With the U.S. pressing even harder for a further revaluation of the Yuan, the concept of a Revaluation in terms of a "Basket of Currencies" is dynamic and could spell the beginning of the end of the overbearing role of the U.S.$ has on China's international trade.

It is the beginning of an effective long-term attack on the role of the $, as China's reserve currency. It means that China is widening out its currency reserves to include the currencies of the main countries it trades with including Europe and its Euro. We look at how this move can lead to a reduction of the role of the $ in global trade and the processes involved.

Consequently the increase in global monetary instability will enhance the attraction of Gold!

Prospects for the Chinese Yuan

This article is not about how strong the Yuan will go. We do not believe it is in the internal interests of China to see too great a revaluation too soon, so the requests from the U.S for a substantial revaluation will continue to be ignored.

The sheer volume of the poor Chinese people looking for work in the new Chinese industrial revolution, has to drive the government to continue growing at just below 10% for as long as possible. The government of China has demonstrated an extraordinary ability and level of control over the economy to ensure that this will happen over the next decade and more. China is well on the way to being the world's largest economy at this present rate of growth. Its currency will have to become one of the most important in the world as a result. The present change in the way the Yuan is valued is an initial step on this road. It will no longer be tenable for the Yuan to continue in the shadow of and 'pegged' to the U.S.$ with these medium term prospects.

The Reformation and Revaluation.

The Yuan cannot afford to depend on the U.S. $ as its reserve currency for much longer. It had to enable itself to collect the currencies of the main nations it trades with into its reserves and be measured alongside them. Hence, it made eminent sense to revalue the Yuan, "in terms of a basket of currencies".

Whilst this basket has been revealed as containing the currencies of the countries it conducts business with, it continues to include the U.S. $.

Once its banking sector has evolved to the standards of world banking, in some years time, the Yuan will be able to take its place on the world stage, as a global currency. The road to this point is a difficult path for China to follow, but it is realising that it must walk that road!

The Process of foreign exchange in a global economy

Perhaps a review of the past and present processes of foreign exchange would be appropriate at this point.

A country can be likened to an individual in business through his banking. Paying and being paid are the fundamentals of anybody's and any nations finances.

- A Fixed Exchange rate system.

In the days of yesteryear, fixed exchange rates and a fixed gold price ensured that if one paid more than a nation received its capital flowed out to pay the debt that resulted. Governments in realising the importance of a balanced "Balance of Payments" endeavoured to ensure that this was always the case. Consequently countries like Britain in its heyday drew wealth in from the colonies into its already full coffers.

As the nation declined so it saw the surplus swing to a deficit over time. Consequently it gave colonies, which were becoming a burden on the finances of the nation, their independence. But the decline continued through the Second World War and on into the sixties, by which time it had shrunk to the status of just another European nation. Sterling had diminished along side this reduction, but was still a global reserve currency, a role no longer suited to the size of the country's finances in the international arena. The U.S.A. with its armies stationed abroad, was also a creditor to the world as its armies pay [in the $] was exchanged into local currencies. The dollars were left in these foreign lands and were called "Eurodollars" for some time. But the world was not happy to accept them so sought to sell them back to the U.S. Primarily for the gold that the U.S. was happy to sell until Nixon stopped it.

This process placed pressure on the $ as capital had to flow out of its monetary system and foreign exchange reserves abroad. Such a burden on a nation unable to pay these debts from surpluses saw the countries internal financial situation weaken as the capital flowed out.

Currencies "Float"!

So in 1971, when both the $ and sterling were "floated" [This followed the devaluation of the $ in terms of gold when its was dropped from $35 an ounce to $42.35 per ounce] to allow them to find their own foreign exchange, market levels.

Britain added capital controls in the form of the "Dollar Premium", to stem the flood of Capital leaving the country as well.

Such a "float" threw a great risk on foreign holders of the $ and sterling in exchanging these two currencies. As they sold the two currencies so the value of their remaining holding of those two currencies fell. So to retain the value of the remaining surpluses, the selling slowed. Countries like Germany with excellent national financial management and foreign exchange surpluses found themselves having to revalue their currencies.

