China to Announce Plans for World Currency Domination This Year

After years of tight state control, China is finally preparing its currency, the yuan, to go mainstream. The State Council revealed it would propose plans this year to allow freer flow of the yuan after a meeting led by Premier Li Keqiang on Wednesday. The announcement underlines Li Keqiang's commitment to furthering China's financial liberalization.

“It’s a positive sign that the new government under Li Keqiang is trying to boost growth by reform instead of launching fiscal stimulus,” Shen Jianguang, chief Asia economist at Mizuho Securities Asia Ltd. in Hong Kong, told Bloomberg. It shows that the “reform ideas promoted by Zhou Xiaochuan have received endorsement from the cabinet,” he said.

In econospeak, the ultimate goal is full convertibility, something enjoyed by the currencies of most developed nations, such as the US dollar, the pound sterling, and the Euro, which are known as key currencies since they are freely traded on exchanges around the world—anti-money laundering rules notwithstanding—and their relative values are decided by supply and demand.

The flow of yuan, on the other hand, has always been highly restricted so that China can maintain control over its domestic financial system. By keeping its currency within its borders, China can aggressively decide exchange rates and interest rates without concern for market forces.

For years, the government kept the yuan weak to protect its precious export fueled economy. Just how precious were cheap goods (and in turn its manufacturing sector) to China? A few years ago it was in fact illegal to take physical yuan outside of the country. Not long before that, the illegal trading of Chinese currency on black markets was punishable by death.

This strategy has been a double edged sword. The reliance on an artificially weakened yuan over market forces and export driven growth over domestic consumption have led to huge trade imbalances. It also hurts Chinese savers whose interest rates have always been lower than inflation.

On an international level, it meant Chinese companies historically couldn’t buy goods from, say Brazil, with China’s own currency. They’d have to acquire dollars first. That’s fine if the dollar is regarded as stable and likely to retain future value. Thanks to the US’s debt-fueled spending and policies of printing money, this is no longer the case. With Europe and its troubled euro faring no better, three quarters of international trade is still settled in dollars. That leaves China with no suitable alternatives.

A free-flowing yuan, however, would allow China to borrow in its own currency (so it could never default on its debt) and compete head to head with the almighty greenback. This latest announcement indicates that China is nearly ready to make this a reality.

Indeed, the internationalization of the yuan has been an ongoing process, a gradual plan set in motion by the Chinese government over the last decade. The yuan was pegged to the dollar until 2005, when it was allowed to float against a basket of currencies. Since then, it has risen 30 percent against the devaluing dollar.

In 2009, it became legal to settle international trades in yuan, as long as the foreign counterparty was willing to hold them. And some foreign banks can now keep yuan as reserves. China is also preparing to raise or remove quotas on foreign investment while giving Chinese companies more freedom to borrow overseas. All of this represents the continued liberalization of Chinese finance.

It’s bad news for the US, who has seen its dollar dominance deteriorate, threatening its reserve currency status, a powerful luxury enjoyed ever since the end of World War II.

In March, leaders of the so-called BRICS nations—Brazil, Russia, India, China, and South Africa—revealed that they are set to approve a new development bank, essentially bypassing the World Bank and International Monetary Fund, set up during Bretton Woods, a symbol of the tectonic shift of power from the establishment to new rising stars. It’s not a threat to be taken lightly. The BRICS nations have combined foreign-currency reserves of $4.4 trillion and account for 43 percent of the world’s population.

“The deepest rationale for the BRICS is almost certainly the creation of new Bretton Woods-type institutions that are inclined toward the developing world,” Martyn Davies, chief executive officer of Johannesburg-based Frontier Advisory, told Bloomberg. “There’s a shift in power from the traditional to the emerging world. There is a lot of geo-political concern about this shift in the western world.”

A decline in relevance for the dollar on the international stage is a ticking time bomb for a country fumbling with staggering debts. If the growth economies can trade with each other directly, circumventing America completely, the demand for US bonds diminishes, which raises the country’s borrowing rates. Today, the US enjoys record low interest rates. But can it last? What happens when the yuan becomes a legitimately viable option? Or worse yet, bitcoin?

@sfnuop