Reserve currencies

Climbing greenback mountain

The yuan is still a long way from being a reserve currency, but its rise is overdue

Sep 24th 2011
from the print edition

AT THE FLAGSHIP store of Yue Hwa Chinese Products in Hong Kong customers can find exotic and everyday items from mainland China without having to cross the border. The offerings include silk brocades, sandalwood carvings, Sichuan peppers and traditional Chinese remedies such as ribbed antelope horns. Horn shavings, boiled in water, are said to quieten the liver and quell fevers.

Feverish visitors from the mainland can even pay for their savings in their own currency, the yuan. The store charges 2,660 yuan ($416) for a whole horn, at an exchange rate of 1.1 Hong Kong dollar per yuan. Nearby money-changers offer a better rate, but some Chinese visitors prefer the convenience of using their own money. That way they can still get a late-night snack at the 7-Eleven after the money-changers have closed.

That is how, not long ago, the yuan set out on its career as an international currency. It crept into Hong Kong in the wallets of mainland visitors. The trickle across China’s borders quickened last year when the government allowed a broader range of Chinese firms to settle imports and exports in yuan. In the same year it set these offshore yuan free. Outside the mainland, the yuan could be transferred between banks, borrowed, lent and invested, just like any other currency.

This offshore experiment is, for many forecasters, a first tentative step towards making the yuan a fully fledged reserve currency to rival the dollar and the euro. But China’s policymakers are in two minds, as they tend to be when it comes to freeing finance. Restricting the flow of money into and out of China protects the country’s immature banking system. When Japan sanctioned the international use of the yen in the 1980s it set the stage for a damaging property bubble.

On the other hand China hates having to rely on the dollar. Officials are troubled by the Federal Reserve’s notably loose monetary policy and by America’s rapidly rising public debt. They fear that stimulus measures put in place to revive America’s flagging economy will sooner or later generate a burst of high inflation and weaken the dollar. That would hurt holders of US government bonds, including China. Around $2 trillion of its currency reserves of $3.2 trillion are in dollars, mostly in bonds. On August 5th America lost its triple-A credit rating from Standard & Poor’s because it had failed to come up with a credible plan to cap its public debt. China’s official news agency, Xinhua, immediately called for a new reserve currency.

Such calls have been made before, during bouts of dollar weakness in the late 1970s and mid-1990s, but the dollar still holds the privileged position in the world’s monetary system it has occupied since the second world war. It faces no immediate challenge to its status, notwithstanding the debt downgrade, because there are few good alternatives. Despite a long and steady decline in its value against other currencies, it still accounts for 60.7% of the world’s $9.7 trillion of currency reserves. That is around three times America’s weight in the world economy as measured by GDP. The dollar’s closest rival, the euro, accounts for 26.6% of the world’s reserves.

How does one currency maintain such dominance? Textbook economics says domestic money has three uses: as a unit of account against which the value of goods is measured; as a medium of exchange; and as a store of value used to conserve spending power for a rainy day.

The won fulfils these roles in South Korea; the yuan does the job in China; and the dollar provides these services in international markets as well as in America. It is the unit of account for commodities such as crude oil that are traded globally. Most trade that is invoiced in a currency other than those of the trading partners is quoted in dollars. And because the dollar is the benchmark for world prices and is used to settle cross-border trades, it makes sense for countries to keep stores of dollar reserves, both as a float and to bolster confidence in their own currencies.

The demand for reserve currencies is a boon to their issuers. Around $500 billion of America’s currency is used outside the country’s borders. Some of this cash is used to lubricate dollar-based international trade. But much of it greases the wheels of cross-border crime such as drug trafficking: crooks need a unit of account, a medium of exchange and a store of value just like legitimate businesspeople.

Indeed, a reserve currency might almost be defined by its appeal to criminals. Of the €900 billion-worth of euro notes in circulation, a third by value comes in the form of the pink and purple €500 note. Cynics say it was issued to capture a share of the international black market from the dollar, for which the largest denomination is $100. An illegal stash of €500 bills would be lighter, easier to conceal and easier to count. The €500 note was withdrawn by banks in Britain after police said its main use was in organised crime. That is a compliment of sorts to the euro. When Somali pirates or Russian gangsters demand payment in yuan, it will be the surest sign that economic power has shifted to China.

