Reserve currency war?

The 2008 Financial Crisis marked a major turning point for the global economy but also a challenge to the economic hegemony which the United States has enjoyed since the end of the Cold War. Today, the United States is experiencing both a financial weakness, but also a steady decline in its image as a global superpower given its foreign policy actions in the past decade. Though originally touted as a viable successor to the USD, the Euro has lost such considerations in the face of the ongoing European debt crisis.

A reserve currency is a currency that is held in significant quantities by many governments and institutions as part of their foreign exchange reserves. If we look back historically, no one currency is immune to be dethroned as the global reserve currency. The British Pound faced a gradual decline after World War I and a complete replacement by the USD after World War II. The Cold War’s polarization of nations around the world around ideological lines provided a great platform for the United States to extend its influence around the world under the guise of combating Communism. With this greater influence came the political and economic alignment from allied nations with the United States. Thus, it is clear that the rise of the USD was very much connected with the United States’ foreign policy during the Cold War era. With the Soviet Union disbanded, the spread of capitalism became truly global and we entered into a new era of globalization which has also shown the complexities of large financial flows to destabilize economies.

In much the same way that the Bretton Woods agreement sealed the fate of the British Pound as a reserve currency, the 2008 Financial Crisis represented a similar unforeseen but large disturbance in the global political and economic landscape. We are now beginning to see China gradually chipping away at the economic hegemony of the United States, with its own diverse set of soft power tactics. China’s large reserve of over three trillion USD has been a potent weapon in its bid to expand its global reach. Outbound Chinese M&A activity such as Lenovo’s acquisition of IBM in 2005 demonstrate the subtle but continued Chinese strategy of appropriating its pent up reserves globally to increase its power projection. More recently, China’s heavy investment globally in an attempt to secure its energy future has put significant Chinese presence in countries such as Angola or Venezuela. Though these countries represent more of ideological allies with the Chinese Communist government, China’s recent offer to purchase Greek bonds is again a sign of their gradual build-up of their foreign power base. If we were to compare this phenomenon in the absolute with the United States’ policies of aiding countries fighting against Communism, then we see some striking similarities which would suggest that China is well on its way to establishing the global influence needed for the widespread use of the RMB.

In the context of China, the political situation is very unlike that of the United States or the United Kingdom at the time of their respective currency ascendency. Though China possesses aspects of a modern market economy, it is today a unique mix of ideological communist governance with the economic benefits of its liberalized economic policies. However one key aspect of its growth model which in its current will limit the adoption of the RMB is its fixed exchange and stringent capital controls imposed by the Chinese government. Though, the People’s Bank of China has over the past decade has let the RMB appreciate on several instances against the USD, the topic of the fixed RMB exchange rate is still a contentious issue today. For the RMB to be a true reserve currency, its exchange rate would have to be allowed to float against other major currencies. Though this is unlikely within the next decade given that such a move would considerably undermine the competitiveness of Chinese exports, there are some fundamental changes in the Chinese economy which hint that the importance of keeping the RMB fixed is waning in the eyes of Chinese policy makers.

Over the past decade we have seen a gradual transition from the export-driven model to the production of higher value-add products, but also the development of a service economy domestically as rising incomes facilitate the demand for luxury goods and services. The Chinese economy has been able to facilitate the development of more high tech manufacturing such as solar cells and the active development of domestic Chinese companies in the technology space (Lenovo, Haier) demonstrates a desire on the part of the central government for China to gradually switch to a consumption economy like that of the United States. Another factor which could curtail the dominance of Chinese manufacturing is the large relative increases in wage rates for workers in manufacturing. It is conceivable that China could have less of a role in global manufacturing as other developing nations like Vietnam come in to take up Chinese output with its cheaper labor. Given these broad economic trends within the Chinese economy, the importance of the RMB fixed exchange rate could significantly diminish in the coming decades thus allowing for a liquid global market for RMB.

Exchange rate aside, the Chinese government has made significant efforts to increase the volume of RMB traded globally and facilitate the creation of markets for RMB denominated securities. Recent efforts to popularize the use of the RMB though ‘dim-sum’ bonds which are corporate bonds denominated in RMB have grown exponentially. China has also negotiated with Brazil to settle trades in RMB. In addition to these steps there have been recent measures to develop Chinese financial markets with the launch of Chinese options and futures markets. The recent innovations in Chinese financial markets demonstrate a gradual sophistication of the Chinese financial system and it is likely that over time, a large market for RMB denominated securities will emerge. This process however will be slow and may likely take decades.

Though trends in the central government’s stance towards establishing freer financial markets for the RMB have been promising, there is a big but less obvious setback for the RMB and this involves both China’s political relations going forward with its major trade partners, but also general concerns around governance and stability. Since its economic reforms, China has steadily built its relations with the developed West, however this relationship can be characterized as being more along trade than any political or cultural lines. Issues around human rights, corruption and fake products are some of the sensitive political issues which have caused tension between China and the United States. Furthermore, provincial rioting and the lack of free speech lead to concerns over further domestic tension which may undermine stability. Unlike the Bretton Woods agreement, which was more or less a transfer of reserve currency status among allies in WWII, the rise of China is a phenomena which has caused political unease in the established West. It remains to be seen if countries such as the United States or United Kingdom will readily adopt the RMB as a reserve currency given their undercurrent of political tension with China. An alleviation of such contentious issues would require a drastic reform of the central government and thus is the greatest challenge to the RMB achieving reserve currency status. Assuming continued growth and the promotion of the RMB, it is likely that the central government will gradually reform to stay in power and maintain stability.

There has been much talk of the rise of China as a challenger to the United States. In actuality this is to some extent an exaggeration given the many domestic political and economic problems which the Chinese leadership must address. History has shown that a change in the reserve currency is gradual and takes place over decades. The United States today is financially weak and arguably in a decline, thus it is conceivable a new currency may take the USD’s reserve currency status. The RMB has the potential to achieve this status given China’s extensive trade relations and its active efforts to project soft power globally. The obvious hurdles of fixed exchange rate and limited financial markets are issues which are already being addressed and will likely change in decades as the Chinese economy adjusts its growth model. The more serious hurdle is the political tension and perception which hold China back as a benevolent global power and hence also the global adoption of the RMB. It is however plausible that the Chinese government will undergo a gradual form of reform in the coming decades to allow the RMB to become the world’s next reserve currency.