Washington, China, and the Rise of the Renminbi: Are the Dollar’s Days as the Global Reserve Currency Numbered?

Abstract

The U.S. dollar has dominated the international monetary system since the end of World War II. While the U.S. economy has generated weak growth since 2009, and accumulated a large sovereign debt, the dollar’s status as an international medium of exchange and reserve currency has not diminished. The Chinese renminbi (RMB), however, barely visible in international trade or financial flows just three years ago, appears to be blossoming. China is now the world’s largest trading nation, and more corporations, particularly in Asia, are beginning to invoice their business in RMB. The Chinese regime is calling for a reform of the international monetary system to expand the internationalization of the RMB. Speculation has begun about whether the U.S. dollar could be supplanted by the RMB. Such a development would jeopardize the enormous economic advantages that the U.S. has enjoyed by possessing the world’s dominant currency. Moreover, it would signal a relative decline in American prestige and global leadership. The answer to the dollar’s potential decline is not to seek obstacles to China’s or any other nation’s economic success, but to change fiscal and monetary policies at home in order to maintain the dollar’s competitiveness.The U.S. dollar has dominated the international monetary system for approximately 70 years. While the U.S. economy has generated weak growth over the past six years and accumulated a large sovereign debt, the dollar’s status as an international medium of exchange and reserve currency (currency held by foreign central banks) has defied the odds and has not diminished.

On the other hand, the Chinese renminbi (RMB),[1] barely visible in international trade or financial flows just three years ago, appears to be blossoming. China is now the world’s largest trading nation, and more corporations, particularly in Asia, are beginning to invoice their business in RMB. The Chinese authorities are calling for a reform of the international monetary system to expand the internationalization of the RMB, and have recently created a number of international and regional financial institutions, which, if successful, could significantly expand the use of it.

This contrast of recent years has led many to speculate that the U.S. dollar could be supplanted by the RMB. Such a development would jeopardize the enormous economic advantages that the U.S. has enjoyed by virtue of possessing the world’s dominant reserve currency. Moreover, it would signal a relative decline in American prestige and global leadership.

Indeed, the dollar’s reserve status has its challenges. But if it loses its status, it will not likely be the RMB that replaces it. The RMB’s rise has been greatly exaggerated, and its current presence in global trade settlement and central bank reserves is still minuscule. At any rate, the answer to the dollar’s potential decline is not to seek obstacles to China’s or any other nation’s economic success, but to change fiscal and monetary policies at home in order to maintain the dollar’s competitiveness.

The Renminbi’s Emergence on the Global Stage

While there have been a large number of factors propagating the use of the RMB in recent years, China’s status as a trading giant is the most significant. China’s share of world exports has risen from 3.9 percent in 2000 to 12.4 percent in 2014.[2] China surpassed the United States as the world’s largest trading nation in 2013, a position the U.S. had held for six decades. China is now the world’s largest exporter and the second-largest importer after the United States. China is now the largest trader among approximately 75 economies in the world.

In December 2014, the RMB surpassed the Canadian and Australian dollars to become the world’s fifth-most-used currency for trade settlement.[3] According to Deutsche Bank, in 2013, 17 percent of China’s trade was settled in RMB, up from almost nothing in 2009.

Chinese outbound foreign direct investment (FDI) is also increasing the use of RMB because it is the predominant settlement currency for Chinese investment abroad. According to The Heritage Foundation and American Enterprise Institute’s China Global Investment Tracker, Chinese outbound FDI increased from just $10.1 billion in 2005 to $86.3 billion in 2013.[4] China is already the world’s sixth-largest outbound FDI investor, and this figure is expected to grow steadily in the coming years as part of China’s “going out” strategy.

In the attempt to bypass the U.S. dollar as a medium of exchange, since 2009 China has signed currency-swap agreements with Indonesia, Argentina, Malaysia, Hong Kong, Singapore, South Korea, New Zealand, and the United Arab Emirates, among others.

