China Just Ended the Dollar Peg (…for the most part) FREEPOM

Economics, FREEPOM, Multilateral Investment Strategies26 Comments

Rise of Multilateral Exchange Rates & the Feds Rate Hike

By JC Collins

On March 25, 2015 I published a post titled When Will China End the Dollar Peg.  In that post we speculated that the USD based managed peg of the RMB will be removed before the end of the year.  Just in time for the implementation of the AEC trade agreement which starts on January 1, 2016.

As we can now determine, China has in fact created an alternative valuation for the renminbi which will function outside of its dollar based exchange rate arrangement.  This new composite index will help stabilize the Chinese currency as the Federal Reserve begins the process of policy normalization through incremental interest rate increases.

The post Fed rate hike effects will be muted and not as dramatic as many have expected.  The large capital outflows from China and other emerging markets which were previously anticipated will be reduced and managed through macroeconomic changes and policy adjustments.

One such policy change is the above mentioned move by the CFETS – China Foreign Exchange Trade System – to measure the value of the renminbi through a composite index.  This index is broken into three separate exchange rate regimes.

  1. A basket of 13 currencies.
  2. The SDR.
  3. And a basket of 40 currencies as determined by the Bank for International Settlements.

The basket of 13 currencies is structured based on the following weighting:

New RMB Composite Index

Now that the Chinese currency has been officially included in the SDR composition the CFETS can also peg to the weights of that basket.  I will write more about the BIS basket and its weights in the coming weeks.  Considering that the BIS is being established as the clearing house for SDR, this move by China could very well be the beginnings of a larger multilateral move towards the creation of a functioning multilateral exchange rate arrangement.

Back on August 15, 2015 I also published a post titled US Dollar Exchange Rate Anchors.  This material was reposted yesterday with attention given to the following quote from that piece:

“Perhaps they will end the dollar “peg” all together a move towards the composite anchor, using either the SDR or perhaps the Asian Currency Unit (ACU).”

This prediction was extremely close to what China in fact implemented with the composite structure described above.  The reasoning behind Chinese logic is that their strong balance of payments position (something which POM readers will be very familiar with), and their corresponding large trade surplus, along with the SDR inclusion and growing RMB liquidity market, will bring stability to the currency, and in time allow it to appreciate against the US dollar.

Measuring the strength of the renminbi against a basket of currencies will better reflect market realities. Realities which aren’t influenced by the waning monopoly of USD geopolitics.

Another way of looking at this composite index it to realize that though the RMB has been depreciating against the dollar this year, when measured against the currencies in the composite index, the RMB has actually appreciated by 2.23%.

This is important to understand because as I’ve stated in many posts the changes to the fixed daily rate which the PBoC has made over the last few months are preparation for a widening of the trading band itself.  This band is now 2%, which means the value of the RMB against the USD can move 2% above or 2% below the fixed daily peg.

As the renminbi liquidity market expands through further swap agreements and reserve accumulation, as well as RMB denominated loans through the newly created BRICS Development Bank and AIIB, the PBoC will begin to widen the trading band in increments.  This will match the growing liquidity market, and could also very well correlate with the incremental interest rate increases by the Fed.

See the post Renminbi Demand Is About to Explode.

As the composite index becomes the accepted measure by the rest of the world, the appreciation of the RMB within this composite index will allow for the Chinese currency to appreciate against the USD as the trading band is widened.  This gradual process will ensure stability and a sustainable transition from the current unipolar USD based monetary framework to a multilateral framework.

When the US dollar begins its broader depreciation sometime in 2016, perhaps at the mid-point of the year, the appreciation of the renminbi in the composite index will accelerate.  This will surprise most commentators and economists.

Once this accelerated appreciation of the renminbi begins, we could start seeing the larger process of SDR substitution accounts and reserve diversification.  Once the multilateral exchange rate arrangements are implemented, the additional multilateral transition pieces can begin.

Another point worth watching is the incremental transition which China is making from a trade based economy to a financial services economy.  Many discuss a decline in Chinese trade exports as a negative, when in fact it is exactly what the Chinese authorities are strategically implementing.

