Premier Reserve Is the Dollar, But Look Out for the Renminbi

IT is no secret that China eyes the dollar’s lofty status with envy and covets it for its own currency, the renminbi. (While called the renminbi, specific amounts are denominated as yuan: think sterling and pound.) Having the dollar as the world’s premier reserve currency is an advantage for American traders and financiers because the fact of paying and being paid in dollars shields them from having to bear any risk of currency values changing. And it is an “exorbitant privilege” for the American government, which can raise money and finance its deficits more cheaply than otherwise because foreigners want to hold the dollar as an asset. It is, above all, a symbol of American dominance even if that is sometimes reflected in the fact that international criminality, too, is transacted in dollars. The dollar’s dominance can be a source of resentment for outsiders. Former U.S. Treasury secretary John Connally rubbed dollar dominance in the face of European counterparts by telling them the “dollar is our currency but your problem.”

But America earned this status for the dollar, as did Britain previously for sterling, by being the world’s largest and richest economy and the largest trader. It did so, also, by maintaining a strong financial position with the rest of the world. All these attributes make the dollar attractive to foreigners.

Alas, what is earned can also be lost. Around 2020, after reigning supreme for almost 100 years, the dollar will give way to the renminbi. It will give way for the same reason that the dollar eclipsed sterling in the interwar years. In 2020 the Chinese economy (measured in real and purchasing-power dollars) will be about 40 percent larger than America’s. Its trade will be larger by about that amount; and China will be a creditor while the U.S. will remain a vulnerable debtor, especially if it cannot resolve its medium-term fiscal problems.

But this prediction runs up against one major problem. Foreigners want more renminbi but can’t get enough of it—or rather, are not allowed to. Chinese assets are attractive to hold, but buying a renminbi-denominated asset is nearly impossible for foreigners. China is far from creating the policy and market environment for the renminbi to become a reserve currency.

Moreover, China’s financial system is government--controlled, lacking transparency to reassure investors and lacking the depth to provide the liquidity critical for investors to be able to move quickly in and out of the currency. In these circumstances, how could foreign governments or private players make payments, hold assets, or denominate economic transactions in renminbi?

The prospects for changing this situation seem remote because of the powerful interests with a stake in preserving the status quo of a closed financial system. China does not allow foreigners free access to its currency because that helps keep the Chinese currency cheap, which helps exporters, a powerful lobby against reform of the currency.

An even more powerful lobby is the state-owned banks. Their managers, and the beneficiaries of the cheap credit that they hand out (typically, other state-owned enterprises), will resist any attempt at undermining their privilege. Privatizing the banks and making them run on market principles—a prerequisite for having a reserve currency—would rob well--connected people of their power. In this light, the 2020 date for the renminbi not just to become a reserve currency but the premier reserve currency seems fantasy.

Despite this situation, the interesting fact is that the policy changes needed to facilitate the rise of the renminbi (the process of “internationalization”) have already begun. The authorities’ own recent five-year plan calls for these changes. But changes are being implemented not with fanfare and in sweeping fashion but in a distinctively Deng Xiaoping–esque (“crossing the river by feeling the stones”) manner.

Reforms are micromanaged and interventionist: for example, not a day seems to pass without some foreign transaction, entity, or country—chosen carefully by the authorities—being granted greater access to the renminbi. Changes are initially restricted to selected cities: Shanghai, Hong Kong, and possibly London. These enclaves are the guinea pigs for the experiment of financial internationalization. In these places, foreigners can more easily buy renminbi. Once successful, the experiment to free the currency will be extended to other places.

These changes are not necessarily happening because China wants to promote its currency internationally, but in large part for other reasons, and the renminbi’s becoming a reserve currency is a collateral bonus. Essentially, a countervailing set of reformist forces is rising against the vested interests to reform the closed Chinese system. Some reformers want to reduce China’s trade dependence on the rest of the world. In 2008 the global financial crisis led to a drastic decline in China’s exports, rendering tens of millions of jobs and people vulnerable to change and dislocation. China was able to counteract that shock by implementing a huge fiscal package. But China’s ability to do so in the future will be limited, and to avoid future vulnerability the exchange rate will have to be freed, which would reduce export dependence on the rest of the world.