The cost of printing $500 billion-worth of notes is negligible compared with the value of the goods and services they can command. In order for those notes to circulate outside America, they must first have been exchanged for $500 billion-worth of goods and services. They represent a cost in real resources. The gap between the printing cost of banknotes and their face value is called seigniorage. Governments that print reserve currencies benefit from extending seigniorage beyond their own borders.

Issuers of international currencies also enjoy protection from currency volatility. A Vietnamese exporter selling to China is exposed to exchange-rate risk: he pays his workforce in dong, the local currency, but receives payment in dollars. If the dollar falls, so do his earnings, but his labour costs are unchanged. American exporters do not have to worry about currency mismatch because both their domestic costs and their export earnings are in dollars.

Nor has America had much need to acquire costly reserves of its own. Under the Bretton Woods system of fixed exchange rates that governed rich-country trade until 1971, members were constantly at risk of running short of dollars if their exports became uncompetitive, whereas America could always print more dollars. This was an “exorbitant privilege”, grumbled France’s finance minister at the time, Valéry Giscard d’Estaing.

Exorbitant privilege v original sin

The privileges of reserve-currency status were not confined to the dollar, though it enjoyed the lion’s share. They include being able to borrow cheaply. The dollars and euros (and, to a lesser extent, the pounds, Swiss francs and yen) that other central banks keep in reserve are mostly in the form of government bonds. The extra demand weighs on bond yields and sets a lower threshold for the cost of credit for businesses and consumers.

This part of the exorbitant privilege contrasts with the emerging world’soriginal sin”, a term coined by Barry Eichengreen of the University of California, Berkeley, and Ricardo Hausmann of Harvard University for some countries’ inability to borrow in their own currencies. Borrowing in foreign currencies (as Brazil and other Latin American countries had done before the 1980s debt crisis) leaves original sinners at risk of default if their currency loses value. Trouble-prone countries have often had to keep interest rates high, even in a recession, to support their currencies and stave off default on foreign-currency debts. Hungary is a recent example of a country in this sort of trap. The Federal Reserve has never had to worry about such things.

China hates having to rely on the dollar. Officials are troubled by the Federal Reserve’s loose monetary policy and by America’s rapidly rising public debt. The divide between the exorbitantly privileged and the original sinners was especially deep after the East Asian crisis of 1997-98. The lesson from that crisis was never to be short of reserves. The investment rate in emerging Asia fell, the saving rate stayed high and the excess saving was sent abroad. It marked the start of an unprecedented build-up of foreign exchange to insure against future balance-of-payments problems. The world’s currency reserves increased from $1.9 trillion in 2000 to $9.3 trillion in 2010. Much of the increase was in China.

The surge in demand for safe and liquid assets in dollars, euros and pounds pushed down long-term borrowing costs. The savings of the emerging world allowed the rich world to spend too freely, one of the deeper causes of the wave of crises that has afflicted the rich world since 2007. America’s financial markets met the global demand for “safedollar assets by repackaging the mortgages of marginal borrowers as bonds, which turned sour. But the resulting financial crisis hit mainly the rich world rather than the emerging markets.

Rich-world banks and investors seeking higher returns when interest rates were low had bought a lot of the ropy mortgage securities. That made room for reserve managers in emerging markets to buy more bonds backed by governments or issued directly by them. Investors were so anxious for yield that they barely distinguished between good and bad credits. Countries with large public debts, such as Greece and Italy, could borrow as cheaply as countries with sound public finances such as Germany. Windfall tax revenue from housing booms fuelled by cheap foreign credit made the public finances of Ireland and Spain look sound until recession (and, in Ireland’s case, the terrifying cost of bank bail-outs) caused public debt to explode.

Some believe the exorbitant privilege is really a curse that lures the reserve-currency country into too much borrowing or printing too much money. Over time this saps the economic and political strength that was the source of the privilege. This paradox was first noted in 1947 in a Federal Reserve paper written by Robert Triffin, a Belgian-born economist.

