Is the Yuan About to Replace the Dollar as the World’s Reserve Currency?

Once again we are seeing articles and research papers stating the Chinese renminbi (yuan) is about to replace the dollar as the global reserve currency.

Here is a working paper by Arvind Subramanian and Martin Kessler at the Peterson Institute of International Economics stating The Renminbi Bloc is Here: Asia Down, Rest of the World to Go?.

A country’s rise to economic dominance tends to be accompanied by its currency becoming a reference point, with other currencies tracking it implicitly or xplicitly. For a sample comprising emerging market economies, we show that in the last two years, the renminbi (RMB) has increasingly become a reference currency which we define as one which exhibits a high degree of co-movement (CMC) with other currencies. In East Asia, there is already a RMB bloc, because the RMB has become the dominant reference currency, eclipsing the dollar, which is a historic development.

The same authors present a case in the Financial Times article China’s currency rises in the US backyard.

East Asia is now a renminbi bloc because the currencies of seven out of 10 countries in the region – including South Korea, Indonesia, Taiwan, Malaysia, Singapore and Thailand – track the renminbi more closely than the US dollar. For example, since the middle of 2010, the Korean won and the renminbi have appreciated by similar amounts against the dollar. Only three economies in the group – Hong Kong, Vietnam and Mongolia – still have currencies following the dollar more closely than the renminbi.

This shift stems from China’s rise as a trader; its share of east Asian countries’ manufacturing trade has risen from 2 per cent in 1991 to about 22 per cent today. Countries that sell to the growing Chinese market or are locked in supply chains centred on China see the advantages of maintaining a stable exchange rate against the renminbi.

This development has two implications. First, it is one more important marker in the shift of economic dominance away from the US and towards China. Not only is China, by some measures, the world’s largest economy in purchasing power parity terms, the world’s largest exporter and the world’s largest net creditor (for more than a decade), but the renminbi bloc has now displaced the dollar bloc in Asia. The symbolism and its historic significance cannot be understated because east Asia, despite physical distance, has always been part of the dollar backyard.

Déjà Vu Rehash

The analysis by Subramanian and Martin Kessler is nothing but a Déjà Vu rehash of easily rebutted arguments that crop up time and time again.

Three Essential Facts

  1. China's bond markets are not big enough or deep enough for the Yuan to displace the US dollar.
  2. Contrary to what most think, having the reserve currency is a a curse more than a blessing.
  3. Neither China nor the US wants to be the global reserve currency.

The first point alone seals the fate in my opinion but let's take a closer look at the "curse of the reserve currency".

Via email, Michael Pettis at China Financial Markets responds to points two and three. ...

I think there is a lot less to all this than meets the eye. I have many times expressed my deepest skepticism 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.

But history aside, there is a much more important objection to the idea that the RMB is likely to become a dominant reserve currency. Reserve currency status involves substantial costs to the issuing country. In fact – and I will discuss this extensively in my upcoming book due February next year (Princeton University Press) – 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 RMB 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 liberalization 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 RMB 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 RMB 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. 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. The paper by Arvind Subramanian and Martin Kessler argues that, regardless of what people like me believe ought to happen, in fact the RMB 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, 7 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 percent 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 RMB.

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 RMB 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 RMB appreciates more. The conclusion, then, might be not that there is a RMB bloc, but rather that the appreciation of the RMB against the dollar is a kind of cap against which other currencies are constrained.

Or let’s take another scenario. Assume the world is in crisis and the US dollar is seen widely as the “safe” asset. In this world, perhaps when risk perceptions rise, investors and traders move generally out of riskier currencies into the dollar, and when risk perceptions decline, traders move out of the dollar into riskier currencies. Perhaps we could even call these trades “risk-on” and “risk-off” trades.

In this case it would be natural to see an increase in the correlation among riskier currencies. Would this be a sign of an emergent currency bloc? No. It would just be a sign that the dollar is the dominant reserve currency and that everyone is treating it as such, buying and selling it is response to changes in risk perception. Is my second scenario a plausible description of the world? Again, it almost certainly is.

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 RMB and these other currencies than the RMB bloc hypothesis. Of course if the RMB 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 RMB. Until then, it is almost wholly irrelevant.

Who is Top Dog?

But where I have a real difference of opinion is the claim that “American optimists” somehow don’t want the RMB to become the dominant reserve currency and want the US dollar to retain the title. This suggest to me that the argument here is really not about the whether or not the RMB is likely to become a reserve currency but rather about whether or not you expect this to be the “China Century”, and if the RMB becomes the reserve currency Chinese dominance will inevitably follow.

In fact I have also argued many times that if the US does not take steps to prevent foreign countries from acquiring unlimited amounts of US dollar reserves, for example by forcing, as Keynes wanted, reserve accumulation to be more evenly divided amount all the major currencies, it will force the US into a very difficult position and can actually hasten the coming of the China Century. As I see it, “American optimists” or at least those who want the US to remain the only “indispensable country”, should actively encourage a greater role for the RMB and a lesser role for the dollar.

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 RMB as the dominant reserve currency is, I think, engaged in bad economics.

There are of course plenty of generals, journalists, and policymakers in China who believe that dominant reserve currency status is desirable and inevitable, but very few Chinese monetary economists, even among those blessed few that do not believe China is going to have a very difficult adjustment, think reserve currency status is likely to happen soon. Among economists, it seems that only foreigners, and based mainly abroad, seem to believe that this process is happening.

Discussion Simplified

Portions of the above discussion may be a bit complicated for some to understand. Let's see if this simplification helps:

  • The US treasury department, President Obama, Mitt Romney, and especially Ben Bernanke all want the Yuan to rise.
  • China does not want the yuan to rise because of export issues.
  • No country is acting as if it wants ownership of the reserve currency, precisely because no country does want ownership of the reserve currency. Currency wars are proof enough.

I consider Michael Pettis to be the foremost expert on international trade. I am very pleased to have him as a speaker along with John Hussman, James Chanos, John Mauldin, and Chris Martensen on April 5 at the Wine Country Conference.

Source: Global Economic Analysis

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