Debt Ceiling, Default and the Dollar (2023)

If the debt ceiling is not raised or suspended by July, the risk of a U.S. government default will increase significantly. Raising or suspending the debt ceiling requires both the House and the Senate to pass a bill to this effect. The Senate is controlled by Democrats, and Senate Republicans are not likely to filibuster debt ceiling legislation (they allowed the adjustment to happen in 2021, and will do so again, as Republican senators are on average more moderate than their party colleagues in the House.) However, House Republicans are strongly committed to extracting budgetary concessions from the White House in exchange for raising the debt ceiling. On April 19, House Speaker Kevin McCarthy published his long-awaited plan laying out the conditions for Republican support for a debt ceiling adjustment. Among other things, the plan foresees capping spending at 2022 levels, rescinding unspent pandemic relief funds, and rolling back energy and tax credits contained in the Inflation Reduction Act, in exchange for a one-year (effectively, until March 2023) debt limit increase of $1.5 trillion. The Democrats, who hold a majority in the Senate, are never going to pass the Republican House bill in its current form, and it is unclear at this point if McCarthy can find the votes to pass the bill in the House. Instead, the proposal is meant to provide the basis for negotiations with the White House over budget policy and the debt ceiling. Meanwhile, the Biden administration insists on a “clean” debt ceiling adjustment (an adjustment without conditions) as a precondition for engaging in negotiations with House Republicans. This would significantly reduce Republican leverage and is therefore a non-starter. The White House and the House Republicans are engaging in a classic game of chicken.

What makes the politics of the debt ceiling more challenging than in the past is that the House leadership, which typically is in firm control of the legislative process, is weak, making it more uncertain that it will be able to approve a debt ceiling increase over the opposition of Republican congressmen, even if it wanted to. McCarthy was forced to make extensive concessions to Republican rank-and-file members, and especially the right-leaning Freedom caucus, to be elected speaker. These concessions weaken his control and make it relatively easy for Republican House members to propose and amend bills as well as making it easier to unseat or threaten to unseat the speaker, thus constraining his actions and room for maneuver. McCarthy was also forced to appoint two right-wingers to the powerful House Rules committee, which gives the Freedom Caucus and less moderate Republican House members greater sway over how a bill is steered through the legislative process, making it much more difficult for the leadership to ensure a speedy process and approval of any bill. Moreover, a very slim majority means that the Republican leadership cannot afford to lose more than four Republican votes if it wants to pass legislation over the opposition of Democrats. This further increases the leverage of Republican rank-and-file members at the expense of the House leadership. A bill that raises the debt ceiling would find the support of minority House Democrats. But a combination of weak leadership and difficult-to-control rank-and-file make the process of proposing, amending and voting on a bill more cumbersome and time-consuming and its outcome less certain. Members of the right-leaning Freedom caucus are especially well-positioned to torpedo any attempts to move any quickly and successfully through the legislative process. 

Concerned about the ability of the Republican leadership to pass debt-ceiling-related legislation against the will of its right-wing members, centrist Republicans and Democrats have begun to explore the possibility of supporting a so-called discharge petition. This would allow them to force legislation out of committee and onto the floor for a vote without support from the speaker or the consent of the relevant committee. A petition requires the support of 218 House members (out of 435 votes). Currently Republicans hold 222 and Democrats 213 seats. So if the Senate passes a bill to raise the debt ceiling and sends it to the House, only five Republicans would need to vote with Democrats to force a floor vote. The problem is that a discharge petition is a procedurally onerous and time-consuming instrument. It would therefore need to be approved soon in order for it to be operative by the time the Treasury exhausts extraordinary measures during the third quarter (see below). To pass legislation using a discharge petition would take around 2-3 months. In view of the likely July/ August X-date (the date when the Treasury will exhaust extraordinary measures and will be unable to meet all its obligations), the petition would need to be voted on in the next few weeks for it to help prevent a default.

The degree to which economic and financial dislocation will intensify as the X-date approaches will depend on how long markets expect any default to last and how forcefully the Federal Reserve intervenes to limit the financial fallout. If markets believe that the default is temporary, short-term bills will sell off, but longer-term bonds may rally. Increased economic and financial uncertainty would nevertheless lead to a sell-off of credit and equities. It is therefore possible, but far from certain, that financial instability will remain manageable as long as markets expect the default to be remedied imminently. If, on the other hand, markets believe that Congress is nowhere near an agreement as the X-date approaches or after a technical default has occurred, then the financial and economic consequences could be very dire. Last but not least, the greater the economic and financial distress that a technical default triggers, the more likely Congress will agree to take remedial action.

The Federal Reserve is not likely to intervene too forcefully until a default is imminent or has already occurred. In the event of a default, the Federal Reserve may decide to intervene to limit financial instability. The most obvious option is to purchase defaulted government debt and replace it with debt the U.S. government has not yet defaulted on. Federal Reserve decision-making will be a function of its mandate to maintain financial and economic stability, on the one hand, and the need to avoid providing direct financing to the government for fear of breaking the law and being accused of meddling in politics, on the other hand. On balance, the Federal Reserve will be reluctant to intervene in a manner that risks exceeding its legal mandate so as not to provoke a political backlash. However, should financial instability get out of hand, it would likely find a legal loophole that would allow it to take more forceful action, such as buying/ lending against defaulted debt etc. Hence, the greater the ensuing financial instability, the more likely the Federal Reserve will intervene. But again, it will be difficult for the Federal Reserve to intervene very forcefully until financial instability has increased sharply, or the government has fallen into technical default.

The base case remains an agreement between House Republicans and the White House, which will include some spending reform in exchange for a one-year extension of the debt ceiling, which would likely result in the issue reemerging right before the 2024 presidential election. We believe this scenario has a > 50% probability of materializing. Still, other less likely scenarios are possible:

1. The US raises or suspends the debt ceiling in such a way that the issue will not reemerge until after the 2024 presidential election (30%)

• McCarthy’s current proposal foresees a debt ceiling increase of $1.5 trillion, which would buy the Treasury about a year. (The CBO projects a deficit of $1.4 trillion for FY 2023.) If an agreement between House Republicans and the White House is reached under the current Republican plan, the issue would likely resurface just before the November 2024 elections, assuming that the Treasury would exhaust extraordinary measures within about six months.
• It is possible that both sides agree to a greater increase of the debt, past the 2024 elections. But such a proposal is currently not on the table and the White House would likely need to make significant concessions for the House to agree to a longer extension. The issue seems to play well with the Republican base and particularly with Republican House members in “safe” red seats, as it provides them with a tool to put political pressure on the administration in an election year 
• If, however, the centrists manage to pass a discharge petition, it is likely that they would opt for a longer extension until after the 2024 elections, as they would not want to deal with this issue in an election year. This is particularly true for centrist (moderate) Republicans at risk of facing right-wing challengers in the primaries. 

2. The US raises or suspends the debt ceiling in such a way that the issue reemerges before the end of 2023 (15%).

• This is not very likely, as Congress would have to pass contentious legislation twice. However, if the X-date were to arrive unexpectedly early in the midst of negotiations (which, admittedly, have not started yet) due to weaker-than-expected tax receipts (see below), both White House and House Republicans would have an incentive to support a short-term extension. Playing hardball that leads to a default in such a situation would be politically costly and undesirable, given that a deal is preferably to a default. 

3. The US fails to raise the debt ceiling and falls into a technical default (2%)

• Once extraordinary measures have been exhausted, a technical default will not automatically follow, provided the Treasury succeeds in prioritizing debt over other payments. If the Treasury were forced to take such desperate measures, the market reaction would be negative and increase the pressure to adjust the ceiling. The probability of a default is low, but it is not zero. Markets are of the same view: one-year credit default swap spreads have risen from 20 basis points in January to more than 100 basis points today. This is higher than in 2011 when an agreement was reached at the very last minute. 
• In principle, a technical default can be remedied quickly. But a technical default could have unanticipated second-round effects. For example, defaulted securities may not be accepted as collateral, which in turn leads to financial problems for repo transactions etc.. Economically, it may not make much sense to sell government debt securities at a huge discount as long as a default is expected to be remedied quickly. As suggested, much will depend on how markets assess the political outlook for reaching an agreement on lifting the debt ceiling. A possible but less likely scenario would be a dramatic financial market meltdown and a wide-spread destabilization. This is less likely because any technical default is likely to be remedied quickly, or because it would force the Federal Reserve to intervene very forcefully. 

