The bilateral currency swap agreement between the European Central Bank (ECB) and the People’s Bank of China (PBOC) is valid for three years and has a maximum size of 350 billionyuan, or 45 billion euros ($60.8 billion).
The deal is the latest of a string of currency swaps that China has created with other nations to promote usage of the yuan in global commercial and financial transactions, with the ultimate goal of rivaling the dollar as a reserve currency.
“The emphasis is on renminbi internationalization,” said Louis Kuijs, an RBS economist in Hong Kong.
The yuan is now the world’s eighth most-traded currency, financial services provider SWIFT said this week, with a market share of 1.5 percent and overtaking the Swedish krona, the South Korean won and the Russian rouble.
To be sure, the Chinese renminbi is still a long way from rivaling the USD as the worlds primary reserve currency. While the renminbi has become the 8th most traded currency in the world at a 1.5% market share, the USD is still the undisputed king, accounting for 61.9% of foreign reserves according to the IMF. One of the main factors holding back the renminbi’s attractiveness as a reserve currency is the fact that it’s value is not determined on the open market but rather set by the People’s Bank of China. A free-floating renminbi is unlikely any time soon, as it’s low value is a crucial element of China’s export driven economy.
However, recent events point to increased attractiveness of the renminbi, and troubling signs for the USD as a reserve currency. The Federal government does not have to default on it’s debt obligations in order to hurt the standing of U.S. debt as the ultimate “safe-asset”; just the threat of a default led to the first ever downgrade of U.S. credit rating in the summer of 2011.
Furthermore, there are signs that markets are beginning to shy away from U.S. debt, leading to higher borrowing costs:
In good times and bad, the world’s financial system has long been able to rely on one thing: that the United States government would pay back its debt on time.
This assumption has made short-term government debt the most basic building block of the financial system, as reliable as a dollar bill.
In recent days, however, the fiscal impasse in Congress has been testing investors’ confidence. As a result, investors have been shifting their money out of the $1.7 trillion market for the short-term government debt known as Treasury bills, worried, for the moment at least, that they may not be the risk-free asset they have known.
The clearest sign of the changing perceptions has come in the prices for the bills that the Treasury Department is supposed to repay in the days right after the debt ceiling is set to be reached.
Normally, as the day of repayment for a Treasury bill gets closer, the chances of getting repaid go up and the bill becomes worth more to investors. Now, however, the opposite is happening, and the bills are becoming worth less than they were previously, making them available for a discount on their face value.
The discount on bills to be paid on Oct. 24 has grown by 400 percent since the beginning of the month; on Wednesday, it jumped 24 percent. That has brought the price that the government has to pay to borrow money for a month to three times what the average AA-rated American company has to pay, according to Federal Reserve data. Typically, the United States government can borrow money for less than big corporations.
Confidence in investments widely considered to have little or no risk has been periodically shattered in the recent past. Until 2008, most investors thought they could not lose money on mortgage-backed bonds that carried a rating of AAA. Last year, investors were forced to rethink their belief that countries in the European Union would always repay their debt.
In the longer term, the fear is that a default would dent the willingness of foreign investors to use Treasury bonds as a place to park their money. Their desire to do so today has made the dollar the world’s most widely used currency.
In remarks prepared for a hearing on Thursday, the head of the industry group for mutual funds, Paul Schott Stevens, said that if a payment was delayed for as little as a few days, “investors will learn a lesson that cannot and will not be unlearned.”
“That lesson is simple: Treasury securities are no longer as good as cash,” Mr. Schott Stevens said.
Let me be clear, the sky is not falling–yet; it seems that politicians on both sides of the political spectrum understand the importance of not defaulting on U.S. debt obligations. However, one has to question the long term effects of even the threat of a debt default. The G.O.P has proposed a temporary debt ceiling increase in exchange for negotiations over budgetary issues. This is not a good compromise, kicking the can down the road will just lead to another debt-ceiling showdown a few weeks from now; one has to wonder at what point global markets will begin to question the USD as it’s main reserve currency. Surely, every-time we have this debate, we risk a credit rating downgrade and further damage the sterling reputation of U.S. Federal debt. As a nation, we literally cannot afford to lurch from one debt showdown to another.
Perhaps investors, fed-up with American political gridlock and uncertainty, will begin to see China, with its insulated and unified leadership, as a safer place to park its money–surely China’s rulers would not even entertain the idea of a default on their debts.
The debt limit is not a political bargaining chip; it must be raised in the very short-term, while entitlement and tax reform are longer term issues (which have been unsuccessfully negotiated for the better part of the past two decades, is it realistic to believe we will be able to reach a grand bargain in a few weeks?!). As the NYT editorial board put it, “First End the Crisis, Then Talk“.