As the weighting of the U.S. dollar is decreased in aligning the yuan to a basket of currencies, People’s Bank of China governor Zhou Xiaochuan has confirmed that the euro, Japanese yen and Korean won are “natural” key currencies to help manage the yuan: “...a basket of currencies can [..] better absorb the impact generated by an unstable US dollar ...” Aside from the major trading partners using these currencies, any country with which China conducts more than $10 billion in annual trade is likely to be included; the Australian, Canadian and Singapore dollars were mentioned, as well as the Russian ruble, Thai baht, British pound and Malaysian ringgit. The central bank governor said: “When you look at currencies used in trade settlement, although some countries and regions prefer US dollar as the currency for trade settlement with China, this situation is changing gradually and trade settlement in local currencies are increasingly the choice of trading partners.”
China has not given details about the weightings applied to any currency. In our recent analysis, “A Snowball in the Making: China's Basket of Currencies,” we mentioned that we believe China will emphasize countries with which it has a trade surplus or with which it would like to do more trade. By managing its exchange rate with a trading partner, China has a tool to subsidize trade with that region. Aside from the euro-zone, the target market with a significant growth potential, Australia, Canada and Russia are worthwhile pointing out. As China is rebuffed in its efforts to purchase natural resources from the United States, it may well want to acquire natural resources in Canada and Australia. China’s resource hungry economy is keen on securing future demand; the public got a glimpse of this at the recently failed attempt to acquire Unocal by the state-controlled Chinese energy conglomerate CNOOC. Separately, Russia with its very large natural resources is an increasingly important partner for China.
The reduced interest in U.S. dollars already has an influence on the markets. While analysts disagree on the weighing of the U.S. dollar in China’s basket of currencies, it is certainly less than the 100% that was in place when the currency was pegged to the dollar with analysts estimating the dollar allocation to be between 30% and 70%. In our view not coincidentally, at a $13 billion U.S. government bond auction on August 8, foreign central banks and investors “surprised” the markets by their lack of interest. According to Bloomberg, these so-called primary dealers purchased 22 percent of the debt sold, the smallest percentage since June 2003.
Indeed, the lack of foreign interest may be a sign that international investors will eventually require higher interest rates as the U.S. dollar requires ever larger foreign investments to feed its current account deficit; while we caused headlines by quoting estimates of a current account deficit that may reach $900 billion in 2006, we have seen higher estimates by reputable economists since. Foreign investments in the U.S. are to a large extent through the purchases of U.S. debt. The Financial Times in an article on August 10, 2005, brings the rise in associated interest payments to the point: “By the end of the year – and for the first time since records began in the 1960s – the U.S. is likely to be paying more to service its debts than it receives in foreign income. As this happens America will find itself borrowing not just to fund current spending, but simply to service previous debts.”
We warned only about a week ago that the U.S. is getting ever more sophisticated in financing its debt obligations, and that the way the U.S. refinances its obligations, is not so different from consumers financing their lifestyle by taking negative amortization mortgages out on their homes. It looks like the future is shaping up faster than we anticipated. Issuing debt to merely service your interest payments is a practice more commonly associated with third world countries, with inflation and hyperinflation.
