Is China ready to dump the dollar?

Earlier this week, during Brazilian President Luiz Inacio Lula da Silva’s high-profile visit to China, leaders of the two countries appeared to test-explode a low-yield thermonuclear device in preparation for a coming ‘currency war’ against the US dollar.

 The two countries would explore ways to use their own currencies — the Chinese renminbi and the Brazilian real —- instead of the US dollar in their bilateral trade transactions, officials said.

Coming on top of a host of currency swap agreements that China has signed in recent times —- with Argentina, Belarus, Hong Kong, Indonesia, South Korea and Malaysia —- the move gave rise to intense speculation that China was preparing to “axe the dollar,” a scenario that analysts have likened to “dropping the nuclear bomb.”

But economists point out that while the real-renminbi trade move would be consistent with China’s more vocal stance of diversification away from the US dollar, it is “impractical” in the short term.

“The real and the renminbi are both non-deliverable and neither country has an open capital account,” point out Standard Chartered analysts Douglas Smith and Mike Moran. “Furthermore, what would Brazilian firms do with renminbi, and why would Chinese firms want the real? Exporters and importers want either their home currency or US dollars.”

In fact, Brazil and Argentina have a similar arrangement to conduct bilateral trade in their local currencies. “However, despite their longstanding trade ties, very little trade has been transacted in local currencies so far this year,” they say.

Even the foreign exchange swap agreements that China has signed with other central banks have been “surrounded by hype,” says RBS’ chief China economist Ben Simpfendorfer. For instance, he adds, since the renminbi is not convertible, “it is difficult to see how foreign central banks can use the swap proceeds to pay for trade transactions with China.”

Additionally, the central banks cannot include the renminbi proceeds as part of their forex reserves because IMF guidelines state that reserve assets must be in “convertible currencies,” which the renminbi is not.

So, what is the purpose of the swap agreements? Simpfendorfer acknowledges that the current global economic crisis has provided an opportunity for China to accelerate the process of raising the importance of the renminbi to the global economy. “Nonetheless,” he adds, “substantive change will take many years —- or decades —- as it requires a fully convertible renminbi and the rise of a stronger Chinese consumer.”

Late last year, China’s State Council authorised the use of the renminbi for settlement for international trade between Shanghai and four cities in the Guangdong province in southern China. This is seen as an effort to “test-drive” the renminbi in preparation for launching it as a regional reserve currency, say economists.

“The trial schemes are worth keeping an eye on as they will offer a guide as to how quickly the authorities intend to liberalise Chinese renminbi trade settlement more broadly,” reasons Simpfendorfer. “Indeed, the trial schemes are arguably a more
important event than the swap agreements.”

Chinese leaders, including Premier Wen Jiabao, have in recent months publicly agonised over the value of China’s US treasury investments; the governor of the People’s Bank of China even floated the idea of a “de-dollarised” international monetary system, but economists saw the “non-starter” idea more as political posturing.

These public articulations gave rise to speculation that China was preparing to diversify its investments away from US dollar holdings. But even the most recent data from the US Treasury shows that China’s holdings of US treasury debt “are still growing in absolute terms,” says Standard Chartered economist Jinny Yan.

In fact, China is probably holding substantially more US treasuries than the data suggests, adds Yan.

However, China is switching from long-term to short-term securities (with tenors of less than one year), Yan says. Some economists see this as signalling that China is becoming wary that US inflation might lead to depreciation in the dollar’s value, which would in turn devalue China’s dollar-denominated holdings.

China’s investment strategy of recent times - of depreciating the renminbi and investing in US treasuries - “will result in a substantial loss of real wealth for China,” points out Moody’s Economy.com associate economist Alastair Chan. “Treasuries are low yielding and, given the likely direction of the renminbi against the dollar, a money-losing investment. This represents a transfer of wealth from China to the US, but there is little the Chinese can do.” 

China, adds Chan, is likely to keep the renminbi stable against the US dollar in the near term because it would be “politically untenable” to move either way. However, “it does see that after the global economy is on a sounder footing, the case for an upward yuan revaluation remains stronger than ever.”

As for the real-renminbi settlement initiative, Smith and Moran see it as “more political than anything else: the political goal is to further highlight the significant trade linkages between Brazil and China, strengthen the BRIC coalition, and add pressure to the US and the Group of Seven to allow greater influence of the BRIC countries in international forums such as the IMF and the World Bank.”

In other words, in the short term at least, China is not ready to “drop the nuclear bomb,” although every once in a while it might sound off with a high-decibel firecracker or two.