This controversial proposal – and the support that it’s getting – also underscores China’s continued emergence as a growing global force in both the financial and political arenas. That’s a trend that successful global investors won’t be able to ignore.

The recent torrent of criticism to swirl around the dollar began with remarks by Chinese Premier Wen Jiabao.  Speaking last month at a press conference leading up to the recent Group 20 meeting in London, Premier Wen voiced his concern about the value of China’s large holdings of U.S. Treasuries.

“We have lent a huge amount of money to the United States,” he said. “Of course, we are concerned about the safety of our assets. To be honest, I am definitely a little bit worried. I request the U.S. to maintain its good credit, to honor its promises and to guarantee the safety of China’s assets.”

Of China’s $2 trillion in foreign currency holdings, about $1 trillion is invested in U.S. Treasuries and notes issued by other government affiliated agencies, such as Fannie Mae (FNM) and Freddie Mac (FRE).

“They are worried about forever-rising deficits, which may devalue Treasuries by pushing interest rates higher,” JP Morgan & Co. (JPM) analyst Frank Gong told The Associated Press. “Inside China, there has been a lot of debate about whether they should continue to buy Treasuries.”

Earlier this year, the Congressional Budget Office (CBO) projected that the U.S. budget deficit would nearly triple from last year’s $455 billion – and would reach a staggering $1.2 trillion. And that was even before U.S. President Barack Obama unveiled his $787 billion in stimulus, bank-rescue and anti-foreclosure plans. And that massive projected shortfall also doesn’t include other fix-up initiatives that are sure to surface in the months ahead.

But rather than sit idly by and watch the value of its reserves be eroded by the U.S. government’s economic policies, China is trying to lay the foundation for future change.

China and the SDR

On the eve of the G-20 summit, Zhou Xiaochuan, governor of the People’s Bank of China, released an essay entitled “Reform of the International Monetary System” on the BOC’s Web site.

Without explicitly mentioning the U.S. dollar, People’s Bank Gov. Zhou asked what kind of international reserve currency the world needs in order to secure global financial stability and facilitate economic growth.

According to Zhou, the dollar’s unique status as the world’s primary currency reserve has resulted in increasingly frequent financial crises ever since the collapse of the Bretton Woods system in 1971.

“The price [of relying solely on the dollar] is becoming increasingly higher, not only for the users, but also for the issuers of the reserve currencies,” Zhou said. “Although crisis may not necessarily be an intended result of the issuing authorities, it is an inevitable outcome of the institutional flaws.”

Zhou called for the “re-establishment of a new and widely accepted reserve currency with a stable valuation” to replace the U.S. dollar – a credit-based national currency. The central bank governor noted that the International Monetary Fund’s Special Drawing Right (SDR) should be given special consideration.

Created by the IMF in 1969 to support the Bretton Woods fixed exchange rate system, the SDR was redefined in 1973 as a basket of currencies. Today, the SDR consists of the euro, Japanese yen, pound sterling, and U.S. dollar.

“The SDR has the features and potential to act as a super-sovereign reserve currency,” said Zhou. “Moreover, an increase in SDR allocation would help the Fund address its resources problem and the difficulties in the voice and representation reform. Therefore,efforts should be made to push forward a SDR allocation.”

Zhou proposed the following actions to move the SDR in a direction that could better accommodate demand for a more stable reserve currency:

• Set up a settlement system between the SDR and other currencies. Therefore, the SDR, which is now only used between governments and international institutions, could become a widely accepted means of payment in international trade and financial transactions.

• Actively promote the use of the SDR in international trade, commodities pricing, investment and corporate bookkeeping. This will help enhance the role of the SDR, and will effectively reduce the fluctuation of prices of assets denominated in national currencies and related risks.

• Create financial assets denominated in the SDR to increase its appeal. The introduction of SDR-denominated securities, which is being studied by the IMF, will be a good start.

• Further improve the valuation and allocation of the SDR. The basket of currencies forming the basis for SDR valuation should be expanded to include currencies of all major economies, and the GDP may also be included as a weight. The allocation of the SDR can be shifted from a purely calculation-based system to one backed by real assets, such as a reserve pool, to further boost market confidence in its value.

China Rallies BRIC Allies

While China has been the most vocal proponent of a new – less-dollar-oriented – global currency system, other countries around the world have taken up the cause.

Russia, as Thursday’s videoconference illustrated, is working with China to push for an overhaul of the current currency system. In fact, the creation of a new reserve currency to be issued by international financial institutions was one of the measures Russia proposed to the G-20 on March 16.