The so-called X-date will likely materialize in late July or early August. In January, the Treasury estimated that it was not likely to exhaust extraordinary measures “before June”, even though it admitted that “considerable uncertainty” attached to its forecast. How soon the Treasury will run out of cash to stay current on all its obligations will depend on the amount of taxes. it will receive in the next few weeks, following the mid-April tax deadline. Tax receipts are difficult to forecast with any degree of confidence. If tax revenues remain strong and the Treasury makes it past the next mid-June tax deadline, when it is expected to see increased inflows, it is likely to have enough cash at hand to meet all its obligations until mid-July. The probability that due to weak tax revenues the X-date will arrive in June is low but not non-negligible (10%). The probability that the X-date will fall somewhere between mid-July and mid-September is high (70%). If the Treasury makes it to mid-September, the X-date would likely be pushed back further into late September or October given fresh cash inflows. Markets hold a similar view: T-bills maturing in late July and early August have higher yields and have become more difficult to trade, suggesting that markets see late July/ early August as the most likely time for a default.

The Treasury is unlikely to resort to unorthodox policies to avoid a default, because these moves would be legally risky and their economic-financial outcome would be uncertain. They would be challenged in court and would therefore fail to reassure markets sufficiently and unambiguously. The Treasury is likely to opt for payment prioritization, provided it is administratively and technologically feasible. One might argue that the greater the financial turmoil leading up to the X-date, the more likely the authorities will resort to gimmicky solutions. But they do not offer a bullet-proof solution, which will make the authorities reluctant to opt for them. They would be challenged in court and would therefore fail to reassure markets sufficiently and unambiguously. Equally importantly, extraordinary and legally questionable measures would reduce the pressure on Congress to fund such solutions, which is not desirable from the point of view of finding a sustainable solution. While unlikely to materialize, the list of unorthodox options includes:

One-trillion dollar coin: The Treasury could decide to have a high-denomination coin minted that is then deposited at the Federal Reserve. But this would be legally risky. The Federal Reserve might refuse to accept the coin, which would then force the Treasury to ask for an injunction. Other actors might also challenge the legality of such a decision. (Both Secretary of the Treasury Janet Yellen and Federal Reserve chair Jerome Powell have dismissed the coin option, if not necessarily its legality.) While it is far from clear that it would prevent a crisis given the concomitant legal uncertainties, from the Treasury’s point of view it would be preferable to a disorderly default. But institutionally, it would do great damage to the Treasury and the Federal Reserve, and the United States. Financially, the measure may fail to calm markets, given legal uncertainties. Economically, the credibility of the Federal Reserve would be shot due what effectively amounts to massive monetary financing of fiscal deficits, which might even exacerbate financial market instability. Politically, Congress would likely view such action as arrogating its prerogatives and as meddling in politics and contest such a move politically and legally. 

Invoking 14th amendment debt clause: The 14thamendment, and specifically the so-called public debt clause, says that the U.S. government debt shall not be “questioned”. Some legal scholars argue that the constitutional amendment renders the debt ceiling unconstitutional and that the government could therefore simply ignore it by invoking the 14th amendment. Other legal scholars disagree strongly. (The Obama and Clinton administrations held diverging views on this issue.) Invoking the 14th amendment would be fraught with similar legal, economic and political uncertainties as issuing a platinum coin. In addition, it might throw the United States into a constitutional crisis, which would do little to calm financial markets. The Biden administration is very unlikely to invoke the 14th amendment and will instead bet that increasing financial instability will lead to a political compromise. 

Instead of opting for such desperate measures, the Treasury is likely to opt for payment prioritization, provided it is administratively and technologically feasible. Although prioritizing payments on financial obligations offers only temporary reprieve, the Treasury is substantially more likely to choose this option to avoid an imminent financial default, provided it is practically feasible. (Both former Treasury Secretary Lew and current Treasury Secretary Yellen have expressed doubt that it is.) While such a decision may also be challenged in the courts, it would nevertheless buy time while not causing the same degree of institutional, reputational and political damage as the other options. Economically, prioritizing financial obligations would nevertheless reduce spending, weigh on economic growth and signal to investors that a default may be becoming increasingly likely. But by buying time for Washington to find a political solution, it will be less destabilizing financially than an outright payment default, which is why the Treasury is far more likely to opt for it than all the other “gimmicks”.

Resiliency of the US dollar as global reserve currency

The dollar is very resilient, if only because there is no viable alternative to it. A global reserve currency refers to the currency denomination of a central bank’s reserve assets, while an international currency refers to the use of a currency in international trade and finance and, more broadly, its private and public use as a store of value, means of exchange and unit of account. While a global reserve currency is generally also an international currency, this distinction is relevant, as central banks may reduce their dollar holdings, while this may leave unaffected the role of the dollar as an international currency. Even today, the share of the dollar in foreign-exchange markets far exceeds its importance as reserve currency.

The short-term impact of a technical default on the international role of the dollar would be limited, provided it does not lead to complete financial and political meltdown, which is quite unlikely. A long-lasting default would lead central banks to sell US government debt without necessarily moving out of the dollar. But with few willing buyers, they would only be able to sell so many debt securities. A short-term technical default would also lead central banks to rebalance their portfolios away from U.S. government bonds and especially short-term bills, if much less so from the dollar. This is so because international trade and financial transactions will continue to be conducted in dollars limiting the extent to which central banks will want to divest dollar-denominated assets. They may somewhat reduce the share of US government securities in their portfolio and move into dollar proceeds to US or international banks. 

In practical terms, it is also virtually impossible for the major central banks to buy alternative safe assets at a reasonable price, which is why the dollar share in global reserves would decline only very modestly in case of a technical default. The limited amount of global safe assets would limit dollar divestment. Global FX reserves amount to $12 trillion, of which $6.5 trillion are denominated in dollars, a large share of which is held in the form of U.S. government bills, notes and bonds. Dollar-denominated holdings amount to 60% and euro-denominated holdings to 20%, RMB holdings to less than 3%, which makes it virtually impossible for the dollar not to remain the dominant reserve currency. The amount of “safe assets” denominated in other reserve currencies is limited. Moreover, the euro and euro-denominated assets suffer from structural flaws due to an incomplete monetary and fiscal union, and the renminbi is not fully convertible. As a result, at least in the short- to medium-term, the dollar would remain the dominant international currency, even if central bank reserve managers decide to reduce their holdings of US government debt or even their dollar-denominated assets at the margin. Until a credible and practical alternative to the dollar emerges, the dollar will remain the dominant international reserve currency and the dominant international currency.

Promoting the RMB Will Limit, but not Quash, China’s Vulnerability to US Currency Sanctions (2023)

China, the world’s second largest economy, and Saudi Arabia, the world’s pivotal oil producer, have been in talks to promote greater use of the RMB in oil deals, while China and Brazil recently agreed to transact bilateral trade in their own currencies, sidestepping the dollar. The push for greater use of the renminbi in its foreign trade reflects Beijing’s desire to limit its geo-economic vulnerability vis-à-vis Washington, particularly for critical imports, such as oil.

The dollar remains the world’s dominant international currency. The dollar, the euro and the RMB account for 60%, 20% and 3% of global foreign-exchange reserves, respectively. In the Americas, Asia-Pacific, Europe and “the rest of the world,” the US currency also accounts for roughly 100%, 70%, 25% and 80% of export invoicing, respectively, while around 90% of all global foreign-exchange transactions are in dollars. It is also the currency of choice for international finance, dominating international and foreign currency banking claims and liabilities as well as foreign currency debt issuance.

Economist Barry Eichengreen and colleagues have spoken of the “stealth erosion” of the dollar’s international position. Since the creation of the euro in 1999, the dollar share of global foreign-exchange reserves has fallen from 71% to 59%. But this alleged erosion has benefitted currencies other than the RMB and the euro. And part of the decline can be explained by changes in currency valuations as well as financial return optimization rather than changes to liquidity preferences.