Under the Bretton Woods arrangement currencies were pegged to the dollar at fixed exchange rates. The dollar in turn was tied to gold at a fixed price. Triffin spotted a dilemma. A rising stock of dollars was needed to finance world trade. The more dollars were supplied, the more the currency’s link to gold would be questioned since America’s gold stocks would support an ever-larger pile of banknotes. This came to a head in August 1971 when heavy selling forced President Nixon to suspend the conversion of dollars into gold.

The Triffin dilemma is echoed in contemporary worries about the rich world’s public debts and its currencies. Easy access to credit lured the euro zone’s periphery into overborrowing. Greece is insolvent, Ireland and Portugal are not far off. For reserve currencies, what is safe is in conflict with what is convenient, argues Stephen Jen of SLJ Macro Partners, a hedge fund, adding that “the euro is efficient but it’s not safe.” Reliable and liquid repositories for rainy-day saving are scarce, which is why reserve managers and bond investors continue to push money into the Treasury market. But this tempts America to overextend itself, amassing debts it may one day struggle to service.

As America’s weight in the global economy drops, supplying the world with most of its reserve currency needs may become too big a job for the country. In his recent book, “Exorbitant Privilege”, Mr Eichengreen argues that a reserve-currency system will emerge in which the dollar, the euro and the yuan share the privileges and the responsibilities. That would make the world a safer place, he reckons, because each issuer would nudge the others towards financial and fiscal discipline.

It is not obvious that one currency needs to play a pre-eminent part. In its heyday, sterling was rarely as dominant as the dollar has it been since took over. On the eve of the first world war the pound accounted for only around half of all reserves: most of the rest was in French francs and German marks. By 1924 more reserves were held in dollars than in sterling.

The dollar is flawed, but so are the candidates to displace it. The euro has no single fiscal authority standing behind it. Nor is there a single issuer of sovereign debt to match the size and liquidity of the market for US Treasuries—although the bonds issued by the European Financial Stability Facility (EFSF), the euro area’s emergency bail-out fund, may foreshadow a single euro bond backed by all its members. For all its shortcomings, the euro still accounts for a quarter of the world’s reserves. Even as the region’s sovereign-debt crisis has deepened over the past year, its currency has gained ground against the greenback.

The speed at which the dollar rose to prominence suggests that the yuan might be an international currency as soon as 2020, says Mr Eichengreen. The greenback overtook sterling in reserves barely a decade after the founding of the Federal Reserve in 1913 as the backstop of dollar liquidity. The Fed pushed the dollar by fostering a liquid market for trade acceptances, the credit notes used to fund shipments. By the mid-1920s more trade was carried out in dollars than pounds and more international bonds were issued in New York than in London.

However, the obstacles to the yuan becoming a reserve currency are bigger than those faced by the dollar in 1913. At that time America was already a trusted storehouse for capital, a democracy where the rule of law was firmly established. China’s recent history is less reassuring, so it will take a while before foreigners feel secure keeping their savings in yuan. The currency would have to be fully convertible so that investors could park their yuan reserves in assets of their choosing and redeem them when needed.

This in turn would require China to allow capital to move freely across its borders, which it has been reluctant to do. In recent years it has eased restrictions on residents taking capital out of the country; for example, more foreign takeovers by big Chinese firms have been allowed to go ahead. But foreigners face formidable barriers to bringing money into China because the government is reluctant to cede control of the yuan’s value or of domestic bond yields to the ebb and flow of foreign capital.

China has taken some baby steps toward setting the yuan free. It has allowed trade in goods to be invoiced and paid in yuan. The proceeds can be put to work in a fledgling offshore yuan market in Hong Kong with restricted links to the mainland. Trade settlement in yuan has grown rapidly, reaching 600 billion in the second quarter of 2011 (around 10% of total trade), according to the People’s Bank of China.

It is a big leap from being a currency in which your own trade is settled to being a fully fledged international currency, and a further jump to reserve-currency status. So far such trade settlement has been a rather one-sided affair: most has been for imports (ie, Chinese firms paying foreigners in yuan for supplies). Few of China’s exporters are willing or able to demand yuan from foreign customers, though those customers should not find it hard to get hold of the currency. China’s central bank has set up swap agreements with the central banks of many of its emerging-market trading partners, ranging from Singapore to Kazakhstan, allowing foreign banks to supply yuan to their customers.

