The most important economic event of 2015 just occurred, and most people didnt hear about it.
The International Monetary Fund (IMF) has accepted Chinas Yuan as an official reserve currency. Just as Chinas entry into the World Trade Organization (WTO) in 2001 greatly increased the countrys prominence in global trade, Chinas inclusion as a reserve currency is a watershed event for global monetary economics. The Yuan will join the U.S. Dollar, U.K. Pound, Euro, and Japanese Yen to become the worlds fifth reserve currency.
What does this mean, and what is a reserve currency?
Foreign exchange reserves are used by governments to back their liabilities. Nations will increasingly store their reserves in Yuan, rather than Dollars, Yen, Euros or Pounds. The Yuan will be used increasingly as a means of exchange for global trade.
What are the implications for the financial markets?
- Like the WTO deal, the impact wont be felt at once. We are likely to look back in ten years and be impressed by the cumulative impact of this change. The immediate effect on financial markets will be difficult to discern, however.
- China solidifies its position as an economic superpower. Although there are concerns about the present state of the Chinese economy, the IMFs endorsement is a critical step toward this being the Asian Century.
- Longer-term, the Dollar will have to share the stage. Although present forces are conspiring to send the dollar higher, the Yuans ascendance is modestly bearish for the dollar over the next decade.
- Americas exorbitant privilege may fade over time. For decades, the dollars reserve currency status has allowed the government to fund large deficits at attractive interest rates. This situation may not exist 10 or 20 years from now if competing reserve currencies gain prominence. On the other hand, lingering questions about the Euro and Yen could cause the dollars status to increase over time.
What should investors do?
- Remember: economics isnt a zero sum game. Chinas ascendance does not mean Americas decline. A growing China adds to the size of the global economy and should be welcomed.
- Be positioned to benefit from long-term growth in China. Chinas rise to economic superpower status is a reason to keep portfolios global diversified and exposed to emerging markets, despite present challenges.
- Tune out the fear. Articles are already being written aimed at scaring investors over the implications of the IMFs decisions, usually centered on the possibility of a dollar crash. We believe these arguments will be proven wrong. The IMF has no incentive to trigger undue volatility in currency markets, and will manage these changes on an incremental basis.