Dollar Dominance and Geo-Economic Power

Dollar dominance puts the US in the position of “mature debtor” (able to borrow in its own currency, limiting financial risks), while it forces China into the role of “immature creditor” (with its foreign claims largely denominated in dollars, increasing financial risks). Ironically, this means the debtor (United States) is more powerful and less vulnerable, while the creditor (China) is more vulnerable and less powerful. Given the role the dollar plays in the international financial system, US financial and economic shocks are quickly transmitted to the rest of the world, including China. (China’s export dependence on the United States exacerbates this vulnerability further.) Continued dollar dominance means that Beijing will have to continue to accept this disadvantage, which exposes it to dollar-related macroeconomic and financial risks.

Geo-economically, Washington derives political power from issuing the world’s dominant currency because others are reliant on the dollar as a means of international payment. Currency and financial sanctions can target individuals, companies, sectors or an entire economy. Granted, it is difficult to see how the United States would impose blanket, economy-wide dollar sanctions on China, barring the outbreak of military hostilities. Not only would this be economically very costly, the US would also encounter significant resistance from partners and allies. Washington is far more likely to resort to “smart” or at least targeted sanctions, as they are more cost-effective and provoke less opposition (and greater compliance) from third parties, whether neutrals, partners, or allies.

Sanctions targeting China’s critical imports and exploiting its strategic vulnerabilities, such as energy or foodstuffs, would be very cost-effective from an American perspective. Beijing is keenly aware of this vulnerability, and this is precisely why China has an interest in insulating its foreign trade, especially critical imports, from targeted dollar sanctions by promoting greater use of the RMB in its foreign trade.

Obstacles to RMB Internationalization

China meets some conditions necessary for the RMB to become a prominent international currency, including economic size and a rapidly growing stock of financial assets. It also has extensive foreign trade relations. But the RMB is not freely convertible and domestic capital markets are relatively underdeveloped. Concerns about the rule of law and China’s geopolitical relations also diminish the attractiveness of the RMB in the eyes of many foreign investors and governments.

In the face of challenges related to the much-needed reform of China’s economic growth model, continued financial fragility risks, and intensifying geo-economic and geopolitical competition, it is difficult to see how China will overcome these impediments. Moving toward full currency convertibility requires a successful reform of China’s economic model, the strengthening of the banking sector, and the development of deep and liquid domestic financial markets. Even if Beijing were able to implement all necessary reforms, which would no doubt enhance the attractiveness of the RMB, China would still need to build greater geopolitical trust.

Despite these challenges, Beijing remains keen to promote the RMB. The global financial crisis of 2008 provided the initial impetus to internationalize the RMB to make China less vulnerable to US economic and financial policies (and crises). The extensive financial sanctions that the US and its allies imposed on Russia in 2022 have provided Beijing with even greater incentives to reduce its vulnerability to potential currency sanctions. Beijing understands that challenging the dollar as the dominant international currency is not a realistic goal in the short- to medium-term. However, promoting greater use of the RMB in China’s foreign trade is a more viable proposition and would help make Beijing less vulnerable to US (and allied) geo-economic coercion.

Promoting the RMB to Reduce USD Dependence

Beijing will therefore continue to promote the use of the RMB for international trade purposes to reduce its vulnerability to dollar sanctions. This will help boost the international use of the RMB – without, however, jeopardizing the dominant role of the dollar. The share of RMB in global payments remains minimal (2%). Only 15% of China’s foreign trade was settled in RMB in 2021. This share is likely to rise, but this will only make a small difference in terms of global RMB use. While it will make Chinese trade less vulnerable to currency sanctions, it will only go so far in lessening China’s financial dependence on the dollar or its trade-related vulnerability.

While the lack of convertibility will hamper the broader internationalization of the RMB, a combination of further selective capital account liberalization and a further extension of bilateral and multilateral currency swap agreements will allow Beijing to conduct more of its foreign trade in RMB, thus providing an alternative to dollar-based trade. This will provide some degree of insulation from potential dollar sanctions. But greater use of the RMB in trade transactions will not lead to is significantly greater use in non-trade-related international (financial) transactions.

But not all trade must be transacted in RMB to afford China’s foreign trade greater insulation from dollar sanctions, provided the sanctions are targeted and selective. The recent agreement between Beijing and Riyadh to explore making greater use of the RMB in their bilateral trade illustrates this. Both countries have an interest in conducting a greater share of their bilateral trade in RMB so they can sidestep potential dollar sanctions. After all, Chinese energy imports would be an easy target for US sanctions. But this is unlikely to lead Saudi Arabia to want to conduct all bilateral trade with China in RMB or hold large amounts of RMB assets.

Conducting trade in RMB reduces the risk of currency sanctions. But it does not eliminate it. Washington could decide (or threaten) to impose dollar sanctions on any entity that engages in a transaction with a designated counterparty, regardless of whether it is conducted in dollars or not. This would represent a significant geo-economic escalation, and such a measure would be controversial politically as well as more difficult to enforce, given the lower level of visibility of non-dollar transactions from a US perspective. But otherwise, there is little that would prevent Washington from doing this. In other words, switching to RMB trade does not eliminate the risk of dollar sanctions to Chinese trade, although it significantly raises the political and administrative costs of enforcing dollar sanctions for the US government.

Beijing’s RMB internationalization policy therefore needs to be seen as part of a broader geo-economic competition with the United States, where both sides try to limit their economic and financial vulnerabilities (securitization), while holding the other party “at risk” (weaponization). The Chinese authorities will continue to push for the RMB to play a greater role in international trade by promoting greater cross-border RMB settlement. This will help enhance RMB use, but only up to a point.

After all, China’s top five import partners (Korea, Japan, US, Australia, and Germany) account for a full 1/3 of Chinese imports. Coincidentally, they also absorb 1/3 of Chinese exports. They are unlikely to conduct much of their bilateral trade with China in a less efficient and politically riskier currency like the RMB. So, unless China can force or nudge its major trading partners to transact in RMB, the currency’s use in international trade transactions will necessarily be limited.

Efforts to promote the RMB for international transactions will gain greater traction with countries that are at more immediate risk of dollar sanctions and with countries that supply critical goods to China, because their trade is much more likely to become the target of US currency sanctions. The use of the RMB for international private financial transactions will remain highly restricted due to limited RMB and capital account convertibility. The RMB will largely remain a “risk diversification play,” imperfectly insulating China’s trade against targeted US dollar sanctions. And it will not represent a threat to dollar dominance as long as Beijing fails to implement the necessary financial reforms and gain greater geopolitical trust.

Geopolitical Rivalry and International Currency Competition (2023)

Beijing’s continued efforts to promote the RMB will only partially mitigate China’s geo-economic vulnerability

> The dollar is and will remain the world’s dominant international currency for the foreseeable future. Issuing the world’s most widely used international currency provides Washington with significant geo-economic power.

> China’s efforts to promote the international role of the RMB have made only limited progress. Limited currency convertibility, underdeveloped domestic financial markets and adversarial geopolitics will continue to limit the attractiveness of the RMB. The creation of a digital RMB will do nothing to this equation. 

> Obstacles notwithstanding, Beijing will continue promote the wider use of the RMB in its foreign trade, particularly with countries who might conceivably become the target of US sanctions as well as countries that provide China with critical goods. The greater international use of the RMB will reflect ‘risk diversification,’ but will fail to undermine the central role of the dollar in international trade, let alone international finance.

See also: Promoting the RMB Will Limit, but not Quash China's Vulnerability to US Currency Sanctions

The Dollar Continues to Rule Supreme

The dollar remains the world’s dominant international currency.[1]The numbers speak for themselves. The dollar, the euro and RMB account for 60%, 20% and 3% of global foreign-exchange reserves, respectively. The dollar accounts for roughly 100%, 70%, 25% and 80% of export invoicing in the Americas, Asia-Pacific, Europe and ‘the rest of the world,’ respectively.[2] Remarkably, currencies other than the dollar and the euro account for only about 20% of Asia-Pacific trade, and this share includes the Japanese yen. The RMB does not even dominate regional trade. The dollar is on one side or the other of 90% of all global foreign-exchange transactions, the RMB is on less than 5%. (The two-way nature of international foreign-exchange transactions means that the total adds up to 200%.) Last but not least, the dollar dominates international and foreign currency banking claims and liabilities as well as foreign currency debt issuance, reflecting its dominant role in international finance. Respective RMB shares are 3% or less. 

