Does the world need another reserve currency?

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Bryan Lee's picture

Keynes famously once wrote: “Owe your banker 1,000 pounds and you are at his mercy; owe him 1,000,000 pounds and the position is reversed.” His clairvoyance would be right if Keynes were to be an American economist with a Chinese banker, citing the statement in dollars instead of pounds. In 2014, China is the largest foreign creditor of America’s national debt, holding USD 1.26 trillion of the USD 17.6 trillion debt.[1] While America’s rampant consumption contributed to the trade imbalance due to excessive imports, the fact that the American dollar is the international reserve currency sedated America’s accumulation of debt as a result of its exorbitant privilege. However, given the shaky fundamentals of the American economy as exposed during the global financial crisis in 2008, US treasury bills cannot be viewed as riskless assets anymore as they have ceased to become a safe haven for flight-to-quality phenomenons. The same could be said for the American dollar, given its weakening relative currency strength due to the enormous fiscal deficit of the American economy and the ensuing low Federal Funds rate, which was kept close to zero from 2009 until today.[2] All these point to an increasing need for another global reserve currency as the world can no longer have a singular reliance on a stuttering American economy to pull it along. This is where other fiat currencies have to be considered to replace the American dollar as a reserve currency.

There are several possible alternatives that have been looked at already. The most natural replacement currently would be the euro. It is the second most widely used foreign currency in the world, adding up to approximately 25% of the world’s foreign exchange reserves in 2013.[3] However, the Eurozone had been badly struck by the crisis in 2012, causing a sovereign default contagion across the PIIGS (Portugal, Ireland, Italy, Greece and Spain). The turmoil also sent the French economy into a tailspin as France owned USD 40 billion of Greece’s USD 400 billion debt.[4] Consumer confidence in Europe was devastated and it led to a string of national recessions, such as in Finland, and many catastrophic events, such as the burst of a USD 847 billion housing bubble in the Netherlands. All these exposed the severe economic imbalances within the Eurozone and subsequently, its overdependence on Germany. Almost 30% of Germany’s GDP, which amounts to USD 1.09 trillion in both 2012 and 2013[5], have been committed to bailouts and supporting the stability of both the euro and the Eurozone. The euro would be highly unsustainable if sovereign debt in the Eurozone is not reduced as Germany’s trade surplus depends heavily on exporting goods to the Eurozone, reaching up to EUR 54.6 billion.[6] Hence, if the faulty fundamentals of the Eurozone and the repercussions of the crisis remain unresolved, the euro cannot replace the dollar as the de facto reserve currency without causing even more structural problems to itself and the global economy.

Moreover, given the strong value of the euro now (EURUSD=1.34)[7], it is inevitable that the euro must weaken if it were to attain reserve currency status. The euro area cannot maintain its regular trade surpluses, since the accumulation of the euro as the premier foreign exchange reserve would mean that a natural trade deficit is required with other trading countries. However, given the fiscal austerity of the Eurozone and the pivotal importance of Germany’s exports to the world and the European economy, this becomes an unrealistic expectation. In this case, given the Eurozone’s strong trade surplus and currency value, using the euro as the reserve currency will spark international deflation as currencies have to appreciate against the euro just to maintain status quo.  This will result in a global debt overhang and economic growth in the world will slow down tremendously. Hence, it is not really a good idea to use the euro as the reserve currency given these circumstances.

The next best alternative would actually be the renminbi. In 2013, China had overtaken America as the world’s largest trading nation, where annual trade in goods amounted to USD 4.16 trillion.[8] This indicated an ongoing shift in the pecking order of global economic power, where China is poised to become the world’s largest economy in 2017, given its consistent annual GDP growth of approximately 8% a year.[9] It also meant that the renminbi would have both the necessary volume and liquidity in the financial capital markets to become a reserve currency. Moreover, China has been pushing the internationalization of the renminbi rather aggressively. From 2011 to 2013, China went from settling 0% of its exports in renminbi to 18% eventually.[10] It is now the ninth most traded currency in the world. Also, the People’s Bank of China has been implementing cross-border renminbi transactions abroad to develop offshore yuan markets in financial centres like Singapore. [11] All these are real signals of China’s intention to internationalize its currency. However, the keen internationalization of the renminbi does not exactly mean that the Chinese government wants to make renminbi the premier reserve currency.

There are several reasons why China would not want to do that. First, China currently has the biggest trade surplus recorded with America, including many other countries as well. If the renminbi were to become the reserve currency, it would mean that the value of China’s debt holding of US government backed securities would diminish severely as the renminbi would appreciate against the dollar. This would harm China’s export competitiveness badly and as a result, the Chinese government is keeping daily fluctuations of the USD/CNY within a narrow band of 2%[12] to protect Chinese exporters. Essentially, the costs of surrendering China’s control over its own monetary policy is larger than the perceived benefits of having the reserve currency status, in spite of all the clamour for another reserve currency.    

