Thursday, July 14, 2022

THE DEBACLE OF USD OR YUAN AS WORLD RESERVE CURRENCY

Renmenbi as a world reserve currency depends on the willingness of both the private and public sectors to use it in international transactions as well as the CCP's desire to take on this role. The push factor away from the dominant role of USD has been due to the burgeoning US national debt and massive money printing by the Fed since 2007. The coup de grace is the Biden admin weaponising the dollar for foreign policy objectives apparent in the Russo-Ukraine conflict. It is a new paradigm that has increased political risk to a country's reserve holdings. This has taken on some urgency with the bi-polarisation going on in the world. Whilst there has been clamour for a new world reserve currency for decades, the USD's position has hardly been realistically challenged for 2 main reasons. (1) is something known as network externality. (2) is the lack of a real alternative currency.

Network externality is the phenomenon by which the value or utility a user derives from a good or service depends on the number of users of compatible products. In simple English, the more the merrier. Many begrudge the USD, but since many use it as reserve currency, the push factor is weak. A good illustration is what happened with the 'Nixon shock' in 1973. The world monetary system then was based on USD backed by gold at US$35/troy oz, and all other currencies pegged to USD. US promised gold convertibility. Over time, there was not enough US gold reserves to support the creation of massive USD necessary for rebuilding the world after WWII. US reneged on gold convertibility and Bretton Woods agreement collapsed. Countries distrusted the US, yet the world continued to use USD as the reserve currency even though it had become 100% fiat, backed by nothing. The reason was because there was network externality

The second reason, lack of alternative, is really an extension of the first reason. Everyone's using the USD, no one is gong to use the Mongolian togrog, for example.

What is a reserve currency? It is simply a foreign liquid asset that a country's central bank holds, (often in cash deposits or other government securities) as a reserve. In the event of a credit squeeze and the country runs out of that currency, the central bank can provide the liquidity for their economic activities. The reserves of course, can only support liquidity for only a few months. It follows that countries will maintain reserves in the currencies their economies deal with. To this extent, several major currencies currently are world reserve currencies such as USD, EUR, Yen, GBP, AUD, CHF, CAD and CNY. In 2020, US was uno numero with 59% of world reserves in USD, EUR 2nd at 24%, CNY a distant 5th at a tiny 2.8%.

The Renmenbi is quite widely used in neighbouring countries of China, and the Belt and Road Initiative countries, even accepted for retail transactions. Countries that do international trade with China perhaps use some Renmenbi. But between countries of other trade blocks, like Americas-Europe, ME-Americas, EU-Asia Pacific, North-South countries, etc, all these have nothing to do with Renmenbi. The highest traded pairs of currencies in 2020 were EUR-USD (28%), USD-Yen (13%), GBP-USD (13%), USD-AUD (6%). The CNY was not even within the top 28 list. To claim that CNY will be the world reserve currency in the foreseeable future is a little far-fetched at this juncture. At best, in the distant future, Renmenbi could expand its reserve currency role to 17% based on its 2019 GDP of US$15b to world GDP of US$88b. That would be fair speculation.

It is fashionable nowadays to pile it up against the USD. Before we criticise the USD, and more importantly before we wish upon the Chinese to internationalise the CNY, we need to understand the fate that lies in store for any world reserve currency. The eventual collapse of the USD was foreseen by John Maynard Keynes who understood that no national currency can play the role of world reserve currency. He had proposed a one world central bank currency he called 'bancor'. In 1959 a Dutch economist Robert Triffin, had famously explained Bretten Woods, an international agreement which used USD as reserve currency, would collapse, and it did in 1971. His theory became known as the Triffin Dilemma. The Triffin Dilemma explains USD, as world reserve currency, is trapped in a death spiral that has taken 50 years to manifest.

What is Triffin Dilemma all about? Any country whose currency is used as the world reserve currency is conflicted in its domestic monetary policies and world economic well being. What is good for the country may not be good for the world, and vice versa. For the bigger good of the whole world, that country sometimes has to subjugate its own monetary sovereignty. With USD as the world reserve currency, the US has to provide liquidity not just for its domestic economy, but for the whole world. In 2019 the US GDP was US$24T and world GDP was US$88T. We are talking humongous numbers. That means US has to ensure outflow of its own currency to the world.

