Yuan as a reserve currency (2010)

See also: Yuan as a reserve currency (Deutsche Bank Research)

Following the creation of EMU, some observers predicted that the euro would emerge as the world’s major reserve currency. More recently, eurozone travails and rapidly rising US indebtedness have re-ignited the debate about alternative reserve currencies (incl. SDRs). Among the possible medium-term contenders for ―top currency‖ status are the yuan and the euro. Neither the UK nor Switzerland, nor Japan, have or will have the necessary economic and financial size for their currencies to become the world’s dominant reserve currency. The eurozone-16 is about the size of the US economy, and China, on current trends, is set to replace the US as the world’s largest economy sometime during the 2020s. China is already the world’s largest exporter and will soon also be the largest trading nation. Contrary to the US, the world’s largest debtor, China is also a large net external creditor, only trailing Japan.

Many observers have therefore drawn parallels between today’s situation and the dollar replacing sterling during the inter-war period and post-WWII. British sterling, burdened by the financial legacy of WWI and WWII, was replaced as the world’s reserve currency by an economically and financially ascendant dollar. This raises a number of interesting questions. How likely are we to witness another such transition in the coming decades? What are the prospects that the yuan will replace the dollar as the dominant reserve currency? What would be its economic, financial and political implications?

Following Papaiouannou & Portes (2008), several conditions underpin a reserve currency (and its international use): the size of the economy, low inflation and exchange rate stability, deep and efficient capital markets, and political stability and geo-political strength.

First, in terms of economic size, China is likely to overtake the US sometime around 2025 and outstrip it thereafter. Second, as regards low inflation and exchange rate stability, the Chinese yuan at first sight seems to fit the bill already. However, China maintains capital controls and a quasi-pegged exchange rate. So it cannot be said to have passed the test yet. However, there is little reason to believe that China will not be able to maintain low inflation and relative exchange rate stability if it moves towards convertibility in a gradual manner accompanied by the necessary domestic institutional reforms (e.g. central bank independence, inflation targeting). Admittedly, this will require a move towards a market-based banking system and this implies that the government will not only have to implement a host of secondary reforms aimed at ensuring financial sector stability post-convertibility but also have to accept a significant diminution of direct control over the financial system. (It will be interesting to see how this plays out.) Like most other maturing emerging markets, China is likely to move from what might be called a ―developmental‖ approach to managing its exchange rate and capital flows to a floating exchange rate and an open capital account. As China’s economy grows in size, it will become less dependent on export-led growth and the US market, making a switch towards a flexible exchange rate regime increasingly attractive in terms of policy flexibility.

Third, deep and efficient capital markets and full currency convertibility are even more important than exchange rate stability. This is where China lags the most. The yuan is not convertible and the authorities maintain tight capital controls. The domestic bond market is relatively small and illiquid and foreigners’ access is, of course, highly restricted. A reserve currency also requires sophisticated foreign exchange and derivatives markets. Beijing has on several occasions affirmed its commitment to gradually move towards yuan convertibility and is seeking to develop domestic bond, derivatives and foreign exchange markets. Last but not least, while China enjoys political stability, it continues to lag as regards the ―rule of law―. As long as it continues to compare poorly with the US and the eurozone, foreigners may remain reluctant to invest in on-shore yuan assets. It is noteworthy that, according to the World Bank, China has made next to no progress on this score over the past decade or so.

In all these areas, China has a long way to go. How quickly Beijing will manage to put in place the necessary conditions for the yuan to emerge as a major reserve currency depends mainly on political decisions taken in Beijing. A gradualist approach is no doubt going to prevail, especially as regards convertibility. It will probably take around 15-20 years for Beijing to put in place the conditions necessary for the yuan to emerge as a reserve currency. Not surprisingly, the yuan’s private and official use is currently very limited. The yuan plays next to no role as an international store of value (e.g. FX reserves), nor as unit of account (e.g. neither HK nor Macao peg their currencies to the yuan). Only recently have the authorities started to allow yuan assets such as deposits to be held off-shore (e.g. HK) and for the yuan to be used in trade settlement, albeit in a pilot project.

