Reserve Currency: China Sun Rises, U.S. Sun Sets

Includes: FXE, UDN, UUP
by: Douglas Borthwick

The title of Global Reserve Currency is a title that is handed down in history by default. In general it is the currency of the world's largest trading partner. The title has been held by the Greeks, the Romans, the Dutch and more recently by the British and now the United States. A currency becomes the reserve currency when the world either needs it to transact trade, or else receives it when transacting trade.

It makes perfect sense, the largest trader wants payment in its own currency, with little interest in the currency of the smaller nations. During the peak of the British Empire it was said that the sun never sets on the British Flag. I'm sure the Romans probably had a similar saying. A popular song in Britain hails back to 1740, when Scotsman James Thomson wrote the poem "Rule, Britannia," a poem that celebrated the British Royal Navy's global supremacy. Back then the British Sterling was the global reserve currency as Britain ruled the waves, thus controlling the trade routes.

It took up until 1890, when U.S. Navy Captain Alfred Thayer Mahan wrote "The influence of Sea Power Upon History: 1660-1783″ for the United States to see the impact of naval supremacy on the world stage. His book helped turn the U.S. toward the sea, eventually overtaking the United Kingdom as the ruler of the waves.

Things have changed in the world since the days of Greece, Britain et al. For one, I have to wonder whether it is leadership of the sea that matters or whether it is being the largest trading partner. If sea supremacy is the major factor, then the U.S. has some time to shine as the global reserve currency. But if being the largest trading partner is most important, then China is moving up the chain very quickly. This is because countries rarely want to upset their largest trading partner. When exports are key to domestic economic growth, a country's leadership will try to woo and keep their largest trading partner come what may.

Perhaps it is for this reason that the BRIC countries are finally being given the respect that they have demanded for quite some time, with China gaining notable traction over the past 12 months. Europe does more trade with China than the U.S. does. Europe has supported China's request for more voting rights within the IMF, at Europe's cost, and the IMF looks likely to approve that request shortly. On July 26th, 2011, Min Zhu assumed the position of Deputy Managing Director at the IMF. Previously he was Deputy Governor of the People's Bank of China.

Within Latin America, China has become much more relevant. China is now Brazil, Chile and Peru's largest export destination, overtaking the United States. Within Asia; China is the largest export destination for Hong Kong, Taiwan, Australia, South Korea, Thailand and Japan. In Africa, China is the largest export destination for the Congo, Angola, Tanzania, Ethiopia and South Africa. Being the largest export destination has its privileges in that the destination can make demands that, given the economic tie to exports, are usually met. The United States' role as largest export destination is beginning to erode, and with it its hold over international trade and thus the U.S. dollar's reserve dominance.

China has already entered into limited currency swap arrangements with many of its larger trading partners. Just last month Australia signed one with China; joining South Korea, Argentina, Indonesia, New Zealand, Malaysia, Hong Kong, Japan, Thailand, Turkey, Singapore and others. Australian Treasurer Wayne Swan said "This is an important symbolic step toward the internationalization of the remnimbi and another milestone in the continued deepening of the economic relationship between Australia and China." These swaps allow trading partners to use the yuan as a settlement currency. The U.S. dollar's influence drops as each currency swap is signed.

Last night, Chinese Central Bank Governor Zhou Xiaochuan spoke at the Boao forum. He said that "no matter how much money the Federal Reserve prints, it forces other central banks to appreciate their currencies, I believe many economies disagree with such action. The U.S. has the responsibility to consider the global economy." He added, the "PBOC is supportive of Europe's LTRO." and said he wants policy coordination at the global level. The last point is directed at China's support, backed by Japan for the IMF, to act on improving the European Firewall.

China continues to show unease with the U.S. dollar, an instrument that makes up for between 65% and 75% of international reserves. Something that is often questioned by PBOC advisers as being less than "prudent." The "prudence" of being long the U.S. dollar is a message that has been heard by other Central Banks around the world. Brazil and Chile have both been vocal about their wariness over the fate of the U.S. dollar, but have seen it as a necessary evil given their trade relationship with the U.S. These trade relationships are changing, and the creation of these currency swap agreements will decrease the global reliance and thus demand for the U.S. dollar.

On Friday, the IMF released its quarterly COFER survey, the Currency Composition of Official Exchange Reserves. It shows that through Q3 and Q4 of 2011 - when the market was extremely anxious about Europe - central banks increased their euro reserves. Indeed from the start of 2011, euro reserves rose by 8.8% amongst all central banks (Note the survey does not include China). Reserves increased by 4.5% in Q3 versus Q4 and by 2.8% in Q4 versus Q3. On August 29, 2011, I wrote a piece titled "U.S. Dollar Weakness, A Reserve Manager Mandates Trump All Others," with its conclusion; "like the postman, the reserve manager will always deliver." An understanding of the reserve manager need to diversify, along with the longer term nature of the reserve manager's portfolio keeps me comfortable in my view of longer term U.S. dollar weakness and euro strength despite whatever is thrown at this honey-badger of a currency.

Reserve managers are long U.S. dollars and believe it less than prudent to be overweight. Demand for U.S. dollars in international trade will begin to decrease. The euro is a likely beneficiary of reserve diversification given its liquidity and the underlying structural transformation going on in Europe. Remember it's not about liking Europe, it's about not liking something that everybody already owns, and for the reserve manager that is the U.S. dollar. I don't see the Chinese remnimbi becoming a reserve currency any time soon, but I do see the U.S. dollar's dominance dropping on the world stage, and for the time being, the euro will be the beneficiary given there are few alternatives with similar liquidity structures.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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