In my 2 earlier blogs "Are Singapore and China guilty of currency manipulation?' (Here and here) I showed that when a country has a Current Account Deficit in its Balance of Payments, ie a trade deficit, it has to sell more of its currency for foreign currencies to pay for net imports, thus their exchange rate goes down as there is a net cash outflow. The US is an exception. Because the USD is world reserve currency and most goods and services are priced in USD, the trade deficit does not lower the value of USD. Nevertheless, just like all countries having a trade deficit, the US experiences outflow of funds when it has a trade deficit. In order to provide cash outflows, US must continue to spend the currency into existence like crazy. Thus it pursues aggressive deficit budgets. It has to raise capital fast to spend into the world economy. Thus it borrows like crazy via Treasury bonds. As a borrower, the US would want their cost of funds to be as low as possible. And because USD is world reserve currency, there is huge demand for it which drives its value (exchange rate) up and interest rates low. For the countries that build up their USD reserves, they need to park it in very liquid dollar assets. There is nothing better than US Treasury bonds, where asset values keep appreciating. And so the game goes on and on and on for decades.

So the US maintains Current Account deficit in order to generate outflows of currency into the world economy. This resulted in budget deficit and huge debts and loss of confidence in the USD. To gain confidence in the currency, the US must work towards a trade surplus. Herein lies the Triffin Dilemma - the US cannot have a deficit and a surplus in its Current Account at the same time.

Here's why the US, and any country whose currency is used as world reserve country, will be entrapped in a spiral of death. The outcome for the high value USD (because it is in demand as reserves) is US businesses relocate to countries with cheaper operating costs. Jobs cannot not be protected and production gets hollowed out. This predictable outcome has already happened. With loss of jobs and production capacity, this leads to the inabilty to service the huge debts necessary to spend budget deficits that provide USD liquidity outflows to the world. Again, this has happened with the US sitting on US$37T national debt. Which then leads to money printing. And again, this has happened which the US has done spectacularly since 2007. Federal Reserves QE were massive printing exercises which leads to serious inflation and devaluation. Massive inflation for US is inevitable. But for various reasons, its self-inflicted inflation had been delayed for many years. For years there had been asset inflation (housing, bond, equity, crypto markets), but the real economy had been spared. Up to now. Reality has finally caught up with this current global inflation which is going to ignite the innate inflationary pressures that has been in their economy for 2 decades.

Read: How a Federal Reserves Bank cheats with creative accounting. See the massive build up of balance sheet via money printing
The views of the Chinese and progressives all over the world, fed-up with the mess the Americans have got us into, and dead wary of the weaponisation of the USD in foreign policies by the West, feel strongly a change is coming. By virtue of China's dominant economy which will soon overtake the US, the CNY should replace the dollar as world reserve currency.

CCP's concern was first raised in 2008 in the aftermath of the global financial crisis. PBOC governor at the time, Zhou Xiaochuan called for establishing an international reserve currency “disconnected from economic conditions and sovereign interests of any single country.” Since the world has taken no interest in this direction, China has taken to internationalising the CNY. The more the world uses CNY, the lesser the risks for China in international trade. The objective is basically self-preservation. With the massive money printing by all western central banks after 2007, China's massive foreign reserves are eaten away by devaluation of these currencies.

China has made various moves to promote the CNY internationalisation policy, such as the Dimsum bonds (allowing CNY-denominated bonds offshore), establish Renmenbi hubs in various financial capitals where offshore CNY deposits are allowed, appointing CNY clearing banks in some capitals, implementing the CIPS (Cross-border Interbank Payment System) as an alternate to SWIFT payment system, promoting the use of CNY in economic blocks such as BRICS and Belt & Road Initiative countries, use CNY in oil purchase programmes, currency swap arrangements with a few countries under the Chiang Mei Initiative in 2000, etc.

The CNY is coming from an extremely low base. There is no significant volume in CNY pair in forex trades. One would have thought with its dominance in world trade, the use of the Remenbi would have taken on a much higher role. The hill to climb here is the 'network externality' mentioned above. The Ukraine war has given the CNY some impetus, but it's still a very very long way to go.