But at first the "float" stemmed the large capital flows between nations, but the Central Banks of each nation tried to minimise movements in the foreign exchange values of their currencies with "dirty floats", or 'floats' wherein they intervened in the market, when they wished, to hold a value of their currency at a level they wanted. This was a bit like guerrilla warfare, adopting the tactics of the guerrillas, striking them when and where they wished and not simply waiting for an attack from the guerrillas.

This tactic brought some stability to the market as it acclimatised itself to greater volatility. Immediately after the "floating" of a currency, movements were still only 20 or less basis points in a day. Today a one to three percentage move in a currency is not considered too brutal, so long as it is not repeated often. We are now used to unreliable exchange rates and hemmed in by Central Bank management of currencies.

A dominant Reserve Currency!

As the $ rose into the role of the globe's reserve currency the nature of its role also changed, much the same as if an individual became the client responsible for 70% or so of a bank's business [who owns who?].

Today, with the $ being the currency of around 80% of the globe's financial transactions, a different phase in global currency roles has appeared.

The role of the $ in the U.S. economy has undermined its role as a global Reserve Currency.

The $ in its national role should function the same as any other country, relative to its Balance of Payments. In its role as the Reserve currency, it should be strong, stable and garner international respect.

There is a distinct difference in the function of the $ inside the U.S. and its role outside it and the divergence is growing with every day of Trade deficits. At some time in the future this divergence will produce a dynamic crisis, with the longer it takes, the more damaging the crisis.

That is why the $ hardly reacts to negative U.S. economic internal news. That is also why it hardly reacts to greater and greater Trade deficits. Holders of the surplus U.S. $' cannot just go to the market and change them into other currencies. If they did the value of the huge remaining reserves would drop alongside the $' value on the foreign exchange a prospect more damaging than the gains in selling any surplus $s.

In the present role as the Global reserve currency, the $ is protected against itself, it seems. $ outflow still occur as with fixed exchange rates, but now that outflow returns to the States in the form of returning Capital investments into short-term debt investments inside the U.S.

So the holders of the surplus $ retain them in the $ but in a form that has not really benefited the U.S. as one would have thought. These dollars are moved into liquid Treasury Bills and Bonds, not back as investments into productive assets, which would engender growth. Rather like an individual who does not invest in making his business grow, but holds his profits on deposit, so the U.S. is suffering indirectly from this state of affairs, with the most important aspect that these deposits are owned by foreigners who do not have U.S. interests at heart. At any time it suits them they remove or add to these short-term instruments. On the surface all looks well as the value of the $ on foreign exchanges looks healthy, but slowly and steadily the liquidity of the U.S. is passing into foreign hands. [In the next part of this two part piece, we will look at the way the U.S. is likely to protect itself from this growing danger].

The U.S. now holds its Creditors captive, allowing the U.S. government to promote growth on the back of consumer spending right into excessive debt, albeit at very low interest rates [because of the return of the surplus $s], apparently with impunity? The U.S. $ inside the U.S. is being managed in a way so as to produce excessive foreign debt, with no requirement to repay that debt, or so it seems. So the huge question is, will the Reserve Currency role of the U.S. $ continue to carry the profligate behaviour of the internal U.S. $, or will it diminish as foreign Creditors seek to protect themselves. This brings us back to China.

The concept of the "Basket of Currencies"

China wants to be able to pay a trading nation in its own local currency. If China sells to Japan and buys from Japan capital goods, it would like to be paid and to pay in Yuan. When it sells to Europe and buys from Europe, it wants to be paid and to pay in the Euro. The pattern of China's international trade is growing that way and quickly. So now is the appropriate time to bring the reality of the situation back by valuing the Yuan in the currencies of its main trading partner, not to a totally unrelated economy and its $.

Until now the currency that was used between the nations was mainly the $, because of its reserve currency role as well as its globally dominant role in international trade. So, it suited the Chinese to value its currency in terms of the U.S. $. When the $ is the currency of trade between China and many foreign nations, China had to [in theory] buy the $ with its Yuan then pay its creditor with the $ [such as oil]. The creditor then has to sell the $ for its own currency or hold it in U.S. in the U.S. banking system. How much simpler and better to be able to cut the $ out and go direct into the foreign currency of its supplier.

