Chinese yuan enters ‘interesting times’ with U.S. rate rise

There’s an old Chinese curse that says, “May you live in interesting times.”

For the Chinese currency, the yuan, these are interesting times indeed. And the implications will also have significant impact on the U.S. dollar and U.S. economy.

The Chinese yuan has now joined the U.S. dollar, the euro, the British pound and the Japanese yen as a currency of global status.

It will be represented officially in the International Monetary Fund’s Special Drawing Rights (SDR) currencies. This is bestowed upon countries that have currencies that meet two IMF conditions for SDR status: They are “widely used” and “freely usable.”

While the yuan will be added to the SDR basket, this move is largely symbolic. At this point in time, inclusion as an SDR doesn’t increase China’s share in the IMF quota of currencies. This more significant step for the yuan is going to take much longer. Being included in the quota would give China a voice in the decision making at the IMF.

This also comes on the news that the yuan is falling quickly against the dollar. Since the Chinese government tends to exert a lot of control over the currency, many observers are trying to figure out what the Chinese government’s ultimate goal is.

A cheaper yuan certainly helps its exports. But when the U.S. raises rates, the dollar will be weakened. This may be a preemptive move to control the fall of the yuan when the dollar is devalued. The dollar and the yuan values have been closely linked (“pegged”) for more than 15 years now. Devaluing now may help stem the amount of speculators attacking the yuan now that the Federal Reserve has raised rates.

Some think that this is end of peg between the U.S. and Chinese currencies. China is likely unpegging the yuan on its own terms rather waiting to allow the open market to set the tone.

China has a lot to lose if the yuan sinks too much, too quickly. For a developing nation — remember even with its “slow” growth, the country’s economy is expanding at more than 7 percent annually — a strong currency will help it buy more raw materials and strategic commodities, like oil.

For example, right now, China is buying huge amounts of oil at low prices to keep in reserve. If the yuan collapses, it takes more yuan to buy the oil.

What’s more, China has quadrupled its debt load since 2007 and its debt-to-GDP ratio is now higher than the United States’.

Runaway inflation in China would have global repercussions, likely setting off a cascade effect across its major trading partners, including the U.S. And commodity-based economies like Australia, Brazil and Canada could get hit very hard.

But it seems the Chinese government is most focused on decoupling from the dollar and given the strength of the U.S. dollar, it makes some sense to have a slightly cheaper yuan and increase exports, since China needs its huge export market to get healthier. But in the currency world it’s a risky game to try to nuance your currency. That’s what is driving so many Chinese into other alternatives.

The Chinese prefer investing in hard assets. So in a situation like this, you can assume they will be finding any way possible to dump their currency and invest in something safe until the storm passes. Expect gold to make in move in January and throughout 2016; bitcoin hit an all-time high recently just as China clamped down on internal flight from the yuan.

Money will also head to the U.S. dollar. But given that we’re entering “no man’s land” with the Fed raising rates and the rest of world continuing to lower rates, no currency play is worth the risk here.

–Gregg Early

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