CHAPTER 14

Dollar vs. Yuan. Can China Dethrone the US Dollar?

“I’m no pawn, so be gone, speed on and on, Kill the king, tear him down”

—Ronnie James Dio

Many analysts talk about trade war as if it was something new and unexpected that started in 2017, and it is a basic error of diagnosis.

The world had been in a trade war for years. The United States has denounced trade barriers imposed by China, the EU and other countries for many years, and the World Trade Organization did little about it. The 2017 National Trade Estimate Report on Foreign Trade Barriers had more than 70 pages of direct barriers imposed on the export of U.S. goods and services.1

The United States also imposed trade barriers in the past. From the 2002 to2003 tariffs of the George W. Bush administration to the highest rise in protectionist measures between 2009 and 2016. The Obama administration imposed more protectionist measures than any other G-20 country in that period.2

However, in the debate about trade wars there were many simplistic comments about the so called “nuclear option,” which essentially meant that China could destroy the US by selling its Treasury holdings.

Nuclear Option? No, there was no nuclear option.

The US has a massive trade deficit with China, the largest in the world, at $375 billion.3 China needs its U.S. surplus more than the U.S. needs China’s trade and finances.

China badly needs the surplus with the United States to keep its extremely indebted growth model, way more than the United States needs China’s purchases of debt of goods. If it does not grow exports to its main customer, the U.S., its problem of overcapacity and debt soars, and the economy crumbles.

China cannot win a trade war with high debt, capital controls and US exports’ dependence. A massive Yuan devaluation and domino defaults would cripple the economy.

The U.S. dollar is the most traded currency in the world and growing according to the Bank of International Settlement.4 The Yuan is 4 percent of currency trade.

China’s currency is not backed by either global use nor gold. At all. China’s entire gold holdings were less than 0.25 percent of money supply5 in 2017. It is as unsupported as any fiat currency, like the U.S. dollar, but much less traded and used as a store of value. China’s gold reserves are an insignificant fraction of its money supply.6

The yuan’s biggest weakness comes from capital controls and intervention.

China does not have a nuclear option on the U.S. debt.

For once, it is not the main owner of U.S, bonds, not even close. China is less than 8.6 percent of U.S. bonds outstanding.7 The United States can guarantee the demand for its debt issues even if China sells and those bonds would be absorbed in days by US large institutions.

If China sells its Treasury holdings, its own currency would massively appreciate and the domestic risks, lower exports, lower growth, outweigh the threat. Even if it sold, demand for U.S. bonds increases when global risks rise and when China has reduced Treasury holdings in the past, Treasury yields have fallen. The Federal Reserve and the main U.S. Fixed Income funds could buy the bonds in a very short period, a week at most.8

China cannot maintain its growth—based on a large debt—if its exports fall. A drop in the growth of China’s exports would mean a collapse of foreign currency reserves. These reserves fell 21 percent since the 2014 highs until the end of 2017.

A collapse in the reserves of foreign currency would accentuate the capital flight that the government in China tries to curb, which would lead to increasing capital controls, and with it, three effects. Lower growth, higher debt and the risk of a very important devaluation of the yuan.

For China, a trade war would be devastating. Selling off their Treasury holdings would be extremely negative for the Asian giant.

If there is something ironic, it is that, whatever happens, politician always thinks that money is their monopoly.

The Chinese currency, the yuan, is only used in 4.0 percent of transactions, in a country that is more than 15 percent of the world economy.

The conspiracy theories are constantly dusted off and we read in different news reports that China and Russia are going to dethrone the US dollar by launching contracts on oil and other commodities in yuan. China and Russia have switched to domestic currencies in trading using financial tools as swaps and forwards, seeking to reduce the influence of the US dollar and foreign exchange risks.

Will these measures dethrone the US dollar as king of currencies?

Hardly. The reports of the end of the US dollar appear to be simply conspiracy theories.

