IMF Includes Yuan in SDR Basket; Does This Threaten a Dollar Collapse in 2016?

U.S. Dollar Collapse 2016Will This Threaten a U.S. Dollar Collapse in 2016?

The International Monetary Fund (IMF) has approved the inclusion of the yuan (or renminbi), the Chinese currency, in its basket of reserve currencies, threatening a U.S. dollar collapse. The IMF’s Executive Council, which brings together representatives of the Washington-based institution’s member countries, has added the yuan to the dollar, euro, yen, and pound in its currency basket for the IMF’s Special Drawing Rights (SDR).

The yuan will formally take its place as a reserve currency starting on October 1, 2016 to allow for an orderly transition. The IMF is satisfied that the yuan fulfills the requirements of a valid and widely used currency for international trade. The IMF’s decision, however, was more the result of political than economic considerations, highlighting the threat of a U.S. dollar collapse.

As with the current reform of the representation in the IMF, the United States opposes any changes that would weaken the role of the dollar, let alone prompt a dollar collapse. However, unlike other decisions that require the mandatory approval of 85% of the IMF’s members, the vote for a currency’s upgrade to DSR designation requires only 70% approval, making Washington’s veto power irrelevant.

China is now the second largest economy behind the United States (the first, if purchasing power considerations were taken into account according to the IMF), but it has also suffered from significant underrepresentation within the IMF. The adjustment of quotas, approved in 2010, which has recognized China’s efforts, lingered under the veto of the U.S. Congress, which has veto power that effectively limits the extent of the IMF’s power.

The inclusion of the yuan in the reserve currencies basket may have finally been approved as compensation for the IMF’s failure to do so earlier; in other words, it may be an attempt by the leadership of the IMF to maintain good relations with Beijing. The yuan’s inclusion also represents a sign of confidence that Chinese authorities will continue to promote economic reforms, some of which were adopted specifically to secure reserve currency approval. (Source: “Momentum Builds to Label Chinese Yuan a Reserve Currency,” The Wall Street Journal, April 1, 2015.)

What Does This Mean for the U.S. Dollar?

In addition to the symbolic recognition of the role of China’s economic power, the inclusion of the yuan as a reserve currency has some important practical consequences.

The yuan’s inclusion as an SDR currency should lead to a gradual flow of funds to the yuan from the central banks, sovereign wealth funds and other multilateral institutions, which has already begun. Some 70 central banks have invested part of their official reserves in the yuan. The mere reallocation of one percent of their international reserves to the yuan would mean some $80.0 billion a year in outflow. (Source: “Relocating China’s Foreign Reserves,” Brookings, November 21, 2013.)

However, the full significance, especially as far as the dollar collapse potential is concerned, becomes more apparent in the context of global trade alliances and emerging economic blocks. Less than 58 years after the birth of the European Economic Community (EEC), which led to the European Union in 1993, the Economic Community of South-East Asia (AEC) was formed in the summer of 2015. The AEC includes the 10 Association of South-East Asia (ASEAN) countries, excluding China.

The AEC will offer a common economic space aimed at the free movement of goods, capital, and skilled workers in a region that has more than 600 million people (with a combined gross domestic product of about $2.6 trillion) and is characterized by deep political and cultural diversity.

Two of its member states are still led by the Communist Party (Vietnam and Laos), one is currently governed by a military junta (Thailand), one is in transition from military dictatorship to democracy (Myanmar), while Brunei’s monarchy is a quasi-equity, Cambodia remains authoritarian, and democratic Indonesia remains the most populous Muslim country in the world. The other members are the Singapore (more “Sing-a-rich” than “Sing-a-poor”), Malaysia, and the Philippines.

The AEC is preparing for a formal takeoff on December 31, making the yuan more threatening in 2016 and raising fears of a dollar collapse at the center of global trade.

Although various measures of actual economic liberalization are yet to be made, especially in some areas that the individual states deem “sensitive,” overall political support appears to be vastly in favor of greater economic integration. Then there is the Regional Comprehensive Economic Partnership (RCEP), including the non-ASEAN members (China, Japan, South Korea, Australia, India, and New Zealand). Note that both associations exclude the United States, rivaling the very U.S.-led Trans-Pacific Partnership (TPP), recently concluded among 12 countries.

Meanwhile, as of January 2015 the yuan has become the most frequently used currency in global transactions, surpassing the Canadian and Australian dollars. Only four years ago, the yuan was used only among a small group of 900 banks. At the end of 2014, that number rose to more than 10,000 organizations. (Source: “Washington, China, and the Rise of the Renminbi: Are the Dollar’s Days as the Global Reserve Currency Numbered?” Heritage Foundation, August 17, 2015.)

What effects will the yuan’s inclusion in the SDR have on international finance? For starters, bond issues and the opening of bank accounts in yuan will rise significantly in areas where such transactions would have knee-jerked toward the dollar. In addition, transaction costs will be lower and will increase the expansion of Chinese companies abroad.

Thanks to the SDR, the yuan would outweigh the relative value of the Japanese yen and the British pound. No doubt, the advance of the yuan is unstoppable. UBS expects central banks will increase their reserves to 500 billion denominated in the “people’s currency,” aka the yuan.

Last summer, the People’s Bank of China, the country’s central bank, implemented the most intense devaluation of the yuan in the past 20 years. The Chinese currency has lost more than four percent of its value thanks to three consecutive cuts made in 72 hours that led to 6.40 yuan on the dollar. (Source: “China lets yuan fall further, fuels fears of ‘currency war,” Reuters, August 12, 2015.)

Here’s the Problem for the Dollar

The IMF’s inclusion of the yuan (or renminbi) in the SDR basket could create a three-way conflict, as predicted by James Rickards, a well-known Wall Street lawyer and New York hedge fund JAC Capital Advisors partner. Rickards, in his 2011 bestseller Currency Wars: The Making of the Next Global Crisis, described three major currencies (and thereby economies) facing each other in a conflict ensuing as a result of the 2008 recession. These currency wars involved China and its yuan, the United States and the U.S. dollar, and Europe and its euro.

As the subtitle of Rickards’ book not so subtly suggests, the effects of such a currency conflict are less than reassuring. “The making of the next global crisis,” perhaps one worse still than that of 2008–2009, may seem like hyperbole. After all, Rickards’ follow-up tome is The Death of Money: The Coming Collapse of the International Monetary System.

While the world collectively knocks on wood over the next few weeks, many believe that in December, the Federal Reserve will initiate the first interest rate hike. Interest rates have been held at historic lows for almost seven years. Now, Federal Reserve Chair Janet Yellen may decide to postpone the rate hike, again, in the wake of the IMF’s move and China’s related efforts to devalue the yuan. The suspicion is that China and other Asian monetary authorities in the region will act accordingly to protect their currencies and prevent slowdowns in domestic markets, fueling a downward spiral. Vietnam, China’s direct competitor, has already done so.

According to investment fund Schroders, the new mechanism for the official listing of the Chinese currency will lead to a shift away from a pure dollar peg to one based on a basket of currencies. (Source: “Large yuan depreciation not expected,” Schroders, August 11, 2015.) Accordingly, a further depreciation against the dollar would become more likely, further delaying the interest rate hike.

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