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Why China's 'Redback' Is the Single Biggest Threat to Dollar Hegemony

The future of the global monetary system is slowly changing from one dominated by the dollar to a new system involving multiple reserve currencies

Maybe it’s oil in the South China Sea that has the U.S. watching China. Maybe it’s concerns over China aggression towards its neighbors, wherever that headline may be found. But what some will say, including major investment houses, the biggest concern in Washington is a loss of dollar hegemony.

If that was too happen, it gives the Treasury Department a serious competitor and that — in theory — makes it harder for the U.S. to drive up debt if it has competition from other major, and liquid, debt markets.

The dollar is not going to lose market share so to speak any time soon. But this October marks Year One of the Chinese renmimbi (RMB) as a serious global player. That’s when it gets loaded into the Special Drawing Rights (SDR) currency basket of the International Monetary Fund , automatically increasing demand for the RMB from central banks in emerging markets that hold nearly a trillion dollars in cash reserves, including cash reserves in SDRs.

The future of the global monetary system is slowly changing from one dominated by the dollar to a new system involving multiple reserve currencies, with China being the obvious newcomer. Unless Europe comes up with a eurobond, then the future belongs to the RMB.

Granted, this thinking comes mainly from HSBC and truth-be-told, HSBC has a foothold in the RMB trade. It’s positioned to become one of the biggest banks in London and Hong Kong that allows companies and investors to buy and sell what it calls the Chinese “redback”.

The redback is coming for the greenback, people. Sound the alarm. There’s a new reason to be worried about China.

Redback Rising

The RMB’s inclusion in the SDR reflects the rise of China as a nation to reckon with. Like Korea, only 100 times bigger, China is opening its capital account and allowing for its richest individuals and corporations to buy assets overseas. The rise of the redback, as HSBC calls it, is recognition of China’s efforts to open up its economy and financial markets, and it will encourage China to continue on its reform path, Paul Mackel, chief of HSBCs forex research in Hong Kong says. If there is ever to be a multipolar world, it depends on China and not the eurozone.

In fact, to make room for the RMB in the IMF currency basket, the weights of the euro and Great Britain pound will be lowered more than those of the dollar and Japanese yen.

Events over the last few years have raised some concerns over the current dollar-centric monetary system, HSBC analysts wrote in a 54 page report published in March.  They blame the obvious: the 2008 financial crisis which had its epicenter in the U.S.

Since late 2014, the elevated levels of volatility in global markets and strength of the dollar caused by the Fed’s policy normalization that is out of sync with lower interest rates in China, Europe and Japan have reinforced those concerns. The U.S. is a big economy, with big banks with a lot of money. It goes without saying that by default U.S. capital is the dominant provider of global liquidity, especially in times of crisis. Countries that aren’t as fortunate believe the U.S. shoulders the responsibility to stabilize the world economy.  The only way to do it is through the dollar.

The U.S. has not always been outward looking when it comes to interest rate policy making. But the Fed now takes its global responsibilities seriously. For example, it provided unlimited dollar liquidity swap lines to other major central banks in the 2008 crisis.  In September, it pushed back a rate hike on concerns of a China slowdown and how a stronger dollar would impact emerging market currencies. A stronger dollar ultimately means it’s stronger against something — and that always means it’s stronger against emerging market currencies.

China was first to sound this alarm in August 2015. That’s when it widened the trading band on the RMB by about 4% up or down. The world was already dealing with a strong dollar. But the Fed figured it might not be ready for a weaker RMB making Made in China a whole lot cheaper to competing economies struggling to grow over 0%.

Still, the Fed’s focus is on domestic issues not China and the world is reeling from an ‘America first’ monetary policy.

Worry about China strength is not all politics. It’s economic. And some countries, particularly the multi-polar ringleaders China and its useful sidekick Russia, think aninternational monetary system less dominated by the dollar is desirable. Russia for political reasons — to take a stab at its old Cold War rival. And China for more pragmatic reasons — respect for being the world’s No. 2 economy and No. 1 in terms of global trade value. There’s no reason, other than Communist Party politics, why the RMB should be a bigger deal than it is today given the global importance of the Chinese economy.

Although everyone likes to chip away at the dollar’s armor, the RMB is more of a chink in the pound and yen.

According to the Bank of International Settlements, the dollar accounted for a whopping 63.7% of reserves at the end of 2014. The RMB was just 1%. But that will change very quickly later this year and will surely replace the pound and yen within a year or two. The pound accounts for 4.1% of reserves and the yen just 3.4%.

In terms of trade finance, the RMB accounted for 3.4% as of the second half of last year, according to SWIFT. The pound: 0.2%; the yen: 2%.

The dollar clearly dominates in foreign reserves held by central banks, dominates as a unit of account and dominates in trade finance. China has a long way to catch up, but it will catch up and will probably rival the euro within a decade.

HSBC sees it at the No. 3 slot, with more political muscle than the eurozone because the eurozone has no single bond market. Central banks are holding paper currency or German bunds priced in euros.

The last time a Chinese currency was widely used internationally was four centuries ago, during the Ming dynasty when trade ties between China and the rest of the world flourished, writes Mackel.

“China’s currency is extending its global reach again, and will eventually challenge the status quo in this dollar-centric international monetary system,” he says. “It’s quite possible we are beginning to move towards a new global economy and financial market where the dollar, euro and RMB each play pillar roles in their respective regions.”

The IMF, which will soon include the RMB on October 1 in its reserve basket, will only facilitate the progression.

Source: Forbes
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