If Beijing manages to meet the prerequisites, the yuan will become a reserve currency. China’s economic size and its share in international trade will grow, increasing the incentives of its trading partners, especially of small open economies, to ―manage― their currencies vis-à-vis the currency of their dominant trading partner (as they do in other parts of the world). As trade with China becomes more important relative to other countries (read: US, EU), countries will have an incentive to hold at least parts of their reserves in yuan-denominated assets – provided the yuan meets the above conditions. From there, it will only be a small step towards the yuan’s greater private use as a store of value, transaction vehicle and unit of account.

This does not mean, however, that the yuan will necessarily become the world’s dominant currency. Prerequisites are, by definition, necessary but not sufficient conditions, for even if China makes the yuan fully convertible, creates deep and liquid domestic bond markets, maintains a strong financial position etc., it will still need to overcome ―network externalities― (that is, an economic agent is more likely to use a currency if everybody else uses it), ―politics‖ and the existence of ―peer competitors‖ (dollar, euro).

Politics will matter greatly. States do not typically finance (accumulate claims on) countries that are, or may be, their geo- political competitors – if they can help it, that is, or if there is any credible alternative. Countries that do not have close political relations with Beijing are therefore less likely to keep the bulk of their foreign assets in yuan (e.g. India, Japan). Naturally, the more dependent a country is on trade with China, the more constrained its choice will be.

What economic, financial and political consequences would a rising yuan and a declining dollar have? First, a reserve currency country (RCCs) derives seigniorage. To the extent that foreigners hold a reserve currency, the reserve currency country acquires foreign goods or financial assets by ―printing‖ money. In the 1960s, economists used to call this exorbitant privilege. By holding currency, foreigners effectively extend an interest-free loan to the RCC. Second, RCCs benefit from a liquidity discount. To the extent that foreigners are more likely to hold RCC liabilities, interest rates are lower than would otherwise be the case. Estimates as to the seigniorage and liquidity discount― benefits vary, but they are frequently estimated to be worth around USD 500 bn and an annual 100 bp in the case of the US.

Furthermore, the RCC enjoys an exorbitant privilege not just because it can finance its deficit by issuing its own currency or debt denominated in its own currency. As the world’s banker, it can also borrow short at low rates and lend long at higher yields, earning the spread, while as the world’s venture capitalist (Gourinchas & Rey 2007), it can sell liquid, domestic-currency-denominated high-grade domestic debt to finance (foreign-currency-denominated) illiquid, high-return assets.6 This may help make a net foreign debtor position sustainable in the long term.

Third, by increasing the number of investors, RCC financial markets may also be deeper and more efficient than they would otherwise be, thus potentially benefitting the international competitiveness of the financial industry. Fourth, to the extent that a reserve currency is in greater use, an RCC may also benefit from improved terms-of- trade. Increasing use of the reserve currency in international trade tends to raise the value in terms of the quantity of goods that can be purchased for every unit of the currency. Last but not least, domestic companies may benefit from lower transaction costs and lower exchange rate uncertainty (though this is empirically contested).

Reserve currency countries incur not just benefits, but also costs. First, the reserve currency will tend to be overvalued, hurting competitiveness and potentially economic growth, due to larger demand than otherwise for its financial assets. Second, RCC economic and especially monetary and exchange rate policies matter greatly to other countries, potentially opening the RCC to international scrutiny and pressure. In this context, some have argued that the country is then compelled to take greater account of international public opinion and other countries’ views. This is somewhat debatable, at least in the sense that whenever push came to shove in the past Washington seemed in the end to have privileged its own interests over those of others (e.g. Nixon shock, Reaganomics, John Connally’s ―dollar is our currency, but your problem). While the US certainly managed to delay and deflect pressure for international adjustment and even get other countries to adjust (e.g. Plaza, Louvre accords), this was only in part due to its reserve currency status, and principally due to the size of the US economy and its importance as an export market for other countries – which arguably were more concerned about their competitiveness, growth and domestic monetary stability than about the potential financial losses on their dollar holdings – and the existence of close security ties in the case of Germany and Japan post-WWII.

