The Pandemic Depression
The Global Economy Will Never Be the Same
In 1962, Robert Roosa, a U.S. Treasury undersecretary at the time, reaffirmed the centrality of the dollar as an international currency by remarking, “It is a role which naturally accompanies our leading economic and political position.” One could be forgiven for misattributing those words to Zhou Xiaochuan, the governor of the People’s Bank of China, who in 2012 attributed the increasing internationalization of China’s currency, the yuan, to “the growing power of the nation and its financial market boom.” Of course, China’s push to expand the yuan’s global role may be hampered by its current market troubles. Although China recently announced that it would liberalize its exchange rate, that reform must be balanced against heavy-handed interventions to freeze its stock market and manage broader turbulence. Both sets of policy moves will ultimately factor into the official and market assessments of whether the yuan is ready for the global stage.
Since the global financial crisis began in 2008, China has made the internationalization of the yuan a priority. It has had no qualms about challenging today’s dollar-based international financial system and demanding a role for the yuan commensurate with China’s economic clout. The cornerstone of this effort has been its push for the International Monetary Fund (IMF) to include the yuan in the valuation basket for Special Drawing Rights (SDRs), a synthetic reserve asset created in 1969 to augment the international liquidity provided by gold and U.S. dollars under Bretton Woods, a system adopted in 1944 that sought to reconstruct the postwar economic order. The SDR is valued through a basket that includes the world’s major reserve currencies—the U.S. dollar, the euro, the British pound, and the Japanese yen. Although the IMF has sent mixed messages over the past few months, it dealt a blow to China’s ambitions when it recently announced that the yuan’s inclusion will come in late 2016 at the earliest. The announcement appears motivated by the desire to give China time to implement additional reforms and allow SDR users to adjust to the new valuation basket, should the yuan be incorporated. Although the IMF’s latest decision is not a prejudgment of the yuan’s chances at inclusion, it does signal its belief that it could not be seamlessly added today.
Understanding why China is so invested in the yuan’s inclusion in the SDR starts with the United States’ own pursuit of a larger international role for its currency in the 1960s. That effort also began with an SDR-based campaign that is emblematic of the historical role of the SDR as a tool of international monetary politics. Shortly after the IMF created the SDR in 1969, a group of U.S. Treasury officials led by Paul Volcker, then undersecretary for international monetary affairs, began pushing for the first distribution of SDRs. They sought to assuage European concerns that the dollar could not provide sufficient international liquidity under the gold exchange standard, a system developed under Bretton Woods that tied the world’s reserve currency, the dollar, to gold at a fixed rate.
Although these officials neither wanted the SDR to take on a major role nor thought that it would, Volcker and his colleagues wrote in a classified memo that distributing SDRs was “very important psychologically” for easing concerns about the dollar. However, the closing of the gold window in 1971 and the move to floating exchange rates eliminated the need for SDRs to augment international liquidity. By 1972, U.S. officials turned against the SDR and began opposing expansions to its role, fearing that it might challenge the dollar. For the United States, the SDR was a short-term political tool, nothing more.
China’s approach to the SDR is also primarily psychological rather than economic. Even if the yuan were included in the SDR’s valuation basket this year, there are two reasons to believe that it would have few economic implications on the ground. First, consider the numbers. SDRs currently constitute roughly 2.5 percent of global currency reserves. If the IMF were to allocate the yuan a 20 percent weight in the SDR, it would add yuan exposure of 0.5 percent to global reserve holdings. Second, SDRs, by design, cannot do much more than add liquidity. In 1968, in order to bring the French on board with the creation of SDRs, the United States agreed to stringent conditions on their function and role. Most notably, the United States agreed to limit the holding of SDRs to official holders such as IMF member governments and major central banks. Adding the yuan to the SDR basket would give SDR holders additional exposure to the currency but would not increase their ease of transacting in yuan in the global economy.
Understanding why China is so invested in the yuan’s inclusion in the SDR starts with the United States’ own pursuit of a larger international role for its currency in the 1960s.