A currency is not a world reserve because it is decided by a government or group of them or because it is imposed militarily. If a currency could have been imposed by military might or political repression, the Soviet ruble would have been a world reserve currency, and the Chinese yuan would not be a mere 4 percent of world transactions. A currency is a global reserve when confidence in it as a means of payment and reserve of value is maintained throughout the world in the face of the evidence of risks with local currencies.

The megalomania and mistaken policies of politicians all over the world with respect to their ability to manipulate the purchasing power of their local currencies are precisely what reinforce the position of the US dollar as a world reserve. That is also the reason why the Swiss Franc, the Canadian dollar or the Australian currency are used more than the Yuan and other apparently almighty military powers. It is not military or political repression that makes a currency attractive, but rather the credibility and the depth of the secondary market.

Therefore, China will fail to dethrone the US dollar:

I believe that China will fail in its attempt to impose the yuan as a currency for global transactions for several reasons.

First, because it wants the world to widely accept the yuan while maintaining monetary repression via capital controls. As the British say, they want to “bake the cake and eat it.” What kind of global reserve can be created when capital controls are imposed? None. No economic agent will accept it.

Second, because most economic agents are aware that the huge imbalances of the Chinese economy will likely be disguised with a huge devaluation. The more this inevitable correction is delayed, the less the possibility of reinforcing the credibility of the yuan as a world reserve currency.

Third, the financial balance is against them. The reason why China maintains completely obsolete capital controls is that domestic economic agents, as soon as markets open, do everything possible to sell yuan and buy gold or US dollars on the evidence of the risk of a huge devaluation. That is why China lost around 21 percent of its reserves in foreign ­currency in a few years.

The only way in which China could pose a threat to the US ­dollar would be to defend sound money and end the disastrous monetary ­policy that governments are conducting. A commitment to sound money ­policies and avoid massive money supply increases. However, that does not seem to be the case, rather to spread China’s monetary imbalances to the rest of the world.

China will likely fail in their war against the US dollar if their objective is not sound money, but to impose their currency devaluations on the rest of the world.

A currency war is the one that everyone denies, and, at the same time, everyone practices. And that is what we are living, with a disproportionate increase in global money supply.

China surpasses the US, Japan and EU in the imbalance between the increase in money supply and real GDP growth and that always ends badly. China’s money supply growth is more than twice the real GDP growth and has been so for many years.

The difference between a global reserve currency and the rest, with all the errors and imbalances that the US makes, is that it benefits in relative terms from the other countries’ mistakes. When governments think that they can implement the same monetary policy as the US because ­politicians decide so. Thus, central bank after central bank, country after country, they approach the monetary cliff under the assumption that “there is no risk,” “everyone does it” and “this time it is different.”

In that race to zero, everyone goes hand in hand. But when they reach the edge of the cliff, the domino of collapses affects only those currencies that played God without considering secondary demand, global confidence, and utilization.

“We can do what the Federal Reserve does even if we are not global, strong and widely accepted as currencies” is the number one mistake of central banks all over the world.

Of course, the rulers of all those paper empires are advised by hundreds of economists who tell them that nothing happens if they increase monetary imbalances. And they are always wrong. But the damage is paid by others.

The advance of cryptocurrencies in this race to see who destroys more the purchasing power of its currency becomes a threat not only to the yuan or the euro but also to the US dollar as well. What Hayek predicted in Choice in Currency9 and Denationalisation of Money10 is unstoppable. The destruction of the monopoly of money in the hands of the states.

The mistake made by China is that it thinks that its currency will be imposed through repression, and not from market confidence. In the US, the Federal Reserve constantly monitors how to maintain confidence and increase use of the US dollar. Because of this, China will likely fail. Like all those before who did not understand that money is not what the government wants, but what citizens accept.

The only way to threaten a global reserve currency is by being stronger and defend its purchasing power. Any other way is likely to fail. Better the devil you know than the devil you don’t.

---