Overview
It is very important to the U.S. that the Dollar is the world’s reserve currency. Controlling the world’s reserve currency has allowed the U.S. to engage in deficit spending for decades. The Federal Reserve has been able to create trillions of Dollars out of thin air and give this money to the U.S. government to spend into circulation. Normally money creation of this magnitude would cause rampant price inflation, but one reason it hasn’t is most Dollars are held outside the US, so any price inflation has largely been exported to other countries. As the Dollar becomes used less and less around the world, all these Dollars will come flooding back to the US, and the U.S. will begin to face higher and higher levels of inflation, especially considering how large the U.S. budget deficit is projected to grow. Just like it is important to get insurance before a crisis, it is important to protect your wealth by placing it into precious metals before the Dollar crash comes. During the 2008 crash, the average American household lost 40% of its wealth. The Dollar crash will be even more severe.
Controlling the world’s reserve currency has also allowed Americans to live beyond their means. For decades the world has been sending America products, and in return America has been sending debt to other countries. This has been fine as long as long as the other countries have confidence that America will one day repay these debts. However, the countries of the world are waking up to the fact that America won’t, or can’t, repay its debts. For years the People’s Bank of China (BOC) officials complained that America was defaulting on its debt by devaluing the Dollar, effectively repaying bonds with money valued less than the bonds were originally worth. Finally, in November, 2013 a BOC official announced that it was no longer in China’s best interest to prop up foreign currencies, and since then China has slowly been selling off its U.S. debt. The U.S. has recently had debates about its debt ceiling, but the real problem is the lending ceiling; at some point the other countries of the world will come to the same realization that China has, and the U.S. won’t be able to borrow any more money. If the Dollar loses its status as the world’s reserve currency, any illusion that the U.S. can pay its debts will disappear.
Some History
One large reason why the Dollar has been able to retain its status as the world’s reserve currency for so long has been because of its position as the “Petrodollar.” In 1971, when Nixon ended the Breton Woods standard (which was the last vestige of the gold standard), he arranged a deal with the newly formed OPEC alliance of petroleum producing countries. In return for military protection from the U.S., these countries agreed to only sell their oil in return for Dollars. This has forced the countries of the world to hold large numbers of Dollars in order to pay for their oil, and it has given OPEC countries large amounts of Dollars to spend.
In recent years, the Dollar’s hold over oil sales has been declining. Iran has been selling oil in currencies other than Dollars (mostly for gold) since 2009. Russia and China have also begun selling oil in their respective currencies.
There was a time when the U.S. would respond to such oil sales through military force. When Iraq agreed to sell oil in Euros it wasn’t long before the U.S. invaded Iraq and set up a new government that would once again sell oil only in Dollars. The U.S. is not in a position to be able to wage more wars though, especially against adversaries such as Russia and China. Instead the U.S. has tried to retaliate through economic sanctions, but these were largely ineffective. Sanctions against Iran have only reduced its oil sales by 40%. Only the European countries went along with U.S. sanctions. Iran was still been able to sell large amounts of oil to Russia and China. The recent sanctions imposed by the U.S. against Russia were also largely ineffective, with many European countries unwilling to follow through and Russia hardly taking notice.
The U.S. used to be able to overpower any country that would threaten the Dollar. Now many countries are openly opposing the Dollar. As the economies of these countries develop, the Dollar will become less significant. The result is that inflation will rise in the U.S. and Americans will find themselves with less and less global purchasing power.
What is the BRICS Alliance?
The BRICS alliance consists of Brazil, Russia, India, China, and South Africa. All five countries are G20 members. While not formally part of the alliance, Iran could be considered part of this faction due to its ties with China and Russia and due to its hostility toward the US.
Together these countries represent 27% of the world’s land surface area, 22% of the world’s GDP, and 42% of the world’s population. Four of these countries are among the world’s top 10 economies. These countries control some of the world’s most vital resources. As these economies become more developed, this alliance will become even more significant. These countries have stated that their goal is to reform the world’s financial system, making it “fairer, more stable, and more efficient.” To the BRICS nations this means creating an alternative to the Dollar.
BRICS Development Bank
The BRICS alliance has established a development bank intended to rival the western-run IMF. The bank is designed to help finance infrastructure and development projects in the BRICS countries and will pool foreign currencies to fend off any future financial crisis. The bank has been initially capitalized with $100 billion worth of currency and is scheduled to be up and running by 2015. Even the IMF itself has diversified away from the Dollar, recently adding the AUD (Australian Dollar), the CAD (Canadian Dollar), the euro, the British pound, the Japanese yen, and the Swiss franc as additional reserve currencies.
