The renminbi, several high-profile authors claim, is well on its way to eclipsing the US dollar as the dominant reserve currency. This is controversial stuff. I think anything that has to do with the supposed battle between the dollar and the renminbi for reserve currency supremacy tends to get everyone’s juices flowing, and not surprisingly has received a lot of commentary, for example in a recent issue of The Economist.
I think there is a lot less to all this than meets the eye, however. I have many times expressed my deepest scepticism about much of what is said about reserve currency status, and especially about most of the arguments based on the claim that "history proves…” History almost never proves the many statements made about reserve currency status, especially when the history of shifts from one dominant reserve currency to another consists of a single case, the shift in the 1920s to 1940s from pound sterling to the US dollar.
History aside, there is a much more important objection to the idea that the renminbi is likely to become a dominant reserve currency. Reserve currency status involves substantial costs to the issuing country. In fact, I do not think that the role of the dollar provides for the US any 'exorbitant privilege', contrary to what many suppose. Rather, I have argued, it creates an exorbitant burden for the US economy, one that forces the US to choose between higher debt and higher unemployment whenever a country takes steps to force up its savings rate or, which is pretty much the same thing, to force up its current account surplus.
It is for this reason that I have never thought that the renminbi would become an important reserve currency – precisely because Beijing has made it very clear that it will not accept any of the important costs that reserve currency status bring. Besides the fact that major reserve currency status would require complete liberalisation of the capital account and a flexible financial system largely independent of government control, with clear and enforceable rules, it would put China’s economy at the mercy of countries that want to turbo-charge growth by running large trade surpluses. Beijing isn’t eager to accept any of these things.
But what about the advantages of reserve currency status – don’t they more than compensate the costs? The two most widely cited advantages in China of reserve currency status are first, that reserve currency status allows a country to borrow in its own currency and second, that it protects a country from accumulating too-large foreign currency reserves.
It turns out that the first 'advantage', however, has absolutely nothing to do with reserve currency status. Lots of countries, including China, borrow in their own currency. What matters is the quality of the balance sheet.
In fact in the case of China if the preconditions for reserve currency status were imposed there is a good chance that it would be harder, not easier, for China to borrow in its own currency. Why? Because at least part of the reason the Chinese government can borrow so easily in renminbi has to do with restrictions on capital outflows and control of the domestic savings through the banking system. Relax both constraints, which are necessary if the renminbi is ever going to become an important reserve currency, and domestic financing may very well be much more difficult.
The second 'advantage' is mostly confused nonsense. For an example of this kind of claim, see this article in the current issue of Caixin:
"Some emerging economies, the theory goes, accumulate a large amount of foreign exchange as a result of trade surplus. They invest the forex in low-yielding US Treasury bonds, while borrowing at high costs from developed countries in the form of foreign investments. One way to break this cycle would be to increase the global use of the yuan. At present, because it is not commonly accepted yet, China is bound to have huge forex storage and forced to invest heavily in the US government debt.
"This has "led to a currency mismatch and significant risk exposure to the forex reserve’s depreciation,” said Zhang Monan, research fellow at the State Information Center, a policy think tank under the nation’s top economic planner, the National Development and Reform Commission. By contrast, he said, Germany does not face similar pressure even though it is also a trade surplus country. This is because it does not need to keep a large forex reserve since the euro is a reserve currency."
This is absolutely wrong. Aside from the fact that no country can accumulate its own currency in its foreign currency reserves, the size of foreign currency reserves has nothing to do with whether or not others accept your currency as a reserve currency. Reserve accumulation is fully explained by the sum of the current account and the capital account.
Any country that runs a surplus on both accounts must accumulate foreign currency reserves, and the reason Germany has a large current account surplus and no foreign currency reserves is simply because it runs a large capital account deficit. Instead of recycling its current account surplus by having the central bank lend to foreign governments, as the PBoC does, it recycles its current account surplus by having German banks lend to other European countries.
Math is math
But let’s leave all of this aside. A paper by Arvind Subramanian and Martin Kessler argues that, regardless of what people like me believe ought to happen, in fact the renminbi is actually displacing the dollar, whether or not we think it can or should. The proof?
"In East Asia, there is already a renminbi bloc, because the renminbi has become the dominant reference currency, eclipsing the dollar, which is a historic development. In this region, seven currencies out of 10 co-move more closely with the renminbi than with the dollar, with the average value of the CMC relative to the renminbi being 40 per cent greater than that for the dollar."
You can’t argue with the math, can you? As The Economist put it in their review of the article, "Seven currencies in the region now follow the yuan, or redback, more closely than the green.” Since this only leaves three recalcitrant currencies, sheer arithmetic shows that the dollar is being displaced by the renminbi.
Well actually you can argue with the math, or at least you can argue with the interpretation of the math. There are alternative – and much simpler, I think – explanations for the increased 'co-movement', and these do a much better job, I think, of explaining what is happening than reserve currency displacement.
Assume for a moment a global scenario in which the largest exporter of manufactured goods in the world has a significantly undervalued currency. Assume further that many of its competitors also have undervalued currencies, and would like to revalue in order better to manage their domestic monetary policies. Assume finally that the world is in crisis, and exporting nations are having trouble maintaining the necessary growth rate of their exports, so they cannot allow their currencies to rise faster than that of their main export competitors.
In this scenario, which currency would the currencies of the smaller exporting countries track, the US dollar, or the undervalued currency of the largest and most competitive exporter of manufactured goods in the world? Almost certainly the latter, right? The smaller exporters would want their currencies to rise, but the rise in their currencies would be limited by the rise in the currency of their largest competitor. This would happen not because they are tracking a new reserve currency but only because they are in export competition with that currency.
Is my scenario a plausible description of the world today? I think it very clearly is. The world certainly is growing slowly, exporters are having real trouble, countries are engaged in currency war, and one can very easily argue that the renminbi is seriously undervalued and acting as a constraint on other Asian currencies. In fact over the past several years many Asian finance ministers have said exactly that – they cannot appreciate their currencies as much as they would wish until the renminbi appreciates more. The conclusion, then, might be not that there is a renminbi bloc, but rather that the appreciation of the renminbi against the dollar is a kind of cap against which other currencies are constrained.
...I am not saying that Subramanian and Kessler are necessarily wrong. I am just suggesting that there are alternative, and in my opinion far more plausible, explanations for the greater correlation between the renminbi and these other currencies than the renminbi bloc hypothesis. Of course if the renminbi were a freely floating currency and there was no longer PBoC currency intervention, and the correlations that the authors find still hold, then perhaps this could be a more powerful argument about the rise of the renminbi. Until then, it is almost wholly irrelevant.
…Unfortunately what should be a technical discussion about the merits for and preconditions of reserve currency status has been completely subsumed into the idiotic argument about whether you are 'for' China or 'against' China. But anyone who conflates his opinion about which country should be top dog with his analysis of the rise of the renminbi as the dominant reserve currency is, I think, engaged in bad economics.
Michael Pettis is a senior associate at the Carnegie Endowment for International Peace and a finance professor at Peking University’s Guanghua School of Management.
He blogs at China Financial Markets.