Wednesday, March 24, 2010
Far too many things would have to go right in China and wrong in the U.S.
When the country emerged as the world's superpower, after a protracted confrontation, it paid a high price. It had formerly exported capital and had its public spending well under control; now it ran extremely dangerous trade deficits and could sustain its funding only by massively selling bonds to its neighbor across an ocean to the west. That neighbor built up large trade surpluses as it accumulated those bonds. No one thought it could ever topple the superpower from its place as world leader. They certainly didn't imagine that the bond-buying nation would go on to make its money the world's reserve currency. But that is exactly what happened.
The U.S. and China today? No. Great Britain and the U.S. in 1918. The pound went into an inexorable decline after World War I that ended with the dollar taking over when the Bretton Woods agreements were worked out after World War II.
The consulting firm McKinsey recently published a study titled, "Will China's Currency Replace the Dollar as the World Reserve Currency?" It's a question many people have been asking.
There are several strong-sounding arguments in favor of the proposition. (1) America's trade deficit has been beginning to seem unsustainable, and shifting demographics mean it's only going to get worse. (2) The U.S. has incurred trade deficits repeatedly for far longer than can be explained by its having the world reserve currency, and the Chinese Central Bank has long been accumulating reserves, thanks to its trade surpluses. (3) The Federal Reserve's lax monetary policy is further weakening the dollar and threatening to trigger inflation. (4) The U.S.'s enormous and growing foreign debt might encourage the use of inflation to devalue that debt. (5) Furthermore the subprime crisis has profoundly harmed American financial systems and consumers.
But there are at least nine even stronger counterarguments. (1) The Chinese capital markets would need to have far more liquidity and transparency before investors would consider using the renminbi (China's official currency, whose unit of denomination is the yuan) as a world reserve currency, and there's no sign of that coming about. (2) The U.S. has never, in its 234 years, missed a payment on its debt. Right at the dawn of the republic, during the War for Independence, Congress concluded that nonpayment of debt would be national humiliation and must never happen. (Argentina's congress took the opposite route when it approved the nonpayment of debts in 2002, to the applause of all the legislators present.) (3) Because China is still a communist dictatorship, its fiscal and monetary policies won't respond to market forces the way a democracy's do, and that creates a strong element of uncertainty. (4) China is facing its own demographic time bomb as a result of laws introduced in the 1980s that limit the number of births. (5) China's economic growth is based on the export of low-added-value products and a controlled rate of exchange, which give it an unbalanced economy with a low level of consumerism. (6) China is effectively two countries, one urban and developed the other rural and undeveloped, and the divide between them could lead to social instability that could threaten the country's economy and currency. (7) The Chinese economy depends too heavily on exports to one nation, the U.S., and (8) has structural weaknesses because of a lack of supply of raw materials. (9) The U.S. economy relies on innovation and competition to generate productivity; without those free-market forces China's medium-term competitiveness is more uncertain.
The pound didn't stop being the world reserve currency overnight. The process started around 1870 and was completed in 1945. For the yuan to take over from the dollar, the Chinese would have to do a great many things extremely well, and the Americans would have to do a great many things very badly. It just does not make sense to bet on that happening. The dollar will continue to be the world reserve currency because, among other reasons, there is no valid alternative, especially now that the euro has been rocked by Greece's crisis.
Napoleon is reported to have said "Let China sleep. For when China wakes, it will shake the world." What Napoleon did not know was that in 1800 China represented 50% of the world's gross domestic product--and today it represents 10%, at market prices. China depends far more on the U.S. than the U.S. does on China.
Many generations will come and go before there is any chance that China's money will become the world reserve currency. It will probably never happen.
Ignacio de la Torre is a professor and academic director of the master in finance programs at IE Business School, in Madrid.
For further reading:
"Reserve currencies: Dilemma for central bank chiefs", Peter Garnham, Financial Times, March 29, 2010
"China 'will not bow on currency'", Al Jazeera, March 25, 2010
"Yuan Poised to Become Reserve Currency", Bloomberg, March 19, 2010
"Will Yuan Replace the US Dollar as the Reserve Currency of Choice?", Riaz Haq, March 18, 2010
"China's Pressing Need to Buy Gold", Vronsky, Gold-Eagle, December 29, 2009