By the end of July yuan deposits in Hong Kong had swollen to 572 billion. The IMF said in July that 155 billion of yuan-denominated bonds (so-called “dim sumbonds) had been issued in Hong Kong since the market was set up, many by branches of mainland banks. Issues by non-financial foreign companies are less common, in part because firms still need permission to bring the cash raised into China. There have been some high-profile deals, though the bonds have short duration. McDonald’s sold a three-year bond last year. Caterpillar, an American maker of earthmoving equipment, has issued a couple of two-year bonds so far. A recent sale in Hong Kong of 20 billion yuan of government debt was heavily oversubscribed.

The offshore yuan market has quickly come up from nowhere and China’s central bank has continued to strike bilateral swap deals to keep it growing. But it is a big leap from being a currency in which a chunk of your own trade is settled to being a fully fledged international currency, and a further jump to reserve-currency status. Only a small fraction of the world’s $4 trillion in foreign-exchange deals each day are for trade settlement. The bulk of currency dealing is for hedging or related to trading in stocks, bonds and other assets. The dollar is one side of 85% of all currency trades, according to the Bank for International Settlements (see chart 2). The yuan accounts for just 0.3% of turnover.

Yet the exorbitant curse will catch up with the dollar one day and the yuan is its most likely replacement. China’s economy is second only to America’s in size and is likely to overtake it soon. It is already the world’s largest exporter. And it has net foreign assets of $1.8 trillion, whereas America owes a net $2.5 trillion to foreigners. Only Japan is in a stronger position.

A global yuan?

Reserve-currency status depends on these three gauges of economic dominancesize of economy, exports and net foreign assets—says the Peterson Institute’s Arvind Subramanian. By 1918 America had the world’s biggest economy and would soon be its largest creditor and exporter; within a few years the dollar also had the lion’s share of the world’s foreign-exchange reserves. If that precedent is anything to go by, the yuan should soon become the main global reserve currency, and not merely a junior alternative to the dollar or the euro.

The rewards to China of opening up fully to foreign capital trump the risks, reckons Mr Subramanian. Turning the yuan into a reserve currency offers China a way out of its mercantilist growth model, which has run its course. Demand for yuan reserves would push up the exchange rate, discourage exports and give China’s consumers greater purchasing power. A push for reserve status for the yuan would go hand in hand with the development of China’s financial system—a necessary step to support the small- and medium-size businesses it needs to serve its domestic market, and for many other reasons. For China to escape the middle-income trap, it will have to let go of the yuan.

The rich world’s monopoly on reserve-currency privileges has given it first call on the world’s precautionary savings. For now, it is clinging on to its privileges. But rivalry from developing countries in the markets for oil and commodities is already exacting a price from the West.

Enter the Dragon

The “Asset Crisis” of Emerging Economies

Yu Yongding


BEIJING – In theory, the difference between capital inflows and outflows in developing countries should be positive – they should be net capital importers, with the magnitude of the balance equivalent to the current-account deficit. Since the 1997-1998 Asian financial crisis, however, many East Asian countries have been running current-account surpluses – and hence have become net capital exporters.

Even odder is the fact that while they are net capital exporters, they run financial (capital) account surpluses. In other words, these countries lend not only the money they earned through current-account surpluses, but also the money they borrowed through capital-account surpluses mainly to the United States. As a result, East Asian countries are now sitting on a huge pile of foreign-exchange reserves in the form of US government securities.

While China has attracted a large amount of foreign direct investment, it has bought an even larger amount of US government securities. Whereas the average return on FDI in China was 33% for American firms in 2008, the average return on China’s investment in US government securities was a mere 3-4%. So, why does China invest its savings so heavily in low-return US government securities, rather than in high-return domestic projects?

One answer lies in the fact that China’s FDI policy over the past 30 years has crowded out Chinese investors from high-return projects, forcing them to settle for less lucrative projects. But there are still potential investors who cannot find any suitable investment opportunities in China, generating excess resources, which in turn are invested in US government securities.

