“Be extremely subtle, even to the point of formlessness. Be extremely mysterious, even to the point of soundlessness. Thereby you can be the director of the opponent's fate.”
A theme being discussed more and more is the idea China is going to save us from the monetary mess in which we are now firmly ensconced. But based on my understanding, it will likely be several decades, if ever, before the Chinese currency seriously challenges the US dollar for global reserve currency status.
USD- Chinese yuan (CNY) Monthly:
However, it is not to say there won’t be a different global monetary solution in the years ahead. It will depend on whether or not there is a repudiation of US debt. If so, I think some new order will take place, along the lines of what Keynes’ talked about -- the Bancor. He knew early on the dangers attached to a dominant world reserve currency. [Mr. Triffin, aka ofTriffin’s dilemma fame, warned the US would be facing structural current account deficits as far as the eye could see in its role of world currency reserve supplier.] Thus, these two were very aware of the danger of global imbalances before it became popular in this cycle. The Great Depression was a valuable teacher for them.
Of course history tells us global monetary systems are more haphazardly morphing events than they are planned occurrences. All we have to do is watch the G-20 to see how difficult serious, multi-global planning can be; heck, those guys can hardly decide on what wine to serve and the order of photo ops.
The handoff from pound Sterling to the US dollar was an unplanned evolving event that accelerated after WWI. There was no great planning when President Richard Nixon took us off the gold standard and ushered in the error of floating rate currencies. The gold was draining out of Fort Knox, something had to be done. Game over. Dirty float for a couple of years, then no pretense whatsoever of anything backing the currencies of the world’s major powers. Just faith! No pretense was justifiable; from that point onward money was a store of value. Purely a unit of exchange it became. Case closed.
So, it leaves us where we are, as I shared with you yesterday, thanks to the excellent insight from Professor Barry Eichengreen. Now I think it is time to explode the myth China’s currency will replace the dollar. Many newsletter writers think that will happen tomorrow. Proving once again newsletter writers never have to answer for their inflated farcicality. But even some serious people believe within the next decade China’s currency will rule. I think even some serious people are wrong.
Rather than turn this into a LONG essay, I will try to breakdown the reasons why I think the Chinese yuan is a very long way from world reserve currency status:
It is never as simple as “the world reserve currency goes to the country with the largest global GDP.” The US surpassed the UK in terms of total GDP back in the 1870s. Yet pound Sterling remained the reserve currency for another 40 years or so.
Remember, the world reserve currency country is saddled with a consistent current account deficit. Thus, China must push out trillions of renminbi and renminbi-based asssets into the world economy. Fine if your model is open and based on consumption. Not so good if it is driven primarily by exports, as China’s is. So we will need to see a big shift in China’s growth model. That will be a wrenching long-term process.
The reserve currency country must open its market to allow foreign investors to hold local assets. This means China will have to make a complete change to its current political structure to allow much more freedoms for citizens (not only allow money to flow in, but allow its citizens money to flow out freely). The system in place is not something that is likely to change anytime soon despite the window dressing. The communist party still maintains absolute power, despite the comments from visitors that all they saw was free market capitalism during their trip to the Orwellian Hall of Mirrors. It shows just how well the central committee is doing its job. If you want a better insight into this issue, I strongly suggest you read, The Party: The Secret World of China’s Communist Rulers, by Richard McGregor. I think this does a great job of showing us how the West in general is duped by the Chinese leadership.
The US is becoming wealthier relative to China. Say what? All true. The fact is since 1991, “the average Chinese citizen is more than $17,000 poorer relative to the average American than he was in 1991.” Per capita income for relatively large states is the best single determinant of competitiveness long term. So, until this trend changes, it is highly unlikely the US will give up the mantle of currency reserve status. [See “China’s Century?” by Michael Beckley, International Security, Vol. 36, No. 3 (Winter 2011/12), pp. 41-78.
Even optimistic assumptions from those who should know, assuming China’s growth remains on track, suggest by 2035 up to 12% of global reserves may be held in yuan. [See Jong-Wah Lee, Asian Development Bank, “Will the Renminbi Emerge as an International Reserve Currency?”]
Officially, all is good. But unofficially, China may be facing its own debt bomb that could dampen growth for years, not just one or two quarters. It happened to Japan. Never say never! “The government’s official debt is only 15 percent of GDP, but it adds up quickly. Ratings agency Fitch estimates a bailout could cost 20 percent of GDP. Add the unpaid cost of the last bailout, debts at state-owned entities, local governments and pension liabilities, and a Breakingviews calculation suggests Beijing’s debt rises to roughly 130 percent of GDP,” according to Reuters Breakingview.
The current attempts at internationalization of the yuan seem backwards. Normally a country opens its capital account and upgrades its domestic financial system before attempting to internationalize its currency. Instead China is offering bi-lateral exchange deals with some trade partners, and that gets a lot of press. But that seems to be mere window dressing as countries are really taking up the credit China is offering. And the developing offshore yuan deposits in Hong Kong may actually backfire, as the unofficial yuan rate in Hong Kong (CNH) is fluctuatiing around the official rate in China (CNY). This may force China’s central bank to actually hold more dollars.
So as much as it might be a good thing for the global economy to have a new reserve currency on the scene, it doesn’t seem as if it will happen soon enough to help in this cycle.