Perhaps more of a concern is a possible ―fall from grace―, that is, the potentially painful economic and financial adjustment that takes place when a reserve currency declines. Under fixed exchange rates, economic policy will be heavily constrained, as the country has to absorb the ―monetary overhang―. The risk of a run on the currency may also become considerable (e.g. post-war sterling devaluations). Under flexible exchange rates, however, this is likely to be somewhat less of a problem. Similarly, an RCC runs the risk of greater instability of demand for money. This perceived risk made the German and Japanese authorities reluctant to push for a greater international role for their currencies in the 1980s.

What are the implications for Sino-US relations? The rise of the yuan as a reserve currency would confer benefits on China. It would boost seigniorage revenue, and might enable China to finance its debt more cheaply (though, compared with the present situation, a lot would depend on how the opening of the capital account affects Chinese interest rates). It might have only a limited effect on Beijing’s ability to resist international pressure for economic adjustment, which is already quite considerable. Beijing’s ability to deflect international pressure will be largely a function of economic size and financial prowess. The larger its economy and the less dependent it becomes on foreign trade, the less vulnerable it becomes to protectionist threats. On the other hand, increased foreign yuan reserve holdings may constrain the policy flexibility of other countries – similar to the way in which China’s dollar holdings and dependence on the US market are constraining it today. Moreover, China would benefit from more efficient financial markets, even though efficient capital markets are also a pre-condition for reserve currency status, and Chinese corporates and banks are likely to become internationally more competitive for the reasons discussed above. Admittedly, the benefits are somewhat difficult to quantify, even if they are real.

What does it mean for the US? In addition to foregoing, or at least benefitting less from, the privileges that come with issuing the dominant reserve currency on account of peer competition, the US might have to ―mop up‖ excess dollar liquidity in the (unlikely) event that official reserve holders actively sell down dollar reserves as compared to refraining from increasing their dollar holdings. Even under floating exchange rate regimes, this may lead to sustained monetary weakness and/or constrain macroeconomic policy flexibility. More importantly, the US may increasingly have to resort to issuing non-dollar-denominated debt in order to finance its deficits (e.g. Carter bonds) and a more binding balance-of-payments constraint would limit the US capacity to run large external deficits. The US would then have to raise taxes or curtail expenditure instead of relying on free and/or low-cost foreign funding. US economic policy flexibility would diminish tangibly.

If the yuan emerges as a reserve currency potentially rivalling the dollar, China will become more powerful and the US less powerful in international economic and financial affairs, especially given divergent net international financial positions and China’s greater economic size. However, the factor that will do most to alter the balance-of-power will be China’s declining dependence on the US market, or conversely the United States’ relatively increasing dependence on the Chinese market.

The emergence of the yuan as a major reserve currency will reflect the underlying shift in economic and financial power, even if it does, independently, provide tangible benefits to China. China’s diminished dependence on the US as an export market coupled with exchange rate flexibility will enhance China’s position vis-à-vis the US. Simultaneously and significantly, the US will face greater constraints in terms of financing its balance-of-payments deficit. This will be compounded by China’s declining relative dependence on the US market, allowing for greater exchange rate flexibility and greater flexibility as to whether and under what conditions to continue to extend credit to the US. Beijing may thus gain a degree of control over how hard or how soft the US balance-of-payments constraint will be, potentially influencing US economic and financial flexibility. This is likely to have ramifications for Washington’s political position in the world – something which the Obama administration’s National Security Strategy in fact acknowledges.

