Don’t Fear a Crash of the Dollar

Economics, Multilateral Investment Strategies, Premium POM

Dollar Depreciation and Renminbi Appreciation

By JC Collins

Last July I published a post predicting that the US dollar would begin to depreciate at the beginning of 2016.  This date range was based on the effective inclusion date of the Chinese renminbi in the Special Drawing Right Basket (SDR) of the International Monetary Fund.

Other factors which were considered was the eventual passing of the 2010 IMF Quota and Governance Reforms in the US Congress, which did in fact happen as predicted by the end of 2015.

The start date of the Asian Infrastructure Investment Banks (AIIB) and the BRICS New Development Bank (NDB) also helped determine the date range provided.  The AIIB just celebrated its official launch and it was communicated that the first infrastructure loans would be issued in the second half of 2016.

The US lobbied for an extended period for the existing SDR basket composition, minus the renminbi.  Pushing the effective date of the new basket out until October 2016 allowed the US government to fund another year of deficit spending under the old financial and monetary framework.  This is directly tied to the eventual and forthcoming depreciation of the USD and the appreciation of the Chinese RMB.

The more I study and analyze this whole sequence of events, the more convinced I am that the conclusions which I have presented to readers are accurate.

Added to the information I have already provided, we can also expect that China will use a larger-than-expected percentage of its US Treasury holdings to fund the AIIB and NDB.  The Silk Road Fund will also benefit from these foreign exchange reserves.

This strategy will help China export its vast infrastructure development capabilities as China provides the funds for the loans to other emerging countries, and Chinese companies perform the work on bridges, roads, trains, airports, ship yards, etc., which will expand across Asia and populate the Silk Road.

The benefit to China is that these funds will be loaned, and as such, will provide a return on investment.  Especially when Chinese companies bid and win and the vast majority of the projects.  This will help offset losses to Chinese reserve holdings as the US dollar begins its cycle of depreciation.

A similar concept of underwriting losses can be achieved through the IMF and its substitution account strategy.  China can transfer reserves to the IMF for larger SDR quotas, and the IMF can lend those funds through an alternative interest bearing substation account which will offset losses on those holdings as the dollar depreciates.

A depreciating US dollar and appreciating Chinese renminbi are the best solutions to address the global deflation which is taking place.  Based on the latest data and shifting multilateral schedule, we can expect that this depreciation will begin in the second half of 2016, and the Chinese currency will begin to appreciate before that time.

I would suspect that the first AIIB and NDB loans will be issued at the mid-way point, and this will drive a turnaround in commodities.

Both China and the United States are well positioned for this transition.  China will benefit from the infrastructure development loans and Chinese companies will feast on the vast opportunities which come from other emerging countries and regions.

The US will see an explosion in exports as the dollar depreciates and American made goods become more affordable to other countries.  This will spur domestic job growth in the US and decrease the debt-to-GDP ratio.  All things which Trump will use as confirmation that he is in fact making America great again, just as he promised.

The other benefit to a depreciating dollar is that imports will become more expensive.  Most kneejerk reactions to that statement do not consider that an increasing cost of imports will act as a method in inflation.  Inflation is exactly what the Federal Reserve will need to continue its normalization of monetary policy in the form of interest rate increases.

Huge pieces are falling into place and the POM thesis is unfolding as expected.  With a few adjustments on timing and scheduling. Below is the post from last July, titled This Is When the US Dollar Will Begin to Depreciate.  – JC

 

The value of the dollar has been based on international demand and investor preferences for USD denominated assets. The reserve status of the dollar has maintained this demand and preference.  Without the reserve status the dollar would have weakened based on the large trade deficit which the United States has developed.  Equally, the trade deficit would not have developed if the demand for dollars was not created with the reserve status.

America’s trade deficit is as much a problem for the rest of the world as it is for America.  The only way foreign investors in dollars and dollar denominated assets can get paid on their investments is for the trade deficit to eventually turn into a trade surplus.

One method of making this happen entails allowing the dollar to depreciate, which would make imported goods more expensive for Americans, but would also make exports cheaper, which would boost domestic production and increase GDP.

