China Enters World Money Machine

Why the political urgency to include the yuan in the special drawing rights (SDR) if China does not meet the usual requirements? The answer is that a new global financial panic comes closer by the day.

These panics happen every five–eight years almost like clockwork. Look at the financial panics in Mexico (1994), Russia/LTCM (1998), Lehman/AIG (2008) and you get the idea. Another panic in 2018, if not sooner, is a near certainty.

The next panic will be bigger than the central banks’ ability to put out the fire. The only source of bailout cash will be the SDR. But a massive issuance of SDRs will require cooperation by China.

This is not because of International Monetary Fund (IMF) voting (China’s vote is not that large). It’s because SDRs are useful only if they can be swapped for other reserve currencies to prop up banks and liquidate panicked sellers of stocks. (The IMF runs a secret trading desk where these SDR swaps are conducted.)

When your neighbors are in full panic mode, they won’t want SDRs from Citibank; they’ll want dollars. But who will swap dollars for the SDRs printed by the IMF?

The answer is China. The PBOC and SAFE would love to dump dollar assets in exchange for SDRs.  But there’s a catch. China will only engage in SDR/Dollar swaps if the yuan is included in the SDR. China does not want to pay club dues unless it’s a member of the club.

The rush to include China in the SDR should be seen as global monetary elites getting their ducks in a row before the next panic comes to destroy your portfolio.

In the 1960s, hippies had an expression to describe membership in a small group. They said, “You’re either on the bus or off the bus.”

Well, the IMF wants China on the bus before the next panic hits.

When trillions of SDRs are issued in the next panic, China will dump its dollars for SDRs (with the yuan inside).

The U.S. dollar will be reduced to the status of a local currency.

The dollar will still be used for local transactions inside the U.S. (the same way the Mexican peso is used inside Mexico), but it will no longer be the benchmark for sound reserve management.

The impact on the dollar from the issuance of SDRs will be highly inflationary. After more than 10 years of trying and failing, the Federal Reserve will finally have the inflation it wants.

But they will rue the day. Instead of the 2% annual inflation the Fed is targeting (really slow-motion theft), inflation of 10% or more can be expected. From there, it will spin even further out of control.

With trillions in SDRs and thousands of tonnes of gold, China will call the shots the same way the U.S. called the shots at Bretton Woods in 1944. The slow death of the dollar, which began in 2009 with the issue of over $250 billion in SDRs, will be complete.

How can you hedge your exposure to a dollar collapse and also profit from the rise of the SDR?  There’s that old saying: If you can’t beat ’em, join ’em! The solution to the fall of the dollar and rise of SDRs is to invest in SDRs.

That’s a neat solution, but not as easy as it sounds. SDRs are for countries only; they are not walking-around money for you and me. There are almost no bonds denominated in SDRs, and no stocks at all.

The IMF has borrowed billions of SDRs from its members to fund its lending operations, but those SDR notes are held in reserve positions and not freely traded.

Eventually, a deep liquid pool of SDR-denominated assets will be created, but we’re not there yet. In January 2010, the IMF released a paper with a long-term plan to support the rise of the SDR.

It included specific instructions for the issuance of SDR notes by multinational corporations such as IBM and Siemens of Germany.

The paper also outlined the purchase of those notes by multilateral institutions such as the Asian Development Bank. It also suggested the formation of a dealer network led by Goldman Sachs and the creation of clearance and settlement procedures (the so-called “plumbing” of a bond market). All this will take years to develop.

Meanwhile, the largest, most sophisticated investors in the world (such as the $1 trillion sovereign wealth funds of Norway and Abu Dhabi) have found a way to synthesize SDRs. They are building portfolios denominated in currencies that match the official SDR weights.

For example, if you select fundamentally strong European companies in your portfolio, but the euro crashes against the dollar, you will suffer dollar-denominated losses even if your stock picks were strong.

Likewise, a portfolio of U.S. stocks may be strong on fundamentals. But if the dollar suffers a 1970s-style inflationary episode, your purchasing power is eroded relative to European and Asian investors.

This phenomenon of exchange rates dominating fundamental analysis is especially true during currency wars.

The reason the IMF has created a six-month delay between the announcement date and the effective date of the new SDR basket is to give the big guys like Norway time to “rebalance” their portfolios toward the new SDR basket.

When you have $1 trillion to rebalance, you can’t do things overnight without adverse market impact that hurts your own position.

A six-month window lets you move daily in small increments so that you hit the target date without too much disruption. This rebalancing will give a lift to the yuan as mega-investors reach to acquire high-quality yuan-denominated assets to conform to the new SDR basket weights.

It will also put downward pressure on sterling and yen, since their allocations in the SDR basket will be reduced to make room for the yuan. The reason the IMF has created a six-month delay between the announcement date and the effective date of the new SDR basket is to give the big guys like Norway time to “rebalance” their portfolios toward the new SDR basket. (The total basket always adds up to 100%, so if a new currency is introduced, some of the other currencies must be reduced in size.)

Membership in the exclusive SDR currency club has changed only once in the past 30 years. The SDR has been dominated by the “Big Four” (U.S., U.K., Japan and Europe) since the IMF abandoned the gold SDR in 1973. This is why inclusion of the Chinese yuan is so momentous.

Regards,

Jim Rickards

for The Daily Reckoning

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