Second, while China’s macroeconomic performance might seem stellar, there are important microeconomic issues that the Chinese economy had failed to overcome since the onset of the global financial crisis. The Chinese government injected a huge fiscal stimulus of 4 trillion yuan in November 2008, where most of the funds were allocated to loss-making state-owned enterprises.[13] While this sustained economic growth through the crisis, the misallocation of capital has led to massive portfolios of non-performing loans in all major Chinese banks. Consequently, limited access to credit by other smaller businesses has fuelled the development of a shadow banking system. Also, the tight credit has spurred excessive household savings, which inflated housing bubbles in China. All these contribute to a rickety foundation that undermines the stability of the Chinese financial system. Opening up the capital market to the world will further exacerbate the instability with large capital inflows and outflows. Hence, before the renminbi can become an effective reserve currency, it has to resolve these microeconomic problems in order to develop a deep and liquid capital market.

Last, there are several political and institutional factors as to why the Chinese government would not want the renminbi to be the reserve currency, especially with the global leadership and responsibilities that entails. The Chinese government is primarily communist in its political values and its constitutions deter any embracement of democracy as the mandate of the government. With all major economies being democratic states, it is difficult for China to lead global economic affairs with a distinct lack of political compatibility with other major countries. Also, the reserve currency role would mean that the People’s Bank of China have the duty to engage in global liquidity management, even at the expense of China’s own national objectives. It also has to play the unique role of being the world’s lender of the last resort. With the heavy responsibility to eradicate poverty and break out of the middle income trap, China will not want to shoulder the burden of the world without fulfilling its promise to its people first. Hence, it is unlikely that the renminbi will upstage the dollar anytime soon as the reserve currency.

In conclusion, as the global economy continues to grow and change, economic dominance shift with the underlying dynamics and the world has to adapt accordingly. With an unassailable debt burden holding down America, there are increasingly more calls for a move into a “de-Americanized world”. This would include the deposition of the American dollar as the reserve currency. While there are indeed structural problems with the American economy, the world is still not in a dire need for another reserve currency. However, a transition towards this development is very much needed and economies like the Eurozone and China must step up soon to facilitate a multipolar economic system as America steps down from its economic hegemony.             

 

[1] (US Department of the Treasury, 2013)

[2] (Board of Governors of the Federal Reserve System, 2014)

[3] (Conerly, 2013)

[4] (Wikipedia, 2013)

[5] (Trading Economics, 2014)

[6] (Das, 2013)

[7] (Yahoo Finance, 2014)

[8] (Monaghan, 2014)

[9] (Trading Economics, 2014)

[10] (Mauldin, 2013)

[11] (The Straits Times, 2014)

[12] (ECR Research, 2014)

[13] (Skidelsky, 2012)

 

 

Bibliography

Board of Governors of the Federal Reserve System. (2014, July). Retrieved from http://www.federalreserve.gov/releases/h15/data.htm

Conerly, B. (2013, October). Forbes. Retrieved from http://www.forbes.com/sites/billconerly/2013/10/25/future-of-the-dollar-...

Das, S. (2013, December). The Wall Street Journal. Retrieved from MarketWatch: http://www.marketwatch.com/story/germanys-economy-isnt-as-strong-as-euro...

ECR Research. (2014, March). Retrieved from http://www.ecrresearch.com/chinas-exchange-rate-policy

Mauldin, J. (2013, September). Business Insider . Retrieved from http://www.businessinsider.com/renminbi-soon-to-be-a-reserve-currency-20...

Monaghan, A. (2014, January). The Guardian. Retrieved from http://www.theguardian.com/business/2014/jan/10/china-surpasses-us-world...

Skidelsky, R. (2012, May). Why China won't rule. Project Syndicate.

The Straits Times. (2014, July). Retrieved from http://business.asiaone.com/news/china-extend-yuan-transaction-trial-spore

Trading Economics. (2014, July). Retrieved from http://www.tradingeconomics.com/germany/gdp

Trading Economics. (2014, July). Retrieved from http://www.tradingeconomics.com/china/gdp-growth-annual

US Department of the Treasury. (2013, May). Retrieved from http://www.treasury.gov/ticdata/Publish/mfh.txt

Wikipedia. (2013). Retrieved from http://en.wikipedia.org/wiki/Eurozone_crisis

Yahoo Finance. (2014, July 29). Retrieved from https://sg.finance.yahoo.com/q?s=EURUSD=X