The Renminbi: Soon to Be a Reserve Currency?

By: John Mauldin, Millennium Wave Advisors / GoldSeek.com

The US Trade Deficit Turns Positive
China Moves to Float Its Currency
Transformational Technologies
Tucson, the Barefoot Ranch, and New York

I get the question all the time: when will the Chinese renminbi (RMB) replace the US dollar as the major world reserve currency? The assumption behind such questions is almost always that the coming crisis in US entitlement programs will force the Fed to monetize even more debt, thereby killing the dollar. Or some derivative line of that thought. Contrary to the thinking of fretful dollar skeptics, my firm belief is that the US dollar is going to become even stronger and will at some point actually deserve to be the reserve currency of choice rather than merely the prettiest girl in the ugly contest – the last currency standing, so to speak.

But whether the Chinese RMB will become a reserve currency is an entirely different question. Of course it will, over time, but the question has always been when. There are some preconditions required for reserve currency status. Quietly, apart from anything that might happen to the US dollar, China is working to meet those conditions. Rather than wallowing in concerns about China’s actions, we might opt for a more thoughtful and constructive response: to welcome the RMB to the reserve currency club and hope that it gets here soon. The world will be a better place when that happens. And off the radar screen, it may be happening right now. Today we look at global trade flows and international balances and try to imagine a world in which much “common wisdom” gets stood on its head. It should make for an interesting thought experiment, to say the least. (This letter will print a little longer than usual, as there are numerous chart s and graphs.)

One of the prerequisites for a true reserve currency is that there must be a steady and ready supply of the currency to facilitate global trade. The United States has done its part in providing an ample supply of US dollars by running massive trade deficits with the rest of the world, primarily with oil-producing nations and with Asia (most notably China and Japan), for all manner of manufactured products. The US consumer has been the buyer of last resort for several decades (I say, somewhat tongue in cheek). Those dollars typically end up in the reserve balances of various producing nations and find their way back to the US, primarily invested in US government bonds. In an odd sense, the rest of the world has been providing vendor financing to the US, the richest nation in the world.

The US Trade Deficit Turns Positive

The US trade deficit (a key component of the current account deficit – see chart on next page) fell to an unprecedented percentage of GDP during the last decade, a development that normally heralds a significant drop in a currency. Fortunately, the “exorbitant privilege” of controlling the world’s dominant currency in reserve holdings, international trade, and financial transactions has helped shield the US dollar from a hard correction; but that status quo is in danger. After flooding the world with US dollars for more than twenty years, the US has reduced its current account deficit by 58% since the 2007-2008 financial crisis began. Looking ahead, I and many other observers believe this measure can continue to improve, due two surprisingly positive factors:

1. The US energy boom in shale oil and gas. The US has caught an incredibly well-timed “lucky break” made possible by the combination of new exploration, production, and processing technologies (such as horizontal drilling and fracking) and by the serendipitous discovery of massive supplies of oil and gas, often in areas that already have significant infrastructure and/or are accessible at reasonable costs. This energy renaissance is part of the reality that has made Houston, Texas, the number one port in the United States, with even more growth coming in the near future when the Panama Canal expansion is completed in 2014. US manufacturers are turning less-expensive oil and gas into value-added fossil fuel products and exporting them to the world. This trend will become ever more important. Indeed, when the first LNG export terminal is opened in a few years, the additional exports will approach $80 billion a year, I am told. From one terminal! There are four in the process of being approved and more on the planning boards. The math is there for anyone to do. Spot prices in the US natural gas-producing areas are under $4. The Japanese are paying more than $14. Even I can do that arbitrage. Just for fun, the next graph, from the Energy Information Administration, shows the rise in spot gas prices over the last six months, from a level that had been far too low. It also shows the arbitrage potential that exists right here in the US.

1. The consequent renaissance in US manufacturing. With cheaper energy and new technologies like advanced robotics and 3D printing, the US is producing more than we ever have – we’re just doing it with fewer people.

These two trends are bullish for the US in general. But that’s another story for another letter. The point today is that the US current account deficit is collapsing. A positive trade balance is not an unthinkable prospect today. It is quite possible that the US will be more or less energy self-sufficient by the end of the decade and could have a positive trade balance not long after that. I should note that exporting value-added chemicals made from less expensive energy will contribute even more to the positive balance than simply selling the raw natural gas.

Should the US achieve a positive trade balance, that shift would have a BIG impact on the rest of the world. For starters, moving from a current account deficit to a current account surplus will disrupt the two most important trade relationships in the world today: (1) the exchange of US dollars for OPEC oil, and (2) the exchange of US dollars for Asian manufactured goods. And while the US will continue to import significant (one could even say huge) quantities of manufactured goods, the quantity of dollars moving permanently offshore will be significantly reduced.

As a quick aside, by definition, a shrinking US current account deficit also means falling liquidity around the world (since the USD makes up one side of the trade in 87% of global currency transactions); and, as our friends at GaveKal have argued for years, a falling US current account almost always means that we will see a crisis somewhere in the world.

