Saturday, March 28, 2009

The Chinese Yuan: The Next World Currency ?

“Fake it ’til you make it” doesn’t work for bailouts.

The U.S. financial system is in a fragile place. As the bailouts go on– and on, and on– the U.S. and the U.K. will increasingly depend on China, Japan and other nations to buy Treasurys. But Wednesday, a U.K. auction of $2.6 billion in 40-year treasury securities garnered only $2.3 billion of bids. And in the U.S., Treasury Secretary Timothy Geithner implied that the dollar could be replaced as the premier currency for world financial reserves–something recently suggested by Chinese officials. (Geithner later backtracked).

As our colleague Liam Denning wrote in today’s Heard on the Street, “The dollar’s pre-eminence, like sterling’s before it, stems from a range of factors including deep capital markets and military power….Beijing’s proposal, therefore, looks more like a shot across Washington’s bow, reflecting concern about the impact of U.S. profligacy.”

Is the world hitting the spending limit for the bailouts, capital injections, and multifarious government guarantees? Deal Journal spoke with Kevin Chau, a currency strategist for IDEAglobal, to find out more.

Deal Journal: What did you think of Geithner’s comments on the dollar Wednesday?
Kevin Chau: When he mentioned having a world reserve currency, be it the International Monetary Fund’s SDR or something else, long term that’s a good plan, because the world reserve currency shouldn’t be tied to one country. We’ve seen the danger with the dollar’s status already. Countries that have a history of saving will flock their money to the U.S., which will create cheaper credit here and entice more people to buy and use debt to do it, which creates a bubble–which created this crisis we’re in right now. Longer term it’s a good idea to move toward a world currency. It’s going to take some time to develop because the world currency will need to build credibility. The U.S. dollar built credibility after World War II, so that was over 50 years or more. Geithner’s statement caused a drop in the value of the dollar mainly because it gave traders an excuse to trade off on some news.

DJ: The problem, though, seemed to be that his statements were taken as a metaphor for the fall of the U.S. as a political and financial power. Is that what is happening?
Chau: Eventually, but that will take time. You will see the emergence of China and the emergence of India eventually. Those are primarily export-driven countries. Once they start to develop a more-domestic economy they’re going to pull more weight. But that will be 10 to 20 years from now. It’s clear to see that the Chinese yuan will be the world’s reserve currency in the future. Many currency experts believe that the U.S. will not be No. 1 in the world in the future; it will share the No. 1 spot with China.

DJ: Geithner got into trouble before for suggesting that China manipulates its currency to keep it artificially suppressed, which then boosts the country’s reserves. Is there a feeling out there that China does this?
Chau: Yes. They do manipulate it, which you can see because it trades within a range. They don’t want it to increase too much.

DJ: So this is troubling because we need other countries to fund our bailouts, right?
Chau: Yes. We are dependent on China, we are dependent on Japan to continue buying Treasurys. We will be injecting more money to keep financing bailouts. That’s why it is important that the U.S. maintain a strong dollar policy, because once you get a weaker dollar, people won’t invest in U.S. assets.

I think that it would be important to see how appetite increases for Treasurys. The Treasury auction yesterday wasn’t great. [Deal Journal explainer: According to Bloomberg, "an auction of $34 billion in five-year Treasury notes drew a higher-than-forecast yield of 1.849%, spurring concern that government attempts to lower interest rates won't work."] If you get more like that, it’s another way of investors saying they’re not interested in the dollar. You have to keep an eye on Treasury International Capital System, or TICs, data, which tell you foreign appetite for Treasuries, agency securities, U.S. corporate bonds and U.S. stocks and shows American appetite for foreign stocks and bonds. Also watch the weekly Federal Reserve report that shows foreign appetite for Treasurys.

DJ: The U.K. government suffered a failed auction of its securities. Does that mean anything for the U.S.?
Chau: Yes. Government debt is considered a safe haven, particularly U.S. Treasurys and the securities of England, German and even Japan. The lack of demand for U.S. gilts will translate to less demand for U.S. treasury securities. As for the U.K. auction, it means that there will be less demand for those assets because of the increase of budget deficits.