The Pandemic Depression
The Global Economy Will Never Be the Same
According to a growing chorus of pundits and economists, China -- already the world’s most prolific exporter, largest sovereign creditor, and second-largest economy -- will someday soon provide the world’s reserve currency. According to this view, just as the dollar dethroned the British pound in the interwar years, so the yuan will soon displace the dollar, striking a blow to U.S. interests. As the economist Arvind Subramanian recently wrote, the yuan “could become the premier reserve currency by the end of this decade, or early next decade.”
This view has gained traction as Chinese leaders have launched a concerted effort to internationalize the yuan. During the G-20 summit in November 2008, at the height of the financial crisis, Chinese president Hu Jintao called for “a new international financial order that is fair, just, inclusive, and orderly.” Beijing soon began to encourage the use of its currency in international trade, swap arrangements between central banks, and bank deposits and bond issuances in Hong Kong. During the first six months of 2011, trade transactions settled in yuan totaled around $146 billion, a 13-fold increase over the same period during the previous year. By mid-2011, yuan deposits in Hong Kong equaled $85 billion, a roughly tenfold jump since Hu’s 2008 statement. The yuan is already accepted as a form of payment in Mongolia, Pakistan, Thailand, and Vietnam. Chinese authorities have indicated that as soon as 2015, they want the yuan to be included in the basket of major currencies that determines the value of Special Drawing Rights (SDRs), the reserve asset issued by the International Monetary Fund. And Beijing has announced its intention to transform Shanghai into an international financial center by 2020.
There is also no denying that the dollar is vulnerable. Central banks traditionally hold foreign currency reserves to ensure their ability to buy imports. But today, more of the world’s imported goods come from China than from the United States. Central banks also hold reserves to ensure their ability to service debt payments to foreigners. Yet such payments flow increasingly to China, and although China’s lending is largely conducted in dollars, dominant creditors ultimately tend to insist on lending in their own currency. To make matters worse for the dollar, it is losing value -- instead of storing it, as reserve currencies are expected to do. Measured against the currencies of the United States’ main trading partners, the dollar has lost a quarter of its value since the advent of the floating currency system in 1973. Over the past four decades, it has lost four-fifths of its purchasing power as measured against a basket of consumer goods. This decline makes central bankers in emerging economies understandably nervous about holding dollar reserves.
Yet the emerging narrative about the yuan’s ascendance is mostly wrong. The global rise of China’s currency will be slower than commonly predicted, and the yuan is more likely to assume a place among secondary reserve currencies -- the euro, the yen, the Swiss franc, and the British pound -- than it is to displace the dollar as the dominant one. Nor is it even clear that China wants the yuan to replace the dollar. Beijing’s steps toward currency internationalization reflect not a fully formed, coherent long-term strategy but rather an evolving process shaped by splits among China’s policymakers over the scope and speed of financial reform. Far from confirming the inevitability of the yuan’s rise, China’s uncertain effort to internationalize its currency has exposed the profound struggles that lie behind the country’s larger push to transform its economic model.
THE RELUCTANT RISE OF INTERNATIONAL CURRENCIES
One might assume that as a country approaches great-power status, it will naturally attempt to internationalize its currency. In fact, rising powers have often done just the opposite. As the economist Jeffrey Frankel has shown, that is what the United States did in the interwar period and what Germany and Japan did in the 1970s, even though the currencies of all three countries later became international. In each of these cases, both the public and policymakers were initially skeptical of the benefits of allowing their currency to be used widely abroad.
Rising powers have had two reasons to fear the internationalization of their currencies. The first concerns competitiveness. When foreigners buy and hold a currency, they increase its value. This appreciation persists as long as the buyers hang on to the currency as a store of wealth. A stronger currency hurts a nation’s exports by making its goods more expensive abroad and creates more competition for domestic companies by making imports cheaper for consumers.
The second reason to fear currency internationalization concerns control of the financial system. Like China today, Germany, Japan, and the United States all emerged as trading powerhouses at a time when their financial systems were tightly regulated. Governments capped interest rates on bank deposits and restricted the investment opportunities of pension and insurance funds so that capital remained cheap. But this “financial repression” stuck savers with low returns, and the demand for artificially cheap capital often exceeded the supply, leaving some borrowers frustrated. Currency internationalization threatened the cheap-capital development model by freeing savers and borrowers to find one another abroad, beyond the reach of regulators.
These reservations about currency internationalization have contributed to long lags between a nation’s emergence as a first-rank power and the widespread use of its money by foreigners. The United States became a larger economy than the United Kingdom in 1872, but the dollar did not begin to displace the pound as the reigning international currency until World War I, and the process was not completed until after World War II. Even then, the United States frequently appeared indifferent to its currency’s newfound status. In the 1970s, President Richard Nixon abandoned the gold standard, sacrificing the international prestige of the dollar on the altar of domestic stimulus. Likewise, Japan resisted currency internationalization until the 1980s, when it became impossible to resist American pressure to allow U.S. financial firms to enter the Japanese market. The deutsche mark became a reserve currency because foreigners wanted to hold it, not because German authorities actively sought that outcome.
