China vs. the Dollar – Round 1

by Aug 27, 2020Market Insights, The US Dollar

The US dollar is the world’s reserve currency, but the greenback has dropped almost 9% since March, igniting widespread fears that it could lose its prominent status. In fact, July was the dollar’s worst month in a decade. However, as the dollar is plummeting, gold is soaring. Historically, gold and the dollar are inversely correlated—gold tends to go up when the dollar goes down and vice versa. We can see this relationship in the graph below (orange=gold, blue=dollar).

The US dollar and the price of gold are inversely correlated - when the dollar goes down, the gold price goes up.

Source: Macrotrends

When the price of gold recently set a new historic record at over $2,000/oz, it was fueled by global investors wanting to hedge their investments against the pandemic’s impact on the economy and, in particular, US finances. What we are seeing today is that these global investors are losing their faith in the US economy and fractured political system.

What makes the dollar the world’s reserve currency?

Most of global trade is conducted in US dollars, and over 60% of the world’s foreign exchange reserves consists of dollars. For example, many foreign governments and central banks are holding their excess funds in US dollars, particularly in US government bonds. Because the rest of the world so readily accepts the US dollar, our federal government can add trillions to its debt and let the Fed add trillions more in stimulus to the economy.

Being the preferred currency comes with several benefits to America, including lower interest rates and seemingly unlimited access to global savings pools. The dollar’s status is also the reason we Americans are rich compared to citizens of other nations—estimates say that 20% of your and my lifestyle is due to the unique position of our currency. Losing the dollar’s dominant status will change everything for all of us.

Will the dollar remain the dominant reserve currency?

The combination of the Fed’s 0% interest rates and the $5.6 trillion in stimulus is pushing our debt to over 100% of GDP, which is impacting the soundness of our financial system, igniting fears worldwide that the US dollar is being debased. And it’s not just global investors who are questioning the dollar’s status as the world’s reserve currency—Goldman Sachs has recently done the same.

Here comes China

Recently, the White House imposed sanctions on 11 senior Hong Kong officials, causing an uproar from mainland China. The sanctions targeted individuals, but the US also penalized any institution that did business with these individuals. Despite Hong Kong saying such sanctions had no legal standing, several Hong Kong–based banks quickly closed accounts associated with the sanctioned individuals.

That the banks complied with the US sanctions is clear evidence of our government’s readiness to use our currency’s dominance for political reasons, and both China and global banks are realizing this. For instance, the US could easily expand its sanctions to include banks it deems as complying with China’s actions in Hong Kong. It’s an eye-opener for China’s own banks—the five largest ones are running extensive offshore operations and have more than $1.4 trillion in US dollar funding.

In other words, should the US fully weaponize the power of the dollar, China’s financial system could end in chaos. The US could prevent China and Chinese institutions from settling any US-denominated transaction. And the threat is very real—just ask Russia, Iran, North Korea, and Venezuela. They went through this ringer before.

What is China’s response?

China is aware of the risk the dollar presents to its banking system, and it is pursuing the creation of a financial system of its own to compete with the dollar. For instance, it has struck a deal with Russia to use the two countries’ currencies for transactions between the two economies. Today, over 25% of these transactions are settled with the Chinese yuan and the Russian ruble. It’s just a matter of time before China and its other trade partners start using the yuan.

Once that happens, as China is the world’s largest importer of goods, the Chinese currency may overtake the dollar in terms of market share, essentially making the yuan the world’s reserve currency. Or it may snag market share away from the dollar and create a world where there is not just one reserve currency but two or more.

And once the dollar starts losing its dominance, you and I will feel the difference. The Fed will no longer be able to get away with its massive money printing, nor can our government keep piling up debt. Foreign central banks and governments would no longer line up to buy US government bonds that they have to keep as reserves for their trading activities, which would severely devalue the dollar and cause significant inflation in the US.

The conflict with China is a serious threat to the US dollar. Since we are all riding on our dollar’s strength, this conflict threatens your cash savings, stocks, bonds, pensions, annuity payments, and retirement savings, which are dollar-denominated. So, pay attention to the dollar–yuan battle since it can escalate quickly and have decades-long ramifications.

Needless to say that when you are diversified into gold and silver, you are not affected by this battle between the world powers for dominance. Gold, the only true form of currency and store of wealth—since it cannot be printed or inflated, nor is it debt-based like all government currencies—can help you weather any paper currency storm. In fact, it enjoys these storms as the battle between currencies weakens them and strengthens the value of precious metals. Just look at the wide smiles precious metals owners are showing in 2020. And with not a lot to smile about this year, owning metals should be a serious consideration for everyone.

May you and your family be well during these trying times.

Joseph Sherman

Joseph Sherman

CEO, Gold Alliance