When will the renminbi overtake the dollar?

January 6, 2011
Santiago, Chile

Without a doubt, the existing global financial system depends on the widespread use of fiat currencies issued by insolvent governments.  The wealth of the world’s large financial institutions requires that there be currencies with sufficient size and circulation to absorb massive capital flows.

The current system is based primarily on the dollar; with a $14 trillion economy, the United States was for years the only country in the world with a sufficient money supply and financial infrastructure to take in the preponderance of the world’s wealth.

It is for this reason commercial loans, commodities contracts, international reserves, and cross border settlements have traditionally been denominated in US dollars.

Competing reserve currencies arose with the advent of the euro and Japan’s post-war rise; while the dollar has continued to remain dominant, these three are the only currencies which have the necessary supply and credit rating.

With trillions of dollars floating around the global financial system, managers are constantly making capital allocation decisions, moving funds in and out of various instruments.  The reserve currencies play a big role in this because unallocated capital is frequently parked in their bond markets.

For example, large corporations or banks that are sitting on billions of dollars in cash typically purchase short-term US or European government bonds because the low default risk.

The dollar, euro, and yen have bond markets of such size that getting liquid is never a problem, even for billions of dollars.  There is always a market for treasury securities, hence they are considered ‘cash equivalents’.

You couldn’t do the same thing in the Kingdom of Bhutan with its tiny $3.5 billion economy. If you tried to move $100 million into Bhutan, its currency (the ngultrum) would spike. In the US, Europe, and Japan, $100 million barely registers a blip.

Over the last few years, though, the confidence has begun to fade quickly, and the reserve currency issuing governments are starting to be viewed with increasing skepticism.

The thing that’s missing right now is an acceptable alternative. There’s really nothing out there in large enough scale to withstand massive capital flows, and as I have written before, the game is now one of judging the ‘least worst’ of these three major currencies.

In what seems to be a 6-month cycle, the dollar and euro have been jockeying for the ‘worst of the worst’ title; markets focus on Greek woes for a few months, then turn their attention back to California and Obamanomics.

With Bernanke’s “100% certainty” and nonsensical economic numbers coming out of the America’s Ministry of Truth (Newspeak: USMiniTruth), we seem to be back in a period where the markets are more concerned with Europe. I think that Japan will be called to the carpet before too long as well.

As such, in an almost ritualistic cycle, financial markets are shifting funds around these currencies… the analogy I like to think of is like a series of buckets.

Imagine three buckets and an increasing volume of water. Capital allocators are essentially dumping the contents of one pail into another– from the dollar bucket into the euro and yen bucket, and from the euro bucket back into the dollar bucket.

Each time this happens, though, a little bit of water spills out into smaller buckets– gold, silver, Switzerland, Norway, Canada, Chile, Australia, etc.

All throughout, central bankers are standing there keeping the spigot at full blast, pumping more water into the system while bankers desperately try to find the least leaky balance.

What’s required is a new bucket that bankers view as strong, sturdy, and large enough to handle the volume. The most likely candidate is the Chinese renminbi… but not yet.

China’s economy is set to be the largest in the world in a matter of years, and it has the money supply to match. While its economic and monetary fundamentals are far, far from perfect, China is arguably in a much better financial position than the west.

It’s going to take several years for the renminbi to overtake the dollar, euro, and yen as a serious contender for the world’s main reserve currency… but it can happen. The major roadblock is that China’s renminbi is not free-floating– the government has imposed severe exchange controls.

I’ve written before that we are seeing the early signs of relaxing controls. China doesn’t do anything overnight, and I think there is a long-term plan in the works.

We have already seen China agree with other sovereign nations to introduce currency swap arrangements, so there are now several countries holding renminbi.  Furthermore, the Hong Kong gold exchange recently announced its plans to launch a new gold contract denominated in renminbi.

To be clear, China already has its own gold exchange, but having one in Hong Kong opens up renminbi-denominated gold contracts to the entire world since Hong Kong has no exchange controls.

On that note, the mainland authorized Hong Kong’s banks to establish cross-border settlement accounts in renminbi last year, effectively providing a way for people to open a renminbi bank account. In fact, we have one.

Each of these measures to reduce exchange controls is one step closer to the renminbi being introduced as a global reserve currency.

Perhaps the most obvious step, though, came in just the last few days. Beijing has already allowed several multinational companies like McDonald’s and Caterpillar to issue renminbi denominated bonds.  Now the World Bank, that unfortunate staple of the financial system, is issuing its own two-year renminbi bond.

This is a big deal… and I think that we’re going to continue to see bigger and bigger steps like this taken throughout 2011 and the coming years.

China’s government has been very clear that by 2020, it wants Shanghai to be a leading global financial center… and Chinese policymakers know that for Shanghai to be a financial center, the renminbi must be freely convertible.

Make no mistake, my friend, the deadline has been set… and if you haven’t started making decisions to preserve your capital, I strongly urge you to start now. More to follow.