The world of FX reserves has been upended over the freezing of Russia’s assets in a way not seen since Nixon closed the Gold Window in 1971. The arrival of the Petro-Ruble marks the end of the Petro-$ that emerged from that previous commodity price driven inflation panic and accelerates the need for ‘The Rest’ to keep their money separate from ‘The West’. Rather than simply replacing the US$ as world reserve currency, we see a role for a basket – likely based on the SDR – and, to revisit an idea from 2019, we would not be at all surprised to wake up one morning and find that as part of China’s move to Build Back a Better Financial System, (for them) that the HK$ has been repegged to the SDR basket.
We believe that much of the recent (excess) strength of the US $ is likely down to a ‘short squeeze’ from international funds deleveraging currency and duration mismatches and thus being forced buyers of $s – not so much a flight to quality as a flight from risk (leverage). This, we feel, is distracting from some very important long term moves underway of the sort not seen since the 1971 crisis when Nixon took the US$ off the peg to gold, a move that subsequently led to the creation of the Petro-$ and fifty years of the US effectively recycling the savings of the world and the creation of the Financial Markets as we know them.
A ‘Strong $ means a strong Economy’ mantra is often trotted out for political reasons (although the “Ruble is Rubble” meme from Joe Bidon went quiet very quickly) and we are not surprised to see the China bears zooming in on the recent weakness in the Rmb as a sign that “China is in trouble”. However, as the chart shows, the recent sell off in the $/Rmb rate (orange line rising) is most likely in response to the strength of the Rmb against everything else (green and white lines rising) and the Chinese authorities are much more interested in a trade weighted basket that this single pair – even if the commentariat only ever think in terms of the $.
Chart 1: Letting the Rmb fall against the $ offsets its strength against everything else.
Hence in addition to the CNY (the offshore Rmb), we show two different baskets, both published by the Chinese Foreign Exchange Trade System; the first is similar to the equivalent DXY Dollar weighted index and is based on the BIS trade weighted index, reflecting what China might be looking at in terms of economic competitiveness. Obviously the Yen, the SK Won and the Euro are important here, not just the $. Notice how this line has been rising/strengthening until the last month, now with the managed weakness against the $, (shown as orange line rising) the trade weighted index has come back a little. A strong $ looks good for investors in US rather than international markets at the moment, but of course we shouldn’t overlook the upcoming hit to overseas earnings that is coming down the pipe (more on that in another piece). There is also the matter of Hong Kong, which as well as being one of China’s main trading counter-parties and increasingly regarded as part of China is effectively pegged to the US$.
The Chinese Government manage the Rmb/$ exchange rate in the context of a wider basket of Currencies. A HK$/US$ peg makes little sense anymore
One of the acknowledged weakness for a currency peg to the $ is that it means you effectively are tied to US monetary policy, something you probably don’t really want to be doing right now and indeed the HKMA had to intervene in the markets to support the peg last week for the first time since 2019. Moreover, in the light of the FX reserves issue and ongoing Geo-Political tensions, it makes little or no sense to have the HK$ pegged to the US$. Equally, however, it would probably be too difficult to peg the HK$ to the CNY right now (the CNY is the offshore Chinese Yuan or RMb)
We wonder if instead, now might be the time for China to embrace the notion of the SDR – the SDR being the Special Drawing Rights at the IMF, an idea that emerged after Bretton Woods in 1943 and something we believe presents an opportunity to act as a secondary ‘Reserve Currency’ in the manner of the Bancor proposed by Keynes back then (see Is it time for the Bancor?). The second (green) line in the chart is a basket based on SDR weights.
Thus, rather than fully opening up the Chinese current account or officially pegging the CNY to the SDR, or the HK$ to the CNY, the next step may be instead for the HK$ to be unpegged from the US$ and then be re-pegged to the SDR basket. We looked at the prospect of pegging the Hong Kong $ to the SDR back in 2019 (watch the peg …to the SDR?), prompted by a very interesting paper by Matthew Harrison and Geng Xiao which can be found here in the Journal of Financial Risk management, and titled “China and the SDR, towards a better International Monetary System” and the logic remains very much in place. However, the recent dramatic developments in the world of Foreign Exchange Reserves will certainly have pushed the idea forward once more, but unlike in 2019, when the idea was for perhaps the Chinese to embrace the SDR as part of its own opening up of the capital account, we wonder if the opportunity to peg the HK$ to the SDR may serve a wider purpose.
While many aspects of the 1970s look eerily similar – energy crises, runaway commodity booms, cost of living crisis, cold wars and hot wars – the big difference is of course China. The freezing of Russia’s FX assets without due process has undoubtedly triggered a serious review among all owners of US$ assets and a variation of the famous saying from 1971 when US Treasury Secretary John Connally said of the rapidly weakening US$ “It’s our Currency, but your problem”. The $ is a problem again, but now less for its role as a trading currency and more for its role as a place to store wealth. Back then China had a GDP around $100bn, a little over one third of the size of Japan and a tenth the size of the US. The problem then was a need to remain competitive against the $, now it is that there is a strong perceived need for a separation of accounts between ‘The West’ (which we could probably designate to be the 30 countries currently supporting the US sanctions on Russia) and ‘The Rest’. The former may account for more GDP in total, but they also account for most of the current account deficits and thus house most of the capital inflows via FX reserves. The latter meanwhile account for more than 70% of the worlds FX reserves – as well as most of the population, future growth opportunities etc.
Thus, in addition to signalling a break from using the US$ (albeit it is still part of the basket), an SDR peg would provide an opportunity to propel Hong Kong forward into international debt markets as well. After all, given it is the IMF, China is not seeking to replace the $ with something Chinese, rather with a better, more basket based, approach. Why wouldn’t all FX reserve countries not seek to have an IMF basket rather than credit balances in, potentially hostile overseas banks? By hostile, we mean subject to overseas foreign policy as well as overseas monetary policy. Why then not also create a large and liquid market in Sovereign SDR loans, allowing the large number of countries now concerned about storing their FX reserves in US Treasuries to instead store them in SDR debt- debt issued (at the appropriate rating) by Sovereigns many of whom would also currently be forced to borrow in $s? Debt to continue building the Belt and Road project and tied perhaps to the Asia Infrastructure Investment Bank? The possibilities are huge. As are the likely disruptions.
The first steps were already underway and have simply been accelerated by the actually not entirely unprecedented, moves by the Biden administration (they had already also moved to ‘freeze’ the gold reserves of Venezuela and Afghanistan); China and Russia were already trading Oil in Rmb, at least partly backed by gold, while India is now talking about direct swap lines with China and Saudi is talking about selling oil in Rmb. The next phase we believe has to be to build a New World Monetary Order, less dependent on the US$ and the HK$ may be the starting gun for this next phase and perhaps letting the CNY weaken last week is an alert to the fact that this may be sooner than we think?