The balance between a decrease in imports and an increase in exports, the outcomes of a depreciated dollar, will gradually allow the US to move from a trade deficit to a trade surplus.  Foreign investors, both private and public, will be paid and America will strengthen both its domestic and international economic standing.

The timing of the dollar depreciation is directly tied to the availability of an alternative reserve asset.  The Chinese renminbi and its increasing internationalization is creating the availability of an additional reserve asset which can be used by China and its trading partners to slowly shift away from dollar denominated assets.

But it isn’t enough to create the level of change and access to reserve alternatives that would be required to correct the balance of payments deficits which have put incredible pressure on the international monetary system.

There is also the concern that increasing the status of the renminbi to a reserve currency will sway the inherent deficiencies of the Triffin Paradox from the USD to the RMB.  The accumulation of USD in the foreign exchange reserve funds around the world is the active cause of America’s trade deficit and balance of payments problems.

The incremental and gradual exchange of this USD accumulation needs to be reversed and brought into balance so the dollar can be allowed to depreciate.  The unwinding of this dollar based framework is challenging and will take considerable more time than many realize.

Trade agreements such as the Trans-Pacific Partnership and the AEC, or ASEAN Economic Community, are being developed as frameworks for the new multilateral monetary realities that will be unfolding in the coming months and years.

The AEC is a trade agreement between ASEAN nations and will include the participation of China and Japan.  It will be effective on Jan 1, 2016, which could correspond with the implementation of the TPP, which is America’s trade agreement with ASEAN.

The Jan 1, 2016 timeframe is important as it will also be the effective date of the new SDR basket composition, which will include the Chinese renminbi.

The IMF will grant the RMB reserve status and set it’s weighting in the currency basket called the Special Drawing Right. There will be a reduction in the USD’s weighting in the SDR to accommodate the inclusion of the RMB.

What the actual weightings will be for each currency in the basket is difficult to determine as only a small contingent of monetary framework developers are building the multilateral architecture.  But we can learn much from the implementation schedule of the trade agreements and changes to reserve currencies which will be taking place.

Though everything is connected and intertwined throughout the financial system, it needs to be understood that the draining of liquidity from equity markets around the world, like is presently happening in China, and soon elsewhere, perhaps by October, are actions that need to happen to make the multilateral transition more effective.

The unfortunate part is that many lose savings and stock market corrections always lead to institutional failures and a tightening of credit.  The fact that global deflation is taking place at the same time does not encourage a sense of confidence in the existing monetary framework.

Which is the point.

Solutions will begin to be offered and presented as a means of correcting the imbalances and staving off the collapse of bond markets and sovereign debts.  This script will unfold from the debt crisis with Greece, and in the larger Euro Zone as a whole.

It is internationally accepted that the reserve status of the USD, and the large accumulation of the US currency in the foreign exchange reserve accounts, have been the direct causes of the imbalances and deficiencies which have caused the current and escalating problems in the international monetary framework.

The inevitable correction to this situation will include the trade agreements mentioned above, in coordination with a depreciation of the dollar.  As stated, the depreciation of the dollar will spur a new era of “Made in America” products, which will create jobs and expand domestic growth. This will lower the debt-to-GDP ratio of the US and make the sovereign debt more manageable.

Many like to see that a collapse of the dollar is unavoidable.  It is important to differentiate between a gradual depreciation of the dollar and a collapse of the dollar.  They are two separate concepts with completely differing outcomes.  America is setting itself up to come out of this transition in a strong economic position.

Though TPP details are scarce and secret, and no doubt there will be some negative parts of the agreement, it will help develop the trade framework which will ensure a market for American made goods.  The Chinese investment into US infrastructure and derelict factories begins to make more sense when considered in this fashion.

Based on the information presented here, and using some basic deduction techniques, it is probable that we could see the beginnings of the USD depreciation in the last part of this year, or early in the first quarter of 2016.

All the pieces are moving in unison.

The broader composition of the SDR, which will include the RMB, will decrease demand for dollars and create an alternative reserve asset to both the USD and RMB, eliminating future balance of payments challenges like the ones which have surrounded the USD. – JC