The world will be moving towards a multiple reserve currency system over the medium- to long-term. It will take China 15-20 years to put in place the conditions necessary for the yuan to emerge as an international reserve currency and longer to become a potential rival of the dollar (and the euro). This is naturally an educated guess only, based on the projection of China’s future economic size, foreign trade and financial market size. Ultimately, the rise of the yuan is a question of how quickly Beijing is willing to push forward with financial markets reform and yuan convertibility. Prerequisites are, by definition, necessary but not sufficient conditions, for even if China makes the yuan fully convertible, creates deep and liquid domestic bond markets, maintains a strong financial position and gains foreign investor confidence through legal-institutional reform, it will still need to overcome ―network externalities‖ currently favouring the dollar and the euro, the relative attractiveness of its ―peer competitors and ―politics‖. A lot will depend on the global political situation twenty years from now.

The following appears to be the most probable scenario: the yuan is set to become a major reserve currency, but it is not a foregone conclusion that it will emerge as the dominant reserve currency 20, 30 or even 40 years from now. For, despite heated theoretical debate, it is possible for two or maybe three major reserve currencies to co-exist. How stable such a system is would depend – as it always does – on the underlying economic, financial and political dynamics. The reserve currency structure (and the extent of a currency’s public and private international use, more generally) is likely to reflect the wider economic bi- or tripolar structure of the international economic system. 

Scholars & the rise of China (2010)

The Chinese economy has been growing at 10 percent annually since the beginning of economic reform in the late 1970s. If current trends hold, China will overtake the US in terms of economic size by 2025. In PPP terms, China will be world’s largest economy by 2020.

Economic analysts are divided about China’s road to economic preeminence. Some foresee dangerous speed bumps while others argue that interdependence can only smooth the ride. Despite China’s dramatic economic rise and increasing financial weight, the Sino-US economic-financial relationship can be best described as one of “asymmetric interdependence” – where Beijing finds itself in a position of “asymmetric vulnerability” – heavily skewed in Washington’s favor.

Several factors and developments could undercut China’s trajectory. Some analysts anticipate rising geo-strategic competition between China and the US. Historically, rising powers make use of their increasing influence, argues Aaron Friedberg, and increasing dependence on imported commodities could lead China to mitigate supply risks by seeking “regional preponderance,” thus increasing strategic competition between Beijing and Washington. From there, it’s a small step to construct a scenario where geostrategic competition leads to economic conflict weighing on Chinese economic development, as predicted by international relations realists such as John Mearsheimer. Other scholars are more optimistic about the possibility of a peaceful “power shift.” David Shambaugh, Robert Sutter and Bates Gill interpret much of Beijing’s international behavior as evidence that China is becoming a “responsible stakeholder” in an international system that, by and large, offers it benefits through an open trading system.

Some analysts anticipate political instability. The lack of post-Mao charismatic leadership and the declining strength of ideology have weakened the foundations of China’s political system, according to Harvard’s Roderick MacFarquhar. Increasing social activism could undermine Communist Party rule and regime stability. Again, from this analysis, it’s only a small step to come up with a scenario where political volatility and uncertainty weigh on economic growth. Andrew Nathan is more optimistic, arguing that the Chinese government has repeatedly proven its ability to respond to newly-emerging social and economic demands. Localized social unrest does occur, but given the combination of regime responsiveness and political control, he maintains that “a spark isn’t going to start a prairie fire in China.” Demographics ensure that demands for political reform will remain manageable as “the middle class won’t demand democracy when it is afraid of an even more numerous class of peasants and migrant workers, and therefore sees the authoritarian regime as a bastion of order against chaos.”

Lack of further reforms might undercut future growth. Pei Minxin, senior associate at Carnegie Endowment, suggests that partial economic reform has led to the emergence of a “mixed” state-centered system that perpetuates the privileges of the ruling elite. This system allows the elite to “tap efficiency gains from limited reforms to sustain the unreconstructed core of the old command economy – the economic foundation of its political supremacy.” He calls this a “trapped transition,” where the ruling groups have little incentive to pursue further reform. Absent economic reform, however, economic growth is bound to decline. A variation of this argument has been put forward by Woo Wing Thye, professor of economics at UC Davis, who suggests the challenge lies in sustaining economic growth while at the same addressing rising social inequality and accommodating increasing middle-class demands for political reform. Optimists, like Barry Naughton, point out that the government has repeatedly proven its ability to successfully deal with various economic challenges and that growth remains largely driven by large-scale economic and demographic forces that are relatively independent of government policy.

