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What You Need to Know Now China Has Entered the World Money Basket

Tuesday, June 27, 2017 2:26
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5 Things We’ve Learned Since China Entered the World Money Basket
 

Beginning in October of last year, China’s renminbi was added to the International Monetary Fund’s currency basket known as the Special Drawing Rights, or SDR.

The IMF, founded after Bretton Woods, established the SDR to be its own international reserve asset – what many have identified as world money.

Prior to Chinese inclusion, the elite currency basket was calculated with the U.S dollar, Euro, Japanese yen and British pound sterling. While China joining the SDR may have been largely status-driven at the time, the yuan and the Chinese economy have become open to heightened concern.

Significant worries over debt, wasted investments and threats of sweeping deflation left macroeconomists seeing a Chinese financial crisis on the horizon. Financial commentators ranging from hedge fund manager Kyle Bass to economist Jim Rickards highlight that the Chinese economy is on a dangerous course.

So what does that mean for China and its inclusion with the SDR’s world money basket?

Here’s five things we’ve learned from the Chinese entrance into world money:

1. October 2017 is Crucial

This October, the 19th National Congress of the Communist Party of China will be held. Thousands of lawmakers will gather in Beijing for the Congress.  The Chinese Communist Party (CCP) does hold ultimate power, but certain influencers are beginning to rise.

For the upcoming gathering, the result will be the largest leadership turnover seen in China in decades. The outcome is expected to be a test to President Xi Jinping. As he begins the start of his second term, the leader is expected to consolidate power.  President Xi could be poised to be one of the most powerful Chinese leaders in recent memory.

The gathering and power moves could make waves in the economy and even impact the Chinese status in the SDR.

Advocates have called for a floating currency.  A floating currency would result in the Chinese yuan’s value being determined by foreign exchange markets.  As China has already signaled its willingness to internationalize the currency by joining the SDR, it could be set to take policy moves a step further in October or later this fall.

However, if it does take the risk of floating its currency it could also put its currency value at significant risk to devaluation.  In the instance a drastic fall in currency value was to happen, it could shock China’s economy and change the balance on the SDR basket values as well.

Paying attention to October’s meetings and the outcomes for the foreign exchange reserves held by China will be vital to understanding the Chinese economy.

2. World Money Hasn’t Eased Geopolitical Tensions

By including China in the world money basket, the United States and major voting members of the IMF believed that internationalization could deescalate tensions in the region.

To put it simply, leaders believed that integrating China could open the doors for greater dialogue and cooperation. That hope vanished quickly after multiple skirmishes in the South China Sea and rising tensions on the Korean Peninsula.

Jim Rickards, a macroeconomic analyst warns that the dynamic warning signs between both regional areas could spell disaster.  As an advisor to the intelligence community and various military outlets, Rickards’ points to North Korea as the most dangerous hot spot in the world today.

“If the U.S. attacks North Korea, China and Russia will inevitably be drawn in to protect their interests. Unfortunately, North Korea is not the only region with the potential to start World War III.”

The tensions have not cooled with new leadership in the White House. Rickards’ notes that regional and territorial disputes have not only continued but seem to have escalated.

“With Trump willing to confront China, and China unwilling to back down, the potential for violence has not been higher since the end of the Cold War.”

Regional tensions matter significantly because the threat of war, sanctions and trade embargo restrictions could be a detriment to the world money basket and the global economy.

Although the entrance of China to the SDR might not have been a short-term solution to conflict, it could still have a significant impact on how the participating members interact in the long-term.

3. Chinese Downgrades Continue

The inclusion of the Chinese currency in the world money basket has had very marginal impact on the demand for the currency and nearly no impact on its credit rating.

On May 24, 2017 Moody’s Investors Service downgraded China’s credit ratings. This was the first time China had been hit with such a move in nearly three decades.

The move came less than six months after the IMF saw the Chinese economy as a potential leader in the global currency market and entered it into the elite world money basket.

Moody’s reported that, “The downgrade reflects Moody’s expectation that China’s financial strength will erode somewhat over the coming years, with economy-wide debt continuing to rise as potential growth slows.”

Other internationally recognized credit rating agencies have also followed a similar path. Standard & Poor’s maintains a negative outlook on China noting that financial risks are rising and a further downgrade is possible in the coming months.

State-Owned Enterprises and highly indebted companies in China continue to expose the economy to high risk. China is now stuck in a debt and credit fiasco that could see growth fall drastically if further credit rating drops are leveled.

