Over the summer, I wrote a Thought for the Week that discussed the implications of China’s currency getting added to the IMF’s basket of reserve currencies. Given the decision this week by the IMF to approve China and add them to the SDR, I wanted to update my thoughts now that we have more information.
A “reserve currency” is one that is held by governments and institutions in very large quantities to facilitate international transactions. Since the 1940s, the most widely accepted reserve currency has been the U.S. dollar (USD).
For example, a country that imports most of its energy would need to have access to dollars in order to pay for oil, since international oil contracts are almost always priced in USD due to its perceived value, safety, and convertibility.
One of the more prevalent conspiracy theories making the rounds across the internet these days, instigated by the fear mongers, predicts that the dollar will lose this status in less than a year, which will subsequently drive our economy down into a deep depression. Their thesis goes something like this: The International Monetary Fund (IMF) added the Chinese currency, known interchangeably as both the Yuan and Renminbi (RMB), to its basket of currencies that are designated with “reserve” status this week. This decision will soon force central banks across the world to dump their USD reserves in favor of the RMB, which would then lead to the demise of our economy due to rampant inflation.
This thesis is pure garbage and intended to do nothing more than scare the American public for the sole purpose of selling some useless newsletter, book, etc. In order to set the record straight, let’s walk through why China could not possibly replace the U.S. as the world’s reserve currency anytime in the next several decades.
Now, before I discredit the fear mongers and expose their fraudulent ways, the first step is to explain the International Monetary Fund’s role and why they matter so much. The IMF is an international organization created back in the 1940s as a way to foster global monetary cooperation, secure financial stability, facilitate international trade, and assist in global economic growth. The IMF executes its mandate through various services and levels of support for member nations. For example, the IMF is one of Greece’s largest creditors, and they have given the country several billions of dollars over the years to help get their economy back on track.
Another function of the IMF is to set recommended guidelines on the use of currencies by central banks across the world. Up until this week, they recognized four currencies in a basket that is weighted based on their prominence and availability.
The four currencies and weightings assigned by the IMF were the US dollar (USD) at 41.9%, the Euro (EUR) at 37.4%, the UK pound sterling (GBP) at 11.3%, and the Japanese Yen (JPY) at 9.4%. Together, they make up the overwhelming majority of global international currency reserves.
Subsequently, they dominate international bond markets and global financial transactions because most countries have an ample supply of these currencies and are willing to accept them as payment for goods and services (think about the oil example above).
This week, the addition of the RMB changed the basket weighting to the following:
• USD: 41.7%
• EUR: 30.9%
• RMB: 10.9%
• JPY: 8.3%
• GBP: 8.1%
The first step is to ask ourselves if the addition of the RMB to the basket of currencies is a bad outcome for the U.S. Despite the fear mongering out there, I would strongly argue that it’s actually a good outcome for three reasons:
1. Playing Nice: China has spent the past twenty plus years manipulating their currency and waging financial warfare on much of the developed world. Now that they have received approval from the IMF, they can no longer act in such a manner because the IMF requires currencies in their SDR to be freely usable.
2. Healthier Global Economy: The decision should lower borrowing costs and facilitate overseas expansion by Chinese companies, which would be helpful for the Chinese economy. Since the world relies on China’s economy more than in years past, the global economy is better off with a stronger and healthier Chinese economy.
3. Deploying a War Chest: China could begin to use a portion of their enormous foreign exchange reserves in a far more efficient manner to stimulate economic growth both in China and globally.
Simply put, a more competitive China that allows markets more access to pricing is a net benefit. But the next question, and the one that fear mongers are using to scare the public, is of the USD’s future as the world’s reserve currency.
There is absolutely no chance that the USD will be dethroned anytime soon for five main reasons:
1. Must be Desirable: The USD is the most widely accepted, trusted, and stable currency in the world. Traits like these take decades to reverse, and given the current strength of our economy and currency, any turnaround is even more difficult to imagine.
2. Global Payments: Weighting in the basket are heavily influenced by their share of global payments. Currently, the Yuan accounts for just 2.2% of global payments versus 45% for the dollar. Furthermore, the IMF chose to lower the weighting of the Euro by the largest percentage, and then the GBP and JPY to make room for China. The USD percentage barely budged in the announced revisions (which won’t change again until 2020).
3. Commodities Use Dollars: Nearly all commodities are priced in USD for the reasons mentioned above. Therefore, if a company in Malaysia wants to buy a barrel of oil from Saudi Arabia, that transaction will need dollars to complete. Rewriting these contracts or forming new ones would take time and equal trust in a replacement currency.
4. Track Records Matter: Although the recent reforms enacted by the Chinese government are very encouraging, they still have a long way to go to convince the world that they are truly committed to allowing markets determine the value of their currency. They must instill trust that they will refrain from market manipulation, and that level of trust will take several years to develop.
5. Must be Available: The world’s reserve currency must be both “desirable” and “available.” Meaning, not only do people need to see real value in the RMB, they also need to be able to acquire it with ease. China could not possibly supply the world with enough RMB and then make it readily available in any timeframe shorter than a few decades.
NOTE: The reasons for the difficultly in supplying enough RMB are extremely technical and beyond the scope of this piece. However, it took the U.S. several decades to achieve its status as the world’s reserve currency, so a challenger would likely need even longer to supplant such a strong incumbent.
If that’s not enough data for you, just take a look at recent IMF data to see why China has a long way to go to dethrone the dollar. In the second quarter this year, about 64% of central banks’ allocated reserves were in dollars, more than triple the 20.5% share in euros, the next most widely held currency. The RMB is nowhere close to the Euro, let alone the dollar.
The bottom line is that there is a big difference between the IMF adding the Yuan to its basket of currencies and the Yuan actually replacing the dollar as the world’s reserve currency. China still has a very long way to go in developing its debt markets before its currency can achieve such a title, and the decision by the IMF to include them will do nothing to negatively impact the U.S. economy.
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