In spite of all the hype regarding the Yuan as a reserve currency I have stated many times recently that discussion of the Yuan as a reserve currency is nothing but ridiculous hype.
My reasons are:
- The Yuan does not float, and there is no indication China is prepared to allow the Yuan to float any time soon
- China is a command economy
- In China, property rights and civil rights are questionable
- Chinese banks are insolvent because of malinvestments in infrastructure and an enormous property bubble
Michael Pettis at China Financial Markets has a similar list of reasons, phrased slightly differently. However, Pettis does add one key item I overlooked: "Very deep and open domestic bond markets"
From a recent email post Pettis writes ....
Is it time for the US to disengage the world from the dollar?
Last week on Thursday, the Financial Times published an OpEd piece America Must Give Up The Dollar I wrote arguing that Washington should take the lead in getting the world to abandon the dollar as the dominant reserve currency.
My basic argument was that every twenty to thirty years – whenever, it seems, that the American current account deficits surge – we hear dire warnings in the US and abroad about the end of the dollar’s dominance as the world’s reserve currency. Needless to say in the last few years these warnings have intensified to an almost feverish pitch.
But I think these predictions about the end of dollar dominance are likely to be as wrong now as they have been in the past. Reserve currency status is a global public good that comes with a cost, and people often forget that the cost is much higher than most countries are willing to accept.
Just as importantly as a public good, dominant reserve currency status requires a number of characteristics. At a minimum these include
- Ample liquidity
- Central bank credibility
- Flexible domestic financial markets
- Minimal government or political intervention
- Very deep and open domestic bond markets
With the exception perhaps of the euro, which may or may not emerge in the next decade on a more rational basis than it currently exists (albeit with more than one defection), no other currency has the necessary characteristics that will allow it plausibly to serve the needs of the global economy.
And no other country, not even Europe, will be willing to pay the cost. This is the important point. If there is any chance that the dollar’s status declines in the future, it will require that Washington itself take the lead in forcing the world gradually to disengage from the dollar.
Ironically, this is exactly what Washington should be doing. Conspiracy theory notwithstanding, claims that the reserve status of the dollar unfairly benefits the US are no longer true if they ever were. On the contrary, the global use of the dollar has become bad for the US economy, and because of the global imbalances it permits, bad for the world.
This cost comes as a choice between rising unemployment and rising debt. The mechanism is fairly straightforward. Countries that seek to supercharge domestic growth by acquiring a larger share of global demand can do so by gaming the global system and actively stockpiling foreign currency, mainly in the form of, but not limited to, central bank reserves. This allows them forcibly to accumulate domestic savings while relying on foreign demand to compensate for their own limited domestic demand.
In practice, dollar liquidity, limited Washington intervention, and the size and flexibility of US financial markets ensure that these countries always stockpile dollars. There is no real alternative to the dollar, and most other governments would anyway actively discourage massive purchases of their own currencies because of the adverse trade impacts. Why? Because if foreigners accumulate euros or yen at anywhere near the rate they accumulate dollars, they would force Europe and Japan into massive current account deficits, and neither Europe nor Japan has any interest in seeing this happen.
Foreign acquisition of dollars, in other words, automatically forces the US into running a corresponding current account deficit as foreign policies that constrain consumption in the accumulating country require higher consumption abroad. Active trade intervention in countries that engineer large trade surpluses have to be accommodated by rising trade deficits elsewhere, and because reserves are accumulated in dollars, this “elsewhere” is the US.
Without government intervention, there is no reason for domestic investment to rise in response to policies abroad. On the contrary, I would argue that with the diversion of domestic demand, private investment might even decline.
So in order to limit the employment impact, capital flows into the US have to finance additional US consumption. Americans, then, are forced to choose between higher unemployment and higher debt, and in the past the Federal Reserve has chosen to encourage higher debt.
If cheaper consumption is such a gift, it is hard to explain why attempts by the US to return the gift to countries whose consumption costs are artificially high – demanding for example that these countries revalue their currencies and so reduce costs for their own consumers – are always so indignantly rejected. No one, it seems, is eager to lower their consumption costs at the expense of employment growth, and yet reserve status may very well require this trade-off.
The massive imbalances that this system has permitted are destabilizing for the world because they permit large and unstable debt buildups both in countries that over-produce, like China and Japan, and those that over-consume, like the US. If the world were forced to give up the dollar, there is no doubt that there would be an initial cost for the global economy – it would reduce global trade somewhat and it would probably spell the end of the Asian growth model. But giving up the dollar would also lower long-term economic costs for the US and reduce dangerous global imbalances.
For this reason the US should take the lead in shifting the world to multi-currency reserves in which the dollar is simply first among equals. The cost of maintaining sole reserve currency status has simply become too high in the past three decades and is leading inexorably to rising American debt and worrying global imbalances.
No One Really Wants Reserve Currency Status
I am quite sure that Pettis has this correct. After all, if reserve currency status was such a gift, why doesn't China take the steps that would make it possible. Why doesn't Europe?
The fact is, for all their bitching, nearly every country on the planet does not want to relinquish their "export growth model". Every week there is some trumped-up report by someone about how China is trading more in the Yuan with Russia and Southeast Asia countries. In the grand scheme of things such trade in Yuan nearly meaningless, not representative of a significant adjustment.
Mathematically, the fact remains, the US runs a huge trade deficit, and countries accumulate US assets, most frequently US Treasuries.
The Fed is fighting back by attempting to force the US dollar lower. Mathematically every currency cannot be weak relative to each other. Central bank actions to achieve the impossible are behind the rise in commodities, especially silver and gold.
Unstable Mess
The irony in this mess is those cheering the demise of the US and the US dollar look at baby-step moves countries like China make in that direction as if that would hurt the US.
The reality is the US would be better off (and so would the world), were the US to lose reserve currency status. Nonetheless, don't expect it any time soon. China is not ready and Europe is in the midst of a sovereign debt crisis that will not go away for years.
Meanwhile the global imbalances between the US and the rest of the world grow. The imbalances within Europe grow with the ECB's One Size Fits Germany policy as well as Trichet's insistence there will not be a writedown in sovereign bonds of Greece, Portugal, and Ireland. Finally, China is overheating, trapped in an unsustainable export-and-build-infrastructure model that is clearly on its last legs.
How and when this mess resolves is anyone's guess, but it likely will not be pretty. Meanwhile, global complacency in equity markets is at record highs.
