The dollar, the RMB and the euro?

By Michael Pettis

Barry Eichengreen had a very interesting piece in last week’s Wall Street Journal. In it he argues that we are approaching the end of the period in which the US dollar is the world’s dominant reserve currency, and suggests what that might mean for the world. Here is what he says:

The single most astonishing fact about foreign exchange is not the high volume of transactions, as incredible as that growth has been. Nor is it the volatility of currency rates, as wild as the markets are these days. Instead, it’s the extent to which the market remains dollar-centric.

…The greenback, in other words, is not just America’s currency. It’s the world’s. But as astonishing as that is, what may be even more astonishing is this: The dollar’s reign is coming to an end. I believe that over the next 10 years, we’re going to see a profound shift toward a world in which several currencies compete for dominance.

I wish Eichengreen were right, but I don’t think he is. Eichengreen argues that one of the main reasons for the current dominance of the dollar was simply the lack of plausible alternatives. This is changing, he suggests, because of the rise of the euro and the RMB.

I am a huge fan of Eichengreen’s and read nearly everything he writes. In fact in January when The Economist asked a number of pundits to suggest who were the two most important economists to rise post GFC, I nominated Hyman Minsky and Barry Eichengreen. I think however on the subject of China he has pretty consistently underestimated the problems the country faces and overestimated Beijing’s accomplishments.

The RMB is unlikely to become a serious reserve currency in the foreseeable future. There are a number of reasons for this. First and most obviously, there are few realistic mechanisms by which the world can acquire RMB. Either China needs to run a large current account deficits, or it needs totally open domestic financial markets in which foreigners can easily acquire domestic RMB-denominated bonds to the tune of several percentage points of China’s GDP annually. I discussed why in a blog entry five months ago.

We are unlikely to see either for many, many decades. Although China will struggle to bring its current account surplus down, there are only two ways it can do so (remember that the current account surplus is equal to savings less investment).

One way is for a further surge in investment. At current levels, however, investment is already so value-destroyingly high (to coin a new adverb), and it is pretty clear that Beijing is desperate to reduce the economy’s dependence on further investment growth, so we can pretty much dismiss investment acceleration as something that is likely to be maintained over the next decade.

The other way is to reduce savings by raising the consumption share of GDP. As I have written before, however, this is going to be excruciatingly difficult, and will likely come about only with a sharp reduction in Chinese GDP growth (in which case one of the main reasons for predicting the rise of the RMB will be undermined).

And how long will it take to bring down savings? The household consumption share of GDP was an astonishingly low 35.1% in 2009, while the total consumption share of GDP, including government and business, was 48%. On Wednesday there were reports that Beijing wants to raise the rate by 2-3 percentage points during 12th Five year Plan.

Only 2-3 percent?

While most people took that as a good thing, to me it was an indication almost of how hopelessly difficult the whole thing is going to be. If the government is successful in increasing consumption by 3 full percentage points, and if we make the generous assumption that this increase occurs fully as an increase in the household consumption share (an increase in government consumption doesn’t count unless it is funded out of privatization proceeds, which is very unlikely), this will bring household consumption up to 38% or so of GDP.

Success? Not at all. Five years ago household consumption was at 40% of GDP, which back then already seemed astonishingly low (and was probably unprecedented in history). It was widely understood back then that such a depressingly low consumption share condemned China to an excessive reliance on investment and a trade surplus for growth. With such low consumption, in other words, it is going to take an awful long time before China can consume all it produces.

I discuss this in a lot more detail in my current newsletter, and especially in light of what has clearly been a very contentious debate in the run-up to the National People’s congress, but I think we can pretty much forget about China’s running a large current account deficit in the next decade, let alone one large enough to feed the world’s need for RMB if the RMB is indeed going to be a dominant reserve currency. That leaves the only other way for the world to accumulate large amounts of RMB bonds: China must open up its capital markets to portfolio inflows representing several percentage points of GDP.

Is that going to happen? For the reasons discussed in my blog entry of five months ago this will require a much greater reform of corporate governance and the financial sector than I think is reasonable to expect and it will probably also mean that reserve growth will actually accelerate – something no one wants to see.

That leads to the second reason why I think Eichengreen’s expectations for the rise of the RMB as a reserve currency are unrealistic. The amount of financial sector reforms required before the RMB can even achieve the yen’s level of acceptance is massive, and in my opinion there has been no significant reform, and in fact a lot of retrogression, in the past decade. Beijing simply cannot permit the necessary amount of capital inflow and outflow until the banks are reformed, liberalized, and made creditworthy.

I will write a lot more about this in the next month or so, but for now it is worth pointing out that the Chinese banking system is one of the least efficient in the world when it comes to assessing risk and allocating capital, and would be bankrupt without repressed interest rates and the implicit (and sometimes explicit) socialization of credit risk. Beijing accepts this because of the tradeoff that gives it banking stability.

Beijing greatly values this stability, even at the expense of capital misallocation, and is in no hurry to give it up by opening up the financial markets and, what’s more, for political reasons I think local governments will resist ferociously any further corporate governance reform. Remember that the phrase “corporate governance reform” in the banking context is just another way of saying that credit decisions will be made on the basis of economic considerations, and not on the basis of government preference. That particular reform will be politically contentious.