Naturally, other concerns range from environmental sustainability and viability of the current investment-heavy, export-led growth strategy to political event risk. According to the “bears,” all of these might create potentially non-negligible risks capable of undermining, or at least significantly slowing down, China’s rise. Nonetheless, short of a complete – and very unlikely – breakdown, a reasonable downside scenario is likely to mean 5 to 7 percent annual growth, rather than full-blown economic stagnation. China is unlikely to be thrown off-course in the way the Soviet and Japanese economies were. Structurally, China’s medium-term growth potential is, after all, significant. Unlike Japan in the 1980s, China is located far from the technological frontier, and its development model is based on a relatively high degree of economic openness, and unlike the Soviet Union, China is better suited to generate total factor productivity by importing foreign technology. Therefore, China will more likely than not continue to register at least 8 percent annual growth over the next decade.

China’s increasing economic size will provide Beijing with growing political, economic and financial influence. While China’s rise has greatly increased its power, this has thus far translated into limited bilateral influence vis-à-vis the US. China’s most important economic-financial lever of influence regarding the US is the threat to sell off its estimated $1.4 trillion in US treasury and agency debt.

Such a move would be costly for Beijing, however, economically and financially, China would shoot itself in the proverbial foot. First, the value of its holdings would decline, and higher US interest rates would weigh on the US growth outlook, hurting Chinese exports. Furthermore, unless it’s willing to accept renminbi appreciation, China would have to find other dollar assets to invest in, as rapid renminbi appreciation is hardly in China’s interest in terms of exports and dollar-denominated US debt holdings. However, if China does re-invest in dollar-denominated assets, this would presumably help ease financing conditions in other segments of the US financial system, potentially offsetting negative effect of higher rates in the treasury market on the economy. Second, if Beijing were to dump large chunks of US debt, it might disrupt financial markets in the short run. The medium-term impact would likely be manageable, as other official foreign buyers with close security ties to the US, including Japan and Gulf nations, would step in, albeit at higher interest rates. Last but not least, any politically motivated fire sale of US debt would trigger a severe political backlash – and not just from the US – as well as undermine China’s standing as a reliable financial investor and economic partner.

Financially, economically and politically, Beijing would pay a high price for significantly raising US borrowing costs and it would end up paying a higher price than Washington – simply reflecting the fact that China is much more dependent on the US than vice verssa. The US has access to a more diversified investor base, with which it maintains close political relations. The US market is substantially more important to China in terms of both exports and imports than vice versa – and the Chinese export sector is relatively more employment intensive.

China’s holdings of US debt do not lend themselves as a coercive instrument and are perhaps better regarded as a limited deterrent. Rising cross-border asset holdings and trade have increased interdependence, raising the costs of economic conflict for both China and the US. Nonetheless, the potential costs of a conflict due to China’s trade dependence are substantially higher for Beijing than for Washington.

However, if and when China reduces its export dependence on the US market relative to US dependence on the Chinese market, and if and when it adopts a substantially more flexible exchange rate regime, the balance of economic and financial power will shift dramatically in Beijing’s favor. Until then, Beijing has a far greater interest in preventing a wider economic-financial Sino-US conflict than Washington does.

Brazilian presidential elections - What should we expect? (2010)

Brazil has come a very long way since the 2002 presidential elections that almost pushed the country into default. This year’s presidential elections will be contested by two candidates with broadly similar views of how to manage the economy, making the elections a relative non-event – at least from a short-term market point of view. If the next government succeeds in implementing a medium-term fiscal adjustment (a big “if”), there is no reason why Brazil won’t be able to achieve 6% growth. This might go some way in silencing some of the critics who believe that Brazil does not belong in the BRICs.

