Prepare for a Sino-American currency oligopoly

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Reserve currencies are usually issued by economies that hold large amounts of global output and trade. They offer highly liquid financial markets and are able to capture large shares of international market transactions. IMF’s latest report on FX reserves state that 62% of known allocated reserves are in USD, which is largely unchanged since the EUR’s creation in 1999. The EUR, which is the second largest reserve currency, only accounts for slightly above 20%. Further, in the last decade the BIS estimates in 2013 that almost 90% of global FX transactions involve the USD with the figure remaining stable for the last decade while other currencies are left behind – EUR, JPY and GBP only have a share of 33%, 23% and 12%.

At the moment, we do not see a correlation between China’s increased share in output and trade with the use of the Chinese Renminbi (CNY) as an international reserve currency. We can trace the root cause of the lack of correlation to the managed float regime that reflects the previous unwillingness of the Chinese authorities to liberalize the CNY. More recently, the Chinese government shocked markets as they realize economic reforms were necessary for their own economic and geopolitical interests. Back in August 2015, The People’s Bank of China (PBoC) announced a reform in their rigid fixing rate mechanism by stipulating that it now will take into consideration the closing level of the USD/CNY spot rate of the previous day to allow for greater market-determined movements in exchange rates.

The initial depreciation shock raised concerns that the Chinese authorities were embarking on a policy of outright competitive depreciation as it frequently did in the past. However, the end goal now is to be part of the IMF’s Special Drawing Right (SDR) basket of currencies whose current member currencies (USD, EUR, JPY, GBP) dominate global bond markets and financial transactions - a natural consequence of SDR membership. The PBoC’s new parameters of the CNY managed float linking the current day fixing to the previous day’s spot closing rate will mean that as time passes, a freely-floating RMB is a very realistic possibility. The potential benefits for China are enormous such as reduced borrowing costs and contracts in major commodities can be priced in CNY. China’s large foreign exchange reserves can also be used more efficiently, since reserve currency countries usually have lower currency reserves relative to GDP.

It appears as though we have discounted the EUR that is the second largest reserve currency. The EUR’s further expansion as a reserve currency is limited given its recent sovereign debt crises. Essentially the government debt market of the Eurozone is fragmented and contained at the country level so there will be no single government debt issue that could rival the US Treasury market. Over time, as China’s reforms progresses, the CNY will become the second largest alternative to the USD, overtaking the EUR. The CNY will probably not overtake the USD in the short term but give it another two decades and we will confront a world of Sino-American currency rivalry. If China manages to accomplish this, America and China might compete to increase attractiveness of their own currencies by engaging in responsible and disciplined fiscal and monetary policy. America’s days of cheap credit will be over. The USD’s political leverage will diminish and sanctions against countries (like Iran and North Korea) will lose effectiveness and exclusion from the US financial system will no longer be a threat. In the meantime however, China must work on the transparency of its financial, political and legal institutions to acquire the faith of global investors, which the Americans have been enjoying (and exploiting) thus far.