There are no official aggregate records of central bank holdings of RMBs, in part, because they constitute a very small fraction of global reserves. However, more countries have recently begun to include RMB assets in their official reserves. For example, the Azerbaijan State Oil Fund, known as Sofaz, plans to invest $500 million in yuan (RMB) assets this year.[5] The Reserve Bank of Australia plans to put 5 percent of its reserves in RMB bonds, and Nigeria’s central bank currently holds about 10 percent of its assets in the currency. In 2012, the Bank of Japan announced its acquisition of roughly RMB65 billion worth of Chinese government bonds, and in September 2014, the British government decided to issue RMB-denominated bonds.[6]

The Advantages of a Reserve Currency

It was Charles de Gaulle who first complained publicly about the power of America’s reserve currency. It is now the BRICS countries who are trying to reform the international monetary system to “dethrone” the dollar. The benefits of an international reserve currency include:

  • Seigniorage—the difference between the face value of money and its production cost. It is perhaps the least understood advantage, but one that provides the largest monetary gain. It currently costs 12.5 cents to print a $100 bill. That bill, however, can be used to purchase real goods and services worth $100 in the market. What this means at the policy level is that the Federal Reserve can essentially print money to buy real assets, as it has done with its quantitative easing policies.
  • Low interest rates. The reserve-currency countries have the ability to run up fiscal debts denominated in their own currency at relatively low interest rates.
  • Convenience. It is more convenient for a country’s exporters, importers, borrowers, and lenders to be able to deal in the country’s own currency than in foreign currencies. Doing so reduces transaction costs as well as foreign exchange risk.
  • More business for banks and other financial institutions. It stands to reason that U.S. banks have a comparative advantage in dealing in dollars, and Chinese banks in dealing with RMB.
  • Political power and prestige. Britain’s gradual loss of reserve currency status coincided with its gradual loss of political and military preeminence.[10]

The Chinese authorities have been increasingly pushing for the internationalization of the RMB (and eventual reserve-currency status) because they realize it can provide enormous economic benefits:

  • As residents of the largest trader in the world, there would be great advantages for Chinese firms to limit their foreign exchange exposures and reduce transaction costs if they are able to transact internationally in their own currency.
  • The People’s Bank of China could have an independent monetary policy (allowing its exchange rate to adjust), permitting monetary policy to adjust to domestic conditions.
  • The Chinese government as well as private-sector financial institutions would enjoy lower borrowing costs without exchange-rate risk because they would be able to issue domestic-currency-denominated bonds.[11]
  • If large countries issue RMB-denominated bonds, Chinese authorities can hold those bonds without exchange-rate risk. This would represent a significant improvement over holding dollar-denominated U.S. government bonds that may lose value if the RMB appreciates against the U.S. dollar.[12]
  • Another reason some have cited in favor of pursuing RMB internationalization is that the process provides an opportunity for “reform by stealth.” Observers have argued that RMB internationalization is not an end goal for China’s leaders, but provides a convenient pretext and motivation to pursue financial liberalization and market reforms.

The Attributes of a Global Reserve Currency

There are a number of critical factors to be met for a particular currency to achieve global currency reserve status. First, the size of a country is paramount, as measured by either gross domestic product (GDP) or trade. The second is the degree of confidence in the value of the currency as measured by the long-term trend of its exchange rate. This is largely a function of the long-term rate of inflation and the issuing country’s position as an international creditor (or debtor).[13] In the early stages of becoming a reserve currency, a trade surplus is necessary since it is the only way foreign residents may need the currency. Usually, a trade surplus leads to that country becoming a net creditor. Third, and no less important, is the size, depth, and openness of the country’s financial markets, including the bond, equity, foreign exchange, and derivative markets.

The Rise of the U.S. Dollar

How did the dollar become the world’s reserve currency, and at what rapidity? An analysis of this sequence may provide a clue to the RMB’s potential for reserve status in the future.

At the beginning of the 20th century, the British pound was the dominant reserve currency in the world. Historians estimate that approximately 60 percent of the world’s trade was invoiced in sterling in the late 19th century. In 1899, the share of pounds in known foreign exchange holdings of official institutions was almost two-thirds, more than twice the total of the next nearest competitors, the French franc and German mark.[15]

At the outbreak of the First World War in 1914, the dollar, like the renminbi today, played an inconsequential role in international trade settlements despite the fact that the United States was the largest trading nation. The dollar also played a minor role as a currency in which to denominate international bonds, even though the U.S. turned from capital importer to capital exporter after 1890.

