Enter the Dragon: China Takes a Symbolic Step Toward Reserve Status

The World's Very First RMB Gold Contract

For the first time ever, China is offering convertibility between gold and their own currency, the Renminbi. To understand the symbolic importance of this, let's first give a bit of background and context.

Gold, as with most other commodities, is commonly priced around the world in US dollars since it currently acts as the world reserve currency—a relic of the Bretton Woods System established after World War II to restore order to the global financial system under America's newly recognized economic and financial strength. In order for other nations to agree to this US-centric based system of finance and global trade, however, there was a stipulation made to enforce responsibility on the US to maintain the dollar's value by allowing other nations to freely exchange their dollar holdings for a fixed amount of gold. That is, the US dollar was directly convertible into gold.

For the most part, this would ensure against temptation by the US to corrupt its newly acquired power by simply printing money to pay off its international debts, something a non reserve-currency nation wouldn't be able to do for very long. Unfortunately, as with many other nations before it, the US eventually succumbed to the power of the printing press to finance its large deficits and before a subsequent run on its (gold) bank took place¹, President Nixon broke the international agreement, essentially defaulting on its debt by "closing the gold window", allowing us to continue printing money ad infinitum to pay off our debts.

Today, only forty years later, the consequences of such a decision are a dollar that has lost over 81% of its value, a 460% increase in inflation (see chart below), and a national debt that has grown from $398 billion (in 1971) to $14.8 trillion—a 36-fold increase!



This massive increase in debt alongside a dollar losing most of its value has accelerated attempts by foreign nations to find a replacement. At first it was thought the euro would be the one to deal the final death blow to the USD's failing reserve status, but financial problems in the Eurozone have cast much doubt upon such a near term contingency plan.

Enter the Renminbi

The direct conversion between gold and China's currency is both a strategic and highly symbolic move. As I said in the beginning, most commodities, including gold, are currently denominated in US dollars; with gold the symbolic measure of a currency's reserve status.

If China can successfully unseat the US dollar from its golden throne by establishing a more attractive gold-RMB link, it will have shown it can succeed in doing so in any other commodity—a major step toward world reserve status. Whether this happens quickly or as a slow transition over time largely depends on the financial, economic, and military strength of our two countries moving forward.

Keep in mind, however, the stakes are very high for the US and such a transition won't be taken lying down. As explained by Barry Eichengreen in Why the dollar's reign is near an end:

In this new monetary world, moreover, the U.S. government will not be able to finance its budget deficits so cheaply, since there will no longer be as big an appetite for U.S. Treasury securities on the part of foreign central banks.

Nor will the U.S. be able to run such large trade and current-account deficits, since financing them will become more expensive.

Some have argued, however, that the position of maintaining a world reserve currency is more a curse than a blessing. In the case of America, this appears to be most true as decades of debt and massive imbalances built over the past 40 years under the current system will prove difficult for the US long term, as Barry's remarks imply.

Consequently, in view of this obvious reality, we are faced with the uncomfortable situation of a government and central bank hell bent on staving off the invisible hand of market forces by drowning the world in ever larger amounts of US dollars. At some point, our current debt-based monetary system will end by collapsing under its own weight and a new system will take its place. Enter the dragon stage left.

As Haywood Cheung, President of the Chinese Gold & Silver Exchange, said yesterday in somewhat broken English, "The whole world will probably dump denominated in US dollars." I guess we'll have to see.

¹ It is unknown how much gold may have been liquidated from the US vaults of Fort Knox before President Nixon closed the gold window. This has been the source of much speculation and a few documentaries, like this one done by the History Channel.

² Renminbi, often abbreviated as RMB, is the official name of China's currency and it is based on primary units of yuán. In foreign exchange transactions, Renminbi is denoted by the letters CNY.

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