China Positions Currency to be Global Standard (In Tectonic Steps)

The movement of tectonic plates happens so slowly that we humans barely notice the shifts. However, taken in aggregate and over time, the changes are massive and literally earth shaking.

Such is China's currency policy. Dramatic, you say? Indulge me. For there are indications -- if only incremental -- that China is moving to make its currency, the renminbi ("RMB"), an international standard of trading -- if not an eventual replacement to the once-all-mighty USD.

The Bank of China, their fourth largest lender, just announced that it is allowing foreign individuals and firms and to trade in RMB, making it the first Chinese bank to widely offer non-corporate RMB deposit services outside Hong Kong and mainland China. The limits on these personal accounts are $4,000 a day and $20,000 a year, and are still heavily controlled by Beijing. Nevertheless, analysts are touting the move as a significant policy shift.

The announcement is part of a series of measures that have eased controls on the RMB. Up until recently, the Chinese government has kept a tight handle on its currency. Keeping the RMB low has been a key ingredient to domestic growth, which is dependent on selling cheap exports to the rest of the world. But over the last year, there are indications that the policy might be softening.

In addition to allowing BOC to open private foreign accounts, many international banks -- including HSBC, Standard Chartered, JP Morgan Chase, Citigroup, Deutsche Bank, Spain's BBVA and South Africa's Standard Bank -- are now offering RMB trade settlement and RMB corporate account services. The international trade settled in RMB has gone from zero to 350 billion (RMB) in just under two years. In another turn, the city of Shanghai has created a new investment window, allowing qualified firms to buy RMB and invest in Chinese companies.

Most importantly, the Chinese central bank in July of 2010 bowed to international pressure and agreed to allow its currency to fluctuate -- as much as .5 a day. Shortly thereafter, China began a RMB settlement system for cross border trade in Hong Kong. As a result, the RMB has appreciated significantly against the dollar -- over 3% -- since July.

What can these events tell us? They signal that China is making its move -- however slowly -- to position the RMB as a global trading standard, forgoing some of its control over the exchange rate. The reason is two-fold.

First, U.S. assets (and therefore the dollar) have proven to be less stable than they once were. The recent financial crisis -- brought on by U.S. speculation -- has shown us that. Further, our continuing deficits, mounting debt burden, unfettered public spending -- and a political stalemate over what to do about it -- give the international community pause. China, along with everyone else is worried about the full faith and credit of America. Why wouldn't they be?

Less willing to expose themselves to the slings and arrows of the U.S. economy, China is giving investors another choice -- the RMB.

But there's another reason. In order to keep the exchange rate near-fixed, China has had to print money like nobody's business. Based on China's regulations, for every dollar increase in foreign exchange reserves, the central bank has to release the equivalent amount of RMB into the economy.

As a result, China's foreign exchange reserves surged nearly 30% after it joined the World Trade Organization in 2001. By the end of last year, China's foreign exchange reserves were almost 20 times their pre-WTO level. In the past ten years, China's M2 (a broad measure of money supply) has expanded at the average rate of 18.8% a year, far above what it needed to sustain its GDP growth. M2 was up again -- almost 20% -- in 2010. This compares with 3.3% annual M2 growth for the U.S. over the same period.

All this excess money in China risks inflation, especially in their very hot real estate and commodity markets. Easing the exchange rate means that the Chinese can stop printing cash and can get a handle on potential inflation.

But what does it mean for the U.S.? As is so often the case with currency fluctuations, there's good and bad. On the positive side, if the RMB is more expensive, Americans buy fewer Chinese exports and Chinese buy more American goods. That's good because our trade deficit with China could shrink, which means China could hold less of our debt and we could become a less indebted country. Maybe.

The other side of the coin is not so pretty. A weaker dollar means... well... a weaker dollar. It means that American citizens are less wealthy relative to Chinese citizens and that we have less purchasing power on a global level. Further, if you believe, as many do, that the American manufacturing base is gone, the potential rise in American exports would not offset that negative.

The larger concern, though, is that a stronger RMB means China won't have to hold as many U.S. reserves, which means they won't have to buy as much of our debt. And if China doesn't buy our debt... who will? That could set off a whole series of problems in the U.S. -- interest rate hikes, inflation, and even potential debt default.

The rise of the RMB isn't going to happen overnight. Indeed, China is being extremely cautious. The RMB is still heavily controlled and will be for years to come. That said, slow movements don't mean small movements. As in plate tectonics, slow can still be massive.