Why the Dollar-Renminbi Transition Is Getting Much Closer Despite Debt Deal
by Arvind SubramanianForeign Policy, October 17th, 2013
The debt deal will do little to delay the day of reckoning for the dollar as the world’s reserve currency.
In my book, Eclipse: Living in the Shadow of China’s Economic Dominance, I argued that the renminbi could overtake the dollar as the world’s premier reserve currency sometime during the next decade. My prediction was based on an econometric analysis of the fundamental economic determinants of a reserve currency (chapter 3) and applying the lessons from the sterling-dollar transition (chapter 5). Such a shift was definitely already imaginable—it was memorably fictionalized in American novelist Gary Shteyngart’s dystopian Super Sad True Love Story, where the only worthwhile currency in America is yuan-backed dollars.
At the time, my prediction elicited three criticisms:
The first critique was based on a misinterpretation of the sterling-dollar transition (see pages 106 to 114 of my book). Nothing has changed on that score. But it is worth noting that that transition was effectively only 10 to 15 years even without the United Kingdom inflicting demonstrably self-destructive costs as the United States is today. Moreover, in the last three years, the renminbi has displaced the dollar as thedominant reference currency in Asia.
On the second point, China today looks more likely to fulfill the requirements for running a reserve currency. The creation of Shanghai as a free trade zone with full renminbi convertibility and the designation of London as an offshore renminbi center attest to China’s intentions to gradually open the capital account. While the financial system is still neither liberalized nor developed, policies to move in that direction may well be announced at the Third Plenary Session of the Communist Party later this year.
There are two key points to remember here. First, China needs to make the necessary changes not immediately but over the next five years or so to create the conditions for a reserve currency. That is doable. Second, a reserve currency does not need an American-style, turbo-charged and sophisticated financial sector. It needs a reasonably open, reasonably transparent, reasonably liquid, and reasonably well-regulated financial system. China can also achieve that over the next decade.
It is on the third point that things have changed dramatically and in the most unexpected way. My prediction was based on an unstated assumption about the United States being normal. But now, the Johnson critique that the United States has unusual trust among investors has been turned on its head. Can investors now trust the United States not to default on its obligations (and thereby on the very instrument that provides the financial plumbing for the depth and liquidity important for a reserve currency)? Will this new distrust persist beyond the bad times, even in normal times?
Making matters worse, the US problem leading to investor uncertainty and mistrust is not a one-off breakdown but a structural problem of ongoing dysfunctional politics. Even though the United States has averted (just about) a debt default this time around, the Great Menacing Farce that we have just witnessed will be replayed a few months down the road and perhaps many times thereafter.
As Michael Clasey, arguing for a downgrade of the US credit rating, put it: “Triple-A credits do not behave like this.” Only a change in the underlying politics can restore the attribute that China does not currently have but that the United States is squandering away.
The bottom line is that, for two years now, China has burnished its credentials and the United States has undermined them from a reserve-currency perspective. And if the dollar’s loss is the renminbi’s gain, my prediction is looking more not less likely to be realized.
When Gary Shteyngart was asked what he always carries with him, his response was: “Renminbi in 100¥ denominations. You never know anymore.”
In my book, Eclipse: Living in the Shadow of China’s Economic Dominance, I argued that the renminbi could overtake the dollar as the world’s premier reserve currency sometime during the next decade. My prediction was based on an econometric analysis of the fundamental economic determinants of a reserve currency (chapter 3) and applying the lessons from the sterling-dollar transition (chapter 5). Such a shift was definitely already imaginable—it was memorably fictionalized in American novelist Gary Shteyngart’s dystopian Super Sad True Love Story, where the only worthwhile currency in America is yuan-backed dollars.
At the time, my prediction elicited three criticisms:
- First, it took nearly 60 years after the US economy overtook the UK economy for the sterling-dollar transition to occur. This was said to imply that even if the fundamentals were moving in China’s favor, the renminbi’s ascendancy was some long way off.
- Second, deep and liquid financial markets, and especially an open capital account were essential for maintaining a reserve currency, and China did not fulfill these requirements.
- Third, and perhaps most important, even if China fulfilled them, reserve currency status for the renminbi was nowhere close to imminence because that status is fundamentally based on trust—and not just any trust, but the trust of foreign investors and traders that China would not misbehave, especially in hard times, by expropriating or (God forbid!) defaulting on its obligations to foreigners. This was Simon Johnson’s critique in his review of my book.
The first critique was based on a misinterpretation of the sterling-dollar transition (see pages 106 to 114 of my book). Nothing has changed on that score. But it is worth noting that that transition was effectively only 10 to 15 years even without the United Kingdom inflicting demonstrably self-destructive costs as the United States is today. Moreover, in the last three years, the renminbi has displaced the dollar as thedominant reference currency in Asia.
On the second point, China today looks more likely to fulfill the requirements for running a reserve currency. The creation of Shanghai as a free trade zone with full renminbi convertibility and the designation of London as an offshore renminbi center attest to China’s intentions to gradually open the capital account. While the financial system is still neither liberalized nor developed, policies to move in that direction may well be announced at the Third Plenary Session of the Communist Party later this year.
There are two key points to remember here. First, China needs to make the necessary changes not immediately but over the next five years or so to create the conditions for a reserve currency. That is doable. Second, a reserve currency does not need an American-style, turbo-charged and sophisticated financial sector. It needs a reasonably open, reasonably transparent, reasonably liquid, and reasonably well-regulated financial system. China can also achieve that over the next decade.
It is on the third point that things have changed dramatically and in the most unexpected way. My prediction was based on an unstated assumption about the United States being normal. But now, the Johnson critique that the United States has unusual trust among investors has been turned on its head. Can investors now trust the United States not to default on its obligations (and thereby on the very instrument that provides the financial plumbing for the depth and liquidity important for a reserve currency)? Will this new distrust persist beyond the bad times, even in normal times?
Making matters worse, the US problem leading to investor uncertainty and mistrust is not a one-off breakdown but a structural problem of ongoing dysfunctional politics. Even though the United States has averted (just about) a debt default this time around, the Great Menacing Farce that we have just witnessed will be replayed a few months down the road and perhaps many times thereafter.
As Michael Clasey, arguing for a downgrade of the US credit rating, put it: “Triple-A credits do not behave like this.” Only a change in the underlying politics can restore the attribute that China does not currently have but that the United States is squandering away.
The bottom line is that, for two years now, China has burnished its credentials and the United States has undermined them from a reserve-currency perspective. And if the dollar’s loss is the renminbi’s gain, my prediction is looking more not less likely to be realized.
When Gary Shteyngart was asked what he always carries with him, his response was: “Renminbi in 100¥ denominations. You never know anymore.”
1)What about the current account? Will China be willing to (or able) supply the world with enough of its reserve currency with a constant CA deficit?
2) Even if a country that issues reserve currency doesn’t have a super-charged financial sector, how close (or — gain– willing) is China to implementing markets on a large scale to foreigners with basic financial instruments that adequately hedge risk and provide liquidity for investors? I think there’s a certain level of trust in legal framework that even policy makers would have to work magic to achieve even if those markets were open.