Investment Strategy

Could China Crash the U.S. Dollar?

Could China Crash the U.S. Dollar?
By Adam Sharp
Date April 6, 2018

Over the last year, cryptocurrencies have captivated the minds of investors around the world.

But what is it about these assets that’s so appealing? And why now?

For me, it’s pretty simple. Independent currency is an idea whose time has come.

Throughout history, governments have proven they’re not good stewards of money. The world has traditionally relied on gold- or silver-backed currency as a “check” on government excess. But it appears that the world is ready for something new.

Billionaire and PayPal founder Peter Thiel says bitcoin is a hedge of sorts against “the whole world falling apart.” What does that mean?

I assume he’s referring to any number of black swan events that could cause financial chaos.

One of my primary concerns over the long term is that the dollar could lose its status as the world’s reserve currency.

What would this look like? To get an idea, we need to look at the origins of the current monetary system.

Off the Gold Standard

The 1944 Bretton Woods Agreement stated that currencies were pegged to the price of gold and that the U.S. dollar was the international reserve currency linked to the price of gold. In 1971, the U.S. broke the agreement when President Richard Nixon officially suspended the dollar’s convertibility to gold.

As a result, foreign governments were no longer able to exchange their dollar reserves for gold.

American debt had piled up during the Vietnam War, and it was no longer feasible to back the dollar with gold.

International demand for the dollar crashed. All of a sudden, America was officially a “fiat money” country. As a result, dollar assets were less attractive as a reserve asset because they couldn’t be exchanged for gold anymore.

Inflation kicked in, and Fed Chair Paul Volcker was forced to dramatically raise interest rates.

The U.S. needed a way to drive more demand for its currency and bonds. In the mid-70s, an agreement was struck with Saudi Arabia…

The “Oil Standard”

The agreement was that Saudis would sell oil only in dollars. They would become de facto U.S. allies and invest much of their profits into U.S. bonds and other dollar-denominated assets.

In fact, Bloomberg recently revealed that Saudi Arabia got special access to U.S. bond markets, which allowed it to avoid the competitive bidding process. The whole arrangement was secret for 40 years and only recently revealed through the Freedom of Information Act.

Eventually, all members of OPEC accepted only dollars for oil, and today oil is priced and sold exclusively in U.S. greenbacks. More than 99% of the $14 trillion annual oil trade is conducted in dollars. The vast majority of other trade is done in dollars as well, since the market is so large and liquid.

This arrangement is known as the petrodollar system, and it’s a big reason why the dollar remains the world’s reserve currency. It’s handy to have dollars around, since they’re the only way you can buy oil.

Having the dollar as the world’s reserve currency gives the U.S. serious advantages. The constant demand for U.S. assets is what allows us to borrow so much money so cheaply. It also gives America significant influence over the world financial system.

The petrodollar system also has its downsides. Because the dollar is so strong against other currencies, it’s hard for U.S. exporters to price their goods competitively in the global market. So our reserve currency status is actually a major reason that we no longer have a large manufacturing base.

If the dollar were ever dethroned as the unrivaled global currency, the effects would be dramatic and would almost certainly inflict a great deal of inflation on U.S. citizens.

Unfortunately, this outcome is looking increasingly likely in the long term. It could take decades to play out, but it’s something every investor should at least be aware of.

China’s yuan is the primary challenger to the dollar today. But the real risk is that the world will lose faith in the dollar and start using alternatives broadly.

This is one of the reasons I’m so bullish on cryptocurrencies. They’ve emerged as an independent and alternative store of wealth at a very interesting time for the world economy.

China Pays for Oil With Yuan

China is the world’s largest oil importer, bringing in 8.5 million barrels of crude per day. That’s 8.5% of the global market.

Just last week, Reuters reported that China will begin paying for some oil with its own currency this year.

This development is unprecedented in recent history but shouldn’t come as a surprise. China and Russia have made it clear that they eventually plan to exchange goods in their own currencies.

The two countries are dramatically expanding bilateral trade and recently completed a new pipeline and high-speed rail between Moscow and Beijing. They have a natural interest in creating an alternative to the petrodollar system, and it appears they intend to do just that.

Today, the dollar is the standard for international trade, so central banks tend to favor it as a reserve. If the dollar loses its virtual monopoly on international trade, it may become a less attractive reserve asset.

That said, the China news – on its own – is not too alarming. Even if the country eventually switched to the yuan for all its commodity purchases, the dollar wouldn’t budge much.

The real question is whether this signals the beginning of a long-term trend away from the dollar as the world’s reserve currency. If that is indeed what’s happening, the implications are gigantic.

If the dollar lost its status as the world’s reserve currency, inflation would hit the U.S. quite hard. Interest rates would likely rise significantly as our bonds lost some of their luster.

We don’t know exactly what the future will hold for the dollar. But more financial chaos is certainly in the cards.

All of this is why I say that cryptocurrency came along at a very interesting time. The future of the world’s monetary system is up in the air. Debt is piling up, and the old system is becoming unsustainable.

World-shifting events (like the dollar losing its status as the reserve currency) are becoming increasingly possible.

For individuals looking to protect their savings from inflation, crypto offers an appealing alternative.

Of course, the volatility will remain high until a large percentage of the population holds substantial crypto assets.

But it’s clear that the potential rewards of owning crypto far outweigh the drawbacks.

Good investing,

Adam Sharp
Co-Founder, Early Investing

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