I would point readers back to the post The Redback Revolution for further information on this topic.

Just like with the incremental changes to the trading band, Chinese trade exports will decreased as more and more renminbi denominated financial products become available internationally.  This is the switch from trading exporting model to a trade services model which was discussed in The Redback Revolution.

I would suspect that we will see more countries begin to measure their domestic currency against a similar composite index.  The combination of SDR and BIS basket, along with a currency specific basket of 13, used by China, has established a path forward for others.  This is how the unipolar dollar exchange rate arrangements will end.

Don’t buy into the doom and gloom reports of the dollars death.  This change by China, and the beginning of monetary policy normalization by the Federal Reserve will not cause the level of volatility and systemic collapse that so many have predicted.

Sure, there will be some swaying, and probably some corporate and banking failures, but the international monetary framework has now been adjusted enough to absorb the volatility which the transition away from the USD unipolar framework will create.

The funny thing is, the US has help engineer the multilateral path forward by the policies of Quantitative Easing low interest rates.  Now that the system is readied for a fundamental shift, the QE policies of the Fed have ended, and interest rates are set to increase again for the first time in almost a decade.

It is interesting to point out that both are policies which so many stated could never change.  The fact that one has already happened, and we are on the eve of the other happening, the only question worth asking is - how did so many get it so wrong?

Perhaps it because they have not considered the multilateral transition which we have been discussing here for the last two years.   - JC

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26 Comments on “China Just Ended the Dollar Peg (…for the most part) FREEPOM”

  1. I am confused how China and the US can prop up the failing nations or should I say for how long. What is going to keep the morphing system from imploding from nations such as Greece, Spain, Italy Puerto Rico and Argentina from setting off the derivatives bomb?

    The stronger nations of the world cannot watch these bankrupt nations go hungry or without staple needs, can they?

    If things are going to get bad enough to see some corporate and bank failures then things are going to be worse for these mentioned nations. Does more debt in SDR valuation really help? I can't but think how the banks or hedge funds will be able to buy the assets of those nations very cheaply. And the corporation and banks that fail too. Just like in 2008 taking out the competition.

    This all seems like "they" are just diving up the pie. When you have mentioned a more fair system it seems it is only for the club members that things get more fair. The prolonging does make the collapse less painful but I worry about the ultimate price. I remember reading about a Tower Of Babel in the Bible and this system is another creation of attempting to override the true system of the Universe. Does anyone see the similarities?

    1. All systems corrupt.

      Some derivatives will fail, and some will not.

      I'm explaining a process, not a moral tale of ineptitude.

      Most people's idea of fairness is "what's in it for me" and "how can I get more while doing less". Unfortunately these types of attitudes infect all demographics and socioeconomic levels.

      In regards to your reference on symbolic and allegorical bible stories, well, they are written as accurate reflections of human deficiencies, and what can be done to correct those deficiencies.

      Unfortunately most read something completely different in those stories, like how to blame someone or something else for an externalized human condition which they help create.

  2. Hi JC, is the world market going to crash after Fed rate hike? if Canada's property going to drop that much surely there would have to be a massive panic event like 2008?

    1. Fear not Sherry, the world market will not crash. There will be volatility though.

      Canada's real estate market dropped 50% in 1986 without a worldwide crisis like 2008. Canada is in for a few rough years though. We are about to feel what 2008 was like for everyone else. Especially our friends south of the border.

      1. Hi JC,

        Australia with it's dependence on natural resources and excessive household debt is i would say in a similar position as Canada. I have wandered for a while now wether this is sustainable or not.

        In light of your recent comments on the near term future of the Canadian economy and housing market, what is your general outlook on the health of the Australian economy and housing market? Would you agree that Australia and Canada share the same prospects in the short to mid term?

    2. Hi Sherry. What I recall from that period, from a "south of the border" perspective 🙂 was that people who were in adjustable rate mortgages suffered greatly when interest rates were raising.

      Then property values dropped. In my individual case it dropped roughly 33% and regained the original value within three years.

      QE kicked in and everyone wanted to purchase a house while property values and interest rates were low.

      Then about three years later the property values began to rise again and new housing developments that sat dormant began to build again.

