Currency Of The Month: Chinese Renminbi – The Next Global Reserve Currency

I will admit some trepidation in beginning this morning’s commentary with such an audacious title, but long-time readers of the Daily Pfennig® newsletter should be neither surprised at my confidence in making such a statement, nor shocked that I would pull no punches in sharing my views on a topic as particular to me as the outlook for the Chinese currency, the renminbi.

In late 2008 and early 2009, the Chinese government began signing bilateral currency swap agreements with a number of trading partners, including South Korea, Hong Kong, Belarus and Indonesia.1 These currency swap agreements essentially provided a medium of exchange directly between the two respective countries, removing the U.S. dollar from the terms of trade. Shortly thereafter, I authored a letter for a Sovereign Society publication espousing alarm over China’s decision to sign a similar bilateral currency swap agreement with Argentina, China’s first such venture outside its immediate trading area. The significance of this particular currency swap agreement, as I wrote at the time, was that the Chinese government had officially launched its initial salvo against the reign of the U.S. dollar as the world’s reserve currency.

Since that time, the People’s Bank of China (PBOC) has entered into 30 bilateral swap agreements with trading relationships across the globe, including some pretty heavy economic hitters joining the ranks under bilateral currency swap agreements with China (Figure #1). I also made a presentation at a February 2010 conference stating that it was my opinion that the days of the U.S. dollar remaining as the world’s primary reserve currency would end by the close of this decade. With five years remaining in the decade, and based on the progress the Chinese government has made thus far over the last five years, this forewarning may yet prove to be conservative.

Source: EverBank Research Team, based on analysis of publicly available data from the Harvard Dataverse Network, People’s Bank of China.

Chinese economic liberalization initiatives are certainly not limited to the currency markets. In November 2014, the Chinese government launched a pilot program linking equity markets in Shanghai and Hong Kong, allowing investors the ability to trade directly across the Chinese border in renminbi-denominated stocks, and representing “one of the most significant liberalizations of China’s capital markets in years.”2 Similarly, China has expanded access to its domestic bond market with the May 2015 approval of an additional 30 large foreign institutions permitted to invest directly in the country’s $5.9 trillion domestic bond market.3

Moreover, the PBOC has formally requested renminbi inclusion in the International Monetary Fund’s (IMF) Special Drawing Rights (SDR) reserve basket of currencies,4 an international reserve asset held by the IMF to supplement member countries’ official reserves.5 At present, the four reserve currencies included in the SDR basket are the Euro, Japanese yen, British pound sterling and U.S. dollar. Suffice it to say, the Chinese government has the renminbi on a defined and concentrated path to join the ranks as a world reserve currency.

China Economic Overview
So why the “sudden” push for the Chinese government to open its capital markets, enter into bilateral currency swap agreements, and challenge the U.S. dollar on its leadership position as the global reserve currency? The situation reminds me of the old financing adage: You should buy assets that appreciate and lease assets that depreciate. The PBOC appears ready to begin leasing U.S. dollars! Quite simply, the PBOC may be weary of holding U.S. dollar reserves in order to conduct global trade, given the manner in which U.S. bureaucrats and monetary officials have been managing internal finances.

The Chinese government certainly seems to feel confident that the time has come for the renminbi to take a leadership role on the reserve currency stage, and with good reason. The Chinese economy is now the largest economy in the world, passing the United States at the end of 2014 based on IMF estimates.6 China is also the world’s largest exporting economy, trading $2.3 trillion in merchandise exports relative to U.S. exports of $1.6 trillion.7 Gross national savings in China now represent 49.5% of Chinese gross domestic product (GDP), compared with U.S. savings at just 17.3% of GDP.8

China surpassed the United States in terms of manufacturing in 2010, and is now the world’s largest manufacturing nation with nearly $3 trillion in annual production output, compared with roughly $2.4 trillion in U.S. output.9 In fact, one-in-four automobiles sold worldwide are now manufactured in China.10 The Chinese economy is also the world leader in gross value of agricultural output for rice, wheat, potatoes, corn, peanuts, tea, millet, barley, apples, cotton, oilseed, pork and fish.11 Based on Organisation for Economic Co-operation and Development estimates, the Chinese government provided farmers $165 billion in agricultural subsidies (2012 estimate), relative to Japan’s $65 billion and the United States’ $30 billion in agricultural subsidies.12

By acquiring nearly $4 trillion in reserves of foreign exchange and gold,13 guess where China ranks in terms of global reserves? You got it: No.1. China is also the world’s largest producer of gold,14 more than twice the production in the U.S., and is also now the world’s largest importer of gold placing the country ahead of India.15

Of course, the Chinese economy is not performing without challenges. Some observers contend that the renminbi may be at risk due to the Chinese economy slowing lately. However, prior to the current era of monetary intervention, economies would naturally cycle through periods of expansion and contraction. Moreover, the financial law of large numbers contends that large entities growing rapidly cannot maintain high growth rates in perpetuity.

Critics also point to recent accumulations in local Chinese government debt, but as I pointed out in a recent Daily Pfennig® article, it makes perfect sense for a government to accumulate debt in a low interest rate environment. The difference, however, between China’s debt accumulation and the U.S. debt accumulation is first, China has been investing in infrastructure with presumably positive investment returns, and second, the Chinese government has $4 trillion in reserves to help offset this increase in debt, as needed.

Outlook For The Chinese Renminbi
In analyzing the progression toward a free floating and tradable renminbi, I would expect the sequence of events to unfold as follows: China continues to open its capital markets to foreign investment. Investors provide additional liquidity to the Chinese economy through bond purchasing. The IMF accepts the renminbi as one of its reserve currencies in the SDR – which, coincidentally, is rebalanced at the end of 2015 – under the condition that the PBOC eliminates the renminbi peg to its current basket of currencies. Then the renminbi becomes a floating currency, and the Chinese government subsequently allocates a percentage of its massive gold reserves (and other hard assets) as backing to the outstanding currency float. Under this type of scenario, the renminbi may have a real opportunity to become one of the most attractive major currencies in the world relative to its fiat currency contemporaries.

Furthermore, if the renminbi is successful in becoming a reserve currency in the IMF’s SDR reserve basket, the IMF will be required to purchase an estimated $1 trillion in renminbi for the SDR holdings,16 also potentially driving up the value of the renminbi, assuming the currency is floating at that point. Clearly, it could be an interesting environment for the renminbi.

On an interrelated point, a fully floating renminbi could have far-reaching consequences for the U.S. dollar, particularly if or when the renminbi eventually assumes a position as a global reserve currency. Once global trading partners are no longer required to trade exclusively in dollars, countries will similarly be released from requirements of holding massive amounts of dollars in reserve, and eventually, the dollar could get sold. Could this be the Minsky moment that would place the U.S. in the same predicament that Britain found itself after losing its reserve currency status? Time will certainly tell. However, in this given scenario, U.S.-based asset values and interest rates could potentially be in for a tough run if this were to unfold.

Before I end this edition of the Daily Pfennig® newsletter, I want to emphasize to all of our loyal readers that this view is my personal take on how things could unfold for the Chinese renminbi and the U.S. dollar. Obviously, in today’s dynamic world, any number of scenarios is possible, which means I could completely miss the mark. But, to me, there just doesn’t seem to be much left in the tank, and you can count on us to keep a close eye on future events. Time will tell if I’m right or wrong.

Until the next Daily Pfennig® edition…

Chuck Butler
Managing Director
EverBank Global Markets Group