China and the G-8

The origin of the Group of Eight was an invitation from French President Valery Giscard d'Estaing in 1975 to six of the major World War Two combatants to meet at Rambouillet in France. Leaders from West Germany, Great Britain, Italy, the United States, Japan and France attended that first meeting. The impetus to the summit, if not the sole topic, was the first post war economic challenge to the west, the 1973 OPEC oil embargo. In 1976 Canada was invited to join and the group stayed at seven until 1997 when Russia formally became a member.

Although formed a generation after the end of the Second World War, the G-7 represented the dominant nations of the defining event of 20th century history. As with the United Nations for international politics, the G-7 was an attempt to secure the victory of the western economic model. For the first 30 years after the war the only antagonist for the western capitalists had been the political and military threat of the Communists led by the Soviet Union. Until the oil embargo there had not been a serious economic challenge to Western Europe, the United States and Japan.

Why relate this history? The nations of the Second World War consensus that have dominated the world for 60 years are close to bankrupt. Their foreign bankers are now calling the shots; those who pay decide the future.

The abandonment of the climate change issue at the G-8 meeting is an example. Though the global warming agenda is a major part of the domestic political positions of President Obama, Chancellor Merkel, Prime Minister Brown and President Sarkozy the issue was removed from G-8 consideration because China, India and others would not go along. This is perhaps a foretaste of what will happen on every topic in which China and the other BRIC (Brazil, Russia, India, and China) countries have an interest.

China, Russia and India have been very public with their concerns for the long term value of the US Dollar and critical of the effect of American deficit spending. In April, China's holding of US Treasuries fell for the first time in eleven months. The amount was small, $4 billion and partially offset by a small gain in Hong Kong. But in the charged atmosphere of today's international economics and in light of US funding needs, the drop was widely noted. From April 2008 until March 2009 the Chinese Government had been steadily acquiring Treasuries; its holding had increased from $502.0 to $767.9, a jump of 53%.

China has also moved to increase the supply and demand for the yuan as an alternative to the dollar by starting limited trade settlement in its currency. On July 6th some firms in five Chinese cities were allowed to begin settling transactions in yuan with companies from Hong Kong, Macau and the ASEAN countries. Non-Chinese banks will be able to obtain yuan from mainland institutions to finance trade.

The Peoples Bank of China (PBOC) has also formulated currency swap agreements with Argentina, Belarus, Hong Kong, Indonesia, Malaysia and South Korea. The PBOC will render yuan to their central banks as needed to pay for imports if these countries are short of the currency.

These moves by the Chinese authorities will not establish the yuan as an international reserve currency. But they will shift some of the trade demand for dollars to yuan. Offered the choice what Asian trading partner of China would not want to remove the volatile and increasingly questioned dollar from their financial equation? The logic is simple and efficient. Why hold reserves in dollars for your China trade and bear the currency risk? Yuan reserves reduce the need for dollars and reduce dollar currency risk.

China has emerged as the engine of growth in Asia and Asian countries are looking to China for the health of their own economies. If yuan settlement becomes the policy of the Chinese Government what trading partner will want to go against Beijing's wishes and opt for dollar settlement? Considering the size of China's foreign trade the potential drop in dollar demand could be substantial.

Until now it has been in China's interest to keep the yuan undervalued for trade competition. Since last summer China has effectively re-pegged the yuan to the dollar after three years of gradual appreciation. But that is likely to be a temporary expedient. If China is serious about using the yuan in trade and in permitting outside players, non Chinese players, to hold and store value in yuan, an essential component of a reserve currency, what better way than to resume a gradual appreciation of the currency? For an exporter in Vietnam or Thailand or even Australia, Japan or New Zealand would not an appreciating yuan be a far better option for your China trade capital than the dollar?

Chinese national interest will determine Beijing's economic policy. But the time is fast approaching when safeguarding her economic development will be far better served by a strong and convertible currency than by a weak yuan priced for export. A strong dollar has been one of Washington's most effective foreign policy tools for more than 50 years; that fact is not unknown in the Chinese capital.

Joseph Trevisani


FX Solutions, LLC


Chief Market Analyst

Joe@fxsol.com