s Zhou Says Some Countries Using Yuan in Reserves.

Some countries are already using the Chinese yuan in their foreign-currency reserves without announcing it publicly, central bank governor Zhou Xiaochuan said.

While China’s yuan has begun to be used as a reserve currency for several years, some countries “may not be willing to say so,” Zhou told Bloomberg on the sidelines of the International Monetary Fund meetings in Washington.

China has stepped up efforts to promote the yuan’s use overseas since the global financial crisis, as expansion in the world’s second-largest economy provides more clout while Europe has yet to fully recover. The European Central Bank will discuss next week whether to begin laying the groundwork to add the Chinese yuan to its foreign-currency reserves, Bloomberg reported yesterday.
Over the course of the past decade there has been countless articles on the end of US dollar supremacy, the crash of the dollar, and the rise of the Yuan and Ruble.

Recent Examples

Prime Petrodollar Nonsense

The most ludicrous of the above articles is by Clive Maund on Kitco. It's a perfect example of misguided, overblown, petrodollar hype.

The central thesis of these articles is

  1. It takes dollars to buy oil
  2. Oil is starting to trade in yuan and rubles
  3. Oil will start trading in other currencies
  4. Collapse of the dollar is at hand
  5. Yuan will soon supplant the Dollar as world's reserve currency

The starting thesis that it takes dollars to buy oil is wrong.

As I have pointed out for at least a decade, it does not take dollars to buy oil any more than it takes dollars to buy gold.

Gold is priced in dollars. But you can walk into any coin store in the UK and buy gold with British Pounds; You can walk into any coin store in China and buy gold in Renminbi (yuan); And you can walk into any coin store in France and buy gold with euros.

Oil is priced in dollars. So what? Currencies are fungible. Even if one did need dollars to buy oil (they don't), the pound, Swiss francs, euros, and every other major currency on the planet can instantaneously be exchanged for any other currency at will.

That holds true at both the front and back end. Thus, there is no need for Saudi Arabia (or any other oil exporter) to demand euros, or francs, or whatever, when the exporters can instantaneously convert to whatever freely traded currency they want.

Regardless of the pricing unit, one does not need to stockpile dollars to buy oil. If oil was priced in euros across the board right now, it would not make a damn bit of difference.

Questions for Yuan Lovers

Please note that in spite of all the yuan reserve currency hype, one currency that is not freely convertible is the Yuan.

When will China have the biggest, most open bond market in the world? Next year? A decade? three decades?

I ask these questions because until China has the biggest, most open bond market, a freely floating currency, and it eliminates currency controls, there is no chance the Yuan will supplant the dollar.

And what about political freedoms and global trust? Will a centrally planned undemocratic economy like China ever get that trust?

Petrodollar Silliness Way Back

I talked about the silliness of the petrodollar thesis as early as 2005. (See Oil Priced in Euros. Would it matter?)

In 2009, we saw Ridiculous Hype Over Secret Oil Meetings.

For discussion of another truly ridiculous idea, please consider Countdown To Dollar Implosion Madness in which the dollar was supposed to collapse in favor of a "Super Sovereign Currency" demanded by China. 

Such stories have continued at an endless pace for over a decade.

I bring this all up because of an interesting email from Michael Pettis at China Financial Markets.

Pettis on Chinese Reform, Currency, and Interest Rate Deregulation

In his email, Pettis writes about China's reform, China's banking solvency, currency controls, and other topics related to possibility the yuan will become the next reserve currency.

From Michael Pettis (emphasis mine)... 
Recent rumors that Zhou Xiaochuan will retire as governor of the PBoC should not be interpreted as an indication that Beijing has changed its mind about the urgency of reform. Given Zhou’s age, it was unlikely that he would remain in his seat for very long, and in fact if these rumors are true, they may simply reflect recognition by Beijing that as the reforms are implemented, conditions are likely to become tougher. Replacing Zhou at a later date would then be more damaging then replacing him now.

Contrary to some of the speculation, if Zhou retires soon I don’t think it would imply that there has been a change in policy or policy objectives. Zhou has always been considered as one of the most determined and articulate of the reformers, warning about the perils of excess credit expansion as long ago as 2006-07.

The kinds of reforms that Zhou is believed consistently to have championed are pretty much the liberalizing reforms that will open the Chinese economy up to a far more efficient and productive use of domestic resources.

Currency and Interest Rate Deregulation

Zhou is also considered to be one of the main supporters of systematic efforts to speed up the internationalization of the RMB, the political implications of which are a little murkier. A relaxation of currency controls of course makes it easier for capital to flow into and out of the country, which benefits wealthy individuals eager either to stash money abroad or to bring in outside money quickly to take advantage of domestic profit opportunities, but I am not sure how aware people outside of monetary circles are that removing capital controls is an extremely risky strategy.

