The Chinese Yuan: Does October 1 Spell Doom For the U.S. Dollar?

(Kitco News) - Move over world currencies. China's currency – the renminbi is taking its spot at the table.

On Oct. 1, the International Monetary Fund will add the renminbi, to its elite basket of reserve currencies in the Special Drawing Rights (SDR).

This is “a momentous event” for the international finance community says Cornell University economist Eswar Prasad.

This international stamp of approval means the renminbi – and its unit, the yuan – meets the IMF’s standard of being “freely usable” in the global economic system, allowing it to join the euro, yen, pound and dollar in the A-list basket. It’s a significant milestone in the renminbi’s growing international credibility, says Prasad. This is the topic of his latest book: Gaining Currency: The Rise of the Renminbi.

Many gold traders are well aware of the "doom and gloom" scenarios that become fashionable from time to time regarding the demise and collapse of the U.S. dollar and the havoc that could potentially wreck on global financial markets. What has propped up the dollar in recent years has been a lack of any strong alternative reserve currency.

Reserve Currencies: A Little Background

First off, let's take a look at the definition of a world reserve currency. It is simple a currency that is held in large quantities by governments and institutions as part of their foreign exchange rese5rves.

Here's a short list of some of the factors needed to be a reserve currency:

1. Trust in the country's government: long-term economic, military and political stability


2. Relative currency stability


3. Deep and liquid capital markets


4. The currency must be an international medium of exchange


5. Even in times of instability, the government guarantees its value and it is a viewed as risk-free asset

The last handover: The end of World War II is marked as the time when the U.S. dollar took over the role of the world's reserve currency, from the British pound sterling.

The question now:  could that position be wrested away from the dollar in the foreseeable future?

China is the biggest foreign holder of U.S. Treasury securities. But, China was seen trimming its holdings of U.S. Treasury securities this summer ahead of the yuan's inclusion in the IMF's SDR.

The numbers: The latest data shows China held about $1.22 trillion U.S. Treasury securities through the end of July, according to the U.S. Treasury Department's monthly Treasury International Capital (TIC) report. That represents the lowest level since January 2013 and is down $22 billion from the previous month.

What's The Worry?

How could the doom and gloom scenario for the U.S. dollar play out?

The crux of the scenario is the U.S. dollar is weighed down by huge structural imbalances including massive U.S. national debt which now tops $19 trillion and the persistent trade deficit.

As Chinese inflows of U.S. dollars have grown over the last decade, they've plowed those proceeds largely into U.S. Treasury securities, but now that may be starting to shift.

In the past, fears have built up over concerns the Chinese would abruptly sell their U.S. holdings sparking a surge in U.S. interest rates and a plunge in the U.S. dollar. Generally speaking, it is not in the best interests of China to sell off U.S. Treasury securities in large numbers and ultimately spark dramatically higher American interest rates and a plunge in the U.S. dollar, economists say.  No matter how much China trims their dollar exposure, they'll still have dollar assets and they'd only be driving the value of their own portfolio lower, some say.

Other Currency Contenders?

In the world arena, the pickings are thin for viable contenders to seize the revered global reserve currency status. While a decade ago, some pointed to the euro as gaining some traction, but that fell apart with the European sovereign debt crisis and now Brexit continuing to weigh over the continent.

Times Are Changing

For now, the U.S. dollar remains the world's safe haven currency.

The trade component: While commodities still largely change hands on the world marketplace via U.S. dollars -- that is changing. Russia and China are trading oil via yuan, not dollars. Also, China is pushing to create a crude oil futures contract that would most likely become a third global benchmark.

Prasad predicts that, as China’s economy grows and its footprint in international trade and finance expands, the renminbi will play a more prominent role as a payment currency. The renminbi now accounts for a small but quickly growing share of global financial transactions, Prasad says.

The renminbi’s rise to the status of a global reserve currency is “happening before our eyes,” Prasad added.  “Many central banks around the world – 34 at last count – have signed local currency swap lines with the People’s Bank of China, which means they have access to renminbi should they need it," Prasad says.

But, there are still concerns. The global finance community will not perceive the renminbi as a safe-haven currency, Prasad says. “In order for the renminbi to be considered a safe place for investors to put their money in times of turmoil, foreign investors and domestic investors in China must have trust in China,” Prasad says. “And that is missing.”

To build that trust, China needs political and legal institutions similar to those of safe-haven countries in Europe and of the United States and Japan. China is missing a democratic form of government with multiple checks and balances. It needs an independent and trusted central bank like the Federal Reserve. And China also would require a legal framework where the rule of law takes precedence over the Chinese Communist Party, and not vice versa, he explains.

What Lies Ahead

While the U.S. dollar might not lose its reserve currency status anytime soon, chinks in the armor are seen.

History shows that reserve currencies come and go. Before the U.S. dollar, it was the British pound sterling, before that it was the Dutch guilder. Before that it was the Florentine florin of the Renaissance period and before that the Arab dinar of the Middle Ages.

The bottom line: the U.S. is running a highly leveraged economy and if higher interest rates were seen amid slowing foreign debt purchases in the future, things could get ugly for American consumers.

Gold continues to be a good insurance policy and a portfolio diversifier. More and more asset managers are bumping up their asset allocation levels to gold, some as high as 30%. What's in your portfolio right now?

By Kira Brecht, Kitco.com
Follow @KitcoNewsNOW