China's Move Away from the U.S. Dollar Means You Need to Invest in the Yuan

China has started diversifying away from the U.S. dollar, yet another sign that it's time to invest in the yuan.

A report from Standard Chartered Bank last week showed China's foreign exchange reserves expanded by $196 billion in the first four months of this year. About 75% of that investment was in non-U.S. dollar assets.

This is the biggest gap between accumulated reserves and purchased U.S. debt by China in at least five years.

As the dollar's value weakens, China has taken steps to distance itself from the currency, and attempted to strengthen its own by investing more in gold and other assets.

Money Morning Chief Investment Strategist Keith Fitz-Gerald said China's diversification means the yuan is backed by better assets than other countries' currencies.

"That is why the yuan is likely to emerge as a new reserve currency, and yet another argument for owning the yuan as an investment," said Fitz-Gerald. "This is the full circle nobody expects and one of the reasons I frequently refer to China's yuan as the only currency on the planet with adult supervision."

Distancing from the Dollar

It's no secret China has been concerned about the value of the U.S. dollar since the U.S. Federal Reserve adopted a loose monetary policy in the wake of the financial crisis.

Chinese Premier Wen Jiabao noted these worries in 2009.

"We have lent a huge amount of money to the United States," Wen said. "Of course, we are concerned about the safety of our assets. To be honest, I am definitely a little bit worried."

China remains the largest holder of U.S. debt, although its holdings have dipped since the start of the year to $1.152 trillion from $1.154 trillion.

Standard Chartered compared China's inflow of new foreign exchange reserves from January to April to purchases of U.S. government debt by China, Hong Kong and London buyers. Net purchases plunged to $46 billion.

Now China is after higher yielding assets because it's increasingly uncomfortable with having such a large percentage of its holdings in the dollar. China's so eager to diversify away from the U.S. dollar it's willing to be exposed to the struggling Eurozone.

Standard Chartered estimates that China bought about $3.6 billion worth of AAA-rated bonds issued by the European Financial Stability Facility, which is backed by members of the European Union and the European Financial Stability Mechanism.

China also is investing more in gold and silver.

"China admits to buying small quantities of gold - about $50 billion in the last year. But it may be buying a lot more gold - and silver, as Imperial China was on a silver standard, not a gold standard," said Money Morning Contributing Editor Martin Hutchinson.

Fitz-Gerald said China's moves aren't surprising as the U.S. dollar continues to weaken, and the outlook for metals like gold and silver remains bullish.

"As the dollar and other assets fail, this is entirely expected because China wants to diversify into hard assets that may serve to better preserve their wealth," said Fitz-Gerald. "At the same time, they are simply bringing underweighted allocations in these holdings up to speed; this too is expected in accordance with modern portfolio theory and asset allocation models China uses to manage its holdings."

China's nerves no doubt have been rattled by Standard & Poor's threat to downgrade the United States' credit rating. The rating agency in April lowered the outlook for U.S. debt to "negative" from "stable." Washington, despite this warning, has still failed to make much progress on reducing the country's debt as the United States nears default.

Bigger Role for Yuan

The U.S. failure to preserve the dollar's value has prompted countries like emerging economies China and Russia to challenge the currency's role as the sole global benchmark.

Zhou Xiaochuan, Governor of the People's Bank of China, said in 2009 the dollar's unique status as the world's primary currency reserve has resulted in increasingly frequent financial crises ever since the collapse of the Bretton Woods system in 1971. Zhou in March 2009 released an essay entitled "Reform of the International Monetary System" on the PBOC Website, calling for the "re-establishment of a new and widely accepted reserve currency with a stable valuation" to replace the U.S. dollar.

That "reestablishment" could mean a push for the yuan as a major reserve currency. Beijing for years has had its eye on expanding the yuan's role in global trade, especially now that China is the world's second-largest economy.

The country has started making it easier to use and invest in the yuan. State-owned Bank of China Ltd. announced in January that it would allow U.S. customers to open yuan accounts to buy and sell China's currency.

"Prior to July 2010 such trading had been confined within China," said Fitz-Gerald. "Then, the government allowed limited yuan trading in Hong Kong, which has surpassed all expectations by blossoming literally from zero to more than $400 million a day. Against that baseline, here they come and here the yuan comes."

Beijing last week said it created new rules to allow foreign firms to use yuan raised overseas for investment in China. This marks the first time China has set a specific policy for yuan-denominated foreign direct investment in the country.

"This policy on yuan-denominated foreign direct investment is a significant stride towards making the yuan an international currency," Deutsche Bank AS (NYSE: DB) economist Ma Jun told the AFP.

Invest in the Yuan

Fitz-Gerald says that as the yuan becomes more accessible to foreign investors, it should become a greater part of everyone's China investing portfolio. The yuan is increasingly becoming the strongest currency option.

"Whether the Chinese intend it or not, the large alternative asset purchases make it ‘backed' by hard assets at least in part," said Fitz-Gerald. "And this is something no other currency on the planet offers at the moment despite the fact that people are talking about a partially asset-backed reserve currency (which is essentially what the Chinese are doing here)."

So how can investors cash in? Fitz-Gerald said investors should get their hands on the yuan itself.

"You can either use direct deposit through WisdomTree Chinese Yuan Fund," said Fitz-Gerald. "Or, if you are in New York City where a branch is, go down to the Agricultural Bank of China and open a yuan-denominated account."

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