Brazil has come a very long way indeed since the presidential elections eight years ago. Fernando Henrique Cardoso, first as finance minister, then as two-term president (1995-2002), defeated hyper-inflation. However, by the time of the elections, economic stabilisation remained incomplete on at least two accounts: the fiscal adjustment in the aftermath of monetary stabilisation was insufficient; and the political consensus in favour of stability-oriented economic policy was incomplete. The prospect of PT candidate Luiz Inacio (Lula) da Silva winning the elections exposed both weaknesses, triggering the 2002 “transition crisis” that almost pushed Brazil into default. The implementation of a decisive fiscal adjustment and the wholesale preservation of the inflation targeting regime based on central bank autonomy under Lula not only completed Brazil’s economic adjustment, but it also consolidated the political consensus in favour of economic and financial stability. It also happened to prove to be an astute and very successful political strategy, allowing the PT to make electoral gains in subsequent elections and Lula to be re-elected for a second term in 2006.

This year’s presidential elections, contested by two candidates broadly committed to the existing economic policy consensus, will be a relative non-event from a short-term market point of view. If PT candidate Dilma Rousseff wins, current macroeconomic policies will remain pretty much unchanged (“dirty float”, 4.5% inflation target, primary surpluses large enough to reduce net debt-to-GDP ratio). Rising government revenues on the back of strong economic growth will give the government sufficient flexibility both to increase expenditure in real terms and to maintain primary surpluses large enough to reduce the level of public debt.

If PSDB candidate Jose Serra wins, we may see a slightly tighter fiscal policy (read: more ambitious primary surplus targets). This might bring about lower interest rates and a weaker exchange rate – an objective put forward by Serra on more than one occasion. If tighter fiscal policy fails to achieve this, the big question will become whether a PSDB government would seek to achieve lower interest rates and a weaker exchange rate through direct government intervention. At present, it looks unlikely that Serra would rock the “boat of policy consensus” that has allowed Brazil to maintain course during one of the worst storms in recent memory, not least because the current course enjoys overwhelming political support. It is worth pointing out, however, that a Brazilian president faces relatively few obstacles when it comes to pursuing less disciplined monetary and fiscal policies.

Both presidential candidates believe that the state has an important role to play in economic development. Arguably, a PT administration would be less enthusiastic about liberalising structural reforms. Otherwise, it would have already implemented them, taking advantage of the president’s incredibly high approval ratings. A “new” Serra government, eager to leave its mark, would no doubt propose a more ambitious reform agenda (e.g. pension, tax reform). Serra is committed to an “efficient” state somewhat more circumscribed in its activities than it is in the vision of the PT. For all practical purposes, however, one ought not to get too excited about the prospect of wide-ranging structural reform under a Serra presidency. The structure of the Brazilian political system is such that it makes wide-ranging structural reform very difficult to implement on account of various “veto players” (e.g. fragmented, difficult-to-control legislature, powerful states, restrictive constitution), no matter how committed a government is to reform. Even under the best of political circumstances, reform will likely be limited and gradual.

What is to be done? The next government should focus its efforts on reforms that are politically achievable and economically effective. As we and others (Hausmann, Pastore) have argued, limited domestic savings are the most important factor constraining growth in Brazil. Therefore, first and foremost, the next government should seek to limit increases in current spending to below the level of nominal GDP growth and ensure that public-sector investment is narrowly focused on projects where the expected social returns exceed (appropriable) private returns. If the government believes that it can muster sufficient congressional support, it should also consider granting the central bank full legal independence and introducing an explicit fiscal rule committing Brazil to public debt reduction – similar to what Turkey has proposed recently, for instance. All of these measures would help boost savings (and investment).

Last year, we revised upwards our estimate of Brazil’s medium-term growth potential to 4.5% from 3.25%. Brazil needs to take advantage of the favourable global outlook (e.g. commodity prices, increasing oil exports) and strong economic growth momentum to raise domestic savings, thus allowing for a sustained increase in investment without weakening its medium-term external position. If the next government succeeds in implementing a medium-term fiscal adjustment, there is no reason why Brazil won’t be able to achieve 6% growth. This might go some way in silencing some of the critics who believe that Brazil does not belong in the BRICs.