But, while China’s foreign assets are denominated in US dollars, its liabilities, such as FDI, are mostly denominated in renminbi. As a result, when the dollar depreciates against the renminbi, the value of China’s foreign liabilities increases in dollar terms, while that of its foreign assets remains unchanged. As a result, China’s net international investment position (NIIP), which is the difference between China’s gross assets and its gross liabilities, automatically worsens. The deterioration of China’s NIIP is a reflection of the transfer of wealth from China to the US.

Since the 2000’s, China’s gross assets and gross liabilities have increased dramatically, owing to the success of China’s trade-promotion and FDI policies. As a result, China’s net international investment position has become very vulnerable to the devaluation of the dollar.

Meanwhile, capital inflows into developing countries have surged since the 2007-2009 global financial crisis. In 2010, China’s capital-account surplus stood at $230 billion, and capital inflows remain large this year. With ever-increasing gross dollar assets and gross renminbi liabilities, a stronger renminbi means that China will suffer additional welfare losses from the valuation effect of exchange-rate movements. (It is worth noting that this is not solely a Chinese phenomenon; all major emerging-market economies are faced with the same fate.)

During the 1997-1998 Asian financial crisis, East Asia’s economies paid heavily for excessive accumulation of dollar-denominated debts. Because governments failed to defend their currencies, they lost hundreds of billions of dollars in foreign-exchange reserves to international speculators.

Whether for self-insurance or to maintain a competitive exchange rate, East Asia has since then once again accumulated too much dollar-denominated debt. This time around, thanks to the deterioration of the US fiscal position and the Federal Reserve’s expansionary monetary policy, “the long-term risk [for] emerging markets’ external balance sheets is shifting,” as Eswar Prasad of the Brookings Institution has pointed out, “to the asset side.”

Rather than confronting a debt crisis, as in 1997-98, emerging-market economies now face an “asset crisis,” but they will suffer the same result: great capital losses on their foreign-exchange reserves. Indeed, the magnitude of the losses will be on par with that of Asian financial crisis, if not higher.

While China’s government should make greater efforts to rebalance the economy by conventional measures, it also should focus more attention on adjusting the currency structure of the country’s gross assets and gross liabilities. In particular, China should try to replace its dollar-denominated assets with renminbi-denominated assets, and its renminbi-denominated liabilities with dollar-denominated liabilities.

If China cannot do very much about existing gross assets and gross liabilities, it should address new assets and liabilities in order to minimize future capital losses. In short, China must take into consideration the ongoing asset crisis facing emerging economies, especially when considering highly consequential questions such as full renminbi convertibility and the currency’s internationalization.

Yu Yongding, currently President of the China Society of World Economics, is a former member of the monetary policy committee of the Peoples' Bank of China and former Director of the Chinese Academy of Sciences Institute of World Economics and Politics.

Copyright: Project Syndicate, 2011.

China’s Landing – Soft not Hard

Stephen S. Roach


NEW HAVEN – China’s economy is slowing. This is no surprise for an export-led economy dependent on faltering global demand. But China’s looming slowdown is likely to be both manageable and welcome. Fears of a hard landing are overblown.

To be sure, the economic data have softened. Purchasing managers’ indices are now threatening the “50 threshold, which has long been associated with the break-even point between expansion and contraction. Similar downtrends are evident in a broad array of leading indicators, ranging from consumer expectations, money supply, and the stock market, to steel production, industrial product sales, and newly started construction.

But this is not 2008. Back then, global commerce was collapsing, presaging a 10.7% drop in the volume of world trade in 2009 – the sharpest annual contraction since the 1930s. In response, China’s export performance swung from 26% annual growth in July 2008 to a 27% contraction by February 2009. Sequential GDP growth slowed to a low single-digit pace – a virtual standstill by Chinese standards. And more than 20 million migrant workers reportedly lost their jobs in export-led Guangdong province. By late 2008, China was in the throes of the functional equivalent of a full-blown recession.

