Gaullism in Beijing? China’s Calls for Reform of the International Monetary System

Chinese Presiden Hu Jintao stated in mid January that the US dollar should not act as the world’s reserve currency of choice, and that China would work to replace the dollar with the renminbi.   His words adhere to a long standing Chinese policy of reforming the international monetary system, and echo a demand made by President Sarkozy of France. 


The US dollar has been the world’s main, but not sole, reserve currency since at least 1945, when America’s economy (in part thanks to the wholesale destruction of commercial competitors in Europe and Japan) amounted to more than 50% of world GDP (compared to about 23% today).  The dollar’s reserve status has meant that the US has enjoyed a number of benefits, including having a government and corporate sector able to borrow freely in its own currency (thereby eradicating currency risk), paying low interest rates on debt thanks to hefty demand for the US dollar, and taking advantage of something called “seigniorage”. That's the profit accruing to an issuer (or seignior) from the difference in value between the cost of production and the currency’s face value; in current terms, seignorage might be seen as a form of inflation tax.  


The status quo riles Beijing.  China is the foremost governmental holder of the dollar as a reserve currency; it allegedly has USD2 trillion in US treasury bond, out of its total foreign exchange reserves of about USD2.8 trillion.  The US Federal Reserve’s determination to print money, combined with a lack of faith in America's economic recovery has reduced the dollar’s face value and raised concerns about its attractiveness as a store of value.  So the crisis has cost China lots of hard earned lucre, added to which the Chinese elite’s prickly nationalism (and ethic of hard work) surely abhors the rents which lazily fill Uncle Sam’s pockets.  Zhongnanhai, then, wants an alternative international monetary system, as overtly (and undiplomatically) stated by President Hu. 


China has taken steps to reduce the US dollar’s reserve currency status, first by diversifying foreign exchange holdings and so reducing at least its demand for dollars.  Reports have emerged of China’s State Administration of Foreign Exchange (SAFE) divesting itself of dollars and expanding its holdings of other currencies, gold, and assets including equities and debt.  This latter category includes euro denominated debt issues from the governments of Portugal and Greece.  China’s engagement in the stricken European bond markets may have a number of motives. First, it maintains diversified stocks of currencies amongst its reserves. Second, it prevents a further fall in the value of the euro, which would weaken Chinese exports -- a move to compare with the soft lending provided by state owned export banks or insurers, such as the US Exim Bank or the UK’s Export Credit Guarantee Agency, which in effect amounts to a subsidy for exporters. Third, China may wish to bolster as an alternative to the dollar the euro, which since 1999 has been the world’s secondary reserve currency.


Beijing also seems to have a strategy to propel the renminbi to reserve status. In September 2010, the chief executive of Hong Kong Exchanges and Clearing, Charles Li, said he saw the renminbi first emerging as a trade currency (over five to ten years), then becoming a currency of investment (over 10 years), before emerging as a reserve currency (in say 20 years).   Li has a reputation in Hong Kong for close dealings with mainland policymakers; his comments are generally very well informed. 


The process is under way.  In 2004, China allowed the transfer of renminbi into Hong Kong through a daily allowance of RMB20,000 for local residents, resulting in accrued RMB assets in the city of about RMB80 billion by mid-2009.  China then accelerated moves by permitting mainland companies to use the renminbi to settle international trade transactions in July 2009, and has continued this liberalising stance – for instance by allowing companies to move renminbi offshore for investment purposes in early 2011.  Beijing has also since 2009 established a range of bilateral currency swaps with trading partners such as Argentina, Belarus, Hong Kong, Iceland, Indonesia, Malaysia, Pakistan, Russia, Singapore and South Korea; the value of these arrangements was about RMB800 billion (USD121 billion) by the end of 2010.  Fast food chain McDonald’s has launched a bond denominated in the renminbi and trade credits have been offered in renminbi to Indonesian counterparties by the Industrial and Commercial Bank of China. 


China’s actions have prompted an agonised debate about the future of the dollar.  A collapse of its value, resulting in searing increases in interest rates in the US, seemed a possibility at the more alarming moments of the financial crisis.  Perhaps the renminbi was a possible replacement.  Yet with clear-eyed hindsight it was a remote chance then, and remains so now. 


The reason for this sanguine view is that reserve currencies are creatures of reputation, which takes a long time to gain and once won is hard to escape.  Perhaps the most important requirements of a reserve currency are confidence in its value, liquidity, in terms of deep capital markets, and ease of conversion.  These conditions the US dollar can provide like no other coin, contrasting with, say, the Japanese yen, the main competitor of the 1980s but one underpinned by weak capital markets.  The euro comes closer and so is the current secondary reserve currency, accounting for about 25% of states’ foreign exchange reserves (although recent events have cast doubt on its integrity).  The renminbi, by contrast, is in no position to rapidly become a reserve currency because China has a closed capital account, shallow and unpredictable capital markets, and the currency trades weakly overseas, notwithstanding recent steps towards internationalisation.  This situation means that while the renminbi might be used for current account purposes, such as settling bilateral trade, it could not play a role for capital account purposes, such as for portfolio investment and reserve holdings.  