Russia and China have also been joined by India and Brazil. Representatives from each of the four BRIC countries met in the weeks before the G-20 summit, and an unnamed source told Reuters that a shift away from the dollar was discussed.

“They (China) did not formally put forward their position for the G-20 summit but unofficially they had distributed their paper regarding the same ideas (the need for the new currency),” the source told Reuters, speaking on condition of anonymity.

Shortly after the G-20 meeting, Russia proposed that the IMF or G-20 study the creation of a new international reserve currency.

“The new global reserve currency has not been discussed at the summit. We only discussed it at several bilateral meetings,” Russian President Dmitry Medvedev’s chief economic aide, Arkady Dvorkovich, told a news briefing.

Weeks later, China agreed to a $10 billion (70 billion yuan) currency swap with Argentina.  That deal will allow China to receive yuan, instead of dollars, for its exports to the Latin American country.

Including the latest deal with Argentina, Beijing has signed about $95 billion (695 billion yuan) of currency deals with Malaysia, South Korea, Hong Kong, Belarus, and Indonesia over the past few months.

These deals undermine the status of the dollar as the world’s leading trade-and-reserve currency, but they also broaden the status of the yuan – something policymakers in Beijing see as being vital to China’s economic success, particularly in light of the current financial crisis.

“Beijing has its eye on raising the status of the yuan,” Ben Simpfendorfer, an economist at the Royal Bank of Scotland Group PLC (ADR: RBS), told The Associated Press. “They are the world’s second-largest exporter and the third-largest economy, so it is in their interest to handle trade in the yuan.”

While it continues to push for reform, China is also realistic about a timetable for achievement.

“”When a problem comes up, it’s always better to discuss it than not. But important reforms take more than one or two days,” Sun Zhongtao, a professor of international strategy at the Central Party School in Beijing, told the AFP. “Under the new system, the dominance of the dollar is set to be challenged. But it’s impossible to reach consensus on such issues overnight.”
But for many analysts, the support that China has been able to drum up in just a short matter of time is evidence of the nation’s growing economic and political clout.

“In the Asian financial crisis, China kept a relatively low profile and it didn’t assume any kind of leadership role at that stage,” Brian Bridges, a political scientist at Hong Kong’s Lingnan University, told the AFP. “Now the contrast is very significantly different in terms of China being much more open and involved in the financial system.”

For Bridges China’s determination to flex its financial muscle and expand political influence is what sets it apart from other would-be success stories, like the Japan of 1980s.

“In the case of China, you have a power which is almost simultaneously both becoming a rising economic power and also [becoming increasingly] involved in political and security issues around the world,” said Bridges. “It’s slightly different from the Japan model, because Japan was first an economic power and there was expectation it would become important in political and security issues. But it never actually fulfilled that role.”

Source:  China Flexes its Muscles and Finds Support in a Bid to Dump the Dollar as the World’s Main Reserve Currency

From November through March U.S. stocks (and most global equity markets) suffered a string of five-straight monthly declines. That’s a very rare occurrence that has only happened on a handful of occasions in the past 40 years.

Sure enough, April saw a sharp reversal of the five-month downtrend. The Dow Jones Industrial Average had fallen over 11% at the March low. But the Dow got up off the mat in April and rose 4.5%. The Dow wasn’t alone. In fact, international stock markets pulled off much more dramatic reversals.

Japan is perhaps the most striking turnaround. I’ve been bullish on Japan since last year… and had been proven way too early through March. But Japan rallied strongly last month – soaring 11% in April alone – it’s biggest single-month gain since 1995! In spite of this rally, Japan remains one of the world’s most undervalued major markets, but now it looks like global investors are catching on.

Hong Kong, another one of my favorite overseas markets, also pulled off a major turnaround in April. After dropping -18% in the first quarter of 2008, the Hang Seng Index jumped 13% last month.

Taiwan, another favorite, rose 4% in April. Mainland China bounced back too – 6.3% last month. But Shanghai shares still have lots of “heavy lifting” ahead -they’re still down 30% year to date.

Perhaps the biggest surprise was commodities. Gold and crude oil rallied pretty much in tandem through the end of 2007 and early 2008. Oil was up another 12% in April – adding to gains of nearly 20% year to date.

The yellow metal however declined nearly 6% last month. That’s gold’s second consecutive monthly decline – perhaps this precious metal will go for five in a row too!

Of course last month’s market action could prove very fleeting indeed. And I doubt that the ultimate “bottom” of this bear market has yet been reached. However, with such broad-based strength in equity markets around the world, we may be in for a decent rally that has some legs.