Currency Swap Agreements
There are numerous other examples of how the Dollar is losing ground as the world’s reserve currency. China (the world’s 2nd largest economy) has entered into direct currency swap agreements with Japan (3rd), Brazil (6th), India (9th), Russia (10th), and Australia (12th). Also, India and Japan have been swapping currency directly since 2011. These transactions reduce the cost of trade between these countries and allow them to avoid holding large volumes of Dollars.
The Danger of “Unpegging”
Many countries have their currency “pegged” to either the Dollar or the Euro. This helps the U.S., because the more countries have their currencies pegged to the Dollar, the more it helps maintain the importance of the Dollar and its status as the world’s reserve currency.
In January, 2015, Switzerland came to its senses. Switzerland knew that the EU was about to begin devaluing the Euro through “Quantitative Easing” and Switzerland didn’t want to be affected by this. The Swiss Central Bank decoupled their currency from the Euro and allowed it to rise. By contrast, this made the Dollar and the Euro look weak, and whenever the Dollar looks weak investors flock to gold as a safe haven. Really the Dollar has been this weak all along, but there simply wasn’t a currency to compare it to that wasn’t also being devalued. After the Swiss made their announcement, gold jumped from around $1,230 an oz. on January 15 to $1,280 and back to $1,275 on January 20. This is a small example of what will happen when China decouples the Yuan from the Dollar.
The Yuan
China is either the world’s largest economy, if measured in terms of purchasing power parity, or the second largest. China has been propping up the U.S. for quite a while by buying U.S. debt. Essentially, China has been sending the U.S. products and the U.S. has been sending them debt in return. This is fine for China in the short term as long as it looks like we will eventually repay our debt. However, U.S. politicians have made it clear that the U.S. is not EVER going to pay down its national debt. Faced with this reality, China is much better off keeping its products for itself and allowing Chinese citizens to have a higher quality of life.
In November, 2013, Yi Gang, a deputy governor at the BOC, said, “It’s no longer in China’s favor to accumulate foreign-exchange reserves.” Yi stated that supporting foreign countries like the U.S. hurts the Chinese people more than it helps them.
Since that time China has been slowly exiting its position as a holder of U.S. debt. It has been allowing its existing bonds to expire and has been rolling over very few of them. Japan has now surpassed China as the largest holder of U.S. debt.
Another signal that China plans to exit its relationship with the Dollar is its participation in the BRICS alliance. BRICS is a coalition of countries (Brazil, Russia, India, China, and South Africa) that has committed itself to develop Eastern independence from the Dollar.
When the Swiss uncoupled from the Euro in January, 2015 there was a small but noticeable effect to the value of the Dollar and gold. As of 11 August, 2015 China has un-pegged the Yuan from the Dollar, and the implications of this will ultimately be huge.
This move by China signals the end of the dominance of the Dollar. The U.S. standard of living will drop as the U.S. will no longer be able to easily trade debt for products. In November, 2014 BOC Governor Zhou Xiaochuan stated that many countries are already holding Chinese Yuan as reserves. As foreign holders of the Dollar stop using the Dollar, those Dollars will come back to the U.S., causing high inflation. Holders of Dollars will try to find something they can redeem their Dollars for, and the U.S. will have very little to offer.
In times past, when the Dollar was being devalued, the Yuan would be devalued right along with it. This acted as a brake, helping to stabilize the Dollar. Going forward, however, not only will China not be buying U.S. debt when the U.S. needs it most, but next time the Dollar will be falling against the Yuan and not just against other currencies.
It is only a matter of time before the Fed has to start another Quantitative Easing program in order to buy U.S. debt. As Alan Greenspan has stated, if Congress decides to keep running a deficit, then the Federal Reserve is duty bound to make sure the debt gets purchased. This next time, however, the Dollar’s slide will be much more noticeable.
What this means for Gold: There will be a massive flight to gold, as gold is seen as a refuge in times of economic collapse. However, those people that don’t already own gold when China makes this move will find it is too late to capitalize on the rise of the gold price. Those people with their assets held in Dollar-based investments will lose purchasing power to a far greater amount than the 40% of wealth that the average American lost in the 2008 crash.