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Q&A: Australia & China to Stop Using the US Dollar in Trade? How Will Business be Affected?

Question

Australia & China to Stop Using the US Dollar in Trade? How Will Business be Affected?

I recently read that China & Australia are going to be using the Yuan as their trade currency instead of the US Dollar. Migration away from the US dollar as a global currency seems to be trending right now. As a small business owner with clients who transact commerce both domestically and internationally, should I be concerned? What can I do to shore up against a weakening US dollar?

Answer

To your main questions: There is actually quite a bit to unpack in your questions. First, I will cover what China and Australia are really trying to accomplish here and how it likely does not impact the US Dollar materially. Then I will cover that which actually does affect the US Dollar, and what you can do to prepare for the various scenarios that may result from US fiscal and monetary policy.

Quick side note: Chinese currency is referred to as the Renminbi and "Yuan" typically refers to a particular unit of the currency. So, when speaking about the currency in general, it is called "Renminbi"--as in "Australia and China are considering settling trade accounts directly in Renminbi." and when speaking about a particular number of units of the Chinese currency, it is "Yuan"--as in, "You owe me 400 Yuan for the excellent economic advice that is about to follow."

Your initial question assumes that China's plan to increase the use of their currency to directly transact business with other countries (which, indeed, is their plan) will necessarily weaken the US Dollar. However, China's move to provide their currency for account settlement with their direct trade partners does not necessarily lead to the devaluation of the US Dollar. In fact, as I hope to demonstrate below, it potentially strengthens the US Dollar.

The switch from the US Dollar to the Renminbi for Australia and China is more about avoiding the expense of settlement and conversion in a foreign currency (the US Dollar) for direct trading. China is proceeding with this direct trade arrangement with Australia and its other non-US trade partners for the sake of saving costs and for the sake of ensuring that they can avoid repeating the absolute collapse of trade they faced as a consequence of the initial months of the Great Recession.

With more direct trade relationships in their own currency, China will be less affected by flights to safety and US Dollar shortages in the next major downturn. (To really understand what I mean by a flight to safety and US Dollar shortage, read the Bank of International Settlement's white paper on why the US Dollar strengthened so materially in 2008.) In the chart below, note the spike in the value of the US Dollar in 2008 following the Lehman bankruptcy and acceleration of the financial crisis. This rapid increase in the US Dollar's value, among other factors of course, compounded the collapse in international trade. Given that China's economy was almost entirely export-driven, these circumstances affected China's economy the most directly.

How other countries settle accounts in non-US trade does not have much of a direct impact on the value of the US Dollar. Instead, it is primarily monetary inflation and deflation that affect the value of the US Dollar. In fact, it is actually the reserve currency status itself along with direct trade with the US that has perpetuated the United State's ability to devalue its currency through monetary inflation! This is depicted in the chart above by the devaluation of the US Dollar during the housing boom and leverage explosion of the US private and public sector through the 2000s (see the first red arrow down). The more we expanded our debt and trade deficits (i.e. borrowing to buy foreign goods and services), the lower the US Dollar declined in value. See the chart below for an even clearer picture of the correlation between the trade deficits and the US Dollar value.

Every time the US maintains a trade deficit, it means that the US is buying more than it is selling to other countries. How does the US do that without a surplus in reserves to pay for the goods? We do this by essentially providing US Treasuries to the countries from whom we import (not physical US Dollars, but rather bookkeeping entries that account for the amount of money owed by the US to our various trading partners, i.e. "IOUs"). By creating bookkeeping entries that expand our debt in the first place, we are essentially creating new credit (buying power), which expands the money supply, and is thus inflationary. So long as foreign countries accept our US Treasury debt bookkeeping entries as sufficient for direct trade of goods and services, they are perpetuating our ability to debase our currency through monetary expansion (inflation).

