China Gets a Seat at the Reserve Currency Table – China’s currency, the yuan, gained inclusion into the International Monetary Fund’s (IMF) Special Drawing Rights basket this week, a move the Chinese central bank has been posturing to achieve for some time. The yuan’s inclusion will give the world’s central banks an additional alternative for foreign exchange reserves to go along with the U.S. dollar, the euro, the yen and the pound.
The U.S. dollar and the euro account for a large majority of special drawing rights currencies with about 45% and 30% weightings, respectively. The basket’s currency weightings will shift to make room for the yuan, with the euro seeing the largest percentage drop from the new formula. The importance here is that the special drawings right basket is crucial to trade as the currencies available within the basket are available for settling transactions. To give a crude example, a developing country might sell goods and get paid in a foreign currency, then convert that currency to dollars, then convert it back to their home currency. In this sense, the U.S. dollar was used to ‘settle the transaction.’ With the inclusion of the yuan, it will now likely become more frequently used for international payments and in foreign exchange markets, giving China a greater role in capital markets for the global economy.
Don’t Expect the Yuan to Take Over the Dollar in Your Lifetime – I’ve seen a lot of questions from clients this week about what will happen if the yuan takes over the dollar as the world’s top reserve currency. The fear is that foreign central banks will ditch U.S. dollar denominated assets (Treasuries) and drive fierce upward pressure on interest rates (which could easily drive our country to recession). I have strong conviction that this will not be the case. I can write about this for days (and I will soon), but the key thing to understand is that in order for the yuan to ‘overtake’ the USD as the world’s top reserve currency, central banks around the world would have to near-unanimously decide to replace their dollar-denominated assets with yuan-denominated assets. This to me seems very highly unlikely. The reason U.S. dollars account for the largest share of foreign reserves is because the U.S. sovereign debt market is the deepest and most liquid in the world. Think about this in terms of the financial crisis of 2008 – what did central banks and investors do? They ran like crazy to U.S. Treasuries. Why? Because even in the wake of one of the worst credit crises the world has seen, the U.S. was still by far seen as the safest house on the street. There’s a reason for that: our economy is the biggest, most diverse, most highly functioning economy in the world. Why in the heck would a central bank be so inclined to replace the most liquid, transparent and diverse economy’s currency for one where the state (China) still restricts foreign ownership of government debt, enforces strict capital controls on foreign investments, and doesn’t even allow their currency to float freely?
The Good Kind of Spending – Congressional leaders this week reached an agreement on a five-year highway bill that would also reauthorize the Export-Import Bank. The bill has a price tag of $305 billion and would give the economy a much needed nudge for infrastructure improvement. Infrastructure spending is good spending, as it flows directly into the economy.
Divergent Monetary Policies – Janet Yellen aired a few comments this week to give further signal the rate hike this year is still “on track.” Meanwhile, in Europe, the tone is nearly perfectly the opposite. With 0.1% inflation and around 10% unemployment for the zone, Mario Draghi is positioning to ease even further adding to the quantitative easing program and lowering overnight rates into even deeper negative territory. The question is, will risk assets flow from the U.S. to Europe as a result?
Downgrades Galore on the Heels of New Regulation – following the 2008 financial crisis, I have a hard time putting any faith in credit rating agencies and their practices (they completely missed the meltdown, and only downgraded banks when there were already ashes on the street). That’s why I’m not overly concerned Standard & Poor’s recently dropped a blanket downgrade on most of the U.S.’s stoutest banks in the wake of a new rule requiring large institutions to hold a stockpile of debt that can be converted into equity if they fail. This is basically a signal from the U.S. government that says, ‘we may not bail you out next time, so you better prepare yourselves.’ I doubt it. Some of the companies however affected by the downgrade included JPMorgan (JPM), Goldman Sachs (GS), and Morgan Stanley (MS).