The biggest stumbling block is China's reluctance to free up Capital Account controls. It has relaxed in many aspects, having ticked off many items in the checklist of IMF's requirements for an open capital account. But many instances of capital flows still require official permission. It is the old Communist control mentality the CCP cannot shake off. This remains the major roadblock to the internationalisation of CNY. One simply cannot have a world reserve currency that is subject to capital controls. China needs to completely liberalise capital flows, but they won't. Basically China wants to have their cake and eat it too.

Those who feel CNY will replace USD as the world reserve currency are misplaced if their persuasion lies solely on the basis of China's dominant GDP. They feel China has the same, and if not, more clout than the US when Chinese GDP is world number one as it is destined. The world economy is oiled by USD liquidity. But many fail to understand this USD liquidity is not primarily provided by the US.  The reality is the USD liquidity is provided by the massive amount of offshore USD deposits. This started way back in London and then in various European capitals where USD deposits were allowed. These offshore USD funds became known as the Eurodollar. Today offshore dollar is in many other capitals. Those in Asian capitals are loosely called Asiandollars. Singapore as an important money market centre, has huge amounts of USD deposits that used to be called the Asian Currency Unit (ACU). The importance of these offshore USD is liquidity is located close to where it it required. How big this pool of offshore USD is, nobody really knows. Since they are offshore, it is un-regulated by US, so data is scarce. Some years back JP Morgan made an estimate that 90% of financing transactions outside of US were funded by the Eurodollar. That's astounding and underlines the importance of offshore funds for a world reserve currency.

The size of China's GDP alone cannot warrant CNY to provide liquidity to the world. An offshore Renmenbi market goes hand-in-hand with CNY internationalisation. An equivalent EuroYuan is required, which takes decades to develop. But it is impossible to see the CCP acquiescence to foreign interest having some sovereign control over offshore CNY. This just won't happen.

By the way, Eurodollars allow some protection to depositors who fear US Federal threat. A Russian oligarch with USD deposits at DBS Singapore has no worries about the US government confiscating his wealth. It is outside the jurisdiction of the US.

China has no benchmark interest rate like the Fed rate or some discount rate dictated by market forces. It has a trading mentality that uses foreign exchange rate as monetary tool to manage price stability. Its interest rate is an officialdom prerogative. A market-driven interest rate is what breathes life into an open market economy for participants to know how to price and hedge themselves.

Not only is capital movement not fully liberated, China's domestic capital market is immature. Its financial institution still works under the umbrella of the "infant industry argument", a classic theory in international trade that new industries require protection from international competitors until they become mature, stable, and are able to be competitive. It simply lacks the varied instruments for countries that acquire massive CNY reserves to invest. We hear recently of Saudi Arabia pricing their oil sales to China in CNY. Where are the Saudis going to park their massive CNY? Internationalising the CNY is not just a matter of invoicing transactions, but China must provide the reserve currency as a store of value. The mechanisms are sorely lacking. Reforms from Beijing are slow in coming and often times conflicting. The road ahead is long.

Last but not least, can anyone envisage China to transition from a trade surplus to a trade deficit economy? If it does not, how will it generate the cash outflows to provide liquidity to the world?

Those criticising the mess the USD is in should appreciate as a world reserve currency, it was set up to collapse. The USD did national service for the world. Yes Americans lived off the fat of the world for decades. Their era of high cosumerism is over as those massive debts and printed money is coming back to roost in a block-buster inflation that I suspect will be a prolonged one. Those urging for CNY to replace USD must know firstly, it is getting a child to run before he can walk, and should the CNY replace USD as world reserve currency, the same fate of failure as predicted by Triffin Dilemma surely awaits the Chinese. As Keynes pointed out, no national currency can play the role of world reserve currency. It needs to be an exogenous creature, outside of world banking system. Thus he proposed 'bancor', an independent currency owned-by no country. Perhaps there can evolve some form of crypto-like algorithmn, or a One World Government currency, controlled by Claus Schwab? How voluntary and independent can that currency be?

No comments: