It isn’t easy being green

by Michael Pettis

The seemingly imminent and inexorable rise of the renminbi as a major, even dominant, reserve and trading currency, has been almost as widely heralded as the equivalent rise of the Japanese yen just twenty years ago. Even my normally skeptical friend Nouriel Roubini seems to think so.  Here is an article from last year’s Telegraph:

The Chinese yuan is preparing to overtake the US dollar as the world’s reserve currency, economist Nouriel Roubini has warned.  Professor Roubini, of New York University’s Stern business school, believes that while such a major change is some way off, the Chinese government is laying the ground for the yuan’s ascendance.

Known as “Dr Doom” for his negative stance, Prof Roubini argues that China is better placed than the US to provide a reserve currency for the 21st century because it has a large current account surplus, focused government and few of the economic worries the US faces.

As my reference to the Japanese yen might suggest, I am pretty skeptical about the likelihood of this happening, at least with some of the more excited predictions.  So, by the way, is the ADB, whose recent report (“The Future Global Reserve System — An Asian Perspective”), suggests that by 2035, the RMB may comprise about 3 to 12 per cent of international reserves.  This is a pretty reasonable prediction, in my opinion, and far from the more feverish claims we see reported almost daily.

If the renminbi ever becomes a major trading or reserve currency, it is going to take a long time for this to happen and will require a radical transformation of the Chinese economy and the role of the government.  This may seem like a surprising statement.  After all nearly every week we see reports about a new breakthrough for the renminbi, and almost every day someone important somewhere speculates publicly about what the world will be like when (never if) the renminbi displaces the dollar.

But away from all “qualitative” arguments about why this is unlikely, and there are many, I think there is a problem with the arithmetic of reserve currency accumulation.  If the rest of the world is going to use the renminbi as a reserve or trading currency, clearly it needs a mechanism by which to accumulate renminbi.  This is something on which a surprisingly large share of people who talk about the future of reserve currencies don’t seem to focus.

Leave aside the fact that foreigners are prevented from having renminbi accounts and that it will probably be many years, if not decades, before the PBoC is willing to allow full convertibility, with limited government intervention and no control over the setting up and trading of its currency.  The world still needs a way to accumulate renminbi in order for it to be a major trading or reserve currency.

How does the world accumulate sufficient renminbi to acquire reserve status?  There are basically two ways.  First, China can run a current account deficit.  Second, foreign capital inflows into China can be matched by Chinese capital outflows.  The second way does not result in a net foreign accumulation of Chinese assets, but it allows foreigners to hold renminbi bonds and other assets to the same extent that Chinese hold assets abroad (above the current account surplus, of course)

Let’s examine the first.  Since the 1950s the US has typically run current account deficits of, I think (this is a back-of-the-envelope calculation), around 0.25-0.50% of global GDP which also, needless to say, is the rate at which net foreign acquisition of US dollar assets has occurred (in the past decade it rose to around 1.5% of global GDP).

There have been periods in which the US current account was substantially lower, or even positive, for example in the late 1940s and early 1950s, but during these periods the world complained mightily about a dollar shortage and its impediment in the development of world trade.  In fact one of the driving reasons for the US Marshall Plan was to provide dollars to foreigners to facilitate trade.

The rise and fall of the yen

What would that imply about the accumulation of the renminbi?  There is a fierce race on among US and European investment banks to predict the earliest date by which China will be the world’s leading economy, and I think the winners say that China will be around 20% of the world in 2020.

I am very skeptical that this will occur, but let’s say that it does.  This would imply that to replace the dollar sometime after 2020 China would probably need to run a current account deficit of 1.2-2.5% of its GDP.  Of course the renminbi might not replace the USD but simply match it.  In that case let’s assume China needs to run a current account deficit of half that amount.

Can it?  Maybe, but I am not sure that is very likely.  Look at the case of Japan.  Twenty years ago Japan already represented nearly 18% of the world (China and Japan are both 8% today) and it was widely assumed that it would overtake the US within one or two decades and that the yen would replace, or at least reach par with, the USD.

But this didn’t happen.  The huge Japanese domestic imbalances – similar to but much lower than China’s today – forced the country into a long and difficult adjustment.  Here is what an article in Sunday’s New York Times says:

In 1991, economists were predicting that Japan would overtake the United States as the world’s largest economy by 2010. In fact, Japan’s economy remains the same size it was then: a gross domestic product of $5.7 trillion at current exchange rates. During the same period, the United States economy doubled in size to $14.7 trillion, and this year China overtook Japan to become the world’s No. 2 economy.

What happened to Japan’s then unimaginably large current account surplus?  It came down significantly, but it never became a current account deficit.

In fact the evolution of the Japanese surplus is interesting.  Two things drove it down relative to the global economy.  First, Japan’s size as a share of the world economy dropped by more than 50%.  Second, Japan’s surplus as a share of GDP declined, although not nearly as dramatically.

In other words there was a slow, painful rebalancing within Japan as household consumption growth declined over the past two decades (I think to about 1.5-2.0% annually) but still outpaced GDP growth, which declined much more sharply (close to 0%).  And there was a sharper global rebalancing as Japan’s current account surplus dropped even more as its share of global GDP fell.

By the way, the contraction in Japan’s surplus was expansionary for the rest of the world, which I think is at least part of the reason why the world was able to grow so quickly in spite of Japan’s lost decade.  Remember that nearly everyone in 1990 would have insisted that a lost decade for Japan (if such a thing were even imaginable) would have been terrible for the world economy.  They would have been wrong.

Given that China’s consumption imbalance is far worse than Japan’s, I suspect that even assuming Chinese policymakers can accept a China with current account deficits, it will take a very long time for China to eliminate its surplus and replace it with a deficit.  But why did Japan continue to run surpluses after all these years, and might China not be different?

Maybe, but I am not sure.  It seems to me that the longer the Japanese distortions (especially repressed interest rates) were in place, the more debt built up, the more the large and growing capital-intensive sector required cheap capital to survive, and the harder it was to adjust interest rates.  China seems to me very reliant on the same set of polices, especially very cheap capital, and it may be just as hard for them to adjust.  For those who haven’t read my earlier pieces and wonder what cheap capital has to do with domestic imbalances, remember that cheap capital transfers income from net savers (households) and so reduces household consumption.  It is, in my opinion, the single most important cause of China’s low consumption.

To get back to Japan’s experience, remember also that when the yen was finally forced to revalue after 1985, as the renminbi will almost certainly be, Tokyo responded to the potential slowdown with the only tool it had – investment expansion and lower real rates.  This is also the only tool Beijing has, and it will almost certainly use it, making the current account adjustment even worse.

Let the foreigners in

For these reasons I am not sure how easy it will be for China to run the necessary current account balances that will allow the world to acquire net renminbi assets.  But what about the second way I listed above?  Can’t China export renminbi investment as it imports foreign investment?

Perhaps, but how much?  I don’t have numbers in front of me, but I believe that gross capital exports from the US have been over the past few decades roughly 2.0-2.5% of global GDP.  That means that before the explosion in the US current account deficit in the past few years the rest of the world was accumulating gross USD assets of roughly 2.3-3.0% of global GDP (gross capital exports plus the current account deficit).

Even if China provides only half the amount of renminbi assets, it would imply a huge amount of gross foreign investment into China.  The table below shows the amount of foreign capital inflows into China as a share of Chinese GDP according to four different scenarios.  I am assuming that the world needs to accumulate half the gross amount of renminbi assets that the world has accumulated annually in US dollar assets (and I exclude the past decade because the numbers were exceptionally high and so any comparison would be unfair):

China’s share of global GDP



Current account deficit of 2% of GDP



Current account surplus of 3% of GDP



As the table shows, this is a lot of foreign investment.  To read it, assume that China grows to represent 20% of the world and manages to run a current account deficit of 2%.  In order to provide half the amount of gross foreign ownership that the US provided, it would need capital inflows equal to 5-7% of China’s GDP.  If China ran a current account surplus of 3%, it would need gross inflows of 8-9% of GDP.  Of course if China is smaller than 20% of the world, the necessary capital inflows would be a larger share of the economy.

By the way please don’t examine these numbers too closely because they are rough estimates based on lots of changing variables over many years.  Their only purpose is to indicate the approximate magnitude of necessary flows relative to the Chinese economy.

And the numbers are pretty big.  For comparison purposes, I believe that foreign investment into China is at the low end of the 1-2% of GDP range, mostly in the form of FDI, and many people believe that a significant share of those inflows may actually be mainland money round-tripped to take advantage of capital and tax regulations.  With the exception of FDI, which is quite small in the scheme of things, China has been very reluctant to let foreign investors into the country, and almost never allows a foreign company to take control of any sizable local company.

Will China be in a position such that the combination of the current account and gross capital inflows will permit renminbi accumulation on anywhere near the scale required for the renminbi to take on half the presence of the USD today?  Perhaps, but I would point out two things.  First, the only other challenger to the dollar was the yen, from a country much larger than China is today, and the domestic imbalances that limited the growth of its currency as a reserve currency, though deep, may have been significantly less than China’s.

Second, if we posit gross capital inflows into China of nearly the amount required, we are also positing, it seems to me, a radical change in the nature of ownership and governance in China, as well as a radical redrawing of the role of the central and local governments in the local economy.

This is an awful lot of Chinese assets to be owned by foreigners, and it requires that a lot more assets than currently available be open to foreign ownership (and, not insignificantly, to the desire of foreign ownership).  The total value of the stock market is about 40% of GDP, and the government owns most of this directly or indirectly.  For how many years can foreigners acquire assets in the amount of even 3-5% of GDP before running into some significant limits?

I am not sure that it will be easy for China to accept foreign investment levels anywhere close to the levels the US accepts (even without taking into consideration that the US runs a current account deficit and China a surplus).  Remember that foreign ownership of assets has a long history in the US, and a very large amount of assets in the US are marketable and in private hands, whereas foreign ownership has a very brief and complicated history in post-1949 China and a much smaller share of Chinese assets is private.

But if foreigners don’t own tens of trillions of dollars of Chinese assets, the only way they can accumulate tens of trillions of dollars of renminbi assets is with a cumulative Chinese current account deficit in the tens of trillions of dollars, a feat which even the US would have trouble managing.

It isn’t impossible, of course, but nor should it be thought of as inevitable

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