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.
- A basket of 13 currencies.
- The SDR.
- 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:
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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