CHINA’S DOLLAR TRAP
If other rising powers have resisted the internationalization of their currencies, why is China’s policy so different? The answer is that the recent global financial crisis confronted China with the dangers inherent in dollar hegemony. China’s economic model had relied on boosting exports by keeping its exchange rate undervalued. This required China’s central bank to purchase large quantities of dollars, reinforcing the dollar’s status as the global reserve currency. But the crisis revealed that the benefits of this model were smaller than they appeared and that the costs could be significantly higher.
The crisis showed that by basing its growth on exports, China had laid itself open to a sharp reversal if foreign markets seized up. In the first quarter of 2009, collapsing demand in Europe and the United States caused China’s annual growth rate to fall to 6.2 percent, after hitting ten percent or more in each of the previous ten quarters. The crisis also highlighted the potential costs to China of accumulating dollar reserves. To keep the yuan undervalued, China had bought $1.5 trillion worth of U.S. financial assets, including about seven percent of all the bonds issued by government-linked lenders, such as the disastrously overleveraged Fannie Mae and Freddie Mac. The crisis convinced Beijing that it could one day take a serious loss on those investments.
China’s leaders responded to the shock by criticizing the international financial system. The effort was launched by Zhou Xiaochuan, the governor of the People’s Bank of China (the country’s central bank). In an article posted on the bank’s Web site in March 2009, he called for far greater use of SDRs as an alternative to the dollar. Other Chinese officials followed Zhou’s lead, arguing that the basket of currencies that determines the value of SDRs should be expanded to include the yuan and that, in preparation for that change, the yuan should be internationalized. Echoing the complaints French leaders made in the 1960s about “exorbitant privilege” -- a country’s ability to borrow cheaply and seemingly without limit in its own currency -- Chinese officials and scholars argued that the United States abuses its monetary freedom and passes on the costs to the rest of the world in the form of currency depreciation and financial instability. The U.S. Federal Reserve’s subsequent quantitative easing and the U.S. Congress’ chaotic efforts to grapple with the national debt only increased China’s frustration.
Even before the crisis, China had been engaged in an internal debate about its export-led growth model. Several years ago, reformers began arguing that an excessive reliance on exports could be dangerous and that China needed to rebalance its growth by encouraging more domestic consumption. In place of financial repression and cheap capital, these reformers wanted savers to get a decent return, which might give them the confidence to consume more. In place of an artificially low exchange rate, they wanted to allow the value of the yuan to rise, which would reorient Chinese firms away from exports and toward the domestic market.
The reformers claimed a small victory in 2005, when China loosened its exchange-rate peg. But in general, the reform agenda has struggled. State-owned banks do not want to pay depositors market interest rates. Politically connected borrowers, such as the state-owned construction companies that build China’s impressive infrastructure, do not want to give up access to cheap capital. Politically connected exporters, on whom provincial governors count to create jobs in their regions, do not want to give up the competitive advantage created by a favorable exchange rate. Groups that have an interest in reform -- savers who receive artificially low returns and consumers who pay a high price for imports -- are no match for powerful producers.
Prior to the financial crisis, the case for reform was also tainted by the suspicion that it represented a capitulation to U.S. demands to let the yuan appreciate. But once the crisis exposed China’s vulnerability, reform acquired a fresh patriotic gloss: advocates could paint themselves as challenging the dangerous hegemony of the dollar. This reframing was enough to tip the political center of gravity away from the status quo. Criticism of what Chinese scholars called “the dollar trap” became widely accepted, and by extension, internationalization of the yuan became an official goal, even though many of China’s leaders continued to believe in export competitiveness, highly regulated capital markets, and a state-controlled banking system.
In effect, the government wanted to have it both ways: booming exports, but reduced accumulation of dollars; continued funneling of cheap loans to favored companies at the expense of savers, but also more domestic consumption. Internationalization of the yuan emerged as an official goal not because it resolved the long-running debate between reformers and mainstream opinion. Rather, it became policy precisely because it blurred that division, allowing people who disagreed to unite -- at least in the short term.
OF CARTS AND HORSES
One consequence of these internal conflicts is an unorthodox sequencing of reform. As the economist Takatoshi Ito has explained, the best way to open a repressed, autarkic financial system is to begin with domestic financial reform. Before large amounts of foreign capital are permitted to flood in and out of a country’s system, banks need to be well capitalized and competently regulated. Bond markets must be deep and liquid, so that they can absorb foreign money without experiencing dramatic price swings. The authorities must welcome a variety of investors, with differing time horizons, investment objectives, and worldviews -- a form of diversity that reduces destructive herd behavior. Only once the domestic financial system has been fortified in this manner is it safe to open the economy to foreign capital inflows, allow the exchange rate to float, and let the country’s money circulate offshore. Currency internationalization should be the endpoint of reform, not the starting point.
