The devastating impact and legacy of the global financial crisis on the US economy has generated a continuing debate about the status of the US dollar as the world’s reserve currency.
On Wednesday, a body set up by the US Congress to monitor the trade and economic relationships between the US and China reported to Congress and said it was no longer inconceivable that the renminbi could challenge the US and it might be able to do so within the next five or 10 years.
Despite the depth of the debate about the US dollar’s privileged and dominant position since World War II, what the US-China Economic and Security Review Commission finds “not inconceivable” is, frankly, inconceivable.
And, while the Chinese authorities might like the idea of the renminbi eventually toppling the greenback in the long term, it is improbable that they would want to do so within the timeframe envisaged by the commission, even if it were feasible.
To do so would involve dismantling the mercantilist model that has driven its relatively recent emergence as an economic powerhouse. It would have to liberalise a currency whose value, now actively and heavily depressed, is at the core of that model.
It would need to liberalise and modernise its banking system and financial markets, allow free capital flows and fundamentally open its economy completely to the rest of the world. It would probably also need to undergo currently unthinkable reforms to its governance and its legal structures and processes. Oh, and it would have to contemplate massive losses on its $US2 trillion or so of foreign reserves tied up in US dollar assets, mainly US Treasuries.
It is not inconceivable that all those things (and probably some others) might eventually transpire, but it’s most unlikely that they are going to happen inside a decade.
China has been cautiously experimenting with a modest internationalisation of the renminbi. Mainland Chinese, and Chinese companies, are now able to hold renminbi-denominated deposits in Hong Kong. An increasing number of Chinese companies are able to undertake cross-border settlements in the currency and there is a rising number of foreign companies issuing renminbi-denominated “dim sum” bonds in Hong Kong.
The obstacles to the renminbi achieving reserve currency status, however, are many and varied.
The US dollar is on one side of more than 80% of the world’s foreign exchange transactions. It is the currency in which all major commodities, including the oil price, are priced and traded.
While the proportion of foreign central bank and government reserves held in US dollars has been edging down, it is still more than 60%.
The dollar is the reserve currency not just because of the size of the US economy or its dominant geopolitical presence but because it has very, very large, sophisticated and open markets, a robust rule of law and exceptionally strong property rights — and a vast amount of government debt on issue.
What the US has are sophisticated, deep and liquid securities markets that can absorb the massive ebbs and flows of capital that are vital to support a reserve currency.
China doesn’t have them and it is inconceivable that it could create them, and the framework around them that would enable them to function in a fashion that would reassure investors, within the timeframe envisaged by the commission.
For all the reasons detailed above, the US is also regarded as the world’s financial safe haven — we’ve seen consistently in recent months that any tremor in the global economy or markets sees capital flood back into US dollar-denominated assets. China is a long way away from being regarded as a safe haven for global capital.
Apart from the status and economic and political power afforded the nation that issues the reserve currency, there are multiple economic benefits, not the least of which is seigniorage, or the ability to swap something relatively worthless — paper and ink — for goods and services of real value.
US companies generally don’t experience material foreign exchange risks and hedging costs and the cost of funds for the US government and corporate sector is lower than it would probably otherwise be. And because of its capacity to borrow cheaply, run massive deficits and have a dollar whose value was supported by China’s sustained buying (in order to cap the value of the renminbi and maintain the competiveness of its exports), the standard of living for Americans was higher than it would otherwise have been. (Or at least it was until the US over-dosed on a cocktail of the debt and the reckless way it was deployed.)
The renminbi will presumably continue to become more widely held and traded, and China is going to have to continue to liberalise and wean itself off its mercantilist strategies (it is already under growing pressure from the US and elsewhere to let the renminbi appreciate) in order to maintain its growth rates. That’s a long game.
The euro had been making progress and eroding the greenback’s share of reserves. It has attracted about 27% of the world’s foreign reserves and before the latest implosion in the eurozone it was Europe’s ambition to displace the dollar.
That ambition — and the geopolitical influence and economic benefit latent in it — remains one of the issues that is holding Europe together today.
The fragile debt-laden state of the eurozone is a setback for the euro, but could also create an opportunity. While the Germans hate the idea of issuing eurozone bonds and effectively blending the debt and borrowing costs of the eurozone — because it would be Germany paying for the profligacy of southern Europe — it would create a new security underwritten by all of Europe and with the kind of liquidity and market depth that supports the dollar.
A future where the US dollar is less dominant, where the renminbi is a significant global medium of exchange and where the euro is also very prominent (and gold is still prized by the fearful) is conceivable. If it is to happen, however, one would expect it to develop over decades, not a handful of years.
*This article first appeared on Business Spectator