Some analysts have spoken of a ‘stealth erosion’ of the dollar’s international position. Since the creation of the euro in 1999, the dollar share has fallen from 71% to 59%. But the alleged erosion has benefitted currencies other than the RMB and the euro.[3] Part of the decline can be explained by changes in currency valuations. And financial return optimization rather than changes to liquidity preferences may explain much of the rest of the decline. Finally, foreign-exchange reserve holdings capture only one, if admittedly, important aspect of the role of an international currency. Other indicators (see charts) suggest that the dollar is alive and well. For now, the dollar rules supreme. It may do so for lack of alternatives; but it rules supreme all the same. 

                                                    Foreign Exchange Reserves 

                                                    (By Currency)

The RMB Faces Major Obstacles

For a country to become the dominant international currency issuers, it needs to meet a number of conditions.[4] First, it needs to have large economy. A large economy engaged in international trade and finance initially provides the impetus for the international use of its currency. Economic size also determines the ability to issue sufficient amounts of safe assets that are held by other countries for liquidity purposes. At present, the United States accounts for 25% of global GDP, China for 18%.

Second, in addition to economic size, a reserve-currency-issuing country must have well-developed financial markets. Markets for government debt need to be deep and liquid so as to allow debt to function as a liquid safe asset. This also requires a stable financial system and a sophisticated financial infrastructure, including derivatives markets. The US treasury market remains the largest and most liquid pool of safe assets, and US capital markets are the most sophisticated in the world. The size of China’s government debt market is expanding rapidly, but liquidity remains very limited. Its capital markets are underdeveloped.

Third, an open capital account is essential for foreigners to raise funds and recycle surpluses in an unconstrainted way. The US capital account is open and the dollar is convertible. By contrast, access, and especially private-sector access, to China’s onshore financial market is restricted and the risk of tighter capital account restrictions is ever-present, given the fragility of China’s financial and, especially, banking system. Although foreign central banks have gained access to Chinese onshore financial markets, access for foreign private investors remains overall very restricted. This sharply curtails the international role of the RMB. Foreign holdings of government can serve as a proxy measure of capital account openness: around 40% of US treasuries are held by non-residents (USD 7 trillion); but foreigners hold less than 10% of government bonds (less than USD 300 billion). 

Fourth, ‘rule of law’ is important for foreigners to hold claims in and on another country. Rule of law generally is often defined as to comprise political stability, economic stability, the protection of property rights, and the predictability of public policies. Heavy-handed government intervention, including measures that prevent foreigners from accessing, or transacting in, onshore financial markets or otherwise interfere in markets in an unpredictable way, limit the appeal of holding a country’s currency. The United States has established a decent enough track record in this respect, recent measures targeting Russia notwithstanding. China, in part due to its economic and financial vulnerabilities and in part due to its state-interventionist economic model, is seen as more likely to intervene, and intervene more unpredictably.

Fifth, geopolitical relations are crucial. [5] A country that has an antagonistic relationship with another country will be reluctant to rely extensively (let alone predominantly) on this country’s currency to engage in international transactions or hold this country’s liabilities. Geopolitical alignment and allegiances matter. (The USSR held much of its international assets in London rather than Washington.) The dollar benefits from America’s wide-ranging and long-standing network of military allies and economic partners, which includes virtually all of the world’s major economies. By contrast, China has a far lesser network, which, other than Russia, does not include any major economy.

In short, China meets some of the conditions necessary for the RMB to become a prominent international currency, including economic size and a rapidly growing stock of financial assets, including government deb (see table). It also has extensive foreign trade relations. In fact, for 120 countries in the world, China is the largest trade partner. Yet the RMB makes up only a tiny fraction of international payments and foreign-exchange reserves. This is owed to the fact that the RMB is not freely convertible and domestic capital markets are relatively underdeveloped. Concerns about the rule of law and China’s geopolitical relations also diminish the attractiveness of the RMB in the eyes of many investors and governments.

Beijing’s Internationalization Policies Amount to a Fully-Fledged Strategy

China is facing difficult-to-overcome obstacles in terms of promoting the RMB. In face of the challenges related to the much-needed reform of its economic growth model, continued financial fragility risks, and intensifying geo-economic and geopolitical competition, it is difficult to see how China will be able to overcome these obstacles. Moving toward full currency convertibility would need to be preceded by a successful reform of China’s economic model, the strengthening of the banking sector, and the development of deep and liquid domestic financial markets. Even if Beijing were able to implement all the necessary reform, which would no doubt enhance the attractiveness of the RMB, China would still need to build greater geopolitical trust. [6]

Despite these challenges, Beijing remains very keen to promote the RMB. The global financial crisis of 2008 provided it with the initial impetus to internationalize the RMB in order to make China less vulnerable to US economic and financial policies (and crises). The extensive financial sanctions US and its allies imposed on Russia in 2022 has provided Beijing with even greater incentives to reduce its vulnerability to potential currency sanctions, if this was at all needed. Beijing understands that challenging the dollar as the dominant international currency is not a realistic goal in the short- to medium-term. However, promoting greater RMB in China’s foreign trade is a more viable proposition and would help make Beijing (slightly) less vulnerable to US (and allied) geo-economic coercion. 

Indeed, looking at Chinese policies over the past decade and a half, it is clear that Beijing has been keen to reduce its dollar dependence. The sum of individual policies amounts to a fairly cohesive, if thus far not very successful strategy to limit dollar dependence. Here is a list of the these policies.

> Allowing RMB overseas deposits and establishment of offshore RMB bond market (2003- )

> Creation of cross-border trade RMB settlement (2008)

> Selective, limited liberalization of capital account restrictions for inbound and outbound investment (e.g. Stock Connect Hong Kong), including providing greater access to its onshore bond markets to foreign central bank (2011- )

> (Modest) move towards more market-determined RMB exchange rate (2015)

> Establishment of bilateral and multilateral RMB swap lines (including the upgrading of the Chang Mai initiative)[7] and creation of a local currency settlement framework to facilitate current account and foreign direct investment transactions with selected countries (2009- )

> Creation of a Cross-Border Interbank Payments System (CIPS), which allows for clearing and settlement, as a possible future substitute for SWIFT (2015)[8]

> Provision of RMB-denominated financing in the context of official and quasi-official bilateral lending, including the Belt and Road Initiative (2013) and the newly established Asian Infrastructure Investment Bank (2016)

> Successful diplomatic effort to include RMB in the IMF’s special drawing rights currency basket currency basket (2016)

> Ongoing efforts to move toward a more market-based, more sophisticated and robust financial and banking system (1999 - )

> Promotion of onshore commodity and commodities futures markets with the goal of turning them into global benchmarks (e.g. oil futures contracts) (2018)

> Creation of a central bank digital currency (or e-yuan), with a view to extending it cross-border (2022)

E-Yuan Won’t Be a Game-Changer

If the RMB cannot dethrone the dollar, might the so-called ‘e-yuan’ do so? No. First of all, private digital money is not going to replace national money. Private digital money does a poor job in terms of fulfilling the store of value (excessive volatility), unit of account (limited market pricing) and medium of exchange functions (high transactions costs). At least, it does so for the time being. Moreover, national governments will be reluctant to see their monetary sovereignty undermined and related benefits appropriated by private markets. Risks related to terrorism financing, money laundering, tax evasion, cyberattacks and financial instability provide further incentives for national regulation, sharply circumscribing the use of private crypto-currencies, including for international transaction purposes.

