Is the RMB Displacing the USD in Asia?: Michael Pettis

November 21, 2012Chinaby Michael Pettis

In Asia, Is the RMB Displacing the Dollar?: Michael Pettis

What are the odds of the renminbi displacing the dollar, and does China want the yuan to become an international reserve currency? Besides the fact that being a major reserve currency would require the complete liberalisation of the capital account and a flexible financial system largely independent of government control, with clear and enforceable rules, it would also put China’s economy at the mercy of countries that want to turbo-charge growth by running large trade surpluses. Beijing, it appears, isn’t eager to accept any of these conditions.

In the past two weeks we have been treated with a mostly positive but nonetheless mixed bag of economic data from China. There has been good news, bad news, good news with worrying underlying trends, and bad news with silver linings. Analysts have announced that things are getting worse and that things are getting better. There was, in other words, plenty to please or displease everyone.

I don’t have much to add to the voluminous analysis, especially since I don’t think anything has changed the underlying trend. Both the historical precedents and the arithmetic of rebalancing mean, in my opinion, that Chinese growth will continue to slow sharply for many years as a function of China’s economic rebalancing.

What’s more, without a significant – and politically difficult – change in the development model, only a renewal of investment growth, which itself only pushes off the rebalancing further and makes it ultimately more costly, can interrupt, albeit temporarily, the process of declining growth.

Rather than go through the data and explain why the latest numbers haven’t changed my opinion, I thought it might be more useful to cite and discuss in some detail a few interesting recent articles and commentary. This gives me a chance to dig a little deeper into the dynamics of China’s adjustment process and to illustrate some of the salient issues.

The first interesting commentary is a paper by Arvind Subramanian and Martin Kessler, both from the Peterson Institute, arguing that a RMB currency bloc is rising in Asia and is displacing the US dollar. According to the abstract:

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 explicitly. For a sample comprising emerging market economies, we show that in the last two years, the renminbi 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 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.

We find that co-movements with a reference currency, especially for the renminbi, are associated with trade integration. We draw some lessons for the prospects for the renminbi bloc to move beyond Asia based on a comparison of the renminbi’s situation today and that of the Japanese yen in the early 1990s. If trade were the sole driver, a more global renminbi bloc could emerge by the mid-2030s but complementary reforms of the financial and external sector could considerably expedite the process.

The RMB, the authors claim, is well on its way to eclipsing the US dollar as the dominant reserve currency. In an OpEd piece in the Financial Times the authors explain their reasoning a little more, going on to say:

In new research, we find that since the global financial crisis, as the US and Europe have struggled economically, the renminbi has increasingly become a reference currency (meaning emerging market exchange rates move closely with it). In fact, since June 2010 when the renminbi resumed floating, the number of currencies tracking it has increased compared with the earlier period of flexibility between July 2005 and 2008. Over the same period, the number tracking the euro and the dollar declined.

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 is controversial stuff. I think anything that has to do with the supposed battle between the dollar and the RMB for reserve currency supremacy tends to get everyone’s juices flowing, and not surprisingly the piece has received a lot of commentary, for example in a recent issue of The Economist:

The greenback has in the past played a dominant role in East Asia. But if anything, the region is now on a yuan standard. Seven currencies in the region now follow the yuan, or redback, more closely than the green (see chart). When the dollar moves by 1 percent, East Asia’s currencies move in the same direction by 0.38 percent on average. When the yuan moves, they shift by 0.53 percent.

Reserve Currency Status?

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.

There is plenty of history about major currencies generally, but this history too leads to few obvious lessons about any future shift away from the dollar. For example the first line in the abstract (”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 explicitly’) is not, as far as I can see, strongly supported by history except to the extent the statement is interpreted so vaguely so as to be almost meaningless.

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 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 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. For an example of this kind of claim, see this article in the current issue of Caixin, which was sent to me by Patrick Chovaneck of Tsinghua University – almost certainly to annoy me because he knows how absurd it is:

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 U.S. 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 U.S. 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.

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