The year is 2050. The recent rise in oil prices above CNY 800/barrel has created an inflationary scare, pushing equities down and government bond yields up. The MSCI world index has fallen below CNY 6500 and Chinese 10 year government bond yields, the global benchmark, have risen to 5.5%. The announcement from Norges Bank Investment Management that they have increased their Renminbi holdings to 50% of their portfolio, pushes USD/CNY to all time lows at 1.3020. The volatility in the market has been good for some: PIMCO has just launched a new global bond fund raising CNY 20bn from investors around the world.
Welcome to a world where the Renminbi has replaced the Dollar as the global reserve currency. The Renminbi becomes the currency of choice for central banks and reserve managers, commodities are priced in Renminbi, trade is conducted in Renminbi and fund managers raise and denominate funds in the most traded currency – the Renminbi. For many, this is not just a plausible scenario, but an inevitable scenario.
The logic is straightforward. Given its size and expected growth trajectory, the Chinese economy is likely to overtake the US economy at some stage between 2020 and 2030. The eclipse of the Dollar by the Renminbi is the logical next step. History supports the argument. The title of global reserve currency has been passed over time from the Chinese liang, to Greek drachma, to Venetian ducato and to the Dutch guilder, as economic dominance shifted (Persaud, 2004). More recently, the US economy overtook the UK economy as the world's largest economy in 1870 and largest exporter in 1912. By 1924 the Dollar had replaced Sterling as the world's reserve currency (Eichengreen 2011).
Lessons from history
Will history be repeated? The Dollar's rise between 1910 and 1945 provides an important benchmark, and highlights the conditions that will need to be in place for the Renminbi to ascend to reserve currency status. For one, US policymakers actively promoted policies to support the dollar's internalisation. Second, the decline of the UK as an economic force, and consequently the decline of Sterling, coincided with the ascent of the US economy and the Dollar i.e. there was a credible alternative to Sterling. Third, not only did the US authorities actively encourage use of the Dollar, but macroeconomic policies ensured the Dollar was viewed as a stable currency and a credible store of value.
Chief amongst these conditions are the policies required to support the internationalisation of a currency. In the early twentieth century the US took a number of steps which contributed to the more widespread use of the Dollar. First was the development of the market in trade acceptances, and this was complimented by the change in legislation to allow US banks to operate overseas (Eichengreen, 2011). Up until this point, UK banks had the monopoly in trade acceptances, providing a costly and cumbersome obstacle to international trade for US traders. Developing a market in US dollar denominated trade acceptances, and allowing US banks to establish banks overseas, ensured that importers and exporters to the US used the Dollar.
The establishment of the Federal Reserve System was a third important development. When Sterling was dominant, the Bank of England played a key role as lender of last resort and buyer of last resort for trade acceptances. The establishment of the "Fed" allowed it to support the use of the US dollar in the same way. In addition, the Fed had the mandate to regulate credit and interest rates in the economy and to maintain the Dollar's value versus gold, providing confidence in it as a store of value.
The lessons for China are clear: the conditions for the Renminbi to emerge as the reserve currency are falling into place but it is not inevitable, at least not without policy action. Full liberalisation of the current and capital account is a prerequisite. There cannot be any restrictions on buying and selling the currency - otherwise other currencies will be preferred. Although China has made some steps, for example in developing the Dim Sum bond market in Hong Kong and allowing qualified Chinese investors invest overseas, investing on-shore is still largely off-limits for international investors.
A stable and vibrant financial and banking system is also critical. China will need strong and stable banks to support the internationalisation of the Renminbi and will need to develop more liquid financial markets, particularly the bond market. Although China made strides in financial reform under Zhu Rongji and Jiang Zemin, since 2005 the pace has slowed and concerns still surround the stability of the banks (Walter & Howie, 2011).