Central bank digital currencies (CBDC), or public crypto-currencies are a slightly different matter. Relying on ‘crypto’ technology, they can help lower transaction costs.[9] CBDCs raise many challenges in terms of their impact on traditional payments systems, credit creation and bank disintermediation as well as the effectiveness of monetary policy. Putting these aside, extending a CBDC like the e-yuan beyond a country’s border raises many of the same issues that plague the international role and standing of the regular RMB. Granted, the e-yuan may allow for lower transaction costs and may facilitate transactions between any two currencies, while sidestepping the need to “trade through” a liquid and widely used international currency and related infrastructure (such as SWIFT). But it needs to meet the same condition as a fiat international currency: rule of law, political and economic stability, deep and liquid financial markets, currency convertibility and geopolitical trust. And if the economic and geo-economic gains outweighed these concerns, it is difficult to see how the United States would stand idly and not create an e-dollar to dampen the relative attractiveness of the e-yuan.

In brief, the emergence of digital currencies, including central bank digital currencies, does not do away with the importance of economic size, deep and liquid financial markets, currency convertibility and geopolitical trust.[10] If anything, an extension of the e-yuan for international use might allow Beijing to exert even greater control over the modalities of its use, given the even greater centralized control a centralized digital technology affords the issuer. This turns it into an even more efficient geo-economic tool than traditional international fiat currencies. All of this may or may make the e-yuan more attractive to some smaller economies, but it is unlikely to make the -e-yuan more attractive in the eyes of actual and potential antagonists.

Beijing Remain Keener Than Ever to Boost the Role of the RMB in its Foreign Trade

The self-reinforcing dynamics of geopolitical and economic alliances as well as the prevalence of network effects and the dollar’s incumbency advantage will sharply curtail the international role of the RMB So will China’s instability to open its capital account. But the large-scale US and allied financial sanctions imposed on Russia following the invasion of Ukraine have further increased Beijing’s incentives to promote wider RMB use in its foreign trade. Beijing will therefore continue to promote the use of the RMB for international trade purposes in order to reduce its vulnerability to dollar sanctions. This will help boost the international use of the RMB – without however jeopardizing the dominant role of the dollar. The share of the RMB in global payments remains minimal (2%). Only 15% of China’s foreign trade is settled in RMB in 2021. [11] This share is likely to rise, but this will only make a small difference in terms of global RMB use (see chart). While this will make Chinese trade less vulnerable to currency sanctions, it will only go so far in terms of lessening China’s financial dependence on the dollar or its trade-related vulnerability. 

Economically, issuing an international currency generates both benefits and economic costs.[12] Among other things (see table), the role of the dollar as the dominant international reserve currency allows America to borrow in its own currency and on more favorable terms, lessening balance-of-payments constraints. Dollar dominance also translates into the US being a ‘mature debtor’ (being able to borrow in its own currency, limiting financial risks), while it forces China into the role of an ‘immature creditor’ (with its foreign claims largely denominated in dollars, increasing financial risks). Ironically, this makes the debtor (United States) more powerful (and less vulnerable) and the creditor (China) more vulnerable (and less powerful). Last but not least, US financial and economic shocks are quickly transmitted to the rest of the world, including China, given the role the dollar plays in the international financial system. (China’s export dependence on the United States exacerbates this vulnerability further.) Continued dollar dominance means that Beijing will have to continue to accept this disadvantage, which exposes it to dollar-related macroeconomic and financial risks. [13]

Geo-economically, issuing the world’s dominant international currency provides Washington with political power due to others’ reliance on the dollar as a means of international payment. [14] The ability to effectively prevent targeted entities from engaging in dollar-based international transactions provides Washington with a powerful geo-economic instrument, if not always to prevent the targeted party from engaging in international trade, but at least to substantially increase the costs of doing so.

Currency and financial sanctions can target individuals, companies, sectors or an entire economy. Granted, it is difficult to see how the United States would impose blanket, economy-wide dollar sanctions on China, barring the outbreak of military hostilities. Not only would this be economically very costly to the United States (and hence relatively inefficient), it would also encounter significant resistance from partners and allies. Hence Washington is far more likely to resort to “smart” or at least targeted sanctions, as they are more cost-effective and provoke less opposition (and greater compliance) from third parties, whether they be neutrals, partners, or allies.[15] Sanctions targeting China’s critical imports and exploiting its strategic vulnerabilities, such as energy or foodstuffs, would be more cost-effective from an American perspective. Beijing is keenly aware of this vulnerability and this is precisely why it has an interest in insulating its foreign trade, and especially critical imports, from targeted dollar sanctions by promoting the greater use of the RMB in its foreign trade. 

Conducting Trade in RMB Will Help, But Is No Panacea

While the lack of convertibility will hamper the broader internationalization of the RMB, a combination of further selective capital account liberalization and a further extension of bilateral and multilateral currency swap agreements will allow Beijing to conduct more of its foreign trade in RMB, thus providing an alternative to dollar-based trade ‘just-in-case,’ or a spare tire if you will.[16] This may not be economically efficient (and more costly for transacting parties), but it provides some degree of insulation from potential dollar sanctions. The greater use of the RMB in trade transactions will not, and to a large extent cannot, lead to a significantly greater RMB use in non-trade-related international (financial) transactions. This will put a natural limit on the extent of RMB Use. (Tellingly, whenever countries draw on the PBoC swap lines, they immediately convert the RMB into USD or EUR, underling the continued dominance and centrality of the dollar in terms of international liquidity.) 

Moreover, RMB use can only expand so far, for countries that run a deficit with China on a continuous basis will find it difficult to raise RMB, and countries (or rather private sector agents) that run surpluses may be reluctant to end up holding RMB assets, given limited opportunities to recycle their holdings. Furthermore, not all trade needs to be transacted in RMB to afford China’s foreign trade greater insulation from dollar sanctions, provided the latter are targeted and selective. The recent agreement between Beijing and Riyadh to make greater use of the RMB in their bilateral trade illustrates this. Both countries have an interest in conducting (a share of) their bilateral trade in RMB in order to be able to sidestep potential dollar sanctions. After all, Chinese energy imports would make for an easy target for US sanctions. But this is unlikely to lead Saudi Arabia to want to conduct all bilateral trade with China in RMB or hold RMB onshore assets.

In this context, it is worth pointing out that conducting trade in RMB reduces the risk of currency sanctions. But it does not eliminate it. Washington could decide to (threaten to) impose dollar sanctions on any entity that engages in a transaction with a designated counterparty, regardless of whether it is conducted in dollars or not. This would represent a significant geo-economic escalation, and such a measure would be controversial politically as well as more difficult to enforce, given the lower level of visibility of non-dollar transactions from a US perspective. But otherwise there is little that would prevent Washington from doing this.

As long as third parties depend on the dollar to a significant extent, they will not want to risk being excluded from dollar transactions or have the American government come after them. The costs of not dealing with a designated party will typically be much smaller than the costs of being excluded from future dollar-based international transactions or related penalties. In other words, switching to RMB trade does not eliminate the risk of dollar sanctions to Chinese trade, but it significantly raises the political and administrative costs of enforcing dollar sanctions for the US government. Beijing’s RMB policy therefore needs be seen as part of the broader geo-economic competition between the United States where both sides to limit their economic and financial vulnerabilities (securitization), while holding the other party ‘at risk’ (weaponization). 

The Chinese authorities will continue to push for the RMB to play a greater role in international trade by promoting greater cross-border RMB settlement. This will help enhance RMB use, but only up to a point. China’s top-5 import partners (Korea, Japan, US, Australia, and Germany) account for a full 1/3 of Chinese imports. Coincidentally, they also absorb a full 1/3 of Chinese exports. They are unlikely to conduct much of their bilateral trade with China in a less efficient and politically riskier currency like the RMB. So unless China is able to force or nudge its major trading partners to transact in RMB, its use in international trade transaction is naturally circumscribed. And this is even before accounting for the RMB’s far less user in international financial transactions. Even if Beijing were to settle a full 2/3 of its foreign trade in RMB (and only in RMB), which is highly unlikely, its share in international as well as international trade transactions would remain below 10%. 

Efforts to promote the RMB for international transactions will gain greater traction in the case of countries that are at more immediate risk of dollar sanctions as well as with countries that supply critical goods to China, for their trade is much more likely to become the target of US currency sanctions. The use of the RMB for international private financial transaction will remain highly restricted due to limited RMB and capital account convertibility. The RMB will largely remain a ‘risk diversification play,’ imperfectly insulating China’s trade against targeted US dollar sanctions. And it is not going to represent a threat to dollar dominance.