This is why the very same emerging-market central banks that complained about the Federal Reserve’s quantitative easing under QE3 are now openly calling upon the Fed to reconsider its tapering stance. Now that Fed has hugely inflated the emerging-market balloon, these economies are more vulnerable to popping. I recently read that the Monetary Authority of Singapore (the Republic of Singapore’s central bank) suggested rather strongly that the US Federal Reserve should consider its role to be that of central banker to the world and that it should thus make sure there is a sufficient supply of dollars to facilitate global trade. (Their suggestion may be due in part to the fact that they have lost $10 billion in the last year trying to keep the value of their currency from rising.)

With the US current account deficit continuing its fall, we need to be alert for the next crisis abroad.It is very difficult to predict exactly when, where, and how markets will panic, but taking US dollars out of the trading system is akin to losing a chair in a game of musical chairs. Someone is going to be left out. It could be Europe or Japan – there are more chapters to come in the sordid European and Japanese economic sagas – but more likely it will be emerging-market countries loaded with a lot of external debt denominated in US dollars who struggle to keep a seat at the table.

Emerging markets, particularly Asian and Latin American economies, took a beating during the 1990s precisely because of boom-and-bust credit cycles caused by hot capital inflows followed by rapid capital outflows. This volatile boom/bust cycle is precisely what emerging-market policy makers were hoping to forestall by holding larger foreign exchange reserves starting in the late ’90s, but trading predominantly in the US dollar left them to vulnerable to swings in market interest rates and Fed policy.

Let’s review the current state of global trade imbalances. Fortunately for us, the Bank for International Settlements just released a paper that gives us the data on this very topic (BIS Working Paper No 424: “Global and Euro Imbalances: China and Germany,” by Guonan Ma and Robert N McCauley).

You’ll want to view following chart in color (if you printed this letter in black and white) in order to appreciate how important the US trade deficit has been to world trade in the past 15 years. Remember, by definition, if there is a surplus in one part of the world, there must be a deficit in another. World trade balances must even out. That can happen through adjustments in the value of currencies or through countries producing as much as they sell. The US is a special case, since 87% of world trade is denominated in dollars; and the demand for dollars is evidently high enough to keep the price up, despite massive quantitative easing.

China Moves to Float Its Currency

Now back to China. I did an extended interview with Louis Gave this past Monday on BNN, the national Canadian business network (part 1, part 2). Let me offer a rough transcription of what he said. I had just commented on my belief that the US is on its way to a positive trade balance, which will make the dollar remarkably strong. The corollary is that there will be fewer dollars available to the world for global trade. Then Louis jumped in:

I think it [a positive US trade balance] is a very important development for the part of the world I come from. I live in Hong Kong. Asia up to now has mostly been a US dollar zone. In Asia we basically produce manufactured goods, sell them to the US, and earn the US dollars we need to trade with one another. So when China trades with Indonesia, the trade is denominated in dollars. When Japan trades with Taiwan, that trade is denominated in dollars.

The big issue is, if we move into a world where the US current account deficit disappears – both through the energy revolution that the US is going through and the consequent manufacturing renaissance – then, all of the sudden, manufacturing in the US is a lot cheaper than elsewhere because the cost of energy is so much cheaper. If the US basically imports [brings back] all of its manufacturing and no longer exports US dollars, how will Asia trade with itself? And how will emerging-market trade grow if they don’t earn the dollars?

I think the answer to those very important questions will increasingly be the RMB. What you have witnessed in the past two to three years is China making a very apparent play to internationalize its currency. In just two years, China has gone from settling 0% of its exports in RMB to settling 18% of its exports in RMB. Two years ago, the RMB was a non-currency [in international trade/finance]. Nobody owned it. Nobody traded it. Today, the renminbi is already – in just two years – in the top ten traded currencies in the world…. [See the table my research staff found, below. –John]

I think this shift is taking place because China has a massive comparative advantage that most people never think of. If I asked, “What’s China’s comparative advantage?” 99 out of 100 people would say “cheap labor,” but that’s not true. Labor is not that cheap in China anymore. China’s comparative advantage is that China – alone amongst emerging-market nations – has a deep and credible financial center. It takes 50 years to build a financial center – to, you know, have auditors, lawyers, accountants, judges. And China is very lucky, because in 1997 the Brits – who are quite good at building financial centers – basically built one in Hong Kong and told China, “Here it is. Try not to mess it up.”

For twelve years, China did nothing with Hong Kong. It was kind of a deal of “You don’t bother us, we won’t bother you. We’ve got other fish to fry.” And that worked well until all of a sudden, in the past two to three years, China has been internationalizing its currency through Hong Kong, and it is taking off like wildfire. We always talk about what you see and what you don’t. Everybody talks about the China slowdown. Everybody talks about the impact this is going to have on commodities, on countries like Canada, on countries like Australia. Nobody talks about what you don’t see. And what you don’t see is that China is slowly but surely internationalizing its currency. It’s slowly freeing capital controls. It’s creating deep and liquid capital markets, and this is going to change the way that companies and individuals finance themselves among emerging markets. It’s going to make for more stable emerging markets and hopef ully for higher growth.

Just as Louis predicted years ago, the Chinese RMB has continued to quickly climb the ranks from an internationally non-existent currency to number nine on the list!

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