China Makes a Bet Against the US Dollar as World Reserve Currency
Yuan: China is Slowly Trying to Replace the US Dollar
- US Dollar hegemony is at risk thanks to changes in the global economy and the long-term consequences of the US-China trade war. China has been working to make the Yuan a more central part of the global economy.
- By issuing debt denominated in USD, China is making a long-term bet that it will be cheaper to pay back its loans over time in the US Dollar; it believes the value of the US Dollar will fall.
- Issuing debt in a foreign currency isn’t uncommon; traders may recall that some famous investors rolled over their USD-denominated debt into JPY-denominated debt ahead of Abenomics and the long decline in the value of the Japanese Yen.
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US-China Trade War Phase 1 Deal
It was early-October when officials from both China and the United States said that progress had been made towards a Phase 1 trade deal, due to be signed before the end of the year. And yet, with the Thanksgiving holiday descending upon markets, there are no clear indications that a US-China trade war Phase 1 deal will be signed before the end of the year.
Perhaps the most interesting news related to the US-China trade war at the end of November was not about the Phase 1 deal itself, but rather some financing moves China is making at the margins.
On November 25, Bloomberg News reported that the Chinese Ministry of Finance was readying a sovereign debt offering, denominated in US Dollars, to the tune of $6 billion. This debt would come in tenors of three, five, 10, and 20 years. Chinese borrowers are issuing USD-denominated debt at a record pace, with $195 billion recorded issuance so far in 2019. Bloomberg News noted that the Chinese USD-denominated bond market is just shy of $750 billion.
This begs the question: why would China be issuing debt in a foreign currency, let alone the US Dollar in the middle of the US-China trade war? The simple answer: it’s all about disassembling the Bretton Woods system that has the US Dollar enshrined as the world’s reserve currency.
This is All Related to Bretton Woods
In July, the Bretton Woods system celebrated its 75th anniversary. Over the past 75 years, the Bretton Woods system by-and-large enshrined the US Dollar as the world’s reserve currency. Having the power of the global unit of account the US Dollar (and thus, the US economy) is afforded a level of privilege that no other country on the planet enjoys.
The foundation of this unique economic and financial privilege has been the fact that the US economy has maintained at least a 25% share of global GDP in the post-World War II era – in the 75 years since Bretton Woods.
Yet the global economy is evolving rapidly, particularly as countries in the West that dominated the 20th century are seeing declining birth rates and declining labor force participation rates. Countries in Asia and Africa are growing faster than their western counterparts in both population growth and productivity (granted, easy to do when you’re bootstrapping technological progress as opposed to sitting on the edge of the technological frontier, but still: faster growth is faster growth).
It’s not difficult to foresee the inevitable shift of power over the coming decades. Bretton Woods institutions have failed to evolve in a manner that allows for greater cooperation among emerging market economies, allowing China to push its One Belt, One Road initiative as a new standard for global cooperation.
In doing so, China is attempting to aggregate enough share of global GDP to allow the Chinese Yuan to take the mantle of the world reserve currency. The US Dollar (and the US economy) would lose the unique economic and financial privilege it’s enjoyed for so many years; and in turn, reduced demand for US Dollars (as it would no longer be the sole unit of account, if the unit of account at all) would very likely see the US Dollar decline in value.
Recall the Early Days of Abenomics
Traders who have operated in markets since the Global Financial Crisis may recall a similar news cycle. For those that were not trading in 2012 and 2013, this may be an interest analogy to consider when examining the facts of why China is issuing USD-denominated debt.
In late-2012, when Shinzo Abe became prime minister of Japan for the second time, he had done so on the back of a campaign that promised significant fiscal and monetary reform (see: The Three Arrows). Per the Mundell-Fleming, or balance of payments model of foreign exchange rate valuations, the combined force of expansive monetary and expansive fiscal policy was priming the Japanese Yen for a long-term downturn.
To take advantage of this forthcoming environment, news stories leaked out that several large investors in Europe and the United States were rolling over their debt, from whatever currency it was issued into, to JPY-denominated debt. None were more famous for doing so than American investor Mark Cuban.
Why Issue Debt Denominated in a Foreign Currency?
By issuing debt in a foreign currency – in the case of Abenomics, the Japanese Yen – investors like Mark Cuban were able to reduce their debt payments over time.
Consider this: your debt is now issued in JPY, not USD. When you issue this JPY-denominated debt, the USD/JPY spot rate is 80.000. As an investor earning his or her income in US Dollars, you will have to convert to the Japanese Yen to repay their debt. When the debt payments are due on year later, the USD/JPY spot rate is now 90.000. While the amount of JPY due to be repaid is the same, it now takes fewer USD in order to pay back those JPY.
By issuing debt in a foreign currency, you are making a bet that said currency will decline in value over time, making it cheaper to pay back the debt.
Just Another Sign that China is Trying to End US Dollar Hegemony
Much like investors issuing debt in the Japanese Yen as Abenomics began to take root, China’s decision to issue debt in US Dollars at a record pace this year is a sign that it betting against the US Dollar.
After all, if China is successful in displacing the Bretton Woods system with it’s own One Belt, One Road initiative, then the US Dollar will lose its place as the world’s reserve currency, plummeting in value along the way. It will be cheaper, over time, to pay back debt issued in US Dollars as, relatively speaking, the Chinese Yuan strengthens over time.
Which is why the US-China trade war is not merely about how the trade relationship will be fixed in the short-term; it is part of a long-term battle on China’s part to displace the US Dollar as the world reserve currency. And China is betting they’ll be successful.
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--- Written by Christopher Vecchio, CFA, Senior Currency Strategist
To contact Christopher Vecchio, e-mail at firstname.lastname@example.org
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