America May Demand SDR Substitution

Economics, Premium POM

Trump to Make Case that International Role of the Dollar is Detrimental to American Interests

By JC Collins

Since the election of Donald Trump last Tuesday the markets have been on fire.  The Dow is at record levels, gold is crashing, and the Chinese yuan is depreciating. But how long can this keep up?

An appreciating USD does not work in the benefit of the US monetary authorities.  Nor does a depreciating renminbi work in the favor of China.  Both will further enhance the trade deficit challenge which America faces and the trade surplus challenge which Beijing faces.  The twisting tension which builds between both extreme ends of the spectrum will cause deeper instability in the international monetary system.

With the next Federal Reserve interest rate increase on the table for December things will only become further complicated.  Trump has already spoken out about China being a currency manipulator, and any Fed rate increase will put additional downward pressure on the Chinese currency.

A story which has come out today informs us that China’s President Xi Jinping has called Trump and said that cooperation between the world’s two largest economies is the only choice.  It is likely that Trump, the negotiator, will work with China on making some of the fundamental changes which we have been discussing here for three years now.

China has always been hesitant to free float the renminbi because of the threat of economic terrorism from the west.  Maintaining the peg gave China some semblance of control over its value as the US would not want to appreciate the dollar too much.

The reformation of the international monetary system requires the rebalancing and reduction of USD denominated reserves.  The lowering of China’s trade deficit can only happen with a stronger and higher renminbi.  Equally so, America’s trade deficit can only be reduced with a depreciated dollar.  The big question is how do you depreciate the dollar, raise interest rates at the same, and keep the dollar as a strong reserve currency?

This is where the negotiation and cooperation comes in.  Both China and America can coordinate monetary reform in tandem.  This also fits with the thesis we have reviewed were China begins to widen the trading band with the dollar in coordination with Fed rate increases.  The US can also devalue the dollar with each step so that each shift in the international monetary system happens gradually with full control over management of the transformation itself.

Even managed as such, there could still be some volatility as liquidity sloshes from west to east and the system rebalances.   But the goal would be to minimize instability in the system while moving forward on monetary reform.

Much of this is dependent upon how the Trump administration manages its relationships with the rest of the world.  Using volatility and currency/trade wars as the pretext to enact monetary reform is not the best path forward.  We cannot assume that a broader acceptance of the SDR as a reserve asset will only come about as a response to instability and financial crisis.

In regards to currency wars and trade wars, it should be noted that Trump has threatened a 35% tariff on China.  This is close to the expected dollar devaluation of 20% to 30% which we have discussed in the past.  A tariff percentage doesn’t always equate into the same percentage of currency devaluation, but it can be used as a guide to understanding the pre-negotiation positions of both sides.  It is conceivable that Trump could agree to 35% devaluation in place of a tariff in exchange for China appreciating the renminbi through a multi-staged process aligned with additional Fed rate increases.

The resistance to using the SDR in a broader capacity has only come from American establishment interests.  With the composition of this establishment now changing we will have to see if such resistance continues.  It is not improbable to imagine a situation where US monetary authorities present a case where the USD is held hostage by its role as the primary reserve currency and needs to be freed for the benefit of American interests.

This would bolster the case for the SDR and create international acceptance.  It would also contribute to the substitution of USD denominated foreign exchange reserves with SDR.  Could America demand that this substitution take place?  What once was considered impossible could very well become possible in the months ahead, as the bigger monetary and financial pieces begin to move.

It was unthinkable to most that Donald Trump would be elected President of the United States.  Some of his campaign promises also appear unthinkable.  But as versions of these policies are rolled out we could very well experience the exact situation which we have been reviewing here.

All of the trade deals have been designed based on the USD unipolar based monetary framework.  It should be no surprise that these trade agreements will now be adjusted to reflect the multilateral aspects of the emerging monetary framework.  All the big pieces are now in play.  Will China and America align on a stable path forward?  Or will we have to experience a manufactured financial period of instability which will be used as the pretext for the needed changes?

Either China or America can overturn the apple cart at any time by ending the peg between the two currencies.  But it is looking more probable that Trump will present a case where the international role of the dollar is detrimental to American interests and China will facilitate the transition as SDR substitutions begin to take place – exciting times for sure.  – JC