China has made some progress convincing private market actors that the yuan is ready for greater global use, but it will have trouble extending its currency’s reach without removing remaining restrictions on its capital account and financial markets, including limits on cross-border investment by individuals and on the trading of stocks and bonds by foreign companies. Internationalization is fundamentally about convincing markets and governments that a currency can act as a deep and secure store of value. SDR inclusion changes none of the underlying conditions governing that calculus.
Like the United States’ SDR efforts in the 1960s, China’s plans for SDR inclusion are based on the political positioning of its currency in the international monetary system. Its officials are well aware that the SDR’s valuation basket has long been a leading indicator of the international monetary system’s future. In 1973, the United States was at odds with France over whether gold should be phased out as a major component of the international monetary system—the United States wanted to see it go, as a way to strengthen the dollar’s role, and France wanted to maintain it. Internally, the U.S. Treasury viewed the SDR’s valuation in gold as a key battleground in this fight because it represented the international community’s official position on international monetary reform. Although in reality gold was phased out by the shift to floating exchange rates (eliminating the need for gold reserves) and gold sales from governments to private holders, its relationship to the SDR held symbolic value. When the SDR’s valuation was changed from gold to a basket of currencies in 1974, it sent a clear message that the United States had won the battle over gold’s future in the international monetary system.
If the SDR’s history tells us anything, it is that its reemergence is a harbinger of major shifts to come in the international monetary system.
This sort of messaging matters far more for China than it ever did for the United States because the dollar was already in a strong position when its push for a more expansive international role began. At that time, despite large U.S. balance of payment deficits, the dollar emerged from the Bretton Woods system as the primary contender for key currency status. When U.S. President Richard Nixon closed the gold window, he thrust the world onto a dollar-standard exchange system in which dollars were already the de facto primary reserve asset. Administrative documents from the U.S. Treasury archives indicate that the administration not only knew this would happen but was counting on it. The yuan holds no such advantage, which makes its inclusion in the SDR’s basket even more valuable as a status symbol. The yuan’s current shares of world payments and foreign exchange transactions are both just over two percent, compared with the dollar’s 45 percent share of payments and 87 percent share of foreign exchange transactions. Since China is starting from a position of relative weakness, it will need all the help it can get to win global recognition for the yuan.
The yuan also faces an established international monetary and institutional landscape built around the dollar. The closing of the gold window gave the United States a blank slate to remake the international monetary system and construct lasting defenses of the dollar’s role. Nixon administration officials were well aware of this opportunity. Just days after Nixon’s announcement, a confidential memo from the Council of Economic Advisers, an agency within the Executive Office of the President, acknowledged that “the future shape of the international monetary system has been opened up far wider” than ever before. China has no such luck and is, instead, fighting against a nexus of long-standing institutions built without its currency in mind. Everything from the dollar’s dominant role in trade and foreign exchange to the use of U.S. Treasuries as the primary form of international reserves is evidence of the success of the United States’s historical efforts.
That is why SDR inclusion is so psychologically important for the yuan. Aside from sheer economic size, China lacks nearly every advantage that benefited the United States in its efforts to expand the dollar’s international role. Inclusion in the SDR’s valuation basket would signal that established Western economic institutions appreciate China’s liberalizations of its exchange rate regime and capital controls and will welcome China into the fold as a major player. This decision is an unofficial referendum on whether the West will endorse China’s economic ambitions and grant it the place Chinese officials believe they deserve. The recent decision to push off the yuan’s inclusion will be taken as a signal that even if China ultimately succeeds, it will be an uphill battle.
As with the decision to create the SDR or the choice to delink it from gold, the outcome of this decision will offer a window into how the dominant actors in today’s international monetary system envision that system’s future. The creation in 2014 of the Asian Infrastructure Investment Bank, considered a Chinese competitor to the World Bank, provided one such test for China’s future role, and the American reaction was far from welcoming. When it comes to the international monetary system, the IMF’s ultimate decision for the yuan may be our best indication of whether China will be allowed to grow within the current structure or will be forced to remake it.
Before today, the SDR has been globally relevant exactly three times in its history: when it was created, when it was delinked from gold, and when 183 billion SDRs (approximately $280 billion) were allocated to IMF member countries to relieve liquidity stress during the recent financial crisis. If the SDR’s history tells us anything, it is that its reemergence is a harbinger of major shifts to come in the international monetary system.