      Today the houses are in demand and can't be built fast enough while we watch for interest rates to begin their rise as well.

      If we had a fixed rate mortgage and kept our accounts balanced then we would have been in a prime position to pick up a house or property for next to nothing and with super low interest rates. Or we could simply stay put and refinance into a lower interest rate mortgage.

      If we stay put and refinance into a lower interest rate our monthly payment would be reduced. This savings could then be put toward diversifying our accounts, further savings or some sort of investment. Thats where we packed the snowball and set it off down the snowy mountain so it can grow in size.

      We can claim that all these things are set up for "they" or "them" but that's only a trick in our heads and the sad part is we play the trick on ourselves.

      If we keep our accounts in order then we will always be ready to capitalise (as much as possible) when the time is right and then our accounts can grow as well.

      As JC said "Canada is in for a few rough years". But if it resembles what the US went through in '08 then there surely is light at the end of the tunnel.

  3. I personally have not meet that many common people who wish to get something for nothing. I have many clients who all are very successful. My employees all work hard and so do I. I believe the leaders of the people have not provided the right opportunities for people to multiply their talents.

    This "what's in it for me" is this not a trickle down effect?

    As far as this human low level of consciousness I agree. As the process plays out it is a shame so many innocent bystanders will be collected up in the tsunami.

    1. Not a trickle down effect, it's a human effect. A selfish extension of our survival instinct. Nobodies fault but our own as individuals.

  4. I'm in the process of validating this article but my vision is beginning to see in triplicate....HELP! LOL.

    "Wednesday morning in Washington, Republican and Democratic Party members of the US Congress announced agreement on an omnibus spending bill that included a provision to legally enact reforms to the International Monetary Fund (IMF) agreed by the Obama Administration in 2010, according to a report by AFP."

    Here is the article.

    "US Congress moves on IMF reforms" (1 hour ago from 1:04pm EST)

    http://www.dw.com/en/us-congress-moves-on-imf-reforms/a-18921709

    Here is the omnibus spending bill.

    http://docs.house.gov/billsthisweek/20151214/CPRT-114-HPRT-RU00-SAHR2029-AMNT1final.pdf

    Heres another article on it.

    "US Congress advances long-delayed IMF reforms" (2 hours ago from 1:04pm EST)

    https://au.news.yahoo.com/thewest/a/30385116/us-congress-advances-long-delayed-imf-reforms/

    1. The omnibus spending bill goes before congress for approval/disapproval on Friday. If the wording of the omnibus spending bill allows the 2010 reforms to be ratified then would it be ratified right away or will it come later? These are tricky words. I'm getting the gist that the wording allows for it but that doesn't mean its passed or even brought before the house. Ryan says when a new bill is submitted congress has to be given 3 days to review it.

      http://thehill.com/homenews/house/263422-house-to-vote-friday-on-spending-bill

        1. Haha thanks Alan. Its either this or venturing out with all these Christmas shoppers.....that would really test my survival skills 🙂

          What's coming to mind is that since China...(well the G20 - the G7 right)...has stepped up to the plate with plan B, is that the US congress will get everything ready to ratify the 2010 reforms with the TPP. Some are saying the TPP won't be voted on until the lame duck session in Nov or Dec 2016 but the white house seems to want to get it in front of congress before that. Also it just seems too late by then. I mean the renminbi will become effective in Oct. 2016 so wouldn't that make the ratification a mute point? If plan B is used then would the ratification simply remove the US's veto power? Maybe a combination of both?

          "White House wants trade vote before lame duck"

          http://thehill.com/homenews/administration/257065-white-house-wants-trade-vote-before-lame-duck

      1. The spending bill passed.

        "Early Friday morning the House passed the $1.1 trillion spending portion of the deal on a 316 to 113 vote, with 150 Republicans and 166 Democrats supporting the measure, after passing the $622 billion tax section of the agreement Thursday on a 318 to 109 vote.

        The Senate soon after passed both parts of the agreement on a 65 to 33 vote. President Obama is expected to sign the legislation into law."

        https://www.washingtonpost.com/news/powerpost/wp/2015/12/18/house-to-vote-on-spending-bill-that-would-avert-shutdown/

  5. All systems corrupt.

    Some derivatives will fail, and some will not.