China is not following this sequence. Mainstream Chinese political opinion still resists rapid domestic financial reform and exchange-rate flexibility, so reformers have pushed forward with currency internationalization before the standard preconditions have been met. Since Hu’s speech in 2008, China has signed largely symbolic central-bank swap agreements with 13 countries, including Argentina, Belarus, Indonesia, Malaysia, and South Korea. In September 2011, Nigeria’s central bank announced that it would convert between five and ten percent of its reserve assets into yuan. But the most significant reforms began in April 2009, when China’s government permitted five pilot regions -- Dongguan, Guangzhou, Shanghai, Shenzhen, and Zhuhai -- to begin conducting trade with Hong Kong in yuan on a trial basis. In June 2010, the experiment was extended to 20 provinces, cities, and autonomous regions. Last year, it was extended to the entire country. The resulting explosion of yuan-based trade has been hailed by some as a success. But as Peter Garber of Deutsche Bank has explained, the growth has been revealingly lopsided, resulting in some serious unintended consequences.
Because foreigners expect China’s currency to appreciate against the dollar, they are eager to buy any yuan that reach Hong Kong, where the currency is called CNH, to distinguish it from the mainland currency, which is sometimes referred to as CNY. As a result, CNH tend to command a premium against the dollar, opening up a gap between the onshore yuan-dollar exchange rate, which the Chinese government manages, and the offshore CNH-dollar exchange rate, which it does not. This differential creates an incentive for Chinese importers to pay foreign suppliers in CNH, rather than in dollars purchased from the central bank at the lower official exchange rate.
As Chinese importers take advantage of the favorable Hong Kong exchange rate, they move money from the mainland into CNH accounts in Hong Kong and then use those CNH to purchase goods from foreign exporters. The foreigners then either hold the CNH in expectation of appreciation or, if they are not interested in currency speculation, sell the CNH to other foreigners who are keen to take the bet. In this way, Chinese currency piles up in Hong Kong. Some market analysts predict that, having already grown tenfold since Hu’s speech in 2008, Chinese currency deposits in Hong Kong will quadruple from today’s level by the end of 2012, rising to the equivalent of around $340 billion.
That is not what Chinese policymakers intended. Technically, the deregulation of yuan-denominated trade payments applies to Chinese exporters as well as importers. If exporters took advantage of the new freedom, the pools of CNH building up in Hong Kong would be drained as quickly as they accumulated. But the incentives for exporters are the opposite of those facing importers. Rather than going through Hong Kong, exporters are better off taking payment in dollars and then selling the dollars to the central bank at the managed rate, which renders the dollar artificially valuable.
The upshot has been a classic demonstration of the law of unintended consequences. Before the opening of the Hong Kong CNH market, Chinese importers bought foreign exchange from China’s central bank, reducing the bank’s stock of dollar assets. Now, importers can obtain foreign exchange indirectly from foreign speculators in Hong Kong, leaving more dollars on the central bank’s balance sheet. Put another way, Chinese importers’ ability to pay foreigners in CNH has the effect of removing a significant source of dollar purchases from the world’s currency market. Assuming that the central bank wants to maintain the yuan-dollar exchange rate, it must offset this effect by increasing its own dollar holdings. China’s attempt to internationalize the yuan, which sprang partly from a desire to reduce the government’s exposure to dollars, has actually had the reverse effect of increasing the central bank’s already vast dollar holdings.
Even beyond this irony, the policy is proving costly. Assuming that China will one day stop holding down the value of its currency, China’s central bank will eventually suffer a portfolio loss as the dollar falls to its natural exchange rate against the yuan. The more dollars the central bank accumulates, the larger this eventual loss will be. Moreover, as the central bank acquires additional dollars, it pays out yuan. To avoid inflation, this monetary expansion has to be “sterilized” by the issuance of bonds or the acceptance of bank reserves on which the government pays interest, imposing a further cost on the Chinese government. The challenge of sterilization grows when the money in CNH bank accounts is used to purchase CNH bonds and then the issuers of these bonds repatriate the capital to the mainland. As long as the Hong Kong market remains comparatively small, China can absorb these costs with little difficulty. But if the authorities are serious about internationalizing the yuan in a sustained way, the costs will quickly grow and the unintended consequences will likely become harder to manage, especially in the absence of domestic reform.
RISKS OR REWARDS?
