Death of the Dollar, Part II

Good-bye, Global Reserve Status...

Written by Adam English
Posted October 15, 2013

Last week, we took a look at what will happen to the U.S. dollar if and when the U.S. government defaults on its debts.

With the cataclysmic global effects this would cause, we barely even touched on one aspect that will happen, regardless of what occurs with a debt ceiling compromise...

The U.S. dollar is going to lose its reserve currency status, a position it has enjoyed for nearly a century. The only questions that remain are what will take its place and when.

We're now seeing the beginning of a currency power grab that the United States cannot hope to trump.

A Quick Recap

If you missed the article last week (or could use a refresher), allow me to recap...

According to the Treasury Department, foreign central banks currently hold $5.5 trillion of U.S.-backed securities as of September 17th.

Not only will international economies tank alongside the U.S. private sector if the U.S. government defaults, but foreign governments will suddenly have to write off huge chunks of their forex reserves, too.

China holds $1.2 trillion; Japan is sitting on $1.1 trillion; and another 11 countries hold between $100 billion and $300 billion.

The sole reason these reserves exist is to stabilize national currencies.

The recurring debt ceiling crises do the exact opposite.

We're about to deliver a one-two punch to all of them by tanking their national economies and destabilizing their money. Imagine how happy these countries will be when their countries are in shamble, because foreign politicians refuse to pay their bills...

The United Nations and International Monetary Fund have been calling for a universal reserve currency for some time, but one already exists.

The euro is widely used today, but it faces many of the same problems as the U.S. dollar: high debt-to-GDP ratios, nearly insurmountable entitlement spending, and an inability to create a burst of economic expansion that can outpace deficits and debt growth.

Plus the EU has no truly effective central bank. And, as we've seen, the euro can easily be imperiled by relatively small and poorly managed national economies.

In short, there is no good reason to replace one deeply flawed currency, the U.S. dollar, with another, the euro.

For now, the only truly international "currency" that is limited to exposure to national issues and obligations, especially from the United States, is gold.

Ben Bernanke chided his fellow central bankers for buying up the yellow metal as the prices dropped.

Central banks have collectively lost $545 billion since 2011 by expanding gold reserves by 20% over two years, while gold prices have slumped 30%. In many ways, however, this represents an opportunity cost: If central banks want to stabilize reserves and shift away from the dollar, they have no other choice right now.

Gold will always serve this function. It is part insurance and part insulation, and nothing else comes close to matching its performance in these regards.

Pretty soon, though, the central bankers who have to take a short-term loss on paper by snapping up as much gold as possible will have the replacement global reserve currency they want...

 

The Only Viable Option

The only real contender for the world's next reserve currency in the long-term is the yuan.

China is projected to surpass the United States as the world's largest economy within three years. By 2040, the Chinese economy could be three times as large. It also has debt equal to about 40% of GDP, roughly half of that of the U.S.

The global economy is going to be defined by what flows into and out of China... and more so than we can possibly imagine, even today.

Here are some of the key developments that are showing China's intentions:

  • China has been busily promoting its currency worldwide. In June it signed a three-year swap agreement with the Bank of England for $32.6 billion worth of yuan.
  • The European Central Bank just signed a deal for a three-year swap worth $61 billion last week.
  • At the beginning of this month, another deal worth $16 billion with Indonesia. Deals have been settled with Hungary and Albania as well.
  • In spite of recent acrimony, China and Japan have plans to promote direct exchanges of their currencies and bring an end to trade that exclusively uses U.S. dollars.
  • Similar plans are being formed between China and Russia, along with all five of the BRICS nations.

All of these plans will undoubtedly be fast-tracked if U.S. politicians continue to fail to handle the most basic aspect of their jobs.

In September, the yuan jumped to ninth in the latest survey by Bank for International Settlements on foreign-exchange turnover. Daily trading more than tripled to $120 billion from $34 billion in 2010.

