Strong US dollar may be what starts yuan's global rise
It's become almost an article of faith that structural weakness of the US dollar will accelerate the internationalisation of the yuan; as one declines, the other will ascend.
It sounds plausible at first. But dig a little deeper, and it emerges that far from it being the US currency's weakness that will propel wider international use of the yuan, it could be the US dollar's strength.
In recent decades, the world has got used to using the US currency. Most of the world's trade is priced and settled in US dollars, even if the goods traded never go anywhere near the United States. When Japan buys oil from Saudi Arabia, it pays in US dollars. And when a Chinese producer ships electronic gizmos to Europe, it gets paid in US currency.
Financial flows are also overwhelmingly denominated in greenbacks. According to the Bank for International Settlements, 85 per cent of all foreign-exchange deals are transacted against the US dollar. And the world's central banks hold the majority of their reserves in US dollars; 62 per cent, according to the International Monetary Fund.
Part of the reason that the US currency has been so widely adopted is that the supply of US dollars is so plentiful. In the last couple of decades, the US has consistently run massive trade and current account deficits. Since 1992, these deficits have pumped an astonishing US$7.8 trillion into international markets, providing more than enough US dollars for world trade requirements.
Not surprisingly, that excess supply has eroded the US currency's value. In the last 10 years, it has fallen by 35 per cent against a basket of other major currencies (please see the first chart).
But far from denting the US dollar's international role, this decline has actually reinforced its ubiquity. Non-US businesses have queued up to borrow in US dollars, attracted by the prospect of reducing repayment costs by owing their debt in a depreciating currency. As a result, the US dollar has become even more widely used.
Now, however, there are signs that the flood of currency cascading out of the US into global markets may be about to dry up.
Since 2007, US consumers have curbed their enthusiasm for maxing out their credit cards. As a result, the US current-account deficit has halved in size, from 6 per cent of gross domestic product in 2006 to 3 per cent last year (see the second chart).
That contraction could be set to continue. According to Leigh Skene at Lombard Street Research, recent wage inflation means that China has now lost almost all the advantage in unit labour costs gained against the US since 1994. If the trend continues, manufacturing in the US will begin to look attractive again, and the US trade deficit will shrink even further.
What's more, if shale gas lives up to its billing as a source of energy, US imports of hydrocarbons will plunge over the coming years. According to investment bank Raymond James, the US could even achieve energy independence by 2020.
Given that petroleum imports have accounted for half the US trade deficit over recent years, the US could even tip over into a trade surplus before the decade ends.
'That means the US will no longer be exporting US dollars to fund the working-capital needs of other third-party trading countries,' says Louis-Vincent Gave, chief executive of Hong Kong-based research and fund-management house GaveKal.
In other words, the gush of US dollars, which has kept the world trading system afloat for the last two decades, will evaporate.
With US dollars in short supply, the currency will naturally strengthen, which means it will no longer be so attractive for non-US companies to borrow in it.
The result will be a US dollar liquidity squeeze that could threaten the currency's monopoly on the world's trade and financial system.
With US dollars harder to obtain, trading companies and financial institutions will begin to look for viable substitutes.
With China already the world's biggest trading economy, the yuan would be an obvious candidate. And if China swings from a trade surplus to a deficit over the coming years as some researchers believe, there could be a sizable potential yuan supply to meet global demand.
In that case, the yuan will begin to replace the US dollar as a trading currency. But paradoxically, it won't be the US dollar's weakness that undermined its dominant international role, but its strength.