Strong yuan no threat to dollar's reserve currency status, for now

Is it a preview of the new financial order, or merely a blip? Chinese exporters on China's border with Vietnam now prefer China's currency, the yuan, to the U.S. dollar.

"In recent years, the dollar has gone in only one direction and that is down," said China exporter Huang Xinyuan, who sells mining equipment and pesticides to Vietnamese customers, Bloomberg News reported Wednesday. "Settling our orders in yuan removes a major risk."

The emergence of the yuan

China has expanded yuan settlement from border zones to its largest financial centers, including Shanghai, Guangzhou, and Hong Kong. Later, Malaysia, Indonesia, Brazil, and Russia will be added to the system, as these nations seek to reduce the dollar's role as the primary medium of exchange in international trade and finance.

Despite the fact that the dollar has, for the most part, held its own against the world's other, major currencies this year, international trade and finance officials are concerned that record U.S. deficit spending, estimated to hit $1.8 trillion this year, and the U.S. Federal Reserve's quantitative easing strategy, will weaken the dollar in the months and quarters ahead -- reducing the purchasing power of those who hold dollars.

The dollar Wednesday weakened about one-quarter cent versus the euro and British pound, to $1.3940 and $1.6135, respectively. The dollar also traded at 6.8831 yuan. However, it's important to note that China does not allow the market to determine the yuan's value versus the dollar, but controls the yuan's value, allowing it to trade in a narrow, pre-determined "band."

China says a fixed yuan exchange rate is necessary to protect its developing economy and embryonic, vulnerable financial system. Critics counter that China is merely delaying a market-determined currency as a way to keep its export prices artificially low, to give them a competitive advantage in international trade.

G-8 speaks too soon

Economist Peter Dawson told DailyFinance Wednesday that China's tight control over the yuan's value is one reason those who believe that the yuan will vie for global reserve currency status with the dollar soon, "are getting ahead of themselves, and of economic and political reality."

"China's economy is growing and it doesn't have nearly the fiscal concerns that the United States has, but those positives are not nearly enough to force major changes in international finance," Dawson said. "Investors have to feel confident that a nation's political system will not, by decree or arbitrarily, suddenly increase or decrease the currency's value," Dawson said. "They must be convinced the nation's central bank has independence, and right now that's simply not the case in China."

Dawson added that some companies and exporters may, however, feel pressure to use the yuan instead of the dollar to gain access to the world's fastest-growing major economy and region (China's economy is expected to grow about 7 percent, Asia's about 5 percent in 2009), but that lure of business does not blot-out the central bank risk.

Further, the prospect that the yuan is likely to appreciate versus the dollar in the years ahead -- currency analysts argue it would strengthen to as low at 4 yuan to the dollar if its rate was determined by the market today -- also does not negate the political reality, Dawson said.

"Sure, China's economy is growing now, and it will support the yuan's value. But let's say you're doing business in China, you have hundreds of millions of dollars invested, and then China says 'We think the yuan should be 15 percent cheaper.' That presents a big problem for your revenue projections and for your business plan," Dawson explained. "It's a risk many businesses and investors won't take."

Hence, for the above reasons and for others, Dawson sees the dollar remaining the world's reserve currency well into the next decade. What the increased use of the yuan in Asia and G-8 chatter about 'a different global reserve currency," will do, Dawson says, is convince the U.S. Congress that the United States "can not run-up budget deficits with impunity," forcing lawmakers to reduce and eventually eliminate the budget deficit.

And that would be a positive development for holders of U.S. dollars, domestic and otherwise, he added.

Monetary Analysis: Aside from the euro, there is no viable, credible alternative to the dollar as a global reserve currency. Further, Europe's extensive social safety net and willingness to sacrifice the needs of investors to the needs of people and society will prevent any wholesale shift to the euro by institutional investors, provided the U.S. gets its fiscal house in order, which it will.

Further, Japan's yen could, in theory, challenge the dollar, but there again, the Bank of Japan has repeatedly intervened to weaken the yen's value, to lower the cost of its exports -- undermining the case for the yen as a reserve currency.

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