China Calls For New Reserve System: Currency ETFs In Focus

by on June 29, 2009 | ETFs Mentioned:

China’s central bank once again stated the need for reform of the international currency system to reduce over-dependence on current reserve currencies (read: the U.S. dollar). While the People’s Bank of China (PBOC) didn’t specifically mention the dollar in its statement, the desire to replace the greenback as a central component of many countries’ foreign reserves holdings was quite clear. “To avoid the shortcomings of sovereign credit currencies acting as reserve currencies, we need to create an…international reserve currency that can maintain the long-term stability of its value,” the PBOC said.

The dollar, which is already facing downward pressures stemming from the general global uncertainty and the record levels of government debt, sunk against its major rivals on news of China’s proposal. Specifically, the PBOC’s plan involves the use of Special Drawing Rights (SDRs), a synthetic currency developed by the International Monetary Fund (IMF), as a super-sovereign reserve currency. Such a development would adversely impact the dollar, which is currently the currency of choice for foreign reserves of many nations.

China is not alone in its calls for modifications to the existing reserve system. Earlier this month at a conference of BRIC nations, Russia also called for the creation of a new reserve currency to replace the dollar as the world’s sole benchmark. China had been slow to throw its support behind Russia’s plan previously, no doubt concerned over the value of its own significant T-Bill holdings.  

The comments reflect China’s worries over potential inflation resulting from the record levels of debt used to finance the U.S. stimulus plans. Although prices have remained stale for now (in fact, deflation is more of a concern at present), an economic recovery could trigger a wave of upward pressures, with some investors betting that inflation rates could reach double digits by 2010. Such a scenario would be a troublesome development for China, as the dollar comprises nearly all of the nation’s $2 trillion reserve holdings.

While the rise in prominence of China and other new world powers has threatened to reduce the role of the dollar in the global economy, I don’t think that a dethroning of the U.S. currency is imminent, for several reasons. First, the two currencies  most frequently proposed as alternatives to the dollar, the Russian ruble and the Chinese yuan, are not (at least at this point) viable options. The levels of wealth in these countries vary greatly – Shanghai and Moscow boast first world economies while rural, undeveloped regions more closely resemble the third world.

Although the idea of a blended-currency “super-reserve” is gaining some momentum, SDRs are not truly a global currency, as they are currently valued against the values of sterling, dollars, yen, and the euro. In order to become a practical international reserve currency, the SDR structure would need to be modified to include the yuan, rupee, ruble, and real, among others. The difficulties in establishing and maintaining a sufficient basket of currencies could prove to be a very daunting endeavor. Satisfying all concerned parties would seem to be a Herculean task.

Funds To Watch

The comments from the PBOC have drawn global attention to an important debate. In light of the recent financial crisis and the changing composition of the world’s economic superpowers, the currency reserve system may indeed be in need of some change. As the debate goes on, many currency funds on the market could be on the move:

  • Market Vectors Renminbi/USD Trust (CNY): While the conspiracy theories and proposed outcomes surrounding the current international currency drama abound, there is little doubt that bumping the dollar from its status would be a boon to China’s currency. Although it is expected to eventually overcome Japan and the U.S. as the world’s largest economy, China is in need of further market reforms if it hopes to become a key player in the currency reserve game.
  • PowerShares DB U.S. Dollar Index Bullish (UUP): While momentum seems to be building behind development of  a new global reserve currency, the dollar is not going to lose its status overnight, meaning market movements corresponding to policy statements may be overblown and present good buying opportunities. On the heels of its call for reforms, the Chinese central bank recently announced that it plans to keep its currency policy “quite stable” for the time being, further indicating that no change or even an extended campaign for change is imminent. UUP is designed to replicate the performance of being long in the U.S. dollar against six currencies: euro, yen, pound, Canadian dollar, Swedish krona, and Swiss franc.
  • CurrencyShares Russian Ruble Trust (XRU): While China has been relatively diplomatic in its efforts to stimulate the reserve currency discussion, Russia has been blunt about its desire to replace the dollar with a new currency. The ruble is another currency that could benefit from a shift away from the dollar and towards a more synthetic international reserve standard.

Disclosure: No holdings at time of writing.