For China, moving away from the dollar makes sense

China's leaders make no secret of the thinking behind their well-publicized moves to diversify their county's massive foreign exchange reserves away from the U.S. dollar. Being so dependent on the greenback's value is simply imprudent, they say, given the size of their reserves -- some $2.1 trillion -- and the global nature of their exports and imports.

While some see this diversification as dooming the dollar, there are plenty of good reasons to believe China's leadership isn't singling out the United States but lessening their dependence on all currencies other than their own.
The Financial Times is reporting that China will issue renminbi bonds to offshore investors. This is important for two reasons: First, overseas investors can now exchange other currencies directly into renminbi (commonly called the yuan) holdings via these bonds, and China will not need to worry about the relative exchange value of other currencies as it retires these bonds later.

The currency a bond or mortgage is held in is critical. One of the underlying causes of the financial distress in Eastern Europe is that people and companies took out loans denominated in currencies like the dollar or Swiss franc. As their own national currencies lost value, the cost of servicing their loans skyrocketed.

In other words, a loan that started out low-risk and manageable can become high-risk and unmanageable if it is denominated in a currency other than your "home" currency.

This uncertainty affects not just the value of bonds written in other currencies but also the value of trade. All global corporations have to constantly hedge their holdings in various currencies lest their profits in one part of the world suddenly vanish due to fluctuations in foreign exchange valuations.

As part of this process to limit the uncertainty of trading not just goods and services but currencies, China has signed agreements with Malaysia, South Korea, Belarus, Indonesia and Argentina that enable exports to those countries to be priced in renminbi instead of dollars.

Given the risks of having the values of one's funds and goods at the mercy of currency fluctuations, then pricing goods and services in one's own currency is simply prudent risk management.

For the same reason -- simple risk management -- it is prudent for China to diversify its foreign exchange reserves (mostly held in U.S. Treasury bonds) out of such extreme dependence on the dollar.

China's recent moves to buy gold and other tangible assets such as farmland and oil exploration rights in Africa are attempts to diversify their assets out of currencies altogether. Looking at the U.S. from the Chinese point of view, which would you rather bet on, the value of the dollar or the land and buildings in the United States?

Prudent risk management suggests holding some of both real estate and bonds, and indeed China just announced its intention to expand its purchases of U.S. real estate.

Older readers may recall that Japan pursued a similar strategy when its holdings of dollars ballooned in the late 1980s. Japanese real estate purchases sparked a frenzy of hand wringing about the nation being sold to foreign creditors, but few paused to note that ownership of U.S. real estate by British investors far exceeded the holdings of the Japanese.

In other words, non-U.S. ownership of U.S. real estate assets has a long history.

From the point of view of basic risk management, diversifying one's holdings and minimizing the inherent risks of foreign exchange fluctuations is simply prudent common sense.

Just as it is in China's interests to diversify its portfolio of assets, it is also in China's interests for the dollar to not just remain stable but to rise in relative value; as a result, we might see a reversal of the dollar's fortunes in the coming months and years.

Charles Hugh Smith writes the Of Two Minds blog and is the author of numerous books, most recently Survival+: Structuring Prosperity for Yourself and the Nation.
Read Full Story
  • DJI30034.63395.991.34%
  • NIKKEI 22526787.54353.921.34%
    Hang Seng26567.68226.190.86%
  • USD (PER EUR)1.200.00640.54%
    USD (PER CHF)1.110.00440.40%
    JPY (PER USD)104.570.24600.24%
    GBP (PER USD)1.340.00270.20%

From Our Partners