    I’m explaining a process, not a moral tale of ineptitude.

    Most people’s idea of fairness is “what’s in it for me” and “how can I get more while doing less”. Unfortunately these types of attitudes infect all demographics and socioeconomic levels.

    I personally would change these statements to:

    All corrupt systems corrupt further.

    Some money games will fail one party, and some will fail the other party.

    I am explaining a corrupt process as a process, not a moral tale whatsoever.

    Most banker's idea's on fairness are "what's in it for me" and "how can I get more digits for less digits" Unfortunately these elite attitudes infect all demographics....

    But yeah, just a clown speaking.

    In all due respect, as I feel for you, and your burden of reading this type of stuff.

  6. "China’s UnionPay Steps Into Mobile Commerce Deal With UK Startup"

    http://techcrunch.com/2015/12/16/unionpay-powa/

    "Apple Pay, Samsung Pay to duel in China next year"

    http://www.cnet.com/news/apple-pay-samsung-pay-to-duel-in-china-next-year/

    "Apple Bringing Apple Pay to China With UnionPay"

    http://www.wsj.com/articles/apple-bringing-apple-pay-to-china-with-unionpay-1450402932

    "Apple to launch Apple Pay in China, take on Alibaba, Tencent"

    http://www.reuters.com/article/us-apple-china-idUSKBN0U104920151218

    "Apple, Samsung to Enter China Payments Market With UnionPay"

    http://www.bloomberg.com/news/articles/2015-12-18/unionpay-apple-agree-to-bring-apple-pay-to-china-in-2016

  7. Greetings JC...

    Interesting thought here, that I would like your comment on....

    I read somewhere that Christine LaGarde's term as head of the IMF
    only runs through June or July next year...
    Supposedly it's a 5 year term...
    There is an outside possibility she may be involved in some court case in France next year....
    Do you think the possibility of her leaving would have any effect on the
    China/Yuan deal...
    All this stuff that has been happening with the Yuan, has mostly happened in the last 5 years....since 2010....

    Take Care

    Tony

    1. I don't think so Tony. I would suspect that we may very well see the current governor of the PBoC become the next head of the IMF. This position has always been held by a European. The next managing director could also be American, but I would suspect they will be Chinese. Lagarde even hinted one time that the headquarters of the IMF could move to China. I don't think that will happen anytime soon, but a Chinese Managing Director is definitely something which is possible.

  8. Greetings JC;

    This is an interesting article you ""MUST"" attended to;

    Is Bloomberg Hiding Something?
    Hugo Salinas Price
    Bloomberg has been gathering data on the total of Central Bank International Reserves for many years. Since December 1, 2010, the information has been updated every Friday, and has been available on a Bloomberg website, accessible only by subscription.
    On Friday, December 11 of the present year, Bloomberg published no information regarding International Reserves as of that date.
    On Friday, December 18, once more, Bloomberg published no information regarding International Reserves as of that date.
    Curiously enough, on Monday, December 1, 2015, we published an article on this website, click here "The Crumbling World Order, and Who Will Pick Up the Crumbs?" which pointed out that International Reserves have been contracting since August 2014 and up to November 27, 2015, had diminished by $752 billion dollars, or 6.25% of the total achieved at the peak back in August, 2014. And we remarked that this contraction was unprecedented, since we have data going back to 1948, and never, ever, has there been a sustained contraction in the total of Central Bank International Reserves since the creation of the present international monetary system in 1944, at Bretton Woods.
    In our opinion, the present contraction of International Reserves announces a secular change of trend to liquidation of international debt and consequently to Depression.
    Why has Bloomberg decided to suspend the publication of International Reserves on its website? Is Bloomberg hiding information from the public? Has Bloomberg been pressured to suspend publication of sensitive data?
    We hope Bloomberg resumes publication of the important data on International Reserves at once.