Third, to become a reserve currency there must be adequate supply and availability of that currency for international traders and reserve managers to acquire. The reserve currency issuer does this by acquiring foreign goods or assets in return. As China is a creditor nation there is not currently a sufficient available supply of Renminbi denominated debt securities for foreigners to acquire.
For China, therefore, becoming a reserve currency issuer may not be unambiguously positive. For sure the "exorbitant privilege" of being a reserve currency issuer is substantial. The US outspent its income and borrowed at subsidised rates for decades because of its reserve currency status. In the process, it went from being a creditor nation to a debtor nation as it supplied IOUs to willing accumulators of Dollars. This is the Triffin dilemma of being a reserve currency issuer. China may prefer to maintain its creditor status and internationalise the Renminbi by lending and acquiring assets with Renminbi. This may slow the process if international investors don't desire Renminbi loans.
A fully convertible, free floating currency arrangement would also risk a sharp upward adjustment in the Renminbi, which is deemed to be undervalued on a Purchasing Power Parity (PPP) basis. China would incur losses on its US$1trn portfolio of US treasury bills and bonds in this scenario. Furthermore, maintaining a competitive currency and a reliance on export growth have been key pillars of China's economic growth to date. A shift to a fully free floating currency arrangement can only take place when the Chinese economy is equipped to transition from export reliance to domestic demand.
An alternative arrangement
So although the Reminbi appears to be the anointed successor to the Dollar, a coronation is by no means certain or imminent. Bank of China Governor Zhou Xiaochuan's call in 2009 for reform of the global financial system, emphasising a role for the IMFs Special Drawing Rights (SDRs) may reveal thinking in China. Clearly there is a desire in China to reform the system to curb the US's hegemony and put in place a mechanism that will allow a stable diversification of their reserves away from US dollars. Of note, however, is China's desire to promote the SDR, rather than the Renminbi, as the immediate replacement to the US dollar. This probably reflects China's hesitancy at taking the responsibilities, as well as the benefits of being a reserve currency issuer.
Under China's proposal, the IMF would issue trillions of SDRs and countries could switch their Dollars into SDRs off market to allow greater use of the SDR as the reserve currency. Any losses from such transactions would be put through a Substitution Account. However this was raised as a possibility in the late 1970s but members could not agree on how the losses in the Substitution Account would be funded. To move to this arrangement would require widespread international coordination. The experience of the G7 in the last three decades has shown that international policy coordination is normally only achieved when it serves the interest of all parties. The US may be reluctant to willingly give up its exorbitant privilege.
That is not to say that that US can afford to be complacent. The big risk from the US's perspective is that the Renminbi or even the Euro does replace the Dollar over time. The US would then have to adjust to a reduced capacity for consumption, higher borrowing costs, and a possible run on the Dollar. Forward looking policymakers would be well served to plan in advance for such an outcome. Forward looking policymaking is, however, in short supply in the US at the moment, given the political deadlock. A more likely scenario is that the reserve currency debate does not come on to US policymakers' agenda until it becomes a matter of financial crisis.
For now, market forces are more likely than international coordination to determine reserve currency status. In that scenario the US Dollar still rules. Having a first mover advantage as the incumbent reserve currency affords network benefits on the Dollar, which empirical research confirms should prolong its position as reserve currency (Lee 2010). Although the Dollar's eventual demise does look inevitable its displacement requires a credible alternative. The rise of the Renminbi as a credible alternative is still many years away and is by no means inevitable.
1. Economist (2011) The rise of the redback 20th January 2011
2. Eichengreen, B. (2011) Exorbitant Privilege The Rise and Fall of the Dollar
3. Lee, J-W (2010) "Will the Renminbi Emerge as an International Reserve Currency?" Asian Development Bank
4. Persaud, A. ( 2004) "When Currency Empires Fall" Gresham Lectures
5. Reisen, H. (2009) "Shifting wealth: Is the US dollar Empire falling?" VoxEU.org
6. Walter, C & Howie, F. (2011) Red Capitalism: The Fragile Foundation of China's Extraordinary Rise
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