Historical precedents also suggest that shifts in reserve currencies require substantial dislocation.  The British pound was the key reserve currency of choice from about 1815 to 1914, when the globalisation of that era ended in the trenches of Flanders.  The US dollar took on a major role by the second half of the 1920s, although this status was only formalised in the 1940s.  The pound by then had been bled dry: by World War One; debt; overvaluation on the Gold Standard after 1925 and an associated deindustrialisation, before the coup de grace of the Great Depression (itself partly caused by the lack of certainty in the international monetary system); the pound’s final departure from gold in 1931; and World War Two. (Two good writers on this subject are Barry Eichengreen, in Golden Fetters, and Charles Kindleberger in his The World in Depression.)  A similar litany of horrors looks unlikely to beset the US in the near term, notwithstanding the rigours of the recent financial crisis. 


Of more value for Chinese policy makers might be discussion of the "economic war" pursued by President Charles De Gaulle of France in the mid to late 1960s, a comparison made by economist Barry Eichengreen in an excellent recent article.  De Gaulle argued that the difference between the gold peg of USD35 per troy ounce and the currency’s paper value (traded at USD40 per troy ounce in London in 1960) was significant and worsened with the inflationary spending associated with the Vietnam War and President Johnson’s Great Society programme.  Accordingly, he applied for the conversion of some of France’s dollar reserves into gold.  De Gaulle’s policy devolved from the Triffin dilemma, an economic theory which dictates that the issue of an international reserve currency prompts conflict between an issuer’s domestic and international monetary policy.  The issuer must paradoxically run a current account deficit in order to provide liquidity at the same time as running a surplus to maintain confidence in the currency’s value.  De Gaulle’s position now appears astute.  After all, the US did devalue in 1971, when Nixon closed the "gold window" and floated the US dollar as a fiat currency, and the price of gold had climbed to USD180 per troy ounce by 1977 (and about USD1000 today).  The Bretton Woods system collapsed between 1971 and 1973, leading the world into the free floating regimes most developed countries pursue today. 


This comparison is of great value, since the Asian economies now resemble their European counterparts then, by virtue of maintaining a pegged exchange rate and their reliance on export-led growth.  However, the differences are also salient.  In the 1960s, the US needed Cold War allies (or clients), and so subsidising their growth through undervalued exchange rates matched strategic imperative (and indeed was more affordable for a relatively bigger US economy).  Arguably, Nixon’s move should be set in the context of his policies of rapprochement with China and détente with the Soviet Union, thereby rendering US clients less important.  China today, by contrast, is not an ally in the same mold as 1960s West Germany or 1970s Japan. It is an overt competitor, and its peg is damaging to US interests.  A further difference is that the surplus countries did jettison their pegs to the US dollar in the 1970s, thereby helping to rebalance the world economy.  This time China (and other Asian states) wishes to maintain the undervalued nature of its currency since it is reliant on a strong dollar to enrich its export sector.  The US also seems to have limited will to force a change; while Nixon merrily imposed a 10% surcharge on imports to force the shift, Obama is reticent about doing so. 


A further difficulty China faces it that it will not prove easy to recast the international system.  In the 1960s, efforts to expand the use of Special Drawing Rights (SDRs), a financial instrument of the International Monetary Fund (IMF) based on a basket of currencies, failed since most states were unwilling to let the IMF play the role of a de facto global central bank.  The debate on international monetary policy suggests a similar jealousy about national sovereignty reigns today (which even the discussions about the euro, the best contemporary example of pooled economic sovereignty, demonstrate). 


The figures speak for themselves, then.  According to research in 2010 by the Federal Reserve Bank of New York, about 65% of cash holdings of US dollars were outside America in 2010, about two thirds of exchange reserves held by industrialised states were in US dollars, over 80% of foreign exchange transactions used the dollar and 39% of international debt issues were denominated in US dollars.  These numbers take account of the recent financial crisis and loss of faith in the dollar. 


Accordingly, for the moment Beijing can really only hope that its currency becomes more internationalised and respected.  The renminbi will probably, for instance, take its place in the basket of currencies from which the IMF calculates the SDR’s value.  In time, it may also become one of a number of secondary reserve currencies (which might include the dollar and the euro, if it survives) and eventually could even overtake the dollar.  In the near term, though, short of war or catastrophe the renminbi will struggle to replace the dollar.  The greenback will stay preeminent in international money, not least thanks to the most powerful forces in the world of finance: habit and inertia.