[1] BIS, Dollar debt in swaps and forwards, Quarterly Review, 2022, BIS, The dollar, bank leverage and real economic activity, Working Paper 847, 2020, BIS, US dollar funding, CGFS Paper 65, 2020, BIS, Dollar invoicing, global value chains and the business cycle dynamics of international trade, Working Paper 860, 2020,BIS, Global dollar credit, Working Paper 483, 2015
[2] Federal Reserve, Is the international role of the dollar changing? FEDS Notes, 2021
[3] IMF, The stealth erosion of dollar dominance, Working Paper 58, 2022
[4] Markus Jaeger, Yuan as a reserve currency, Deutsche Bank Research, 2010
[5] Federal Reserve, Geopolitics and the US dollar’s future as a reserve currency, International Finance Discussion Paper 1359, 2022
[6] Federal Reserve, Geopolitics and the U.S. dollar’s future as a reserve currency, International Finance Discussion Papers, 2022
[7] IMF, Evolution of bilateral swap lines, Working Paper 210, 2021
[8] Lawfareblog, Why China’s CIPS matters (and not for the reasons you think), 2022
[9] BIS, The digitalization of money, Working Paper 941, 2021
[10] Eswar Prasad, The future of money (Cambridge 2021)
[11] PBoC, RMB Internationalization Report, 2021
[12] Elias Papaioannou and Richard Portes, Costs and benefits of running an international currency, European Commission European Economy Economic Paper 348, 2008; Pierre-Olivier Gourinchas and Helene Rey, From world banker to world venture capitalist, NBER Working Paper 11563, 2005
[13] BIS, Global dollar credit, Working Paper 483, 2015; BIS, The dollar exchange rate as a global risk factor, Working Paper 695, 2018; BIS, US dollar funding, CGFS Paper 65, 2020
[14] Henry Farrell & Abraham Newman, How global economic networks shape state coercion, International Security 44 (1),;2019
[15] Daniel Drezner, Sanctions sometimes smart, International Studies, 13 (1), 2011
[16] Barry Eichengreen et al., Is capital account convertibility required to for the RMB to acquire reserve currency status? Center for Economic and Policy Research, Discussion Paper 17498, 2022

Size matters – USD and RMB as a reserve currencies (2015)

The rise of the RMB as a reserve currency has garnered a lot attention lately. The Chinese authorities have taken numerous measures aimed at internationalising the RMB and making it “freely usable”, the latter being a pre-condition for a currency to be included in the IMF’s SDR basket (e.g. opening domestic bond and FX market to foreign central banks; making, or attempting to make, the exchange rate more flexible).

At present, a little more than 1% of global FX reserves are invested in the form of RMB-denominated assets.  Some analysts predict that as much as USD 1 tr of global FX reserves could shift into RMB once it is included in the SDR basket. This estimate is presumably based on the likely weight of the RMB in the SDR basket. The share of RMB assets in global (ex-China) FX reserve holdings would then rise to more than 10%. This may well be the share of reserves central banks will want to hold in RMB, but is there a sufficient supply of RMB assets?

Foreign central banks invest in safe and liquid assets. In practice, this means that the bulk of FX reserves is invested in high-grade, central government debt issued by advanced economies. Central banks are far less keen to invest sizeable amounts in higher-risk and/ or less liquid assets. Not surprisingly, almost 2/3 of global FX reserves are denominated in USD and another 20% in EUR. Foreign official institutions held about USD 4.8 tr worth of US debt securities as of the middle of 2014, of which USD 3.8 tr were US treasuries. 80% of foreign official holdings of US debt securities are concentrated in US treasuries. As the foreign official sector includes sovereign wealth funds, central banks are likely even more heavily invested in treasuries. 

Credit risk matters, as the decline of foreign official holdings of US agency debt illustrates. Today foreign official institutions hold a mere USD 400 m of agency debt, compared to almost USD 1 tr in 2008. The financial distress Fannie and Freddie experienced during the global financial crisis seems to have scared foreign central bank away. Size necessarily matters. Outstanding US treasuries amount to USD 13 tr and marketable treasuries to almost USD 11 tr. Japan comes relatively close second with USD 8.2 worth of government debt securities outstanding. Only six other countries have central government debt exceeding USD 1 tr (UK, Italy, France, Germany, Spain and China). If one looks at the size of the total bond market, the difference is even starker. With global FX reserves amounting to USD 11.5 tr, the bulk of these reserves will necessarily need to be invested in the US treasury market given its superior size and liquidity as well as, generally, creditworthiness.

Leaving aside liquidity, which is an issue in the Chinese government debt market, there may not be enough RMB assets out there for central banks to invest in if USD 1 tr is to be shifted into RMB. Assuming that 90% of RMB-denominated reserve holdings are invested in central government debt, foreign central banks would end up holding 50-60% of the USD 1.7 tr market. While foreign holdings in the US and Germany are roughly at similar levels, it is far from obvious that Chinese policy-makers or foreign central banks for that matter would feel comfortable with this given the potential implications for domestic interest rates and the exchange rate as well as asset prices and liquidity. This is especially salient in a context where the investor base would largely consist of domestic commercial banks, on the one hand, and foreign central banks, on the other.

No doubt, structural factors support the emergence of the RMB as a reserve currency. In the short term, however, a dearth of RMB assets will make a very substantial shift of FX reserves into RMB difficult. China’s bond markets have been growing vigorously over the past decade. And even though economic growth is slowing, there certainly is room for the central government to issue more debt. It will therefore take time before 10% of global FX reserves are invested in Chinese assets. 

Equally important, if the demand for high-grade assets outpaces the ability of the dominant reserve currency country to provide them without jeopardising its financial strength, the system may well be inherently unstable (so-called Triffin dilemma). According to the CBO, US government debt will remain stable as a share of GDP until the end of the decade and then increase under the so-called “current baseline scenario”. (This scenario assumes no policy changes.) True, the US net international investment position has deteriorated sharply in the past few years. Ironically, this has been due to a strengthening economic outlook and rising US asset prices, including the USD. Net fiscal and external requirement will ensure debt sustainability and maintaining confidence in the USD as a reliable reserve currency over the short- to medium-term, but perhaps not the long term. Meanwhile, the demand for safe, liquid assets denominated in a convertible currency is set to outpace the US ability or willingness to provide such assets. Central banks will have an incentive to move into riskier USD assets or move into non-USD assets, including RMB assets. (The slew of sovereign credit downgrades in the eurozone and a declining of German government debt securities will not offer much of an alternative, either.)

In short, the RMB is set to become a more important reserve currency, as China’s sheer economic size and importance in world trade continues to grow, as the demand for reserve assets increases and as China increased the supply of high-grade RMB assets. Like Japan and Korea before, China will gradually remove capital controls and put in place stable, liquid financial markets. This will also facilitate the RMB’s rise. It would be very surprising, however, to see the RMB share in global FX reserves reach even 10% in the near-term given the limited size and liquidity of high-grade RMB assets.

Political economy of Sino-US relations (2012)

US fiscal deficits and Fed quantitative easing have led to a lot of disquiet in Beijing. The Chinese government is worried about financial losses on its increasing US asset holdings and the nefarious consequences a super-loose monetary policy will have on its economy. With US unemployment forecast to remain high and China’s global and bilateral trade surplus set to widen, tensions over trade imbalances will not go away anytime soon. Neither, therefore, will the risk of trade protectionism or even a trade war. 

Fears of a full-blown Sino-US trade war are over-blown, at least in the short term. It does not focus on technical, legal and procedural obstacles that constrain or facilitate such a conflict. Instead, it analyses the economic-financial vulnerabilities and incentive structure both sides face in terms of escalating the present conflict over imbalances and RMB valuation into a broader trade war. It concludes that while both sides have an interest in avoiding a costly conflict, the US lesser vulnerability relative to China will make a full-blown trade war over the next couple of years very unlikely. However, as a rapidly growing China becomes less dependent on the US market, the risk of a conflict will increase tangibly – unless the bilateral imbalance issue is resolved. 