As the Chinese economy grows and penetrates a greater number of nations with its trade, the spectrum of currencies it uses grows alongside it, so now, hopefully, the supplier to China is also buying goods from China, so now pays in its local currency. China, in turn, will use the currency of its trading partner to pay this partner, by going to its reserves, which now hold that foreign currency [Paying Roubles for Russian oil?]. This would apply to all the nations it trades with. In direct trade with the U.S. it will still use the $ to buy goods with and in turn be paid in the $ for goods it supplies.

But as China matures and grows into its burgeoning role in global trade, eventually to overtake the U.S. it has to cut this currency umbilical cord to the U.S. as it has now done.

Consequences for the U.S. $ and international foreign exchanges.

The small revaluation was handled professionally and its impact did not cause sharp falls in the U .S. $. China and those that followed it acted with two concerns in mind: -

1. The Chinese [as would any nation] will always look to their interests alone and exclude those of other nations.
2. They realise that the U.S.$ policy on the Balance of Payments front has to bring the $ down heavily over time, or in some future crisis, eventually. It is inevitable. Chinese foreign exchange reserves will then be in a far better position to cope with a future $ crisis than it was, pegged to the $.

Indeed we have been distracted to date, by the media focus on the perceived consequences of the revaluation of the Yuan on the U.S. $. Whilst it has been noted that the Chinese have been concerned about its need to reform its financial system, now heavily burdened by bad debt and its need to let the foreign exchange market mature, which would allow financial institutions and corporate sectors to use the foreign exchange market to hedge their exchange rate risk, the future impact of the revaluation will be far greater and structural.

Even Greenspan confirmed that any revaluation of the Chinese Yuan would have little impact on the States, saying, " That does not mean that our current account deficit or our trade deficit will shrink very much, if at all, because what we will find is we will displace those goods from other, only slightly lesser low-cost sources of materials."

China 's systemic control over all matters in China including financial matters is far, far greater than is the case in the developed world. This means that its control over growth, inflation et al, is considerably more effective than in the West. So the first impact for the $ is that Chinese global trade is set to grow enormously and overtake the U.S. in global trade dominance, eventually. There is no doubt that when ready the Yuan will take a leading place on the world monetary stage, to the detriment of the $.

But this will not directly affect the U.S. $, but it will indirectly.

There will be major consequences for the global monetary system that can never be reversed. Rather like the turn of the century on the British Empire and the first/second world wars on sterling, the U.S. will see the acceptability of the U.S.$ brought into question, much the same as lesser currencies are now.

Detailing these consequences: -

• The message has been sent to the rest of the world that the $ is no longer acceptable as the sole global reserve currency!

• Secondly, action to prevent the dominance of the U.S. $ in a nations reserves is now a matter of choice.

• The use of the $ in global trade will begin to decline substantially, so as to protect and diversify foreign exchange reserves.

• The value of the U.S.$ on global foreign exchanges will eventually, more accurately reflect the state of its Balance of Payments.

• The decline in purchases of U.S. Treasury instruments by foreigners will match the diversification of Chinese and other nations reserves.

• U.S. interest rates will have rise to compensate for the loss of value of the U.S. $ in the short-term apart from rises due to inflation fears.

• The U.S. $ is bound to be struck by a series of debilitating crises on the foreign exchanges of the world eventually.

• The States will eventually have to account for its unbalanced Balance of Payments as Capital inflows diminish to lower than outflows.

• The States and other countries will have to take positive action to prevent Capital outflows draining U.S. Capital.

• The importance of other currencies, particularly the Euro, will eventually rise and take a far greater portion of most nations foreign exchange reserves.

• The gold price will rise, alongside the recognition of the importance of gold in the nation's reserves.

The only defence the developed world has against this inevitable process is to incite separation and possibly conflict, solutions used throughout mankind's history. If that does not happen then the developed world must simply wait until the level of Chinese wealth has risen to that of the West or the level of wealth in the West has fallen to that of China.

From the perspective of gold, this process will incite Investors to move into gold over the longer term, whilst the love of gold in China, as they grow wealthier, will permit them to move into gold over the longer term. Such a positive current into gold will ensure that it has a rising star for many, many years to come.

In the second part of this article we will look at the potential and consequences, of Capital Controls, a clear prospect for the global monetary system, eventually.

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