How Shall America Respond to Chinese Yuan as a Global Currency?

George Koo, Henry Tang

February 29, 2012

http://www.chinausfocus.com/finance-economy/how-shall-america-respond-to-chinese-yuan-as-a-global-currency/

Since the collapse of Lehman Brothers and the ensuing tsunami from Wall Street that almost swamped the financial world in 2008, China has been busy signing bilateral currency swap agreements in order to minimize the exposure of holding too many dollars.

Such swap agreements allow the two signatory nations to do business with each other using their own currency and skip having to buy dollars and settle the trade invoices in dollars.

Ostensibly such swap agreements facilitate bilateral trade by making it more convenient to do business for both parties. Some of China’s first agreements, such as with South Korea, Argentina and Brazil, appeared to be for this purpose. But, there are other benefits to swap agreements.

Swap agreement with a weaker economy gives the smaller country a lifeline into global trade with dollars they don’t have or not having to spend what few dollars their central bank do have.

Up to now, China has entered such swap agreements with18 countries and counting. The latest was signed with Turkey on the occasion of Vice President Xi Jinping’s stopover on his world tour after the U.S.

For such countries as Iceland and Belarus, they get to swap their struggling kronas and roubles for the strong and stable yuan, the basic unit of China’s Renminbi (RMB).

By adjusting the exchange rate between the two currencies along with financing, the swap agreement can also serve as a kind of trade subsidy and foreign aid as apparently is the case with Pakistan.

Currency swap deal can also serve as a tool for diplomacy as China’s premier, Wen Jiabao, demonstrated in his recent visit to the United Arab Emirates. A highly publicized 35 billion yuan swap agreement was signed amidst much fanfare and an implied step forward to getting oil from the Persian Gulf.

By far the most noteworthy swap deal to date was announced on the occasion of Japan’s Prime Minister Noda’s visit to Beijing in late December. The significance and size of this deal far surpass all the others.

This is a deal between the second and third largest economies of the world.  China is already Japan’s largest trading partner. Their bilateral annual trade exceeds $340 billion, nearly tripling in a decade. Their swap agreement means being able to opt out of using billions of dollars in their transactions.

Furthermore, as part of the agreement, Japan will be allowed to buy yuan denominated bonds issued inside China. In effect, Japan has been invited to participate in the growth of China’s future economy as well as in the much-anticipated appreciation of the RMB.

This is a classic example of where shared economic interests can trump even animosity stemming from bitter memories of WWII Japanese atrocities and continued tension over the possession of uninhabited islets in East China Seas.

Bilateral swap agreements also suits Beijing’s preference for instituting changes in small steps, by allowing Beijing to gradually loosen the control of its RMB outside of China in measurable and predictable increments.

Countries that have such swap deals with China will in effect diversify from their dependence on the dollar as their only hard currency reserve by holding on to the Chinese yuan as a de facto reserve currency. Not only can they use the yuan in their trade with China but presumably also with other countries that have swap agreements in place with China.

Thus by proliferating bilateral swap agreements, China will in effect be creeping up on having RMB become a reserve currency and an alternative to the dollar.

How shall the United States react to this ongoing development? First of all, let’s concede that there is not much the U.S. can do about it. Everybody knows that the long-term value of the dollar is on a declining trajectory. That is a direct consequence of the US ongoing fiscal policy and nothing is on the horizon that will reverse the trend. It’s natural for other countries to diversify and not want to hold too many dollars.

However, we believe the US has the option to react positively or negatively. The positive side is simple. Coexistence of the yuan alongside the dollar takes the pressure off the dollar as the only viable reserve currency. This should enhance a more stable worldwide economy and one less thing for the Fed to worry about.

For a myriad of reasons, there is no likelihood that the yuan will replace the dollar as the reserve currency, at least for the foreseeable future. It would be in Washington’s interest to work with Beijing and coordinate their economic policies.

A negative response is for Washington to continue to confront and bicker with China. In November, President Obama announced the Trans-Pacific Partnership as ostensibly an antidote to China’s expanding economic influence. It remains to be seen whether TPP will have any real impact that will benefit the member nations.

On the other hand, China along with Japan and South Korea are already members of ASEAN+3 multi-lateral agreement on a $120 billion regional currency swap fund. The fund was set up to bail out member nations in times of illiquidity or balance of payment shortfall, possibly rippling from the European financial crisis. The members are considering doubling the fund in response to the perceived increasing threat of global instability. That’s a tangible safety net compared to the feel good promises of the TPP.

Unfortunately the coming presidential campaign along with the vociferous members of Congress is unlikely to ease up on their bellicose rhetoric directed to China. They really should take a page from the British.

After the China-Japan swap agreement was announced, British Chancellor of the Exchequer, George Osborne, rushed to Hong Kong in January. The government official of the former colonial ruler was in its former colony to pitch London as Hong Kong’s European satellite and get a piece of the growing RMB exchange business.

It is after all better to make money together than sending hot air missiles at each other. If China and Japan can overlook their deeply rooted differences for mutual benefit, why can’t the US and China, where the differences don’t go much beyond the rhetorical?

George Koo is a retired international business advisor and board member of New America Media and Henry Tang is retired investment banker and founding chairman of Asian Financial Society