On Wednesday, the Fed cut rates again as I expected to 2%. The financial media seems convinced that the Fed intends to “pause” sometime soon. That has helped the beleaguered U.S. dollar (talk about a bear market!) to stabilize somewhat.

If the buck can stage a more convincing reversal of fortune at this point, I would expect commodities to correct further, while global stocks (particularly emerging markets) should continue to get a boost. Stay tuned…MIKE BURNICK, Senior Editor & Global Markets Analyst

“I’ve already called this credit crunch, ‘the worst financial crisis since the Great Depression’…and unfortunately, we’re not through it yet” says Eric Roseman.

It’s true the worst of this credit storm has probably passed. But banks, companies and individual investors are still facing funding pressures. That tells me the absolute bottom of this crisis has yet to arrive.

The highest estimates I’ve heard say it will take US$1.7 trillion to clean-up this credit crisis. The more conservative projections allude to a US$500 billion cleaning bill (remember when half a trillion dollars seemed like a lot of money?).

Either way, it’s not time to buy aggressively into stocks.

But investment-grade bonds are starting to look increasingly attractive – particularly as credit spreads start to stabilize among highly-rated corporate debt instruments and Treasury bonds. But it’s still too early for bargain-hunting in equities and riskier debt markets.

The Smart Money Isn’t Following the
Sucker Stock Rallies

This morning’s edition of the Wall Street Journal points to lingering concerns in debt markets. According to the Journal, credit spreads for higher risk bonds, short-term inter-bank lending rates and investment-grade corporate financing remain under severe pressure.

Stocks might have mustered a big rally yesterday, but the smart money in credit markets is showing a very different picture on the state of the American economy.

How will investors know it’s time to load-up on distressed common stocks again? Is there a set of indicators that allow you to measure credit stress?

As the bottom of this bear market eventually arrives, look to credit markets for signals that it’s time to resume your buying. Bonds and credit spreads will provide a far more accurate gauge to global investors than stocks, which tend to harbor false recoveries or “sucker” rallies.

Yield-Curve Inversion Warning in 2006-2007

Back in 2006, the Treasury yield curve turned negative, and accurately forecast an economic recession. Back then, I was writing about it - warning about this dangerous anomaly.

Today, it’s still my opinion that bonds represent the “smart money” in the financial markets. Historically, bonds have accurately predicted economic recessions more often than not.

An inverted or negative yield-curve occurs when short-term interest rates yield more than long-term rates. That’s an anomaly in fixed-income markets that has historically preceded a slowdown or an economic recession about 12 months later.

At the time, most analysts refuted this price action, but it still proved incredibly accurate. By July 2007, the credit markets had begun to unwind and stocks tanked, finally hitting bear market territory for the first time since 2002.

While Treasury bond inversion accurately forecasted trouble ahead, that wasn’t the case for the Dow or the S&P 500 Index.

In stark contrast, the S&P 500 Index in mid-2006 was still in bull market mode, defying the repeated warnings from the Treasury market as yield inversion grew louder. And most high-risk credit markets, namely high-yield or junk bonds, also continued to race higher even as the Treasury market began predicting trouble.

The Credit Crisis Check-List

I thought I’d give you a little insight to how I gauge the markets. These are the indicators I’ve been watching like a hawk for years. And today, I’m using this checklist to predict when the current credit crisis will bottom. More importantly, I’ve got my eye on these indicators so I know exactly when I can re-enter the stock market. You can do the same.

I’ll elaborate on each of these indicators so you can better identify what to follow and eventually, call your broker and start loading-up on equities again!

• LIBOR and SWAP rates
• Credit spreads
• Mortgage-backed securities
• Junk bond defaults
• Credit hedge fund failures

LIBOR and EURO LIBOR are important short-term overnight lending rates. LIBOR or the London Interbank Offered Rate has historically traded slightly above the official Federal Funds rate. Euro LIBOR has also historically traded just above the European Central Bank’s official base rate since the currency was introduced in 1999.

The SWAP Rate -
A Sign That Banks Aren’t Confident to Lend

The difference between LIBOR and overnight interest rates set by central banks is called the SWAP rate. This spread number must relax or narrow before credit markets get a “green” light to unclog and start lending as usual again.

But since last summer when sub-prime began to boil, overnight lending rates have skyrocketed. Despite the Federal Reserve’s best efforts to lubricate the wheels of the funding markets since last summer, inter-bank lending rates remain high. And institutions are reluctant to commit overnight funds to one another.

