Friday, January 7, 2011

New reserve currency: Renminbi-Yuan by Shan Saeed

Chinese Yuan or Renminbi would be one of the currencies where central banks most likely park their funds going forward. Apart from Gold and Silver which are REAL CURRENCIES, Yuan would take a market share in reserves of central banks very quickly.

Make no mistakes, existing global financial system depends on the widespread use of fiat currencies issued by insolvent governments of advance economies. Wealth of the world’s large financial institutions requires that there be currencies with sufficient size and circulation to absorb massive capital flows.

The current system is based primarily on the dollar; with a $14.3 trillion economy, the United States was for years the only country in the world with a sufficient money supply and financial infrastructure to take in the preponderance of the world’s wealth.

It is for this reason commercial loans, commodities contracts like oil payments, international reserves [62% in USD], and cross border settlements have traditionally been denominated in US dollars.

Competing reserve currencies arose with the advent of the euro and Japan’s post-war rise; while the dollar has continued to remain dominant, these three are the only currencies which have the necessary supply and credit rating.

With trillions of dollars floating around the global financial system, managers are constantly making capital allocation decisions or asset allocation in their portfolios, moving funds in and out of various instruments like bonds, commodities, equties and currencies. The reserve currencies play a big role in this because unallocated capital is frequently parked in their bond markets. Bond market is very bearish and sovereign default risk is high as the moment. Yield curves are the perfect predictive of the future growth of economies.

For example, large corporations or banks that are sitting on billions of dollars in cash typically purchase short-term US or European government bonds because the low default risk. But game has changed. Sovereign default risk is going of the roof. New challenge for IMF.

The dollar, euro, and yen have bond markets of such size that getting liquid is never a problem, even for billions of dollars. There is always a market for treasury securities, hence they are considered ‘cash equivalents’.

You couldn’t execute the same thing in the Kingdom of Bhutan with its tiny $3.7 billion economy. If you tried to move $100 million into Bhutan, its currency [the ngultrum] would spike. In the US, Europe, and Japan, $100 million barely registers a blip.

Over the last few years, though, the confidence has begun to fade quickly, and the reserve currency issuing governments are starting to be viewed with increasing skepticism.

The thing that’s missing right now is an acceptable alternative. There’s really nothing out there in large enough scale to withstand massive capital flows, and as I have written before, the game is now one of judging the ‘least worst’ of these three major currencies.

In what seems to be a 6-month cycle, the dollar and euro have been jockeying for the ‘worst of the worst’ title; markets focus on Greek woes for a few months, Ireland, Spain is coming soon, then turn their attention back to California and Obamanomics. Spain/Italy/Portugal/Belgium/France are all in the line of fire. Fiscal mismanagment and Budegt deficits are all messed up in these countries. Euro single currency would be a toast for the next 6-months ending on 30 June 2011. While Dollar would be a toast for the remaining part of the year ending on December 31, 2011. US dollar would losr 9-10% of its value against Pound Sterling, Yen, Canadian Dollar and Euro

With Bernanke’s “100% certainty” and nonsensical economic numbers coming out of the America’s Media and Press, it seems to be back in a period where the markets are more concerned with Europe. I think that Japan will be called to the carpet before too long as well.

As such, in an almost ritualistic cycle, financial markets are shifting funds around these currencies… the analogy I like to think of is like a series of buckets.

Imagine three buckets and an increasing volume of water. Capital allocators are essentially dumping the contents of one pail into another– from the dollar bucket into the euro and yen bucket, and from the euro bucket back into the dollar bucket.

Each time this happens, though, a little bit of water spills out into smaller buckets– Gold, Silver, Switzerland, Norway, Canada, Chile, Australia, etc.

All throughout, central bankers are standing there keeping the spigot at full blast, pumping more water into the system while bankers desperately try to find the least leaky balance.

What’s required is a new bucket that bankers view as strong, sturdy, and large enough to handle the volume. The most likely candidate is the Chinese renminbi… but not yet.

China’s economy is set to be the largest in the world in a matter of years in 5 years time, and it has the money supply to match. While its economic and monetary fundamentals are far, far from perfect, China is arguably in a much better financial position than the west.

It’s going to take several years for the renminbi to overtake the dollar, euro, and yen as a serious contender for the world’s main reserve currency… but it can happen. The major roadblock is that China’s renminbi is not free-floating– the government has imposed severe exchange controls. Capital controls are the big impediment.

I’ve written before that we are seeing the early signs of relaxing controls. China doesn’t do anything overnight, and I think there is a strategic / long-term plan in place that Chinese leadership is working upon. I admire Chinese leadership and its strategic economic insight.

We have already seen China agree with other sovereign nations to introduce currency swap arrangements, so there are now several countries holding renminbi. Furthermore, the Hong Kong gold exchange recently announced its plans to launch a new gold contract denominated in renminbi.

To be clear, China already has its own gold exchange, but having one in Hong Kong opens up renminbi-denominated gold contracts to the entire world since Hong Kong has no exchange controls. Shanghai Gold Exchange was set up in 2001 and one of the busiest exchange centres around the world. PBC [ the chinese central bank] has allowed 5 banks to make Gold and Silver related transactions for clients.

On that note, the mainland authorized Hong Kong’s banks to establish cross-border settlement accounts in renminbi last year, effectively providing a way for people to open a renminbi bank account. In fact, we have one.

Each of these measures to reduce exchange controls is one step closer to the renminbi being introduced as a global reserve currency.

Perhaps the most obvious step, though, came in just the last few days. Beijing has already allowed several multinational companies like McDonald’s and Caterpillar to issue renminbi denominated bonds. Now the World Bank, that unfortunate staple of the financial system, is issuing its own two-year renminbi bond. Chinese government has started doing trade with Malaysia, South Korea, Russia and Indonesia in Yuan related transacations. All reported in big press.

This is a big deal… and I think that we’re going to continue to see bigger and bigger steps like this taken throughout 2011 and in the coming years.

China’s government has been very clear that by 2020, it wants Shanghai to be a leading global financial center… and Chinese policymakers know that for Shanghai to be a financial center, the renminbi must be freely convertible. The deadline is all set to be followed. If you haven’t started making decisions to preserve your capital, I strongly urge you to start now. Ponder upon Chinese Yuan in the evening

Disclaimer: This is just a research piece and not an investment advice. Investors are strongly encouraged to execute their own due diligence before making any investment or strategic asset allocation of their portfolios.

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