China benefits greatly from its access to the US market. It affords China to pursue an export-led growth strategy, underpinned by sizeable domestic and foreign investment in the tradable sector and supported by an undervalued exchange. It also provides China with access to advanced technology supporting productivity growth. Appreciating its exchange rate would make exports less competitive. All other things being equal, it might reduce economic growth at the margin due to a less favourable contribution from net exports and, possibly, lower investment in the tradable sector. However, it would also shift resources away from the tradable sector and might lead to increasing investment there. The net effect of RMB appreciation on employment would not necessarily be negative, for the non-tradable service sector tends to be more employment-intensive than the relatively more capital-intensive, export-oriented manufacturing sector. The relative strength of the growth and employment effects naturally depend on the magnitude and speed of the appreciation. It is nonetheless worthwhile noting that current account surplus adjustments do not necessarily have a negative impact on growth. 

Why then do the Chinese authorities seem so adamantly opposed to RMB appreciation? The uncertainty RMB appreciation would create is something China is concerned about, especially as regards its effects on employment in the coastal areas with its large pool of migrant labour. Thus far China’s economic strategy has been very successful. Not surprisingly, decision-makers prefer a very gradualist approach to economic reform. Rightly or, very likely, wrongly, there is also concern that acquiescing to US demands might get China into trouble similar to Japan after the Plaza and Louvre Accords of the 1980s. Finally, Beijing may be hoping that a more domestically-oriented growth strategy will bring about adjustment without significantly adjusting the RMB, for instance, via moderately higher inflation and concomittant real exchange rate appreciation. Whatever the precise reasons, Beijing is visibly keen to defend the status quo. 

The US benefits from large Chinese trade surpluses, allowing it to consume more than it produces, while finding in China a ready and affordable source of financing. Chinese demand and, more specifically, Chinese official demand for high-grade, liquid fianncial assets has helped keep US government financing costs down. (How many basis points this is worth is subject to intense debate.) On the other hand, a large bilateral deficit has a negative effect on US growth and employment. The Peterson Institute, which has taken a decisive stance on this issue, estimates that a 20-25% appreciation of the yuan would reduce the US current account deficit by USD 50-120 bn, assuming that other Asian currencies are similarly revalued, and create upwards of 500,000 jobs. This would reduce the US unemployment rate by one percentage point. The IMF estimates that US trade with China trade subtracted an annual 0.17 ppt from US growth in terms of negative net exports during 2001-08. Moreover, although the US ability to run up large debts is considerable given its reserve currency status, it is not infinite. If left uncontrolled, debt accumulation could jeopardise US economic and financial stability at some point in the future. It will make the US and the US government increasingly dependent on foreign financing. In short, the US would benefit from a RMB appreciation, but it would certainly not resolve all its economic woes. Nonetheless, Washington is eager to change the status quo. 

In this context, it is useful introduce some concepts from strategy and diplomacy as well as game theory. It is useful to distinguish between “coercion” and “deterrence”. An agent A exercises coercive power by getting B to do x by threatening y or promising z. An agent A deters B by persuading B that the costs of a given course of action will outweigh its benefits. In other words, deterrence aims to persuade the opponent not to an initiate action, actively or passively, by threatening to impose or raise the costs of this action, or by rewarding the other party for not doing so. Deterrence comes in two forms: (1) punishment by raising costs of an action and (2) denial of objectives by raising the costs in such a way as to offset to the coveted benefits of an action. Finally, deterrence is associated with maintaining the status quo, while coercion is usually associated with changing it. These concepts can be profitably applied to Sino-US relations. 

The Sino-US economic-financial relationship is best described as one of “asymmetric interdependence” (and hence “asymmetric vulnerability”), heavily skewed in Washington’s favour for now. Rising cross-border asset holdings and trade have increased interdependence, raising the absolute costs of economic conflict for both sides – but the costs of a conflict are substantially higher for Beijing than for Washington. This is so because the US market is substantially more important to China in terms of both exports and imports than vice versa. Chinese exports are also relatively more employment intensive than US exports. Last but not least, China is more dependent on US technology imports than the US is on lower- tech Chinese imports. This severly diminishes China’s ability credibly to deter, let alone coerce, Washington with the help of its vast holdings of US debt and its continued financing of US current account and fiscal deficits. China’s relative greater trade vulnerability also accounts for Washington’s coercion potential. Washington would like to reduce its bilateral current account deficit with China and it would like to see this happen as a result of China adjusting its policies, notably RMB appreciation. Excluding “extraneous” measures (e.g. making threats and promises in non-economic areas), the US can take, or threaten to take, measures aimed at offsetting the benefits China derives from RMB undervaluation (denial) or at raising the costs above the benefits (punishment) in order to coerce China into appreciating its currency (e.g. tariffs, WTO case, meeting currency intervention with currency intervention, intellectually property rights). These measures differ in terms of their legal implications and economic effectiveness. But they all aim to raise the costs of Chinese exports or the costs of maintaining an inflexible exchange rate (in case of counter-veiling currency intervention), thus directly or indirectly leveraging China’s dependence on the US market. China would face significant economic costs in the event of incrementally rising US trade protectionism, much greater than the costs the US would incur even if China responded in a tit-for-tat manner. After all, Washington benefits from “escalation-dominance” as long as game remains confined to economic-financial sphere. 

What about Beijing’s deterrence potential? Deterrence seeks to preserve the status quo. China possesses an only limited economic-financial deterrent potential vis-à-vis the US. China’s influence has undoubtedly increased dramatically due to intensifying trade and investment linkages, especially vis-à-vis other countries. Ironically, its vulnerability has also increased due to greater openness and exposure to the international economy, at least vis-à-vis the US. (Just compare 1980 and 2010.) China’s trade integration and ownership of foreign assets have therefore become both a source of influence and vulnerability. In relations with the US, it translates primarily into greater relative vulnerability. Therefore, Beijing has a greater interest in avoiding a trade conflict than Washington. Being more dependent on trade than the US, China’s financial deterrence potential is often thought to derive mainly from both its large holdings of US government debt and its continued financing of the US federal government deficit. However, a threat to “boycott” Treasury auctions or dump US debt in the secondary market would not be credible. Similar to the threat to impose counter-veiling trade measures, it would only function as a deterrent if China were, irrationally, willing to incur higher costs than Washington. By triggering a rise in US interest rates, and possibly even financial market dislocation, such actions would push up US interest rates, slow US growth and Chinese imports – the very outcome, Beijing seeks to avoid. Furthermore, China would have to find other dollar assets to invest in, unless it is willing to accept RMB appreciation – and too rapid a RMB appreciation is again the one thing Beijing is keen to avoid. Second, the US has access to a more diversified investor base, with parts of which it maintains close political relations (e.g. Japan, Middle Eastern oil exporters) than Beijing has markets to invest in. Last but not least, any politically motivated fire sale of US debt would trigger a very severe political backlash – and not just from the US. The White House would find it very difficult to control a revanchist Congress dead-set on trade sanctions. 

All considered, China’s deterrent potential is limited – at least as long as it remains unwilling to accept RMB appreciation. Sino-US economic-financial-diplomatic action can be modelled as a sequential, perfect information, non-zero-sum game, where Washington might well end up making a strategic commitment (in game theory terms) by threatening and subsequently implementing trade sanctions if Beijing does not appreciate its currency. This might appear irrational from a purely economic benefit/ cost point of view. Free trade is a non-zero-sum game, after all. However, if the White House were forced into a brinkmanship strategy by Congress, China would be better off backing down, for both protectionist counter-measures and financial retaliation lack credibility, as both kinds of responses would undermine the very thing China is keen to preserve: unfettered access to US markets and solid US growth. This is so quite independent of the likely retaliatory measures Washington would take in response to Chinese retaliatory action. Faced with US trade sanctions, it would be irrational for Beijing to opt for anything other than a tension-reducing RMB appreciation. This this would allow Beijing to remain in control of its economic policy and stick with gradualism. The costs are also likely to be much smaller than the potential costs incurred in the event of trade conflict escalation. It would seem eminently rational for Beijing to back down and pre-empt US measures by letting its currency appreciate, modestly but gradually. It may, however choose to engage in a temporary tit-for-tat trade strategy to test Washington’s determination to pursue a gradual turning the screw strategy vis-à-vis China, thereby hoping to deter further US measures. However, if Washington calls it bluff, Beijing will be better off backing away from a politically more difficult-to-control trade conflict. 

