Thursday, 28 April 2016

SDR, Alternative Currencies, China and the Collapse of the Dollar

SDR has thrust into the limelight of late because of the talk of the imminent death of U.S. dollar as a global reserve fiat currency, and importantly,  the news of the inclusion of RMB into the SDR currency basket since Nov 2015.

 CNY Inclusion into SDR 
Before we get into that, what is SDR? SDR stands for Special Drawing Rights, which sounds more like some kind of law than a name for a basket of world's major currencies.

5 major global currencies, BGP, USD, EURO, CNY, JPY
5 major global currencies

Before the inclusion of Chinese Yuan, the IMF's SDR is consisted of USD, EUR, JPY, and GBP, and their percentages of each currency are as follows,

2011 - 201541.9% 37.4% 9.4% 11.3% 0.0%
2016 - 202041.73% 30.93% 8.33% 8.09% 10.92%

Note that USD percentages have hardly changed. The other 3 currencies need to shrink to make room for CNY.

If you like delicious pie charts, enjoy these two I prepared earlier (please note that their decimal places have been rounded off). If you like chocolate, let me know, I'll make some bar charts instead.

SDR currency compositions for period 2011 - 2015
(Click to enlarge)

SDR currency composition for period 2016 - 2020

 World Currency 
While it's not officially a currency, but you can think of SDR just another currency because of its characteristics it shares with other fiat currencies. Think of it as a global or world currency. I think you agree "World Currency" sounds better, and IMF Special Drawing Rights is quite a mouthful.

Another way of thinking about SDR is this: ECB prints Euro, the Fed prints USD, BOJ prints Japanese Yen, BOE prints Bristish Pounds, and PBoC prints Chinese Yuan, and finally, IMF prints XDR (the currency code for SDR).

Because XDR is treated like another currency, it too therefore has exchange rate with other currencies. You can look it up simply on an currency exchange rate website like XE.

Click here to see the exchange rate between XDR and USD.

Just like sovereign currency where its exchange rate fluctuates with other currencies. At the time of this writing, the exchange rate between XDR and USD is as follows,

1.00 XDR = 1.4052 USD.

If you haven't heard of SDR, it's because the IMF considers SDR to have an insignificant role to play (italics are mine) in the world of trades and finance.

A couple of things had lifted the profile of SDR recently. The 1st reason is the inclusion of RMB into the SDR, making it the 5th addition to this "world currency".

Billboard ads in Bangkok Airport for Chinese Yuan as a world currency
CNY is being inserted into the World Currency

The photo of this big airport billboard has been making the rounds in the net. The billboard is erected in Bangkok airport (note the Thai script in the top right corner of the billboard). Interestingly, this billboard was seen in March 2015, some 6 months before the official announcement of RMB inclusion into SDR. Obviously, Bank of China couldn't wait.

Since CNY is now one of the top major global payment currency, its inclusion into SDR is IMF's way of recognizing its importance in the global financial sphere.

 The Death of the USD 
The 2nd reason for the attention SDR receives is the increasing talk of USD fiat currency's status as the world's most important reserve is coming to an end. Especially by such high profile name in the currency game like James Rickards.

This chart is usually shown to make that point. There were no global reserve currencies as such before 20th century. The heading should be read as "World dominant currencies since 1450"

Chart showing global reserve currencies from 15th to 20th centuries
Chart showing global reserve currencies from 15th to 20th centuries

You know what they say, we all want to live forever, but we all have to die sometimes.

I would like to argue that the USD global reserve currency was born under the Bretton Woods system in 1944, and so USD global reserve currency role has only been in existence only for some 72 years (not 94 years as indicated in this table).

So while USD isn't quite close to a century old, but it's still getting on a bit, and some believe it's time for it to retire so others can take over. At least, we should start to think about the next candidate to take over USD's role.

Aside from historical precedence like those depicted in the chart above where USD is getting close to the century's mark, many are pointing out other reasons for USD's impending doom. The most often cited example is that USD is a fiat currency backed by nothing but people's trust. It has no intrinsic value. It's worth whatever people say it's worth. When people's confidence in the currency is lost, the currency will collapse. Confidence is a fragile thing. And so recurrent propaganda becomes paramount to strengthen that confidence.

Before 1971, USD was backed by gold until Richard Nixon took the gold standard off in order to print as much money as it needed in order to finance the Vietnam War. The move was supposed to be temporary, but US government has never put the gold standard back. As a result, USD became a fiat currency that's backed by nothing. Not something tangible anyway.

While USD has lost its gold backing since 1971, but soon enough, its status was boosted by the petrodollar system that the U.S. secured with the OPEC countries. In return for that unprecedented privilege of the petrodollar, U.S. government provided Saudi Arabia a military umbrella, especially against the strong and enemy neighbor of Iran.

USD's unrivaled status was slowly being eroded on two more fronts: the gradual crumbling of the petrodollar system, and the exuberant printing of USD by the Fed.

 The 4 Alternatives to USD 

1. Cryptocurrency

The talk of the collapse of USD leads to the creation of such thing as digital currency like Bitcoin as a solution to fiat currency. The idea of such currency is created out of the concentrated power of central bank. Because the Fed is a central bank that prints the global reserve currency of USD, that makes the Fed the most powerful central bank.

The idea of cryptocurrency like Bitcoin is born soon after 2008 when the Fed started its money printing programs to solve a problem that created by - at least partly - the Fed easy-money policy a decade before.

