Is the U.S. Helping the Chinese Yuan?

There has been much talk over the last decade that the Chinese currency — the yuan — may become recognized as a global currency. Some have even gone so far to say that the yuan could one day replace the U.S. dollar as the world’s reserve currency.

Some of this talk has faded over the last couple of years due to the strength of the U.S. dollar. And with the Chinese stock bubble bursting a few months ago, expectations are down further for the Chinese currency.

While the U.S. dollar could certainly lose its status as the world’s reserve currency one day, I have been highly critical of the argument that the yuan would take its place. It is not a freely floating currency. It cannot be easily traded on open markets. This fact alone keeps it from competing.

My thoughts were confirmed this past summer with the implosion of the Chinese stock bubble. It wasn’t the falling stock prices that convinced me but the Chinese government’s reaction to it.

The Chinese government is still labeled as a communist government, even if in name only. Over the last three decades, it has tilted towards more free market policies, and the people have certainly benefitted from it as compared to communism.

Still, the Chinese bureaucrats are a bunch of central planners who want to keep a tight thumb over the Chinese economy. When stocks began plummeting, they instituted authoritarian rules that you would expect coming out of a third-world dictatorship.

The Chinese government prevented short selling. It prevented major shareholders from selling. It allowed almost half of the companies to halt trading for a while. It helped and encouraged stock buying. In other words, maybe they are just a bunch of old-school communists, at least when the going gets tough.

Despite the heavy central planning, the Chinese bureaucrats still seek a place on the world stage. While they haven’t been explicit about trying to replace the dollar as the world’s reserve currency, they have been seeking a status for the yuan as a global currency.

The Chinese government is trying to get the yuan included as part of the International Monetary Fund’s basket of currencies called the Special Drawing Rights (SDRs).

According to the last review at the end of 2010, the allocation of the SDRs consists of 41.9% in U.S. dollars, 37.4% in euros, 11.3% in pounds sterling, and 9.4% in Japanese yen.

Some Unexpected Support for the Yuan

While the Chinese seek to have the IMF include the yuan in its basket of currencies, it seems more of a fantasy, at least until the Chinese make it a freely traded currency.

Based on the yuan’s closed market, along with the draconian moves of devaluation and heavy-handed stock market interventionism, I thought the yuan had virtually no chance of being considered by the IMF as part of its SDRs. But I may have miscalculated one key player: the U.S. government.

Last week, President Obama met with Chinese President Xi Jinping in Washington, D.C. The White House issued a statement indicating U.S. support for the inclusion of the yuan “in the SDR basket provided the currency meets the IMF’s existing criteria in its SDR review.”

Now, maybe Obama was just playing nice with the Chinese president and trying to be diplomatic. It is not hard-core support for the yuan, but it is a generally favorable statement. But why on earth would the Obama administration even go out of its way to say favorable things about the yuan?

It seems to be fashionable these days for politicians to blame everyone but the actual U.S. government for problems happening inside the U.S. They will blame immigrants, terrorists, the Chinese, the Russians, cheap overseas labor, and everything else you can think of.

The problem is that this is just playing to crowds. I’m not saying it is all insincere propaganda, but the president has to live in a different world than those campaigning for office. Obama knows this as well as anyone, as many of his campaign promises went out the window as soon as he was in office.

We’ll see if this leads to anything, but the Obama administration at least seems to be lukewarm at this point in the IMF’s acceptance of the yuan as part of the SDRs.

But why would Obama do this? It is easy to make fun of Obama and say that he is a pushover, but I think we have to dig a little deeper here.

The Chinese Ace in the Hole

This whole thing might easily be explained by a few statements Secretary of State John Kerry has made.

When John Kerry was going around defending the Iran deal, he mentioned a few times that the U.S. should not isolate itself from its allies in the world. He said that if the U.S. rejects the Iran deal, the U.S. dollar will cease to be the reserve currency of the world.

Now, maybe this was an exaggeration. Maybe Kerry said this in an attempt to get support for the administration in agreeing to the deal. But it is kind of an odd argument for the Secretary of State to be making.

I believe Kerry may have been somewhat telling the truth in this. It isn’t so much that the Iran deal will make or break the U.S. dollar — it is more a fact that the administration and other insiders are genuinely concerned about the U.S. dollar losing its reserve status.

Having the dollar as the world’s reserve currency has been a huge subsidy to both Americans and American politicians. For American consumers, it helps keep prices down.

For the U.S. establishment, it means the Fed is able to create more money out of thin air with fewer obvious consequences, and it also means the U.S. government is able to spend more than it otherwise would.

Because of U.S. dollar dominance, it is also part of the reason dollars are held by central banks as part of their reserves. Japan owns almost $1.2 trillion in U.S. Treasuries. China owns over $1.2 trillion.

However, when the Chinese recently announced the devaluation of the yuan, the Chinese central bank ended up having to support the yuan by selling off some of its foreign reserves. In July, China had already reduced its holdings of U.S. debt by just over $30 billion. We don’t know if this is a trend, but the U.S. government certainly doesn’t want it to become one.

Mutual Assured Destruction

During the Cold War, we had this notion of mutual assured destruction. All the nuclear powers still have it to some degree today. The hope is that neither side will use nuclear weapons due to self-preservation. If one side nukes the other side, it can expect the same thing back.

We are now in a game of mutual assured financial destruction. Neither side wants to push the envelope too much.

The U.S. obviously still holds a lot of power both financially and militarily. Still, the U.S. is vulnerable, especially as it relates to the status of the U.S. dollar, along with all of the debt that is held by foreign central banks.

The U.S. government could default on its debt, but it is highly unlikely to do so anytime soon. This would mean an abrupt end to the U.S. dollar as the world’s reserve currency.

The Chinese could start an avalanche of dumping U.S. Treasuries, but they really don’t want to go there, either. The Chinese bureaucrats depend on U.S. trade. In addition, if they started selling their U.S. debt quickly, they would be effectively devaluing their own holdings.

If the Chinese have any plans to dump a lot of U.S. debt, it would be much smarter to do it slowly.

The latest indications from the Obama administration are likely just an attempt to keep the waters calm. Neither side wants to do anything that is going to really anger the other.

At this point, there probably isn’t a great chance that the yuan will be included by the IMF. I still believe it will have to be freely traded first. If the Chinese allow this to happen, we should view it as good news. Anything that makes China a little more of a free market should be seen as a positive.

In the meantime, you don’t have to worry about the U.S. dollar losing its status to another currency. If anything, the world is starting to realize that it doesn’t really need a reserve currency. Countries can just trade in their own currencies.

Or maybe they will figure out that they can use gold and silver, which have been around a lot longer than the U.S. dollar.

Until next time,

Geoffrey Pike for Wealth Daily