Taps Coogan – March 17th, 2022

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One of the finance narratives that yours truly finds particularly tedious is the notion that the Chinese Yuan is going to imminently replace the US Dollar as the global reserve currency.

To that point, Mish Shedlock recently published an article titled “The Yuan Will Not Replace the US Dollar, Nor Will It Be Backed by Commodities” in which he again describes why the Yuan is not a viable reserve currency. He lists eight criteria for a reserve currency (in this case with respect to the Yuan):

What Would It Take for the Yuan to Dethrone the Dollar?

1.) China would have to float the yuan
2.) End capital controls
3.) Respect property rights
4.) Have a bond market big enough (China has virtually no gov’t bond market)
5.) Inspire global trust
6.) Be willing to have trade deficits
7.) Stop export mercantilism
8.) Have a currency market big enough

As Mish correctly notes, China only meets criteria ‘8.’

The first criteria, floating the Yuan, is an immediate show-stopper. People forget that the Chinese Yuan is fixed to a currency basket dominated by the US Dollar. Mechanically, that makes the Chinese Yuan a loose derivative of the US Dollar. Until China drops the peg, talk of it overtaking the US Dollar is pointless.

The second criteria is also an immediate show-stopper. People forget that China maintains tight capital controls that restrict the ability to freely convert from Yuan to other currencies. A currency where you need a central government’s blessing to transact into other currencies (not just in the exceptional cases involving sanctions) simply trades the potential for sanctions from the US for the certainty of restrictions in China.

The third criteria is also a show stopper. Here is an old investing truism: totalitarian Marxist dictatorships-for-life don’t make trustworthy long term depositories for foreign capital. For examples of this rule, see every single totalitarian Marxist dictatorship-for-life in history (North Korea, Cuba, Sandinista Nicaragua, Stalin’s Russia, Venezuela, Belarus, etc…). Don’t underestimate the difference between a run-of-the-mill one-party Marxist system like that in Vietnam and Loas and a totalitarian Marxist dictatorship-for-life.

So on and so forth…

As Mish correctly notes, the most viable alternative to the US Dollar is probably the Euro, which meets most of the eight criteria and is by far the most popular alternative to the US Dollar. However, the Euro has two major problems. The first is that, beyond diversification, its offers no clear benefits versus the dollar. As we are currently seeing, the Eurozone is as likely to freeze assets and apply sanctions as the US and it is tied into the SWIFT system. Second, it has negative nominal risk-free rates which means reserves held in Euros are very likely to be negative yielding on a nominal basis. In other words, you have to pay to hold Euro reserves. It is hard to overstate just how unappealing that is.

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