There is a brewing issue lingering in the background that will likely move to the forefront of the financial press in the months and years to come. It's the emergence of the Chinese yuan and renminbi. It's the coming of age of a nation’s currency. There is little doubt that eventually, if China continues to move in the direction it is today, that the Chinese currency will become more widely accepted. China is in a hurry to join the upper tier of nations with reserve currencies. And considering the amount of trade China does in the world and the fact that it is among the richest nations of the world, an independent currency is warranted.
Many believe that this is a threat to the reserve currency status of the dollar. It is not. That will not deter the many writers that hold such a view from declaring such an evolution to be a crisis in the dollar and a prelude to the end of the dollar’s existence as we know it. There will be calls of coming upheaval and a possible international monetary crisis the likes of which we have never seen.
This kind of panic talk sells books and articles galore, but has little to do with the real world. Any historian of money need only look at the period when the British pound sterling lost its reserve currency status to the dollar to understand that England was little affected by the transition. And in a more current example, just look at the creation of the euro. The euro replaced much of the dollar reserves that comprised the treasuries of the world. Where it used to be almost all dollars and gold that made up the reserves of nations, today it is dollars, euros, yen, pound, and gold.
In that transition, again, there was no great upheaval. But the power of fiction can be so much more enjoyable to contemplate than the power of facts and history. So, we will get a multitude of scenarios that could occur that will suposedly lead to the downfall of the dollar and subsequent fall of the United States because of it. Yet, even as we hear these warnings sounded by writers today, they come in the midst of a strong dollar, as many currencies around the world are being devalued. And we are told that it is these falling currencies that are the real threat to the US economy.
So which is it? Are devaluing currencies and a strong dollar a threat, or is it a weak dollar that is the threat? The answer is neither, if it is a market-oriented valued currency. As long as a currency is convertible and freely open to market forces, the value of a currency will be reflected by its underlying fundamentals.
And as I said, the time will no doubt come when the yuan becomes accepted as a reserve currency. What needs to happen to achieve this open goal of China? To become a reserve currency, (and by that I mean a currency that is accepted and held as reserves by governments as a premier currency of choice), first the currency needs to be trusted. If there was no trust of the dollar, the dollar would fall like a rock and be discarded as a reserve currency. The fact is, the dollar is the most demanded currency in the world -- not by decree, but by the value of the market. It is not an arbitrary value. There are reasons.
First, the dollar is freely convertible and marketable anywhere in the world, on demand, except where it is prohibited by governments. But even there, the dollar is the preferred choice of money if it can be obtained. The dollar is easily recognized throughout the world, and has a 200-year reputation of stability versus other currencies. Aside from rare periods in US history, the dollar has performed reliably against most other currencies of the world. Even as a fiat currency it has done well on a relative basis.
Another reason for the dollar’s acceptability is that the laws and courts of the US honor the sanctity of contracts between individuals, businesses, and nations. And then there’s the fact that we are the major trading partner of the world. We import and export to almost every nation of the world. Given the fact that the US is such a huge trader and the richest nation in the world, it has more currency outstanding that can be accumulated. This is one of the reasons that small nations who do not trade much even given very strong currencies - such as Switzerland for example - do not become reserve currencies. There just isn't enough currency to go around. The dollar market is by far the deepest and most liquid in the world.
Which brings us to the logical reason why we can expect China to become a reserve currency -- eventually. China is becoming a trade partner with most nations of the world. It should have its own currency. But China is nowhere near that point. Why? Because it doesn't have a convertible currency. The renminbi which is the name of the domestic currency meaning the "people's money", is very much like the pound is in England in that it is the domestic currency; and the yuan, is the international expression of that currency, similar to pound sterling, the British form of an international currency.
The renminbi is pegged to the dollar and has no value or history without piggybacking the dollar's value. It's true that it has recently been allowed to float within a narrow band, but it is not a market oriented band -- it is a government decreed one. Further, its money is controlled through the government via capital controls. Money is not free to flow in and out of China. It is permitted to. This distorts the value of the currency.
For the yuan to become a true international currency the Chinese government would have to allow the yuan and the renminbi to float and seek their own level for a good period of time to find their true value. To the Chinese government’s credit it has been moving toward convertibility for the last several years. But they would need to eliminate the band on their currency, end their tie to the dollar, end their capital controls on their domestic currency, and allow the free flow of money into and out of the country, something the communist government doesn't relish doing. Freedom in the movement of money increases individual liberty, and that in the communist's book is dangerous.
And even if after years of gaining the trust of the world in the new money of China, what about the sanctity of enforcing contracts made within the Chinese justice system? What good would a money of trust be, if the contracts made in yuan or renminbi could not be trusted and enforced?
So you see, the Chinese have years to go if they want to play with the "big boys" like the euro zone, England, Japan, and the US. A more likely scenario would be that the Chinese will take baby steps, slowly developing bi-lateral contracts with friendly nations. They have already made agreements with several nations such as Russia, Viet Nam, Sri Lanka, Japan, and Thailand to trade directly in renminbi, thus bypassing having to convert to the dollar. And they may get to be one of the many currencies backing the SDR held as reserves by central banks which will give them new credibility. There are international meetings scheduled to discuss this very possibility.
They will also likely try to create their own international trade zone and international banking structure to challenge the US's dominance in the world. This is much more appealing to the communist government: not to join a "club", but to create a "club" that they can run. And this is one of the reasons the Chinese government is buying gold and encouraging its citizens to buy gold. Gold ownership is a shortcut to gaining economic and monetary power in the world.
The Chinese understand the "Golden Rule": "He who owns the gold, makes the rules". And they intend to make the rules.
So, by hook or by crook, the Chinese are on the move. They make no secret of the fact that they want to be a major player in the "currency wars". But at the end of the day, the US will do just fine as long as they play by the market rules of the game. Just as the euro never hurt the dollar or the American people when governments diversified out of the dollar and into euro's, and the dollar never hurt the pound or the British people, the yuan and renminbi will not be a threat to the US or its citizens. Only the US government can do that if they pursue irresponsible fiscal and/or monetary policies.
Proponents of the dollar crisis theory will immediately say that if the dollar wasn't a reserve currency we would have to pay for foreign goods in other currencies rather than our own. But if the dollar is freely accepted by people everywhere, why wouldn't they voluntarily choose to be paid in dollars unless the dollar was suspect. So long as the dollar preserves its value, it will be accepted – reserve currency or not. So, it comes down to the integrity of the dollar. It's the use value that is important.
Only when governments devalue their currencies intentionally or pursue unsound fiscal policies will the people of a nation be harmed. And this is the greatest threat to the US -- fiscal irresponsibility. For no currency can survive that. International free trade, and market-originated currency values never hurt the world, the nations of the world, or the people of the world. Only governments can do that.
In the last analysis it is trust in the integrity of a currency, and in the credit of a nation, that enables them to trade and borrow on international markets. It is this that will be the final arbiter of international trade relations and the value of currencies. As a nation, it is our job to look to ourselves and our own finances, which are dangerously out of control, rather than worry about other nations competing against us, whether in trade or in money.
One nation’s gain is not another nation’s loss in a market of free trade. Trade whether among individuals, businesses, or nations is always a win-win proposition– as long as it is voluntary trade. An emerging Chinese currency that competes with the dollar may be inevitable, but it is no threat. Not as long as the US government keeps its fiscal and monetary house in order.
That is the real challenge of the future.