The Currency That Would Be King

Dollar haters have a new love.

It’s a currency that’s been a dark horse contender in the race to replace the greenback for years now, and according to some analysts it recently surged ahead to become the most likely challenger.

The latest data point supporting this argument is the country-in-question’s growing role in the world of global payments. The use of the currency in global payments has increased substantially over the past two years. However, the percentage change — up 266% — masks the distance between it and the leaders.

Sure, it has moved from No. 13, where it accounted for 0.6% of global payments as measured by the Bank for International Settlements, to fifth, where 2.2% of payments were made with the currency. But at the end of 2014, 40.2% of global payments were in euros while 33.5% of payments were in U.S. dollars.

To catch these two front-runners, use of this dark horse would have to increase by 1,827.3% or 1,522.7%, respectively.

That’s not likely to happen anytime soon, and chances are that its issuing government doesn’t want this to occur anyway.

Of course I’m talking about the yuan.

If demand for it suddenly ballooned, it would kill the Chinese economy, not help it grow.

According to World Bank, exports comprised 26.40% of Chinese GDP in 2013, which is just a fraction less than the 26.72% of GDP attributed to exports five years ago. While Chinese government officials have made a lot of noise about weaning the country off of its addiction to exports, the reality is that selling stuff to other countries remains very important. A rising demand for yuan would dent trade.

When demand for a currency increases, the value of the currency also goes up. This is great for consumers who live in the country with the rising currency because they can now buy foreign goods at a cheaper price. Unfortunately, businesses in the country with the stronger currency now sell less of their goods to other countries, since their goods cost more when priced in other currencies.

This double-edged sword makes the issue of a strong or weak currency something of a political hot potato. And it’s the basic debate going on in central banks around the world today… but it takes on special meaning in China, where the government pegs its currency to the U.S. dollar.

Pegging It

In an effort to stabilize its exchange rate, everyday China sets the official rate at which yuan can be traded for dollars. However, in a nod to changing conditions, the yuan is allowed to fluctuate within a 2% band around the official exchange rate.

This combination of a peg and a floating rate is meant to allow market forces to work, but not go overboard. The Chinese allow flexibility, but only on their terms. And that takes us back to the issue of a rising currency.

If Chinese leaders wanted more global payments to be made in yuan, then they would have to make yuan more available to foreign entities. Rising demand for Chinese currency on the world markets would lead to upward pressure on the exchange rate for yuan, which the Chinese government controls.

If the government kept the yuan artificially low to assist Chinese exports, then the country would face the charge of being a currency manipulator, which carries penalties from the World Trade Organization. If the value of the yuan were to rise, then exports, which account for a quarter of GDP, would be hurt.

To make matters worse, once sufficient amounts of yuan were available away from China, more of the currency would trade outside of the government’s control. Offshore yuan trading already occurs. In this unpegged environment, the yuan is free to move against other currencies based on market conditions without constraints.

If offshore trading overshadowed mainland trading, the Chinese government would lose control over the exchange rate, and thereby lose the ability to set one of the most important components of its very large export business.

So while the Chinese might rail against the U.S. dollar from time to time, and might even talk about how the yuan should occupy a more prestigious place among world currencies, it makes little sense for a country that uses a command economy to turn control of its currency over to international forces.

In other words, don’t buy into the “end of the dollar” arguments you hear from time to time. For better or worse, the dollar’s status as the reserve currency appears to be safe for years to come.

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Rodney

P.S. Charles talks about an interesting demographic trend in China that will have a significant impact. Keep reading

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Categories: Currencies

About Author

Rodney Johnson works closely with Harry Dent to study how people spend their money as they go through predictable stages of life, how that spending drives our economy and how you can use this information to invest successfully in any market. Rodney began his career in financial services on Wall Street in the 1980s with Thomson McKinnon and then Prudential Securities. He started working on projects with Harry in the mid-1990s. He’s a regular guest on several radio programs such as America’s Wealth Management, Savvy Investor Radio, and has been featured on CNBC, Fox News and Fox Business’s “America’s Nightly Scorecard, where he discusses economic trends ranging from the price of oil to the direction of the U.S. economy. He holds degrees from Georgetown University and Southern Methodist University.