Thanks to a massive fiscal stimulus, China veered away from the abyss in early 2009. But it paid a price for this bank-funded investment boom. Local governments’ indebtedness soared, and fixed investment surged toward an unprecedented 50% of GDP. Fears surfaced of another banking crisis, the imminent collapse of a monstrous property bubble, and runaway inflation. Add a wrenching European crisis to the equation, and a replay of 2008 no longer seemed far-fetched.

While there is a kernel of truth to each of these China-specific concerns, they do not by themselves imply a hard landing. Nonperforming loans will undoubtedly increase in response to the banking sector’s exposure to some $1.7 trillion of local-government debt, much of which was incurred during the stimulus of 2008-2009. But the feared deterioration in loan quality is exaggerated.

The reason: With rural-urban migration projected to exceed 310 million people over the next 20 years, there is reason to believe that much of the apparent overhang of housing supply will be steadily absorbed. Like Shanghai Pudong in the late 1990’s, today’s Chineseghost cities” are likely to be teaming urban centers in the not-so-distant future. Meanwhile, deposit-rich Chinese banks have ample liquidity to absorb potential losses; the system-wide loan-to-deposit ratio is only about 65%well below earlier pre-crisis levels that were typically closer to 120%, according to a recent analysis by the Xerion team of Perella Weinberg Partners.

Nor is the Chinese property market about to implode. Yes, a building boom and speculative excesses have occurred. But a year and a half ago, the government moved aggressively to dampen multiple property purchasesraising down payments to 50% for second homes and to 100% for third homes. While that halted much speculative activity, house prices have remained at elevated levelsunderscoring lingering affordability issues for China’s emerging middle class.

Notwithstanding that problem, major imbalances in Chinese property markets should prove to be the exception over the next two decades. While there could be supply-demand mismatches in any given year, with an average of roughly 15 million citizens a year slated to move from the countryside to newly urbanized areas, demand should rise to meet supply.

Inflation is always a serious risk in China – especially with headline increases in the country’s Consumer Price Index surging through the 6% threshold this summer. The government has responded forcefully on four fronts.

First, food inflation, which accounts for about half the recent run-up in overall prices, has been addressed by administrative measures aimed at cutting fertilizer costs and removing bottlenecks to increased supplies of pork, cooking oil, and vegetables. Second, in an effort to curtail excess bank lending, reserve ratios were increased nine times in the past 11 months. Third, the rate of currency appreciation has edged up. Finally – and perhaps most importantly – the People’s Bank of China has raised its benchmark policy rate five times since October 2010. At 6.5%, the one-year lending rate is now 0.3% above August’s headline inflation rate.

If food inflation recedes further, and the headline inflation rate starts to converge on the 3% core (non-food) rate, the result will be the equivalent of "passive monetary tightening" in real (inflation-adjusted) termsprecisely what the inflation-prone Chinese economy needs.

All of this underscores a potential silver lining. An increasingly unbalanced Chinese economy cannot afford persistent 10% GDP growth. Provided that there is no recurrence of the severe external demand shock of 2008 – a likely outcome unless Europe implodes – there is good reason to hope for a soft landing to around 8% GDP growth. A downshift to this more sustainable pace would provide welcome relief for an economy long plagued by excess resource consumption, labor-market bottlenecks, excess liquidity, a large buildup of foreign-exchange reserves, and mounting inflationary pressures.

For China, there is a deeper meaning to recent global developments. A second major warning shot in three years has been fired at this export-led economy. First, the United States, and now EuropeChina's two largest export markets are in serious trouble and can no longer be counted on as reliable, sustainable sources of external demand. As a result, there are now major questions about the sustenance of China's long powerful export-led growth model.

Accordingly, China has no choice but to move quickly to implement the pro-consumption initiatives of its recently enacted 12th Five-Year Plan. Strategic transition is what modern China is all about. That’s what happened 30 years ago, when economic reform began. And it needs to happen again today. For China, a soft landing will provide a window of opportunity to press ahead with the formidable task of increasingly urgent economic rebalancing.

Stephen S. Roach, a member of the faculty at Yale University, is Non-Executive Chairman of Morgan Stanley Asia and the author of The Next Asia.

Copyright: Project Syndicate, 2011.