Are Emerging Markets about to Switch US Treasuries for SDR Bonds? (FREEPOM)

Economics, FREEPOM

By JC Collins

The first issuance of SDR denominated bonds in the Chinese market is being implemented by the World Bank.  Let that sink in for a moment.  The World Bank, the great bastion of the western banking elite, will be providing SDR bonds specifically for the Chinese market. This is a major defeat for all of those who repeatedly promoted the idea that wealthy interests within China were attempting to overthrow the western banking structure or implement a competing system.

A second issuance of SDR bonds will take place through the China Development Bank.  The purpose of both issuances is multiform.

First, SDR denominated bonds will allow for the diversification of the currency composition of foreign exchange reserves.  This will allow the governments of emerging markets, whose central banks have carried the bulk of US Treasury bond debt for decades, to minimize their exposure to the single currency Treasury Bonds and exchange rate pressures.

Second, it will provide Chinese investors with an alternative which will slow capital outflows and could even potential reverse and lead to large capital inflows.

Most emerging markets suffer higher risk by the large accumulation of US Treasuries.  The USD based exchange rate regime which most of these nations follow allows for destructive exchange rate swings when the Federal Reserve decides to raise interest rates.

The Chinese monetary authorities have been very vocal over the last few years about the Fed not raising rates.  This has provided time for the renminbi to be added to the SDR basket composition and to implement the SDR bond framework which is now being utilized.

As official foreign exchange reserves are diversified from US Treasuries to SDR bonds this risk is minimized.  This SDR diversification serves the purpose of both China (and other emerging markets) and the United States.  The US is in a situation where increasing interest rates will cause large ripples in the international monetary and financial systems.  This could potentially even lead to a financial crisis in China.

The substitution of Treasuries for SDR bonds will provide the Federal Reserve with just enough wiggle room to move forward on modest interest rate increases.  As the transition from US Treasuries to SDR bonds takes place across the emerging world, the pressure on both the US and emerging nations in regards to interest rate increases will decrease.  US interest rate increases could leapfrog with foreign exchange reserve diversification.

A decrease in demand for US Treasuries, which is already happening, will help push up interest rates at home.  This will also align with the interest rate paid on SDR bonds.  The Federal Reserve will not be able to keep the interest rate lower if it wishes to keep the dollar relative and compete with the yields provided on SDR bonds. But the increases must align with the larger dynamic of foreign exchange diversification and substitution.

As the accumulation of US Treasuries decreases and comes into balance with the international monetary realities, the dollar will be able to realize some much needed depreciation, which could be in the range of 20% to 30% against the currencies of its largest trading partners.

Such depreciation will make American made goods more competitive and increase exports.  This will lead to more job creation at home and help lower the debt-to-GDP ratio and facilitate debt management, which will become more expensive as interest rates increase further.  It’s a dance of monetary perfection and must be handled with great care and strategy.

Another benefit of the broader use of the SDR through bond issuance is that it will provide the International Monetary Fund with a new source of financing. Such financing could be used to manage a sovereign debt crisis in the Euro Zone and possibly even an Asian crisis sparked by outpaced US interest rate increases.  Think of it as a contingency plan in case the rebalancing is out of alignment at any point or time.

Emerging markets would do well to diversify their reserves sooner rather than later and decrease the risk to US interest rate increases and exchange rate volatility.  Accordingly the US will need to time any interest rate increases carefully to ensure that there isn’t a large rush out of Treasuries.  Some of the geopolitical challenges taking place in Eastern Europe and the South China Sea could very well force the hand of either.

After almost three years of writing about the above it is fascinating to see the process unfolding in the real world.  It is still my position that the transition will happen through agreement and that no large war between major players will take place.  Outside of all the military posturing I would suspect that the foreign exchange reserve diversification will continue and pick up pace throughout 2017.  Expect interest rate increases during this period.

Soon other emerging nations, such as Vietnam, India, and other BRICS members, will begin to issue their own SDR denominated bonds.  Once the trend picks up steam the demand for Treasuries will decrease and interest rates will increase.  Without a doubt, this will be the biggest monetary transformation since the end of World War Two.  – JC

Also read:

Depreciating US Dollar will Strengthen SDR Denominated Assets – Understanding O-SDR, M-SDR, R-SDR and Substitution Accounts

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