Another set of reformers recognizes that the government-controlled system of allocating cheap credit is creating massive distortions in the economy. State-owned banks provide cheap credit to firms, which tilts the incentives to use capital rather than labor. And firms have done so in spades: the ratio of investment to GDP in China is historically unprecedented. But this also means that the share of the economic pie going to labor has shrunk, creating political restiveness. Policymakers realize that addressing this political problem will require ending the cheap-credit policy. If that happens, Chinese firms will look abroad to finance investments, forcing the government to open up its financial system. This will create the conditions for the renminbi to be traded firmly. The current system of keeping the economy closed and exchange rates cheap has led to the accumulation of a cash pile of more than $3.3 trillion. China has acquired power from this cash. If Europe collapses and needs external resources, only China will have the ability to rescue Europe, and China will extract concessions in return. But there can be too much of a good thing. The reformers in China have recognized that they cannot afford to accumulate more foreign reserves because their value is bound to decline. At some point, the Chinese currency will have to become stronger relative to the dollar by as much as 30 percent. These dollar assets will then be worth a lot less. The longer China sticks to its current policy, the more reserves it will accumulate and the greater the losses it will incur. Chinese policymakers are aware of this dilemma and realize that opening up the economy is unavoidable to prevent even further losses in the future.

Pressure on China to open up will come from another source. We need to imagine the impact of economic changes that are likely to occur. Trade within Asia, with China at the center, is now in the trillions of dollars. Soon, exporters and importers will ask why this should be transacted in dollars. Once trade shifts to renminbi, trade financing will also shift to renminbi, and China’s banking system will have to be able to meet this demand. They’ll want to increase their overseas operations, and Chinese industrial companies will want to expand overseas. Thus, demand will grow for the Chinese government to allow a progressive trade and financial globalization of the Chinese economy. Hong Kong and Shanghai are key players pushing the government in this direction.

What will happen to the vast dollar holdings around the world? We can turn to history—specifically how the baton was handed over from sterling to the dollar—to see how the transition to the renminbi might unfold. And history suggests there will be organic and gradual changes in the demand for renminbi compared with the dollar. Traders will want more renminbi to settle transactions, and investors will want to hold renminbi as a store of value. These changes are already happening. Several central banks are switching more of their -foreign-exchange assets to yuan (Nigeria is a notable recent example), not just in anticipation of higher returns but because importers and exporters in their countries need reliable access to renminbi. The Indian central bank recently allowed Indian firms to raise capital in renminbi. The flood is coming. It’s being held in check only because China hasn’t opened the sluice gates. But there is an important political dimension to the renminbi’s international status. As China moves away from its current policies and opens up its economy, there will be stiff opposition from the internal vested interests that have benefited from cheap currency and credit. To overcome that opposition, China’s authorities can play up benefits of the renminbi having international reserve status. The argument will be that the economic losses and dislocation from currency appreciation and a more open financial system will be outweighed by the gains to national prestige from encouraging the renminbi to rise to reserve-currency status and overtake the dollar. China’s nationalist pride must never be underestimated. “Renminbi Rules” could be the slogan of, even a lifeline for, China’s policymakers as they seek their difficult but desired exit from the current policies. Sooner than almost anyone thinks, that slogan within China could also become the reality without.

There is an irony in relation to currency dominance and the resentment that it elicits. After all, currency dominance is somewhat misplaced and overdone. Misplaced because it reflects rather than causes other forms of economic dominance, overdone because the dirty secret is that currency dominance is not an unalloyed blessing. The strong dollar has had a cost for America. Cheap money played a role in the reckless policies of overconsumption that led to the financial crisis of 2008. A reserve currency is like the bartender who plies the customer with alcohol. The alcoholic still bears responsibility for his actions, but free-flowing booze facilitates the indulgence. To change metaphors, a reserve currency is to some extent a poisoned chalice. American policymakers could not resist drinking from it. China, too, will drink deeply—and quite soon.

This essay was published in Newsweek International's Special Edition, 'Issues 2012,' on sale from December 2011-February 2012.