Bitcoin keyring

Allan Greenspan who was the Fed Chair who led to the 2008 Housing Bubble is telling us this very loose monetary policy is a bad idea.

So the BitCoin is created because it's diametrically opposite to central banks: it's a decentralized currency that can't be printed without cost of physical production of money.

If people's confidence of USD havn't begun to erode, such idea like cryptocurrency wouldn't even being entertained, let along being created. It's not only being created, but thriving, which is simply reflect people's gradual crumbling of confidence in the mighty dollar.

2. Precious Metals
We also have the good old fashion gold as an alternative to fiat currency. It's suggested that if gold standard was never taken off the USD, then we wouldn't have this easy-money policy that led to the loss of confidence.

I don't know if just having a gold standard would keep the USD reign supreme forever. I think the fall in the dominance in any currency is due to its economic decline. I don't think the fall of the British Empire, and all its Western empires that shows in the chart above were because they switched to fiat currency system.

Gold bars, gold ingots

An Chinese proverb says, "Wealth does not pass three generations" (富不过三代). I don't know how true this saying holds, and I don't know if this expression about family fortune applies to the fortunes of empires or superpowers. Looking at the chart, the 6 Western empires lasting from 85 to 110 years, or a century on the average. It seems there's a limit to how long a global power lasts (which seems to be the longevity of a human life as well). At least since 15th century in the West. So USD as a global dominant currency, and USA as a superpower still has 30 more years to run. This shouldn't come as a shock because as little as 5 years (and at most 10 years), Chinese economy is going to be the largest.

For those (Mike Malony is the most well known example) who study and believe in this historical perspectives would expect the time of the Fall of America as a Superpower, and naturally preceded by the Fall of the Dollar is near. Indeed no empire or superpower can retain its status without economic clout.

Top 10 gold producing countries bar chart
Data source: Wikipedia
(click to enlarge)

China's net gold imports from 2009 to 2015
(click to enlarge)

The 1st chart showing Chinese is the biggest producer of gold in the world, and the 2nd chart telling us that at the same time they're the big net buyer of gold. If you put these charts together, they tell us that in recent times, Chinese government bought gold like there's no tomorrow.

There's no shortage of reasons as to why Chinese government is buying so much gold.

Some say that the gold maybe needed as an unofficial condition for Chinese Yuan to be included into IMF SDR.

Jim Rickards is stating that because China holds so much American debts, gold is a good hedge because if the American government bond yields fall, gold tend to go up, and vice versa.

Some say that China is preparing to be the next global reserve currency. To many, a gold-back Yuan is far more preferably than a debt-based Dollar. That is, if the Chinese is decided to back the Yuan with gold.

Some believe that China, like the rest of us, is preparing for the collapse of the Dollar when the confidence is lost. Gold would provide a shelter from this currency shock.

Whatever the reasons may be, they're all good reasons.

Including former Fed Chair Alan Greenspan, more and more are coming to the understanding that gold is sound money,  a currency that's more superior than all fiat currencies.

3.  Chinese Yuan
And then there's the speculation that CNY is going to take over the game when USD retires.

There has been a trend in recent years that crude oil is increasingly being traded in Yuan rather than the traditional Dollar. In other words, the speculation of a petroyuan system.

When U.S. was a enemy of Iran, Saudis and Yanks view Iran as a common enemy. Now that U.S. has normalized relationship with Iran, China and USA is now on an equal diplomatic footing in providing security umbrella to the Saudis. Besides, the Chinese buys more oil from the Saudis than the Yanks. In this new geopolitical dynamics, Petrodollar system won't be in the best interests for the Saudis.

President Xi Jinping and King Salman holding sabres
President Xi Jinping and King Salman

Remember there's no such thing as permanent friends, and eternal foes. There's only national interests. Think of diplomatic relationship between US and Iran, China, Vietnam, and Cuba. Don't be surprise that when you wake up one day and find out that USA is now friends of Russia and DPRK, and enemies of UK and Japan. Well, remember Boston Tea Party and Hiroshima? Why wouldn't Riyadh know how to play the same game?

But CNY is far from ready of being a global reserve currency. For one thing, its currency still hasn't internationalized, or fully convertible. In fact, it wasn't even fully qualified to be included into SDR because it's not an international currency. But IMF does so as a symbolic gesture in recognizing the importance of CNY. For example, in 2015, CNY has overtook JPY as the world's 4th most-used payment currency.

The CNY's ranking is expected to move up the rank quite rapidly in the near future because as recently as 2012, the Yuan ranked 12. In just 3 years, it had moved up to the 4th place. And this typically comes as the expense of the Dollar.

And so it's high time that RMB is included in this SDR basket. There's no coincidence that the top 5 global payment currencies happen to be the same 5 currencies in SDR.

Global payment currencies ranking by countries

Well, the Yuan have at least a few decades to take over the role of USD, if at all.

4.  SDR
Many speculated the idea of using SDR to replace USD when it's time for the USD to retire as the world reserve currency. To many, because of USD as a world currency and together with the Petrodollar System, the US have been having a "free ride" on the financial system for a long time.

Some believe what's most likely to replace USD fiat currency won't be something else, but another fiat currency. Or preferably a basket of currencies like SDR where no one country's currency dominates. SDR seems to fit the bill.


Of course, all these are simply possibilities that are being speculated for the expected coming of the collapse of the Dollar.

Nobody knows which of these alternatives will win out, or something completely different will emerge.

The 3 currencies can be think of not just alternatives to USD when it collapses, but rather as a hedge for any eventuality.

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