This simple, abstract game-theoretical framework may have to be enlarged in order to include Chinese “linkage” strategy. Economic-diplomatic interaction takes place in a much broader bilateral (and multilateral) framework. In game-theoretic terms, Beijign and Washington play multiple games simultaneously. Excluding extreme and extraneous measures such as expropriation or the freezing of financial assets, the broader relationship does give Beijing a greater deterrence potential than a purely economic-financial analysis suggests. If China makes co-operation in areas considered vital by Washington (e.g. Korea, Iran) conditional on Washington not taking more aggressive action on the bilateral imbalances issue, Washington may be deterred. The bottom line is that even if a broader perspective is adopted, a trade war would be avoided, for Washington or at least the White House will work very hard to avoid it in the first place and prevent Congress from forcing it into an aggressive first move. Nonetheless, a limited escalation is possible, if Congress succeeds in making a first move and China temporarily chooses a tit-for-tat strategy to verify US commitment. An outright “war” is unlikely. Several safety valves exist that make this so. 

First of all, Beijing may simply resume a gradual, controlled nominal appreciation of the RMB against the USD. Even if bilateral imbalances remain sizeable, this should allow the Treasury to manage political pressure from Congress more easily. From China’s point of view, less risk attaches to this course of action than allowing the US to take the initiative. In the context of shifting towards greater domestic-consumption-led growth, which given the rapidly increasing size of the economy, will sooner or later become inevitable, this will be a desirable “exit strategy” – and may yet be embraced by Beijing. 

Second, the imbalances may resolve themselves, via the real appreciation of the RMB, making a nominal appreciation unnecessary. Greater focus on domestic growth in the context of the next five-year economic plan (2011-15) may help limit the overall current account deficit to levels similar to what the Chinese authorities forecast. The IMF forecasts the Chinese current account to move back to 8% of GDP by 2015 (or USD 800 bn) from last year’s 300 bn deficit. The Chinese authorities, by contrast, see it settling down at 4% of GDP. This may not be enough to eliminate frictions altogether, but 4% of GDP, incidentally, would be close to the quantitative targets that the Treasury floated a few months ago. However, a lot will depend on what happens to US unemployment and growth. Most likely, the bilateral trade balance will remain a cause of friction. 

Third, even if the bilateral trade imbalance remains significant and Beijing does not revalue the RMB, the US administration may continue to hold the line in order gain support for policies whose success depend on Chinese co-operation (e.g. Iran, North Korea). 

Fourth, if the trade deficit remains large and if Congress succeeds in pushing the administration to take more forceful action and if the president decides not to veto legislation, then forceful US coercive action will take place. While this may lead initially to a tit-for-tat game, an escalation to the point of a full-blown trade war remains unlikely, for Beijing will have a huge incentive to avoid a broader confrontation. From China’s perspective, it would preferable to accept RMB appreciation rather than ultimately risk a trade conflict that would end up imposing higher costs on China than a largely, self-managed RMB appreciation. 

Naturally, the wild card remains Congress and its ability to override presidential vetoes and force the White House to take action against China.If Congress is the wild card on the US side, Chinese public opinion and “saving face” may be the wild card on the Chinese side – both of which might throw a spanner into rational, diplomatic game. If raison d’etat, rationality and pragmatism prevail in both Beijing and Washington, recurring tensions will remain manageable. This is based on the assumption that both parties seek to maximise employment and growth rather than purchasing power. Because Washington would incur substantially lower costs in the event of a bilateral trade conflict, it is in a position to coerce a rationally acting China in to making concession on RMB valuation. Naturally, Washington may refrain from taking action, lest Beijing refuses co-operation in other games Washington and Beijing are engaged. In reality, however, domestic forces may lead a state to pursue “irrational” policies. 

What are the domestic forces influencing government policy? In China, the PBoC is primarily concerned about monetary and financial stability. Cognisant of the need to sooner or later re-balance the economy towards greater domestic consumption driven growth, the PBoC is relatively sympathetic towards gradual nominal exchange rate appreciation, especially if domestic inflation and asset prices surge further. The MoF, linked to the export sector, on  the other hand strongly opposed to currency appreciation. The ultimate arbiter is the prime minister, responsible for economic affairs, and the president, who needs to take into account the broader Sino-US relationship. The prime minister and president have sent ambiguous signals, occasionally decisively rejecting foreign pressure. The political leadership appears to be concerned about the RMB issue in as far as employment and economic and domestic political stability are concerned, but they will also be influenced by the desire to maintain good relations with the US. 

While bureaucratic politics no doubt influences economic decision-making, China’s top leadership does not face the cross-pressures as the White House. This should make easier for the Chinese government to act “rationally” which the US government that is more open to domestic pressure, especially from Congress and, arguably, from public opinion. In the US, Congress is in a position to push, even force, the executive to take a tougher stance vis-à-vis China. This is also more likely happen than in China due to the more democratic nature of the political system where members of congress have to run for re- election frequently. It is no coincidence that high unemployment has forced the RMB issue back on the domestic political agenda. The government in the guise of the Treasury may seek to “hold the line”. The White House’s reluctance to take a more forceful, coercive stance vis-à-vis the RMB issue reflects the acknowledgment that Washington needs Beijing’s support on a number of top priority foreign policy issues rather than the belief that behind-the-scenes diplomacy will yield better results than coercive measures. But the White House may at some point find it opportune for domestic political reasons to give in to domestic pressure. After all, “all politics is local.” Ironically, US-based companies with extensive export capacity in China and exporting to the US benefit from an undervalued RMB and therefore oppose RMB appreciation. In other words, the US government is more open to influence and pressure from domestic political forces than the Chinese government. 

This makes it more likely for Washington to become more aggressive vis-à-vis China, while China, with a government more insulated from domestic political pressures, is more likely to act “rationally”. It also makes it easier for the US to credibly adopt a brinkmanship strategy. If this analysis is correct, it has two very major implication: in the very short term, a trade war is very unlikely; but over the medium term, the risk of a trade conflict will increase – unless, of course, imbalances narrow substantially. Here is why. Offering the largest market to other countries and issuing the reserve currency provides the US with immense (structural) power. Any country highly dependent on trade with the US, even if holding US assets will be in a relatively weak position to deter aggressive US action, let alone exert economic-financial pressure on the US. This is why China, for now, would find it in its interest to acquiesce into RMB appreciation in order to avoid a trade war. However, China’s relative trade dependence will be declining as the size of its economy approaches and outstrips the US. Relatively speaking, US trade and financial dependence on China will be increasing. Similarly, the increasing international use of RMB may help gradually make China less dependent on US dollar assets (relative to the size of its economy). 

Rapidly rising GDP combined with a greater focus on domestic growth will help tilt the balance-of-economic-and-financial power in Beijing’s favour. Once the tipping point is reached, the balance could change very dramatically given large Chinese holdings of US government debt. A declining Chinese dependence on the US market will make Beijing more confident on account of lower costs of an economic conflict. A declining and over-confident US relative to its actual position and a rising China might end up engaging in an economic-financial conflict. When China’s economy approaches the position of the US and its trade dependence on the US dimnishes but its financial leverage remains large due to large US debt, its leverage will increase increase rapidly. Beijing will then not only be more likely to stand its ground in the event of US pressure; it may also become more aggressive vis-à-vis Washington. This would also be a time when an escalation would not be easily contained by either side’s recognition that it is in a substantially weaker, more vulnerable position. Near economic parity, when it is not obvious who is more vulnerable, the risk of misperception and miscalculation will also rise. Then, the risk of a wider trade conflict will be much higher than it is today. In short, if this analysis is correct, Sino-US trade conflict and protectionism will be increasing over time, unless the issue of bilateral imbalances is resolved to both side’s satisfaction. Policy-makers in Beijing and Washington take note.