More Evidence U.S. Dollar Dominance Is Beginning To Fade.

Summary

·         The Chinese have been actively working to reduce the dominance of the U.S. dollar in global trade.

·         The Chinese are not seeking to supplant the dollar with the yuan, but rather to have nations conduct international trade in their own respective currencies.

·         The Chinese yuan may take a prominent role in the issuance and settlement of loans at the AIIB, which nearly all developed nations have joined.

·         One of the reasons why the dollar became the global reserve currency is due to its privileged position in the oil trade.

·         Oil-exporting nations have been reducing their reserves of U.S. dollar-based assets due to low oil prices, meaning that they are now less wedded to the dollar.

Over the past several months, I have published a series of articles to this site that discussed how the reserve currency status of the United States dollar is currently in jeopardy. These articles have generated considerable controversy among readers due partly to the fact that many simply cannot conceive of this happening. However, there have been some developments over the past few days that show that this could indeed be happening and, if so, is likely a sign that the current strength of the dollar is likely to be temporary.

In a recent article, I discussed how the Chinese-led Asian Infrastructure Investment Bank was created as an alternative to the United States-led Asian Development Bank. I also discussed that this organization is simply one of a group of organizations seeking to provide an alternative to the current U.S. dollar-dominated global financial system. Many commenters stated on this and other articles that the Chinese yuan will not supplant the U.S. dollar as the global reserve currency. China itself denies that it is attempting to do this.According to The Global Times (a paper that is controlled by the Chinese government):

The establishment of the Asian Infrastructure Investment Bank (AIIB) has been depicted by a few overseas media outlets as if China is building its own version of the Bretton Woods system…

Some foreign observers claim that the AIIB is the beginning of the Chinese yuan's hegemony. What they are actually trying to imply is that "China is another U.S."

This kind of statement is nonsensical, which uses historical experience to fool readers. It is divorced from truth and shows no common sense and doesn't stand up to any scrutiny.

Through the Bretton Woods system, the U.S. was able to wield supreme influence over its allies, which had been severely battered during the war. China today is in a totally different position.

The AIIB will not confront the World Bank or IMF, nor will it turn the current international monetary order upside down. The spirit of the AIIB is diversity and justice.

This essentially confirms the statement that I made in my previous article. The ultimate goal of the Chinese is not to impose a system in which the yuan is the reserve currency. Rather, it is a system in which nations trade with one another in their own local currencies instead of needing to use the U.S. dollar as an intermediary currency. To that end, the Chinese have made a push for the Chinese yuan to take a prominent role in a basket of currencies that the AIIB will use to both make and settle loans.

 According to The South China Morning Post:

Beijing will push for the yuan to be included in a basket of currencies used to denominate and settle loans from the Chinese-led Asian Infrastructure Investment Bank (AIIB), according to think tank sources.

Beijing will also encourage the AIIB and the Silk Road Fund to set up special currency funds and issue yuan-denominated loans through both institutions, the sources said.

If the U.S. dollar is used, it weakens China's bid for the yuan to be a global currency.

The efforts are part of a drive to internationalize the Chinese currency and come as the International Monetary Fund prepares to discuss the possible inclusion of the yuan as its fifth reserve currency and as part of the basket that forms the IMF's Special Drawing Rights.

The sources' claims appeared to be backed by a state media report, which said that a basket of currencies called the "AIIB currency" would most likely be adopted as the bank's currency of settlement.

Hao Hong, chief economist and managing director of research at Bocom International, said the AIIB's grand vision for infrastructure investment came with challenges but China should do its best to establish the yuan as a currency for settlement and denomination.

"If the U.S. dollar is used instead, it weakens China's bid for the yuan to become a truly global currency and to challenge the hegemony of the U.S. dollar," Hong said.

Yifan Hu, chief economist with Haitong Securities International, said it would be too hard to reach a consensus on an AIIB currency basket…

"In my view, the U.S. dollar will be used in the early stages of the AIIB, and then [the bank] will gradually move to a mix of the yuan and the U.S. dollar," Hu said.

The sources said China would push for broader use of the yuan at the AIIB and the Silk Road Fund, as part of efforts to promote the yuan as an international currency…

The sources said that there was still a long way to go in the internationalization of the yuan and the greenback would continue to dominate the global financial system for the next few years.

Thus, despite the seemingly ominous language of parts of this article, China's goal is not for the yuan to become the global reserve currency but to increase the use of the yuan in international trade. This fits in with the goal that I described earlier as China is the largest trading partner of many of the world's nations. Thus, if trade is to be conducted using local currencies then it makes sense that the yuan would play a larger role in trade settlement. If China is successful in this, it would mean that global demand for U.S. dollars would be lower than today as U.S. dollars would only be necessary when conducting trade involving the United States and not in nearly all international trade, as is the case today. The fact that nearly every developed country in the world - Japan and the United States being the notable exceptions - has joined the Asian Infrastructure Investment Bank indicates that the Chinese may succeed in this goal.

One of the biggest reasons why the U.S. dollar became the dominant currency in international trade is because of its dominance in the oil trade. This is what I have frequently called the "petrodollar standard." In short, back in 1973, the Kingdom of Saudi Arabia, the largest exporter of oil in the world, agreed that all exports of oil must be paid for using U.S. dollars. Other oil exporters quickly followed suit, creating strong global demand for U.S. dollars. This is because those countries that import oil need to keep reserves of U.S. dollars in order to purchase the oil that they import. It also created significant global demand for U.S. Treasury securities as those nations that export oil, faced with growing reserves of U.S. dollars, found that the most convenient thing to do with these dollars was to purchase U.S. Treasuries. This has helped to keep interest rates artificially low in the United States and kept the value of the U.S. dollar relatively high.

However, the recent decline in oil prices has put strain on this system. This is because many oil-exporting countries have made their government budgets with the expectation that the triple digit oil prices that were seen over the past few years would be permanent. When this failed to occur, this forced oil-exporting nations, which previously operated with budget surpluses, to operate with budget deficits. In order to cover their government expenditures, these nations began selling off their Treasury securities (and other assets). According to BNP Paribas, 2014 was the first year in eighteen years in which oil-exporting nations in aggregate sold off more assets than they purchased.

As already stated, this occurred in 2014, which is in the past. We are more interested in what effect this will have in the future. Fortunately, Goldman Sachs sheds some light on this (via Zero Hedge):

We estimate that the new (lower) oil price equilibrium will reduce the supply of petrodollars by up to US $24 billion per month in the coming years, corresponding to around US $860 billion over the next three years. The ultimate impact, however, will depend on a number of key current account buffers (goods imports, net factor income, and service imports).

Thus, it appears that should oil prices remain at today's depressed levels, then there will be significantly lower global demand for U.S. Treasuries over the next few years. This may also provide an opportunity for oil-exporting nations to diversify their reserves away from U.S. dollar-denominated assets once oil prices do begin to recover. As I mentioned in a previous article, China has been pushing to pay for all of its energy imports using yuan and China is both the largest importer of energy in the world as well as the largest customer of Saudi Arabia. As the oil-exporting nations reduce their U.S. dollar-based holdings, they are less wedded to the dollar and this may make these countries more willing to agree with the Chinese.

Source: Power Hedge.