    Take Care

    Tony Graupp

    1. Though the end goal is the elimination of reserves altogether, Bloomberg is not the only source for reserve data. As such, I doubt they are attempting to hide information which can be obtained by alternative methods, such as the central banks themselves. Interesting though, as Bloomberg serves as the go-to-place for so many.

  9. As Napoleon Bonaparte said 200 years ago;

    ""We will pay in gold or we will not pay""
    =================================

    01/December/2015
    The Crumbling World Order and Who Will Pick Up the Crumbs?
    Hugo Salinas Price

    In the last fifteen months, from August 1, 2104 to November 27, 2015, International Reserves, as calculated by Bloomberg, have fallen three-quarters of a trillion ($752 billion) dollars, or 6.52%. International Reserves peaked at $12.032 Trillion on August 1, 2014, and have fallen since then to $11.28 Trillion on November 27, 2105.
    Central Banks increase their Reserves by purchasing Government Bonds - denominated in Dollars, Euros, Pounds or Yen - when those currencies come into their hands as a result of a surplus of exports over imports; all countries strive to have such surpluses, because if they are not able to export more than they import, then they are condemned to devalue their currencies in order to make their exports more attractive; they are also burdened with higher interest rates on their borrowings, as a result of the threat of further devaluation. Higher interest rates in turn, exacerbate the outflow of Reserve currencies and make devaluation all the more necessary.
    The fact is that countries holding Reserves have not been paid for the totality of their export surpluses. To hold Reserves is to grant credit. The proof is that Reserves held by the exporting countries are Bonds, that is to say, certificates of debt. The last figure for International Reserves, as of November 27, is $11,280,000,000,000 Dollars - $11.28 Trillion Dollars. The figure nicely documents the total value of what the exporters of the world have sold to the countries which issue Reserve Currencies, and for which they have not been paid, since August 15, 1971.
    At the present time, the system at work since the end of World War II is operating in reverse. Reserves are falling, the majority of which are held in Dollars. Government Bonds held as Reserves are being sold off. An important contraction in world commerce is taking place.
    The exporting countries are not obtaining excess funds (from their exports over their imports) with which to purchase Government Bonds for Reserves. On the contrary, a flight of Capital from the exporting countries to the Reserve issuing countries is taking place, and the Central Banks of the exporting countries are selling off their Reserves, to provide funds for the Capital flight.
    When 6.52% of the total Reserves has been sold into the market, one would expect the value of the related Bonds to fall, and their interest rates to rise, other things being equal. If their interest rates have not risen, it must be due to the generosity of the buyers of the Bonds. Perhaps the entities that show such generosity in their purchases are the same entities who sold the Bonds in the first place, the Federal Reserve among others?
    The Fed and the ECB have been in comfortable position of lowering interest rates and thus raising the value of the Government Bonds they sell. When the long term Bond rate is lowered from 4% to 2%, the value of those Bonds tends to double. But when the 2% rate rises just a bit to 2.25%, the value of the long term Bond falls very sharply. The Fed and the ECB must buy back the Bonds which are being sold in this liquidity crisis, or else the whole Bond universe collapses.
    China's Yuan has recently been accepted by the IMF, to form a part of its "basket of currencies" and as of Oct. 1, 2016 the Yuan will be anointed as a Reserve Currency by the IMF. When that happens, China will have its own Reserve Currency, and less need to maintain its present enormous pile of Reserves in Dollar and Euro Government Bonds. So the sell-off of International Reserves might become even stronger. The Fed and the ECB have enjoyed selling Bonds at ever higher prices and ever lower interest rates, so low that in Europe these Bonds have a negative yield. They will have to develop an appetite for Bonds, because China is going to send a bunch of them back to the sellers when the Yuan achieves Reserve Currency status. As China liquidates a portion of its Reserves, guess what China is going to buy with the Dollars and Euros it receives for its Dollar and Euro Bonds?
    The majority of Reserves are held in Dollars, as we have said, and when the Dollar Bonds are sold, they are sold for Dollars to satisfy the Capital flight, and buying the Dollar makes its relative value rise. From a low point, some years ago, of about 71 against a basket of currencies, the Dollar has appreciated to 100 at the present time, increasing the strain upon debtors (in the exporting countries) who owe Dollars by some 41%. The strain upon the debtors increases the urgency in getting out of Dollar debt and stimulates the related Capital flight.
    What we are witnessing these days is a mighty contraction in economic activity around the world, that reinforces itself. International Reserves are being sold off in a desperate search for liquidity. The contraction was originally seeded by a slow-down in the economies of the Reserve-issuing countries, i.e., USA, Britain, Europe and Japan.
    The Chinese evidently have some plans which they are not divulging, for we see that China is purchasing huge amounts of gold. In the meantime, the US insists on trashing the price of gold, as if to say that the Dollar is and will remain the world's supreme currency till the end of time.
    China is quietly accumulating gold and saying nothing. But we can try to guess what China is thinking: "The US is mired in an insoluble problem. Do nothing to provoke the US. The US will destroy itself in a huge collapse."
    A world struggling with increasingly severe economic problems is not a world that is going to be in the mood or in condition to continue to respect international treaties regulating commerce, much less such regulatory dreams as co-ordinate action on "Climate Change".
    What lies ahead is a situation where each country will attempt desperate measures to ensure a minimum of internal stability. Treaties will be ignored or thrown overboard. Devaluations around the world will proliferate; some countries will declare bankruptcy. The gravity of the crisis will make these events inevitable. We have just seen India refuse to abide by the rules of the World Trade Organization (WTO); the WTO rules say that governments are not to grant subsidies to sectors of their economies. But India is forced to subsidize its agriculture, because it has a population of over 1 billion and 67% of the people depend on cheap food for survival. So the statist international rules - emanating mainly from the US - to regulate the whole world will be trashed, eventually.
    When push comes to shove, China, with 1.3 billion or more population, will take unorthodox measures. The pressure of the enormous population of China, made up of quite intelligent men and women, is going to force its government to stop adhering to international covenants. China will take whatever measures can offer hope to the Chinese.
    China will then say to the world: "We sell cheap. Very cheap. But, we sell for gold, for very little gold; and we pay with gold for what we buy - for very little gold, but we pay gold. You want our stuff, you find a way to pay us in gold. Or else, what do you have to offer us, in exchange for our stuff? You have something we want - we pay in gold. Rest of the world, do as you please."
    The nations of the world are not going to flounder endlessly in the crisis that is upon us. Out of the huge crisis, China will break away and state its terms. And the terms will be: GOLD. The rest of the world will follow.

