Brazil’s central bank announced today that transactions between China and the South American nation will increasingly use their own currencies rather than use the US dollar.   Rumors of a Chinese/Brazilian move to break away from USD hegemony first surfaced at the G20 meeting in London last month.  This week, with Brazil’s president Luiz Inaςiao Lula Da Silva involved in high level economic talks in Beijing,  it seems the rumors are swiftly turning into actual policy initiatives.

SKY reports:

The move is significant for two reasons: not only is it a direct challenge to the dollar as the world’s transaction currency of choice but it is coming from two countries with some of the world’s largest foreign-exchange reserves—most of which are held in (yes, you’ve guessed it) dollars.

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It’s not the first time we’ve heard such posturing. A year ago China – the world’s largest consumer of U.S. government debt – warned it could move those assets into better performing currencies like the euro and as recently as March, the country’s central bank governor pondered replacing those dollar holdings with a standard reserve such as the one used by the IMF. Such words have in the past seemed idle threats but with the prospects of countries like Brazil, Russia, India and China (the so called ‘BRICS’) outpacing shrinking markets in West, a currency agreement between such emerging market titans could challenge the monetary status quo.

We’re still extremely curious as to the specifics of this somewhat “apples and oranges” agreement between the two currencies.  Brazil’s currency floats like any other major currency on world FX markets, while the Chinese renminbi is carefully managed by Beijing at just under 7 per dollar.   It is also interesting that the arrangement is not exclusive and still allows either nation to use USD as a matter of choice — a flexibility which doesn’t exactly ring of confidence in either one of the competing currencies.

The Financial Times reports:

An official at Brazil’s central bank stressed that talks were at an early stage. He also said that what was under discussion was not a currency swap of the kind China recently agreed with Argentina and which the US had agreed with several countries, including Brazil.

“Currency swaps are not necessarily trade related,” the official said. “The funds can be drawn down for any use. What we are talking about now is Brazil paying for Chinese goods with reals and China paying for Brazilian goods with renminbi.”

An aide to Mr Lula da Silva on his visit to Beijing said the political will to enact a similar deal with China was clearly present. “Something that would have been unthinkable 10 years ago is a real possibility today,” he said. “Strong currencies like the real and the renminbi are perfectly capable of being used as trade currencies, as is the case between Brazil and Argentina.”

While many economists scoff at the relative strength of both the Renminbi and the Real — and point out that a real shift away from USD hegemony would take decades to occur, we must point out the following 3 facts which are inescapably true:

1. The United States has a massive debt which is growing larger.
2. The trade deficit in the United States continues unabated.
3. The Federal Reserve has shown that it is willing to “print” dollars as a response to liquidity issues within the US banking system.

We continue to watch with concern as the Federal Reserve continues to throw money at the weakest parts of the US economy, tarnishing the dollar and preserving those parts of our economy which should be allowed to fail.  If Ben Bernanke believes that such actions won’t ultimately destroy the privileged role of the US dollar — he is seriously mistaken.

The Wall Street Journal and  The Financial Times both ran euphoric stories this week about recent gains in emerging markets, driven primarily by US and European funds pouring back into markets such as Brazil and Russia and supported by recent positive movements in oil and metals prices.

Both articles quote identical statistics:  Brazil’s Bovespa equity index is up 75% from market lows.  Russia’s RTS index is up 80 per cent from its low last year.  The MSCI Emerging Markets index has risen more than 50 per cent since its low last October, with a large proportion of the gains coming in the past few weeks.  Neither article mentioned that the MSCI Emerging Markets Index is still down about 60% off its peak in 2007 or that  steel is still on average more than 40% off its highs in June 2008.

According to the FT, “Strong performance has been fueled in part by a realization that these markets were oversold at the end of last year. Investors, spooked by the banking crisis in the UK and US, suddenly became risk-averse and withdrew large amounts of capital from BRIC markets.”

“Behind the optimism,” adds the WSJ, “are signs the worst of the global slump may have passed, and that China’s massive stimulus plan is kicking in, heralding a pickup in demand for commodities and agricultural products.”

But is this all only so much wishful thinking?  Brazil’s central banker Henrique Meirelles strikes a more realistic tone:  “Brazil is showing signs of recovery on the margins, but that doesn’t mean [the crisis] is over.”

Nonetheless, foreign capital is pouring into the country – about $3.7 billion this year.  Meirelles is in a situation now where the Brazilian Real has appreciated 5% against the dollar in the past week, largely the result of over $1 billion of new capital entering the country in the past two weeks.

China’s Stimulus Program

Recent data suggests that despite persistently weak demand for Chinese exports in overseas markets, the effects of China’s fiscal stimulus are beginning to appear.  Beijing has pumped billions of dollars into construction projects and other spending aimed at stimulating demand and propping up growth.  Without a recovery in the export sector, however, these initial results may be short lived.

According to Li Shufu, chairman of Geely, one of China’s largest private carmakers, last month’s 10 per cent rise in passenger vehicle sales “is driven by a temporary policy” and represents “superficial growth.”  “Only a strong recovery of the economy can help the Chinese auto market,” he concluded.

Michael Pettis, a professor at Peking University’s Guanghua School of Management, explains:

China is not likely to collapse economically, and we may see one or more “rebounds” over the next few years, but the glory days of growth are well and truly behind us until the financial system is sufficiently reformed that it leaves behind governance constraints that almost automatically assure systematic and massive capital misallocation. That will take many years. Meanwhile the transition to a healthier and more balanced economy – which was slated to be long and difficult in the best of cases – is likely to be longer and more difficult as a consequence of the fiscal and banking response to the crisis.

Admittedly, China’s financial stimulus efforts and more specifically their moves to replenish strategic commodities reserves are moving metals prices globally.  The real movement in emerging markets equities, however, seems to be purely American in origin.  Billions in quantitative easing, bailouts,and the recent ‘investor-sponsored’ bank recapitalization of the current US stock market rally have led to an environment in which Wall Street investors are optimistic about an economic recovery and are willing to gamble on depressed emerging market energy and commodities plays outperforming in the event of a recovery.

We’re sorry to say, but it smacks of a gambling addict doubling down in a casino in a desperate effort to win back everything he’s just lost.

Rail freight statistics for the US, Canada and Mexico are showing continued weakness in total volume and across all major commodities  groups and do not point to any economic recovery in the real sector having occurred so far this year.

The Association of American Railroads reported today that US rail traffic in April was down 23% compared to April, 2008.

U.S. rail freight also fell in all 19 major commodity groups tracked by the AAR for April, including coal (down 13.4%); metals and metal products (down 62.1%); motor vehicles and equipment (down 46.7%); and grain (down 28.3%).

Canadian rail carload traffic was down 26.4% year-on-year in April and 22.2% y-o-y for the first four months of 2009.

Canadian carload declines in April 2009 were led by chemicals (down 32.7%); metallic ores (down 32.7%); and coal (down 37.1%).

Combined total volume on US and Canadian railroads is down 19% year to date, compared to the same period last year.

“Unfortunately, it’s hard to find much in rail traffic data in April to support the idea that the economy is starting to see ‘green shoots’ — it may still just be weeds,” said AAR Senior Vice President John T. Gray.