China is winding down its rigid currency controls and gradually merging the differences between onshore and offshore yuan that it implemented to create its export economy. The value of the yuan has been strictly controlled onshore in the past, which led to differences between the domestic yuan (CNY) and the yuan circulating offshore (CNH)...

The People's Bank of China (PBOC) widened the intra-day trading band on the onshore CNY exchange rate in April 2012. At the time, officials and the PBOC governor issued statements allowing the CNY to be traded more freely.

Since that time, the rates for the onshore and offshore varieties of yuan have converged, although they are not identical yet.

Take a look at these two charts, and you'll see the effect of the tighter intra-day trading band for the onshore CNY yuan:

CNH and CNY vs. USD chart
*Charts from Bloomberg.com

The intra-day trading limits cap the peaks and troughs.

As of the writing of this article, an offshore yuan was worth $0.1639, while an onshore yuan was worth $0.1637. The difference is relatively small, but significant to the FX market.

The yuan has come a long way though, and is very close to becoming a fully convertible currency.

The Deadline

All of China's obvious efforts to make the yuan the international reserve currency of choice comes with a deadline: It has two years to get into the big leagues.

The International Monetary Fund is reviewing its special drawing rights (SDR) basket, which uses four key international currencies to supplement member countries' official reserves and bolster liquidity.

This SDR basket is worth about $300 billion and is used to facilitate conversions between national currencies and what the IMF considers to be the four best reserve currencies.

China has proposed using SDRs, calculated daily from a basket of U.S. dollar, euro, Japanese yen, and British pounds, for international payments. The deadline for completing that review is 2015.

Based on the international political climate, spectacular rise of yuan being used in daily international trade, and tenuous condition of virtually all other currencies with a large circulation, the yuan is virtually guaranteed to be included.

No wonder China wants to elevate the position of SDRs...

Once this happens, China will quickly overcome the euro in internationally-held reserves and challenge the U.S. dollar.

Other nations will be more than happy to help, as their trade with China continues to ramp up and America's economy stagnates. They'll also undoubtedly breathe a sigh of relief that they are no longer dependent on a country with bumbling, suicidal politicians and a reserve currency with unprecedented inflation risks from a $3.6 trillion central bank balance sheet.

"You do it to yourself, just you, you and no one else."

China's official press agency, Xinhua, allowed a story to run that decried the "U.S. fiscal failure, which warrants a de-Americanized world." The story flatly states the world should consider a new reserve currency "that is to be created to replace the dominant U.S. dollar, so that the international community could permanently stay away from the spillover of the intensifying domestic political turmoil in the United States."

Given everything China is doing to boost the yuan, we know this isn't just rhetoric...

Our country will lose its special status on the international economic stage.

Americans will have to pay significantly more for all forms of borrowing costs.

Our government will have a much harder time selling its debt to anyone, besides itself and the Fed.

The way things are going, Uncle Sam is encouraging every other nation in the world to accelerate the process, all while all currency safeguards have been disabled by the Fed to promote tepid economic growth and juice U.S.-based equities and stocks.

Years of planning by Chinese officials are coming to fruition. Before we know it, the Fed will be hoisted with its own petard, the U.S. dollar will devalue and lose its prominence, and you and I will take the brunt of the beating as we watch the yuan become the preferred global reserve currency.

During this transition, follow the lead of the central bankers that will implement the shift...

Buy gold and don't worry too much about short-term price fluctuations in U.S. dollars.

Take care,

adam english sig

Adam English

follow basic @AdamEnglishOC on Twitter

Adam's editorial talents and analysis drew the attention of senior editors at Outsider Club, which he joined in mid-2012. While he has acquired years of hands-on experience in the editorial room by working side by side with ex-brokers, options floor traders, and financial advisors, he is acutely aware of the challenges faced by retail investors after starting at the ground floor in the financial publishing field. For more on Adam, check out his editor's page

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