U.S. Dollar Still Dominates. By most macroeconomic indicators, the dollar’s status as the dominant reserve currency should be in serious jeopardy. The U.S. government’s gross debt is now approximately 100 percent of GDP. Future unfunded liabilities from entitlement spending are approaching $100 trillion.[19] The aggressive use of unconventional monetary policy has swollen the central bank’s balance sheet from $900 billion in 2007 to $4.5 trillion in 2015 and greatly expanded the monetary base. The U.S. economy has grown below 3 percent for nine consecutive years, an unprecedented period of subpar growth.[20]

All these factors should have weakened the dollar’s reserve currency appeal, but nothing can be further from the truth. In fact, foreigners have sharply increased their holdings of U.S. financial assets. Since the end of 2006, foreign investors have purchased $3.5 trillion in Treasury securities. They now hold $6 trillion in U.S. government securities, up from $1 trillion in 2000. The private share of government debt (that which is not owned by the U.S. government) now stands at 56 percent. In some respects, then, the dollar’s role as the dominant reserve currency has strengthened since the Great Recession.[21]

The dollar’s greatest asset is the size, depth, and openness of America’s financial markets, including the bond, equity, foreign exchange, and derivative markets. Jonathan Anderson of Emerging Advisors Group calculates that global investors have access to $55 trillion worth of American assets, including bonds and stocks. They can also get their hands on $29 trillion worth of euro-denominated assets and $17 trillion of yen-denominated assets. But when it comes to Chinese assets, just $0.3 trillion or so are open to foreign investors. This puts the RMB on a par with the Philippine peso, notes Anderson.

RMB Potential. Since 2009, the Chinese authorities have gradually initiated a process of internationalizing the RMB. The probability that China will succeed in promoting the RMB to at least regional reserve currency status is significantly higher than it was for Japan.

First, China’s economy is larger, having overtaken Japan’s in size in 2010. It is likely to be significantly bigger by the end of this decade. China is the world’s largest trading nation, having surpassed the U.S. in 2013. It is the world’s largest exporter and second-largest importer.

Second, despite developing nation status, China is already promoting internationalization, whereas Japan was reluctant when it was roughly at the same stage of economic development in the early 1970s.[24]

The Dollar’s Future as a Global Reserve Currency

What is the likely outlook for the dollar’s dominant reserve status? Many had predicted the dollar’s demise during the most recent economic crisis (2008–2009) given that it had first started there. However, the U.S. recovery subsequently has been much stronger than that of the other major developed countries, and its reserve status has remained solidly stable.

While China could easily surpass the U.S. in GDP (measured at current exchange rates) within a decade, the U.S. will still remain the world’s second-largest economy. The U.S. is the world’s second-largest trading nation, and total trade has increased from 15.2 percent of GDP in 1990 to 23.3 percent of GDP in 2014.[33] These conditions bode well for the future of the dollar.

As emerging markets continue to rise, however, the U.S. will unavoidably account for a declining fraction of global GDP, reducing its ability to supply safe and liquid assets on the scale required. It is logical to believe that other currencies will fill this void.

By far the greatest threat to the dollar’s reserve status is the U.S. budget deficit and projected federal unfunded liabilities. In surplus as recently as the late 1990s, the U.S. budget deficit currently exceeds 100 percent of GDP. The federal debt has more than tripled since the turn of the millennium. Worse yet, according to the U.S. Debt Clock, the total value of future unfunded liabilities is $96 trillion—$812,000 per person. This does not include state liabilities, and some economists consider the figure to be considerably higher.

If this current scenario persists, it is clear that American debt will fail to hold its value. While it is difficult to predict when this will occur, if sovereign debt fails to hold its value, investors will lose confidence and the dollar will likely lose its global reserve status. But the RMB is not likely to fill the void any time soon.

Conclusion

The last time a Chinese currency was used as an international medium of exchange was four centuries ago, when China’s share of global GDP was approximately 30 percent, the country was a major global trading power, and Chinese copper coins circulated throughout East Asia to India and beyond.[34]

During the Great Recession, which started in the United States and produced trillion-dollar budget deficits, many predicted the demise of the dollar’s reserve status. So far, this prediction has not materialized.

One thing, however, seems certain: No reserve-currency country, including the U.S., will be able to finance its current account deficit as freely as the U.S. did in the years leading up to the Great Recession. If the financial markets read a reserve-currency country as behaving irresponsibly, in the manner the U.S. did before and after the financial crisis, the markets will naturally curtail the rate at which they accumulate those reserves, and find an alternative. The fate of the dollar’s status and all it means to American prestige and global leadership is in America’s hands. The RMB is not the threat to the dollar.

Washington is.

Full article: Washington, China, and the Rise of the Renminbi: Are the Dollar’s Days as the Global Reserve Currency Numbered? (The Heritage Foundation)

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