China has a rigid, unsophisticated, and largely insolvent financial system with vague delineations between what is and what isn’t implicitly guaranteed by local governments or by Beijing. Managers have little experience of risk management. An elimination of capital controls and a significant increase in the use of the RMB in international trade and capital flows (currently it is a little more actively traded than the Mexican peso, and its use over the past two years has grown slightly faster) could subject the banking system, especially given the uncertainty that surrounds the Chinese economy, to shifts in capital flows.

I don’t think China’s banking system can handle the risk, especially of large inflows followed by sudden massive outflows. These could easily destabilize the Chinese economy at a time when it is most vulnerable. I have heard some analysts, both Chinese and foreign, argue that this kind of risk can be managed by the simple expedient of restoring capital controls as soon as there is a problem, as Malaysia did in response to the 1997 crisis, but it isn’t quite as easy as all that. Regulators are always eager to try to calm markets down whenever a rise in uncertainty threatens to become destabilizing, and to impose capital controls during a period of uncertainty is almost guaranteed to increase the uncertainty substantially. At any rate, during the nearly thirteen years I have lived in China, the elimination of capital controls was always something to be expected within the next five years, and I personally never believed then, nor do I believe now, that we were or are likely to see significant relaxation of capital controls anytime in the foreseeable future.

There have been rumors that Governor Zhou understands this risk, but had nonetheless pressed forward on the issue of currency deregulation largely because, frustrated by the slow pace of financial sector liberalization, he saw this as a way of exerting pressure on the pace of domestic reform. In that case if he were indeed to retire very soon, the timetable for RMB internationalization, such as it is, would probably be pushed back.

Because he had also personally committed very strongly to interest rate liberalization within two years, which, unlike currency deregulation, I believe is an important goal and a plausible timetable, there is a chance that if he does indeed retire soon, the next governor might not feel the same commitment to maintain the schedule. In that case over the next two years, during which time I expect nominal GDP growth to drop by at least 2-3%, pressure by powerful vested interests for whom access to cheap capital was their primary economic advantage might cause the PBoC postpone interest rate deregulation and perhaps even to lower interest rates.

If Zhou leaves, the goal of weaning SOEs and local governments off their addiction to credit would remain, but the cries of pain would be heard a little more sympathetically. Policy objectives, in other words, are unlikely to be changed if Governor Zhou were to retire, but the timing of the reforms might be extended, especially of those reforms to which Zhou had a personal commitment. Zhou had a prestige both domestically and internationally that will be hard to match, and he probably would have found it easier than his replacement to press his views on the president and the premier.

China is slowly moving in the right direction and inevitably the long delay it allowed before rebalancing the economy means that the process will be very difficult and bumpy. There will be steps forward followed by steps backward, as Beijing balances one group against another, but I don’t think we should read too much into events yet. It will take at least another six months to one year before we can say for sure whether or not Beijing has consolidated power enough to rebalance the economy successfully. Until then, we need to be patient. Each step backwards does not mean the end of the reform process.
Hype vs. Reality

For all the hype, the Yuan trades as actively as the Mexican Peso. Yes, this will change, s.l.o.w.l.y.

Right now, the US Has ...

  • The largest, freest capital market in the world. 
  • The largest bond market in the world. 
  • A freely floating currency.
  • Political freedom.
  • Strong property laws.
  • Democratic form of government.

Trade Math

By the way, it's important to note that foreign governments accumulate US dollars as a function of math.

For example, the US runs a trade deficit with China. China must accumulate US dollars (or US dollar assets such as US treasuries). Those who argue otherwise, do not understand the trade mechanics.

Sure, there will be more trading in currencies other than the dollar over time. But the idea that the yuan will soon rein supreme is complete silliness.

All Things End

All things come to an end, including US dollar supremacy. Yet, don't expect a miraculous rise of the yuan or anything related to the seriously misguided petrodollar and petroyuan theories.

As Pettis points out "China has a rigid, unsophisticated, and largely insolvent financial system with vague delineations between what is and what isn’t implicitly guaranteed by local governments or by Beijing."

Currency Crisis Awaits

China is indeed "largely insolvent" to phrase things politely. But, it's not just China. The entire global financial system is insolvent.

A global currency crisis can start anywhere, at any time. Three likely places to look are the euro, the yen, and the yuan.

In baseball parlance, Euroland is the batter's box and Japan is on deck.

If a global currency crisis does start soon, then gold, the much maligned US dollar, and US treasuries will likely be the beneficiaries, not the illiquid yuan.

Precisely what the next currency system will look like is unknown. But if the system changes in a major way, neither the yuan nor the US dollar will be at the heart of it.

Mike "Mish" Shedlock

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