Should the US find that its ability to simply print new money (i.e. create new debt obligations) every time we want to buy something beyond our productive means is lessened, that would actually be deflationary for the US Dollar--not inflationary. So, getting all the way back to your original question, you and your clients' purchasing power in US Dollars would actually go up if this were the case on a global scale.

Regarding the devaluation of the US Dollar, while our direct trade relationships have allowed the US to get away with our spending problems for some time, the chief enabler of late has been the Federal Reserve. The "QEs" I have labeled in the first chart represent the general period of time through which the Federal Reserve was implementing its Quantitative Easing initiatives to expand the monetary base with the hope that these actions would create spill over into the economy to offset the effects of deflation and spur inflation. To their credit (no pun intended), their efforts have initially achieved the result of keeping our currency lower in the face of deflation.

The Fed's primary mission is to offset the potential effects of deflation with the hope that the economy will begin to grow enough to avoid a slowdown in spending and a reversion back into recession. The Fed is willing (openly, mind you) to devalue the US Dollar to spur inflation with the hope that this will increase consumer spending. The hope is that by driving aggregate consumer demand, job growth will follow, followed by income growth, followed finally by increased investment. If the Fed is successful in the aggregate, this could spur greater economic growth, and the US would be at less of a risk of slipping back into a recession.

Bottom line: I see three potential scenarios unfolding in connection with Fed Policy actions to combat deflation:

1) If the Fed is perfectly successful in their endeavors achieving both moderate inflation and spurring sustainable economic growth, the US Dollar will be devalued further in their attempt to avoid deflation. This means that your purchasing power would be eroded each year, but on the other hand, the economy would be growing at a more rapid pace, giving you and your customers more business to enjoy, and likely more profits to help you offset the effects of inflation.

2) If the Fed is successful in achieving inflation but not economic growth, this would lead to stagflation. I have already written about this in greater length elsewhere, but stagflation basically describes a scenario in which inflation rises at the same time that the economy is contracting or stagnating. This means that you and your customers would have less business at the same time that your cost of living would be rising. This would be the 1970s all over again.

3) If the Fed is not successful in achieving inflation or economic growth, this would lead to deflation, a deep recession, massive debt restructuring, and logically, lower rather than higher prices as aggregate demand collapses. This means that your purchasing power would skyrocket but your income may be negatively affected for you and your customers due to a contraction in overall economic activity. Reduced resources would be redirected to necessities, lowering consumer demand and causing further economic contraction. This would continue until much of the excess debt of the last several decades has been restructured (aka written off through bankruptcy), thus reducing the burden of debt, allowing for the slow--but not impossible--build up of savings, which will eventually lead to more spending and investing.

So, unfortunately, you have an even harder task ahead of you than just watching out for a weakening US Dollar! You have to position both for a weakening US Dollar while remaining hedged against a potential deflationary recession.

Shameless plug: that is where JRW comes in. We are working with clients to be prepared for both scenarios.

In general, as value-oriented investment advisers, we target discounted, opportunistic, and value-add investments that are intended to provide cushion against a deflationary recession.

In order to hedge against inflation, we target tangible assets (real estate, commodities, equipment) as well as equity-oriented investments that tend to appreciate in value in inflationary environments.

Given our current economic landscape, we have also had clients maintain shorter-term investment positions as well as cash and cash equivalents that provide available "dry powder" in the event of a deflationary downturn.

Finally, most of the investments that we recommend have a strong, ongoing income component, which provides the ability to more patiently endure a downturn or delay in liquidity, while also providing additional capital for reinvestment to take advantage of discounts in a deflationary environment.

Click to access our list of available investment offerings that meet these criteria. If you would like a personal review of investment options and strategies that may be suitable for your particular needs and goals, please call (877) 579-1031 or email clientservices@jrwinvestments.com.


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Australia, China, debt, deflation, Dollar Shortage, Federal Reserve, inflation, QE Infinity, QE1, QE2, QE3, Quantitative Easing, Renminbi, stagflation, trade deficit, US Dollar

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