Friday, 25 September 2009

China and the New World Economic Order

Immediately following World War II a new world order arose. The economic structure was symbolized by the 1946 Bretton Woods Agreement which established the World Bank and the International Monetary Fund.
The torch of global economic leadership was passed by Britain to a newly confident and idealistic United States. Although it took another few decades before the US Dollar supplanted the British Sterling as the world's reserve currency the momentum was already clear by the late 1940s.

The world is seeing another major systemic shift today.
Much has been written about China's influential role as a trading nation. However, it is sometimes forgotten how important a role the country plays in the stability of the international monetary system.
When you have over two trillion dollars of currency reserves to invest it is difficult not to be noticed. In June 2009 China held USD 776 billion worth of US Treasury securities.
China's investment patterns move markets and even the hint of action by China has an impact. The Chinese have made their long term intentions clear but they are aware that their short term behaviour must be responsible.
China is vexed by its reliance on the USD and the government is gradually implementing policies to diversify its currency options. On the contrary, the US understands its dependency on China for funding its deficit.
The US administration sent Treasury Secretary Geithner to Beijing in June. Geithner's brief was to assure the Chinese that the USD is a stable currency and a good store of value.
Like any good banker he went to his major depositor and pledged that the US economy is sound and the client need not worry about their deposit.

Subsequent to the visit the Chinese have upped the ante.
They subscribed to USD 50 billion of notes issued by the IMF. The notes were not denominated in USD but instead used the IMF's Special Drawing Rights (SDR).
According to the IMF "the value [of the SDR] is based on a basket of four key international currencies, and SDRs can be exchanged for freely usable currencies."  The SDR is backed by the good faith of the Japanese Yen, the Pound Sterling, the Euro and the US Dollar.
The SDR and the USD are both paper currencies that lack the backing of any hard assets (e.g. gold).
The IMF transaction was a clever and calculated move by China. 
By providing fresh funding to the IMF the PRC has increased its influence in an essential supranational entity.  Additionally, the use of the SDR signals that China is keen to reduce the international role played by the USD.
There are other indications of China's intent to diversify out of the USD.
China's Central Bank it has suggested that the SDR be considered as an alternative currency for managing trade flows. Recent press reports point to China negotiating with the IMF to purchase some (or all) of the 403 metric tons of gold the Fund is selling.
For a communist nation the PRC has quickly learnt one of the fundamental principles of capitalist investing, diversification. Some bankers suggest putting all of your eggs in one basket and then watching the basket like a hawk. The more prudent strategy is to diversify and place your eggs in several baskets.

The Chinese economic structure is not yet sophisticated enough to allow the 'internationalization' of the Yuan

The global economic system is in a period of transition. It may even be the beginning of the end for the Bretton Woods system. Investment managers are paid not only to manage risks but also to generate returns.
Periods of great uncertainty such as the current Global Economic Crisis offer ample doses of both risk and opportunity. Sometimes it is easy to miss the forest for the trees.
Simply diversifying currency exposures may help protect a portfolio of reserves more than the use of the most sophisticated proprietary risk management tool available to institutional investment managers.

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