Fenil's Library

Currency swap with multiple nations is a good bet, but will take time working

Vivek Kaul. Mumbai

The Indian stretchable time was at work again. The Woodpecker Airlines flight I was supposed to board was late by an hour.

“Let’s have some coffee,” I said.

“Not a bad idea,” she said, leading me to the nearest coffee shop.

“Good coffee,” I said after taking my first sip and looked to her for a confirmation.

“Good as usual,” she said. “Now tell me what China is doing to bring down its dependence on the US dollar.”

“Oh, a number of things,” deciding to plunge headlong into a discussion so waiting for the flight became more bearable. “First, it has been buying metals like copper, aluminum, nickel, titanium and zinc. It has also been buying iron ore in huge quantities from Brazil since the beginning of this year with the intention of building a store house of real physical assets instead of having a major portion of the foreign exchange reserves invested in financial securities issued by the US government. It has also been buying gold. Since 2003, China has increased its holding of gold by 73% to 1,054 metric tonnes, valued at around $31.3 billion, which makes it the fifth-largest holder of gold in the world. Still, all these investments make up a very small part of the nearly $2 trillion foreign exchange reserves China has. A bigger game is being played somewhere else,” I explained.

“And what is that game?”

“China is trying to enter into currency-swap agreements with countries like Argentina, Brazil, Belarus, Hong Kong, Indonesia, Malaysia and South Korea. It has signed agreements worth $95 billion in the last four months.”

“What’s a currency swap agreement?”

“Let me give you an example. China recently overtook US as Brazil’s major trading partner. Up till now, they have been carrying out trade in US dollars, which means that if China buys something from Brazil, it pays Brazil in dollars and vice versa. The Brazilian President, Luiz Inacio Lula da Silva, better known as Lula, said in an interview recently, “Between Brazil and China, we need to establish a trade that is paid for in our own currencies. We don’t need dollars. Why do two important countries like China and Brazil have to use the dollar as a reference, instead of our own currencies? It’s crazy that the dollar is the reference, and that you give a single country the power to print that currency. We need to give greater value to the Chinese and Brazilian currencies.” If Lula and China have their way, China will pay Brazil in yuans when it buys something from Brazil and Brazil will pay China in real (the Brazilian currency) when it buys something from China.”

“And how will that help?” she asked, taking a noisy sip.

“It will take the US dollar out of the equation for China to some extent. Right now, when China exports goods and services, it gets paid in US dollars. Vice versa, when it imports goods and services, it needs to pay in dollars. If China can expand this currency swap system, it no longer needs to be dependent only on the US dollar for international trade. It will accumulate a lesser amount of dollars in the days to come by getting paid for exports in currencies other than the dollar as well. Also, China is a big importer of commodities these days and it can pay for those using its own currency, the yuan. And as China imports more in the days to come, countries around the world will start accumulating yuan, and that improves the chances of yuan becoming an international reserve currency like the US dollar currently is.”

“Interesting.”

“I’m not done yet. Nouriel Roubini, one of the few economists who correctly predicted the current financial crisis, recently wrote, “Traditionally, empires that hold the global reserve currency are also net foreign creditors and net lenders. The British Empire declined — and the pound lost its status as the main global reserve currency — when Britain became a net debtor and a net borrower in World War II. Today, the United States is in a similar position. It is running huge budget and trade deficits, and is relying on the kindness of restless foreign creditors who are starting to feel uneasy about accumulating even more dollar assets. The resulting downfall of the dollar may be only a matter of time… China has already flexed its muscle by setting up currency swaps with several countries.””

“So are you saying the yuan will displace the US dollar as the international reserve currency soon?” she asked.

“I am not saying that. All I am saying is China is trying to make yuan the international reserve currency.”

“Well, what’s the problem with yuan becoming the international reserve currency?”

“That’s because I have only explained the positive side of things. See, for a currency to become an international reserve currency, it needs to be extremely liquid.”

“Liquid?”

“Yes. When we say a certain asset is liquid, we mean it can be bought or sold at any point of time. That would mean there are buyers for the asset at all points. Take the China and Brazil currency swap plan. China accumulates reais (plural for real), when it sells goods and services to Brazil. It should be in a position to exchange the Reais it has accumulated to yuan at any point of time. But, currently, the Brazilian real is bought and sold only for a few hours every day, and these few hours are not at a point when the Chinese currency markets are open. So, currently, in order to change real into yuan, first reais will have to converted into dollars and dollars in turn will have to be converted into yuan. That’s a major weakness of the currency swap arrangement now, and it will take some time improving,” I said, emptying my cup.
“Oh, okay. Let’s go now. You need to check in now.”

k_vivek@dnaindia.net
(The example is hypothetical)

References: Brazil and China: Moves Towards a New Economic order?, Rachel Ziemba, www.rgemonitor.com, May 18, 2009; China Seeks to Dethrone the Dollar, Transforming the Yuan into the Dominant Global Currency, Keith, Keith Fitz-Gerald, May 27,2009; China and Brazil to Ditch U.S. Dollar? Hardly, Marc Chandler,www.seekingalpha.com, May 20, 2009.