This lack of confidence among banks in the United States, Canada and Europe, is spreading to Asia. As banks grow wary of lending to one another and question inter-bank collateral, the cost of funds increases exponentially. And that slows economic growth.

LIBOR Rates Say Banks Are Holding onto Their Cash -
A Sign the Credit Crisis Is Still With Us

From its high last fall, U.S. dollar LIBOR SWAP rates managed to decline before Christmas. That was after the Fed and other central banks injected gobs of credit to stabilize the financial system.

But since March, LIBOR SWAPS and its European counterpart, Euro LIBOR SWAPS, have jumped. This is an important signal that the credit crisis is not over. Until LIBOR SWAP rates decline and return to normal spreads above central bank monetary targets, the crisis continues.

CREDIT SPREADS are another indicator worth watching. The spread between risk-free Treasury debt and other bonds like corporate debt and junk bonds is called a “credit spread.”

When the economy is strong and deal-flow is rampant, credit spreads will narrow. That happened as we headed into 2007 last year. Junk bonds, which are below investment-grade credits, saw their yields hit historic lows versus Treasury bonds last spring. That was just ahead of the July sub-prime blow-up. At the time, high-yield bonds paid under two hundred basis points (2%) above T-bonds – unbelievably low.

Today, that spread is just below 10%. And it’s likely it will rise further as default rates climb in a recessionary economy. Until credit spreads for riskier bonds begin to tighten or narrow significantly, the economy remains on the rocks.

Those Mortgage-Backed Securities
We’re All So Fond Of

MORTGAGE-BACKED SECURITIES encompass a wide spectrum of instruments ranging from synthetic illiquid CDOs or collateralized debt obligations to bonds issued by government agencies like Fannie Mae (FNMA) and Freddie Mac (FHLMC).

You’ll be able to tell when stability returns to the mortgage-backed area by watching the mortgage-backed derivatives and the more conservative mortgage bonds guaranteed by FNMA. When both of these numbers bottom, that’s a sign this credit crunch is easing.

The good news is that PIMCO’s Bill Gross, the world’s savviest bond investor, has loaded-up on 30-year mortgage bonds guaranteed by Fannie Mae. These bonds yield almost 2% more than Treasury bonds. That’s a bullish sign that investors are returning to the safest segment of the tattered mortgage market.

However, the mortgage-backed market still has a long way to recover. In all likelihood, the CDO market and other synthetics tied to mortgages will probably never trade at par-value again. But at some point, deep value investors will start buying some of the more liquid CDOs, and that will point to a bottom in this market.

Sometimes It Pays to Watch the Junk

JUNK BOND DEFAULTS typically hit a high in excess of 5% of outstanding instruments during a recession.

At the moment, the junk bond default rate is under 2%. That suggests many more financially leveraged and indebted companies will head into bankruptcy or credit default. I would have to see a much higher default rate among American high-yield or junk bond companies before turning bullish on the stock market.

CREDIT HEDGE FUNDS represent the largest segment of total hedge fund assets, now an estimated US$2 trillion. Combined with leverage, credit hedge funds are the dangerous pariahs of the investment world in 2008 as more of their investors scramble to redeem assets.

Many credit hedge funds have already collapsed or have been liquidated since 2007. As assets are liquidated to meet growing redemptions, hedge funds must unwind leverage and ultimately, abandon many positions in the credit markets that are illiquid. This will snowball into a major disaster for leveraged hedge funds in asset-backed, distressed and event-driven hedge fund strategies.

The end of the credit crisis will likely coincide with a major blow-up at one of the largest credit hedge funds in the world. To date, the failures have mostly represented second-tier or smaller industry players.

Hang In There, This Will Pass

The above credit market check list is by no means absolute. But if you’re looking for a bottom in stocks, these numbers can help you gauge when it’s time to buy again. And of course, I’ll continue to watch all these indicators for signs of a bottom. And I’ll let you know the moment I see it coming here in the A-Letter.

This credit crisis will eventually pass. The worst is probably behind us for most segments of the debt markets but danger still lurks for equity investors. Tread carefully and heed the signs of credit, not stocks, for a true bear market bottom.

ERIC ROSEMAN, Investment Director

EDITOR’S NOTE: As Eric watches for signs this credit crunch is easing, a related crisis is emerging worldwide. It’s a dangerous cocktail of worldwide food and fuel inflation. This disastrous combination has already sent commodity prices sky-high and sparked protests, hoarding, strikes and deadly riots the globe over. Today is your last day to find out FREE of charge exactly why these record-high food prices will continue to rise – and how to use that information to make up to 910% on these soaring commodities. You have until MIDNIGHT tonight. Click here.