A Yuan Reserve Currency Is Coming - Brace for a $2 Trillion Global Disruption

Nov. 14 Update:  On Friday, Nov. 13 the International Monetary Fund made a recommendation that virtually guarantees a yuan reserve currency.

IMF head Christine Lagarde said the yuan now "meets the requirements to be a 'freely usable' currency.

Original story follows:

It's almost certain a yuan reserve currency will become reality 11 months from now, triggering a foreign currency shift of as much as $2 trillion - an existential threat to the U.S. dollar's status as the world's primary reserve currency.

Last week, Bloomberg reported that International Monetary Fund (IMF) officials have told Chinese officials that the yuan will join the organization's basket of reserve currencies "soon."20140120_reserve-currencies

Sources told Bloomberg that Chinese officials are so sure the IMF will decide in their favor that they're already drafting statements to celebrate it.

The IMF board will meet in November to make a final yuan reserve currency decision. If it decides in favor of China, the yuan will join its basket of currencies, known as Special Drawing Rights (SDR), at the end of September 2016.

The last time the IMF conducted a review of the SDR basket, in 2010, it decided that the yuan was not yet "freely usable."

But since then, the People's Bank of China has exerted great effort to liberalize its yuan policies to make it trade more like other major world currencies. In fact, China has sought yuan reserve currency status for decades.

Inclusion in the SDR basket by itself isn't a huge deal - it's mainly a system of global liquidity that gives members the right to obtain currencies in the basket to meet balance-of-payment needs. They're also held as an emergency buffer in the event any one currency fails and the nation in question still needs to buy stuff in the world's market place - like food and fuel, for example.
The total value of the SDR basket is only about $280 billion, not a large sum compared to global foreign exchange reserves of about $11.46 trillion.

But as an SDR world reserve currency, the yuan would have special status. After all, there are only four other currencies in the IMF basket - the U.S. dollar, the Japanese yen, the euro, and the British pound sterling.

Suddenly the yuan will become a disruptive force...

The Yuan Reserve Currency Will Reshape the World's Markets

The IMF "stamp of approval" would encourage China's many global trading partners to add yuan to their reserves while reducing their holdings of other currencies, such as the U.S. dollar and the euro.

Standard Chartered Plc. and AXA Investment Managers have estimated that SDR status will draw $1 trillion of the world's foreign exchange holdings into a yuan reserve currency. But we're talking about the currency of an economy that will soon be larger than that of the United States.

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"I think that's low and the figure may hit $2 trillion as China's onshore capital markets mature because China is growing far faster than Westerners are prepared to accept," said Money Morning Chief Investment Strategist Keith Fitz-Gerald.

A shift of $2 trillion would affect 17.45% of all foreign exchange reserves. And the biggest loser would be the U.S. dollar.

"More than 60% of total declared reserve holdings are dollar-denominated, and roughly 40% of the world's daily $5 trillion currency transactions are dollar-based," Fitz-Gerald said. "That's going to change."

It's already begun. Use of the yuan in global trade has been growing rapidly. And it's the fourth most liquid currency as measured by global payments.

"As of August, the yuan accounted for 2.79% of the world's total payment volume. That's a jump of 9.13% at a time when payments across other currencies have fallen by 8.3%, according to Swift," Fitz-Gerald said. "Plus, there are now nearly 2,000 financial institutions processing payments in yuan, some 600 of which don't even have an office in China."

A yuan reserve currency, powered by the rapidly expanding Chinese economy, will eat away at the dominance of the U.S. dollar over time until it displaces it as the world's primary reserve currency.

The Yuan Reserve Currency Is Bad News for the U.S. Economy

"It's not so much that the dollar is going to collapse as it is that China is going to grow past it," Fitz-Gerald said.

But rising demand for a yuan world reserve currency will over time result in less demand for the U.S. dollar. And that will have grave consequences for the U.S. economy.

When the dollar loses reserve currency status, the world will chase Chinese yuan to settle their international transactions. The United States will have fewer buyers of its debt, restricting its ability to run up its credit with no consequence.

This will also inhibit the U.S.'s ability buy goods abroad. Instead of buying goods with dollars it issues, the United States will have to convert those dollars into yuan first.

All that international money that once flowed to Wall Street will instead flood to Shanghai and Shenzhen.

When that begins to happen, the days of debt-fueled expansion will be over, and the U.S. will be facing a long period of sustained, slow growth - upending the financial system as we know it.

And there's no stopping it.

"China has had the largest economy in the world for 18 out of the last 20 centuries," Fitz-Gerald said. "The difference is, they're driven by 1.3 billion people that want to live the way we do, an economic machine that is still very much in growth mode, a working population that is a prime age - 18 to 54 - and they've got $3.1 trillion in reserves. We're $221 trillion in the hole."

Follow me on Twitter @DavidGZeiler.

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