The tensions in China’s currency policy emerge clearly from the wide range of official statements intended to explain it. Some leaders openly state a preference for diversification away from the dollar but are careful not to call for the yuan’s preeminence, even within the next several decades. Rather, they predict a lengthy and complex process of change in the international monetary system, with increased demand for yuan restricted mostly to East Asian markets. Other policymakers in Beijing advocate including the yuan in SDRs and believe that SDRs should ultimately displace the dollar as the world’s main reserve asset. But even as they advance this vision of a radically transformed monetary order, these officials shy away from acknowledging a policy of currency internationalization, speaking instead of a more limited agenda of trade and investment facilitation. They suggest that their policy is a response to market demand; by allowing yuan to be used in trade transactions, these officials maintain, China is merely acceding to requests from importers and exporters. China has concluded swap agreements with foreign central banks only because foreigners requested them, they claim -- despite the fact that foreigners have drawn down only a small fraction of the yuan swaps that Beijing has provided.
Yet even though China’s leaders struggle to rationalize a conflicted policy, it would be wrong to conclude that yuan internationalization is doomed. After all, China has managed such contradictions successfully before, often pursuing reform not by tackling the status quo head-on but rather by allowing an alternative to grow up around it. For example, in the 1980s, during the early stages of the transition away from central planning, farmers were still required to meet Mao-era quotas and were paid at prices set by the central planners, but farmers were also allowed to sell anything they produced in excess of their quotas on the new free market. Today, private companies coexist with state-run firms and five-year plans exist alongside a capitalist free-for-all. In a similar fashion, China is allowing a free yuan capital market to grow up in Hong Kong in parallel with the largely unreformed, restricted capital market on the mainland. The policy mix might not be consistent, but it could ultimately prove effective.
Indeed, inconsistency might hold some advantages. It allows China to experiment with change while retaining the option to retreat if the side effects become intolerable. It could permit policymakers to foster the development of the Hong Kong market, so that the institutions necessary to make a currency market function can gradually take shape there. If Chinese and foreign companies issue greater volumes of CNH bonds of short and long duration, a market-driven yield curve will emerge, Chinese traders will learn the art of interest-rate arbitrage, and Chinese companies using this market will learn the ropes of treasury management. The system can be tweaked and tested before it is rolled out on the mainland, and in the meantime, it may generate price signals useful to China’s government. If the CNH appreciates suddenly against the dollar, this will warn the authorities of rising pressure from speculation. If short-term interest rates rise relative to long-term ones, this might signal that investors have become pessimistic about the economic outlook. In time, the onshore and offshore markets could conceivably converge as capital controls are loosened.
Of course, there is a significant risk that a gradual approach -- and the resulting tension between a free offshore market and a controlled onshore one -- could prove hard for the Chinese government to manage. The rising cost to the central bank of purchasing dollars to offset foreign yuan holdings in Hong Kong might encourage foreign speculators to bet that the central bank will seek to reduce that cost by allowing faster yuan appreciation; the result could be even more speculative purchases of CNH, setting off a vicious cycle. Likewise, leakage of capital from Hong Kong to the mainland could fuel inflation; as the economist Robert McCauley has explained, this fate befell the United States when it clung to capital controls in the face of growing offshore dollar markets in the 1970s. But it is also possible that the benefits of China’s experimental technique could outweigh its obvious costs and contradictions. Anyone who has watched China’s extraordinary economic performance, achieved while it ignored many of the West’s textbook development prescriptions, should be modest in predicting that China will inevitably trip up this time. But even if China’s policy of gradualism with regard to its currency succeeds, the yuan is not going to displace the dollar anytime soon. The dollar enjoys an advantage that its predecessor, the pound, never had: formidably deep capital markets both inside and outside the United States, which operate mainly in dollars.
The chief purpose of a reserve currency in today’s global economy goes beyond its traditional ones. Central banks hold foreign exchange war chests not just as a cover for essential imports and debt payments; they hold them as insurance against the virulent crises to which modern finance is susceptible. As capital markets have gone global, banks all over the world have borrowed in efficient dollar-based markets. As a result, when markets suddenly dry up, borrowers are left screaming for dollars. So long as dollar funding remains attractive to private firms, central banks will hold a large proportion of their reserves in dollars, too. Even if the dollar loses value steadily, central banks will probably be prepared to absorb that cost, which amounts to an insurance premium.
Given China’s economic strength and the likely appreciation of its currency in the future, the yuan might eventually emerge as a secondary reserve currency. If a reliable yuan bond market develops, first in Hong Kong and then perhaps on the mainland, foreigners will increasingly include yuan assets in their portfolios, alongside British pounds, euros, Swiss francs, and yen. Asian nations, with deep economic links to China, will be particularly likely to do so; the yuan already serves as an unofficial anchor for several of their exchange rates. But that is a far cry from displacing the dollar. China is rapidly catching up to the United States in terms of the overall size of its economy, and perhaps in other measures, too. But China’s monetary dominance should not be assumed. If it ever does arrive, it will have been long in coming.