I have been following what China has been doing with its currency since the head of China’s central bank proposed replacing the dollar with an international reserve currency at April's G20 meeting.  Today the chairman of China's second largest bank, China Construction Bank, said that he is exploring offering renminbi-denominated trade finance credit that could make the Chinese currency more widely used internationally.  More...

Since December, China has signed currency swap agreements with seven of its trading partners including Argentina, Belarus, Brazil, Hong Kong, Indonesia, Malaysia and South Korea which enables these countries to pay for Chinese exports in yuan rather than dollars. This means that 95 billion, in what would normally be dollars, will now be transacted in 650 billion yuan over three years.

China, Argentina's second largest trading partner, entered into a bi-lateral 70 billion yuan ($10.2 billion) currency swap agreement that enabled Argentina to place orders for Chinese imports in yuan and not dollars. They followed with a 100 billion yuan ($14.6 billion) currency swap agreement with Indonesia and a 20 billion yuan ($2.9 billion) agreement with Belarus. Most recently, they closed an agreement with Brazil.

All this activity is making the U.S. general public increasingly fearful that these swap agreements are a step toward making the yuan a convertible currency that will replace the dollar as the world's reserve currency.  But the general public doesn't understand the essence of currency swaps and convertible currencies.   

First, China’s currency can’t be exchanged on foreign exchange markets for other currencies because the Chinese government has deemed it non-convertible.  Unlike the dollar, yen, or euro, this limits the yuan's use in international trade transactions.  So China has opted, in the near-term, to enter into these bi-lateral currency swap agreements.

A currency swap between countries is basically a foreign exchange agreement where one currency is traded for another for a negotiated period of time.  In essence, the swap is like a loan where one country gives its currency to another in return for an equal amount of the other country's currency at a later date. For example, the U.S. Federal Reserve has been executing currency swaps for years in conjunction with IMF loan programs to support developing nations which might require immediate financial assistance.

Beijing's big concern is the $2 trillion in dollar assets they have accumulated over the years through exports to the U.S. in addition to the huge quanitity of U.S. treasuries they have purchased.  China is looking long-term to reduce its reliance on the dollar and thereby its risk.  At this point in time, currency swap agreements offer their best option. 

Last week I posted a video in which Jim Rogers, co-founder of the Quantum Fund with George Soros, expressed his view that Asia is now the center of global economic strength and that the United States (the largest debtor nation in history) and United Kingdom are in decline.

Today, Reuters reported that George Soros said that China's global influence is set to grow faster than most people expect.  He told an audience at Shanghai's Fudan University, "In many ways, Chinese banking has benefited from being isolated from the rest of the world and is in better shape than the international banking system."  More...

Tuesday morning the Financial Times reported that China and Brazil are planning to use their own currencies to trade rather than using the dollar.  This means that China would pay for products like Brazilian oil and beef using the Brazilian Real and not the U.S. dollar.  Brazil would, in turn, accept the Renminbi from the Chinese.  Although, this prospective trade agreement wouldn't break the U.S., it could be a first leak in the dike.  The Chinese have already expressed their support for Russia's initiative to develop a new global reserve currency as an alternative to the U.S. dollar, but the $2 trillion the Chinese have in foreign exchange reserves have kept them from being more aggressive. An agreement with Brazil would allow them to reduce their dollar reserves slightly, since they wouldn't need the dollar to trade with Brazil.
 
Why do you care? If another currency or basket of currencies eventually replaced the dollar as the reserve currency, the U.S. would face higher interest rates to attract capital, reducing economic growth for the long-term. Consider an article published in "The Economist" on May 14th which said, "Having spent a fortune bailing out their banks, Western governments will have to pay a price in terms of higher taxes to meet the interest on that debt. In the case of countries (like Britain and America) that have trade as well as budget deficits, those higher taxes will be needed to meet the claims of foreign creditors. Given the political implications of such austerity, the temptation will be to default by stealth, by letting their currencies depreciate. Investors are increasingly alive to this danger..."

According to the Federal Reserve, there is $829 billion dollars of U.S. currency currently in circulation; the majority being held outside the United States. As of May 7, 2009, the total U.S. federal debt was $11,256,266,640,050.20, ranked 12th in the world. This debt is about 80 percent of GDP. Its no wonder the Chinese are concerned.

Didn't Confucius say, "A journey of a thousand miles begins with a single step."