A long way to go

The third thing that will limit the rise of the RMB as a dominant reserve currency is, I think, that the geopolitical conditions in this region are pretty bad. The most obvious major countries in the region that can help the process of RMB internationalization – Japan, Russia, India, Korea and to a lesser extent Vietnam and at least one or two others – have a deep mistrust of China and are unlikely to assist the process beyond some minimum level. Remember that one of the reasons sterling never achieved the dominance that the dollar has today is that the French and the Germans, not to mention some other European powers, actively undermined its role in favor of their own currencies. I don’t see why this won’t happen again.

Finally I would also point out that many of the RMB “successes” that everyone touts as evidence of the inevitability of the RMB are really not successes. The fact that Chinese companies are now more likely to bill their transactions with their foreign affiliates in RMB rather than dollars makes it seem like its use in trade is soaring (from a very low base), but it changes almost nothing meaningful, and the widely-reported swaps between the PBoC and other central banks consist for the most part either in disguised loans to countries that will take loans from almost anybody, or indirect ways of preserving dollars (as a member of the board of one such foreign central bank told my central banking seminar).

The belief in the rise of the RMB, in my opinion, is just a replay of the equally fervent belief twenty years ago in the rise of the yen, and the RMB has many of the same constraints that the yen had, but only more so. The RMB still has a long way to go before it will even match the yen.

Perhaps paradoxically, in spite of my belief that several countries will leave the euro (or “adjust” their relationships), I am more sympathetic to Eichengreen’s arguments about the euro. I think once the European crisis has stabilized in the next five to six years the euro will be on a sounder footing – perhaps that should read “on a less absurd footing” – and the euro will become increasingly important as a reserve currency. I agree with Eichengreen that the current dominance of the dollar is extraordinary, completely unprecedented historically, and simply cannot be maintained.

Nor should it. This may be a long shot prediction, but it seems to me there is a growing sense in some US circles that maintaining the dollar as the reserve currency is a public good whose cost was manageable during most of the post-War period but, perhaps since the 1980s, has become increasingly heavy for the US. If we can divorce talk of the dollar from talk of the rise or decline of the US, I think an increasing number of US policy-makers will start to see that the US would be better off if the world were forced to accumulate SDRs or other currencies rather than dollars. This, of course, would be terrible for export-led growth strategies in Asia, but given fears first of a rising Japan and now a rising China, the fact that disengaging from the dollar is bad for Asia will not be a strong argument against it in the US.

The US should take the lead

In fact it is ironic to me that it is considered pro-American to want the dollar to maintain its role as the world’s dominant reserve currency and anti-American to call for a change. I have a very different take. As I see it the dominant role of the dollar is as a public good provided by the US that, because a number of countries have taken to gaming the system, is proving too costly for the US.

In other words I think the use of the dollar as the dominant reserve currency may mean slower economic growth and higher debt for the US. A lot of strange conspiracy theories center on the role of the dollar as the linchpin to American power. In a debate on a well-known current affairs program on Chinese television two years ago, a Chinese professor from a famous Beijing university assured me that American economic dominance occurred because the dollar was the world’s primary reserve currency.

Leave aside that the US was the largest economy in the world, with the most advanced technology and the highest per capita income, by the late 19th Century, at least six or seven decades before Bretton-Woods, this is the sort of claim that can only be made by someone who has a very weak grasp of monetary economics. The strongest argument in favor of the importance to the US of the dollar’s reserve status is that it permits the US government to fund itself cheaply, and in its own currency, with the savings of the rest of the world. But this argument may get it exactly backwards.

Any country with credibility and an actively traded currency can fund itself in its own currency. So why do foreigners own such a large share of US government debt? Isn’t it because they have to buy US Government bonds to hold as reserves, and aren’t foreign purchases needed to make up the shortfall in US demand for government bonds?

No. US investors can easily fund US government debt. Foreigners own US dollar assets, of which US government bonds are the safest and most liquid, because they run current account surpluses. This is true almost by definition. Countries with current account surpluses have no choice but to acquire foreign assets, and the country whose assets are thus acquired has no choice but to run the corresponding current account deficit.

Countries whose domestic policies require large trade surpluses, in other words, must buy the assets of those countries with liquid and open asset markets that are able to run large current account deficits. In practice the US is the only economy large enough, flexible enough, and open enough to act as the counterpart to the net current account surpluses accumulated by the rest of the world.

If countries that have accumulated massive reserves, like Japan, Germany and China, chose to diversify their holdings, or were forced to, away from the dollar, this would be tantamount to saying that the US current account deficit would have to contract and other countries would be forced into absorbing those surpluses. The US would also borrow less because a lower trade deficit would require less fiscal or household borrowing to maintain any given level of growth and employment.

But very few other countries can absorb the US trade deficit. In that case countries that rely on large current account surpluses to absorb their excess capacity would be forced into reducing their surpluses and reducing their capacity. Their growth, in other words, would be lower.

The US, on the other hand, would be “forced” into either higher growth or lower debt levels. This does not seem either like a good thing for surplus countries or a bad thing for the US.

This is an abbreviated version of the newsletter that went out Tuesday. Academics, journalists, and government and NGO officials who want to subscribe to the newsletter should write to me at [email protected], stating your affiliation, please. Investors who are clients of Shenyin Wanguo Securities will already receive the newsletter. Investors who are not clients but who want to buy a subscription should write to me. also at that address.

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