Chinese-Economic-Growth

These economic hits matter to the IMF and world money because the Chinese currency is now being considered as part of a world reserve.

Separate from the SDR, the currency being accepted as part of the IMF’s currency Composition of Official Foreign Exchange Reserves (COFER). That puts it at world reserve currency status. This has had little impact on China’s rating status so far, but could provide a long-term context for the future.

Further downgrades of Chinese credit could adversely impact how the IMF’s status is viewed as a standard measurement of global currency.

4. Regional Power Ambitions are Building

For China, being a part of the elite IMF world money “club” was as symbolic as it was meaningful.  The entrance showed that the world recognized China could no longer be ignored, that Chinese economic integration was too powerful to be excluded and that the yuan was a vital piece of international trade.

The world money evolution also had geopolitical ramifications.

The power grab for China continues to be regional influence, not simply a gradual internationalization of its currency.

By pushing back against U.S and other major powers influence in the Asian region, China could assert its political and economic influence.

Nomi Prins, a former Goldman-Sachs managing director who routinely worked in Asia says that such institutionalized moves supersede the IMF.

“China’s power ambitions go well beyond the Special Drawing Rights (SDR). They include international diplomacy, sustainable energy dominance, and becoming a focal point for alliances through Europe, Russia and the ASEAN states.”

Prins’, an economic analyst by training levels that, “The ASEAN–China Free Trade Area (ACFTA) is a prime example of why the SDR, or world money, for China and the region is important as China expands its influence. So are new trade and financial pacts with Russia where the yuan and ruble exchange in deals without involving U.S. dollars.”

Currently, China is seeking to build a Pacific-based alternative to the Trans-Pacific Partnership (TPP) for which the U.S has backed out. Chinese inclusion into the world money system may have further contributed to such ambitions.

Leadership in China is pushing the Regional Comprehensive Economic Partnership (RCEP), an alternative to the TPP. Being a part of the world money basket could offer an added bargaining power as both China and Japan would be significant members.

As the largest economy in Asia and a recognized part of the global reserve currency basket, China now bolsters another dimension to its regional power position.

5. Gold Still Matters to China

China is the world’s largest gold market. While China may now be a part of the world money basket, it seems that gold is still the investment that mainland China seeks for protecting their wealth from currency risks.

China’s gold imports are expected to jump 50% as demand for gold continues to rise.

According to Bloomberg, “Mainland China is set to import about 1,000 metric tons from the territory in 2017, said Haywood Cheung, president of the century-old exchange in Hong Kong which trades physical gold and silver. That compares with net purchases of 647 tons last year.”

The same Bloomberg report noted that gold holdings are up worldwide. It noted that bonded warehouses were already being built and that financial use of gold could be driven higher throughout the year.

China gold imports

Source: Bloomberg

Factors driving demand for gold could be that the property market in the country (and around the world) appears to be slowing and volatility due to Chinese credit risks continues to soar.

Since 2014, China has experienced massive capital outflows. It is believed that more than $1.2 trillion has left the country since the surprise devaluation of the yuan in August 2015.

While participation of China in the world money basket was thought to be a move to restore credibility both domestic and international – the recent moves in gold paint a different picture.

The Future of World Money and the Yuan

President Trump identified China as a currency manipulator during his 2016 election campaign, but his branding did not last. The administration could still pursue outcasting the Chinese currency.  However, at current, it does not appear to be something that the White House is directed toward legally filing. What that means for the world money basket and the yuan is time.

The yuan is experiencing a slow weakening which could bring about greater liberalization and the ability of the currency to be free-floated.  By doing this gradually over time, the Chinese economy could feel less of an impact. The weakening matters because it would likely drop the value of the yuan and have a positive effect both for the United States and potentially the SDR.

For the short-term future, Chinese involvement in the SDR appears to continue to be largely symbolic. For the long-term a continued series of credit downgrades could put Chinese membership in the IMF currency basket in question.

Paying attention to not only how credit agency organizations report on China, but how the IMF views its economic outlook will offer significant clues for the future.

Craig Wilson   Craig Wilson@craig_wilson7  for the Daily Reckoning

Ed. Note: Sign up for your FREE subscription to The Daily Reckoning, and you’ll receive regular insights for specific profit opportunities. By taking advantage now, you’re ensuring that you and your family will be financially secure for the future. Best to start right away – it’s FREE.

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