    Take Care

    Tony

  10. “Liberty becomes a question of morals more than of politics.”

    “Liberty is the harmony between the will and the law.”

    “Free trade, to improve the condition of the people and fit them for freedom.”

    “Liberty has not only enemies which it conquers, but perfidious friends, who rob the fruits of its victories: Absolute democracy, socialism.”

    “Political atheism: End justifies the means. This is still the most widespread of all the opinions inimical to liberty.”

    “The object of civil society is justice, not truth, virtue, wealth, knowledge, glory or power. Justice is followed by equality and liberty.”

    “All liberty is conditional, limited and therefore unequal. The state can never do what it likes in its own sphere. It is bound by all kinds of law.”

    “Inequality: the Basis of society. We combined and put things in common to protect the weak against the strong.”

    “Divided, or rather multiplied, authorities are the foundation of good government.”

    “Duty [is] not taught by the state.”

    “Men cannot be made good by the state, but they can easily be made bad. Morality depends on liberty.”

    “Liberty consists in the division of power. Absolutism, in concentration of power.”

    “Bureaucracy is undoubtedly the weapon and sign of a despotic government, inasmuch as it gives whatever government it serves, despotic power.”

    “Bureaucracy tries to establish so many administrative maxims that the minister is as narrowly controlled and guided as the judge.”

    “Power tends to corrupt and absolute power corrupts absolutely. Great men are almost always bad men, even when they exercise influence and not authority; still more when you superadd the tendency of the certainty of corruption by authority.”

    “Despotic power is always accompanied by corruption of morality.”

    Lord Acton

    http://www.acton.org/research/lord-acton-quote-archive

    As a link to justify my opinion in my previous post.Not that all these opinions by Lord Acton are mine also.

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