China Edges Closer To Reserve Currency Status

Includes: FXCH
by: QFinance

By Anthony Harrington

While there are always many currents roiling the waters for foreign currency (NYSE:FX) traders, two broad trends now heaving up over the horizon are set to change the game fundamentally. Today, everyone takes it for granted that the U.S. dollar is the deepest pool of liquidity on the planet, and therefore the world's dominant reserve currency. There is no doubt that the Federal Reserve's succession of quantitative easing (QE) programs has deeply irritated countries with large U.S. dollar reserves - who wouldn't be irritated if someone else's actions took, say, 20% off their wealth without them being able to do anything about it? But the world needs dollar liquidity to oil the wheels of international trade. This has been especially true of emerging market countries, particularly in Asia, where trade is normally settled by agreement in dollars.

However, until now, the plentiful international supply of U.S. dollars has been generated from two major sources. First, avid U.S. consumer demand continues to suck in goods from abroad, which creates dollar outflows; and second, the U.S. has, until now, needed to spend dollars buying oil and gas to keep the wheels of industry - and U.S. motorists - turning. These dollars flowed out from the U.S. to the petro-dollar nations - such as Saudi Arabia, the Middle East and China - then flowed back into the U.S. in the form of investments in US securities and bonds. The plentiful return of dollars on this cycle helped to keep dollar rates low, which, allied to extremely accommodating "loose for longer" monetary policies from the Fed, made the dollar a favorite currency to borrow in, for emerging market governments and companies.

However, the U.S. is now getting closer all the time to being energy self sufficient, thanks to fracking and the huge shale oil and shale gas deposits that have been discovered. Once the U.S. stops buying oil abroad, the effect is going to be profound. This won't impact its status as a reserve currency but it will push a number of central banks to look much harder at the renminbi [RMB] as an alternative. At the moment, of course, the RMB is nowhere near open enough to be a reserve currency, but China's new Premier has plans to change all that - or at least that is the guidance he is giving to markets.

Writing in The Diplomat, Jun Jie Woo and Suvi Dogra point out that China's success to date in internationalizing the RMB has had huge implications. They cite a Bank of International Settlements survey, which shows that the RMB has finally made it into the league table of the world's most actively traded currencies - not bad for a closed currency! The People's Republic of China has been extending the number of countries with which it has currency swap arrangements, which allows companies trading between a "swap country" and companies on the Chinese mainland to settle their trade in local currencies instead of in U.S. dollars (settling in dollars exposes them to all the gyrations of the FX market).

In September, for example, China and the U.K. announced a three year £21 billion currency swap deal between the Bank of England and its Chinese counterpart. The U.K. Treasury has made no secret of the fact that it wants to establish London as the leading international center for trading the RMB outside of mainland China and Hong Kong. It all began back in 2004, Woo and Dogra point out, when China established Hong Kong as an official offshore RMB settlement center, with the Bank of China, Hong Kong, as the RMB clearing bank in the territory. By mid-2012 Hong Kong had been joined by London with Singapore following in 2013. In this way China is steadily increasing (and encouraging) RMB usage in three major trading cities. The U.S. and Japan, both huge trading nations with China, already have direct currency links. Brazil too has a 30 billion real swap arrangement with China.

Zero Hedge recently quoted Bundesbank Executive Board member Joachim Nagel's observation that the Chinese currency is "already well on its way to becoming one of the future global reserve currencies," thanks to its increasing convertibility. Nagel cited figures from SWIFT which show that the percentage of trading transactions settled in RMB jumped from virtually zero to around 12% between 2010 and 2012, with every sign that this is increasing. It is already a trading currency, in the light of these developments, and reserve status is now not very far away, he concluded.