China’s devaluation of the Renminbi (yuan) came as a surprise to many observers. The People’s Bank of China debased the yuan 1.9% against the US dollar yesterday. That was followed up today by another 1.6% devaluation.
These aggressive moves raise fresh questions about China’s true intentions for its currency. We need to ask then what China’s ultimate aim is in devaluing the yuan.
Simply put, this devaluation is latest step in the yuan’s ascendency towards reserve currency status.
China has ambitions to join the International Monetary Fund’s (IMF) basket of currencies. The so-called Special Drawing Rights (SDRs) are long touted as the long-term replacement for the US dollar’s hegemony over global finance.
China wants this because of the privileges, both economic and political, that come with reserve currency status. At its simplest, it opens up Chinese financial services to the world, along with all the benefits that accompany that.
It’s not as far-fetched as you might think. The IMF views the yuan’s devaluation as a sign of the currency’s maturity. Why? Because the devaluation allows markets to play a bigger role in setting the value of the yuan on foreign exchanges.
Gaining the IMF’s acceptance isn’t enough for China. Joining its basket is the first step. The second step is to position the yuan as the leading currency within that basket. To do this, China needs gold — and lots of it. The more gold China holds, the greater the influence it wields in the IMF’s SDRs basket.
I’ll expand on why devaluations and gold point to massive changes in the global economic order soon. But first, it’s worth looking over the mainstream’s response to the devaluation.
Analysts aren’t wrong about the yuan’s devaluations. But they are focusing too much on the immediate economic factors influencing China’s decision.
By this I’m referring to China’s recent efforts to prop up its economy. The People’s Bank of China have pulled out all the stops too.
Several interest rate cuts have kept the economy ticking along in the past year. Yet it’s had no lasting effect. Domestic demand isn’t rising despite the injection of credit into the system. China is simply plodding along from one fix to the next.
The latest sign of its troubles came last week. Official figures showed Chinese trade plunged 8.3% year on year in July. Both exports and imports declined in equal measure. Chinese trade is now at its worst level since the 2008 global financial crisis.
From that perspective, the PBoC’s decision makes sense. The devaluation allows China to lower the cost of its exports. That’s what currency devaluations do, after all. They make exports more competitive on the global marketplace.
China needs to do this because it produces too many goods. Domestically, Chinese consumers can’t consume all these goods on their own. But the alternative is to cut back on exports. That’s not an option either.
Closing down entire industries is the last thing the government wants. They can certainly do without the unrest caused by millions of unemployed Chinese.
Naturally, the PBoC and government want a more globally competitive China. The health of the economy depends on a rebound in exports. But there’s an old saying about killing two birds with one stone that’s apt here.
Devaluing the yuan boosts China’s economy in the short term. But that’s only one side of the story. The other is far more interesting. And it starts and ends with the IMF.
Yuan devaluation: preparing for reserve currency status
The Chinese government makes no bones about its desire to join the elite of global currencies. The world’s second biggest economy is right to want this. That’s partly down to finance, but mostly revolves around politics. Greater financial influence gives China the kind of clout to throw its political weight to shape the world in its image.
But achieving this involves the IMF’s approval. Why is that? I’ll refer you to something I wrote earlier about China and the IMF:
‘The IMF’s Special Drawing Rights (SDRs), if you’re not familiar, is essentially a basket of currencies. In other words, it’s a supplementary foreign exchange asset that the IMF controls. The value of the SDRs is based on a combination of four currencies. These include the US dollar, the British pound, the euro, and the Japanese yen.
‘China has its sights set on joining this basket of currencies. And it’s long believed that it’ll do just that when the IMF decides the time is right. The IMF recently indicated it’s only a matter of time before the yuan is accepted into its basket.
‘Once it does, it’ll give the yuan major credibility in global finance. We’re going to see international reserves of the yuan rise exponentially. Simply put, it’ll liberalise China’s capital accounts. That, in turn, will open up China’s financial services to the rest of world’.
I’m not alone in thinking that the SDRs are China’s ultimate aim either. From the Australian Financial Review:
‘Citi analysts believe the move has come about due a combination of market pressures and the review by the International Monetary Fund to grant the renminbi, Special Drawing Rights (SDR) status, a step towards official government investors holding the currency.’
Better yet, why not just take the IMF’s word for it:
‘The new mechanism for determining the central parity of the renminbi announced by the PBoC appears a welcome step as it should allow market forces to have a greater role in determining the exchange rate’.
You might be thinking, ‘so what’? Does it matter if the yuan joins the IMF’s SDRs basket? It does, because it’s the start of a shift towards a global reserve currency. Put another way, it’s a global shift away from the US dollar. The importance of such a transition in global finance can’t be understated. It would spell the end of the US dollar’s 70 year reign as the reserve currency. And it raises serious concerns about how this changeover plays out.
Consider that the US remains the world’s biggest economy. You can’t trade on global markets without holding US dollar reserves. It means that the US government can spend far in excess of what it takes in taxes and export revenues. That’s allowed them to build up an incredible amount of debt, standing at well over US$15 trillion.
Once it loses its sole reserve currency status, it’ll limit how far the US can accumulate debt. That’s not something the US economy is ready to manage.
Nor can it rely on its link to oil (the petrodollar) to save it in the long term. Oil contracts, led by China and Russia, are increasingly settled without using US dollars.
Is it enough then for the yuan to devalue to attain the IMF’s approval? Not quite. While it’s a step in the right direction, all it does is give China a leg up towards SDR status. And this is where gold comes in.
Any new global reserve currency, even as part of the SDR basket, depends on gold reserves. Gold is the easiest, and fairest, way of determining a currency’s share of influence in the basket.
China, contrary to reports, is hoarding gold like never before.
Gold and the global reserve currency
Whether you’re a gold investor or not, you may have heard that gold is in a bear market. The price of the metal fell by US$50 in the last month, sitting at US$1,110. Yet there’s no economic theory to support why that’s happening.
Demand for physical gold remains high. Despite this, the price of gold in the futures market is falling. What gives?
Manipulation. I’ll explain why.
Gold prices are determined in futures markets. That means gold contracts are settled using cash, outside of markets where physical gold gets traded. Markets using cash to settle payments come with no risks.
Imagine if I was to offer you gold that I didn’t have. We’d agree on a price, you’d pay up, and I’d give you that gold at some point in the future. What would your response be to that idea? You probably wouldn’t pay me a dime. But that’s what happens on gold futures markets every day.
The effect this has on gold prices is obvious.
Making promises to give gold that a seller doesn’t have artificially increases supply. The markets create these uncovered contracts, giving the illusion that there’s more gold than there really is. What you’re left with is a situation in which the supply of contracts is increasing, but the supply of physical gold itself isn’t.
The end result is that gold prices go down because supply is ‘going up’. Except, of course, gold supply isn’t going up. Artificially low prices work in China’s favour. It gives it the opportunity to buy up gold reserves at rock bottom prices. And prices have been steadily falling since 2013.
Don’t read too much into recent claims saying China’s gold reserves are lower than expected. That’s nonsense. China’s reserves have grown rapidly in the last five years in preparation for what’s coming.
As the world moves towards a global currency, something will take its place. It won’t be the yuan, or any single currency. It’ll be the IMF’s Special Drawing Rights.
For that to take place, the yuan needs the IMF’s acceptance first. Once that happens, the end game for the US dollar will ramp up. The yuan’s devaluation is merely the latest step in this process.
Contributor, The Daily Reckoning
PS: Just like gold, the share market benefits from low interest rates. Both the US and Australian stock markets are continuing to push higher in 2015. Some say we’re already in the bubble of all bubbles.
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