The Chinese Reserve Dilemma

Debate continues about the role of the Chine renminbi as a reserve currency. As the portion grows of the world economy in Chinese hands, so does the portion of world trade settled in Chinese currency. Reality confronts worry.

Back in February CNBC reported that a “survey of 200 institutional investors - 100 headquartered in mainland China and 100 outside of it - published by State Street and the Economist Intelligence Unit on Thursday found 53 percent of investors think the renminbi will surpass the U.S. dollar as the world's major reserve currency.” Ansuya Harjani wrote that “skeptics of yuan internationalization argued that the renminbi will never be liquid enough across all asset classes to serve as a viable reserve currency, and that people will not trust the renminbi as a store of value.” The survey itself reported:

As China's economic influence grows, the global importance of the renminbi will become magnified. Indeed, while for decades it has been a 'greenback world', dominated by the U.S. dollar as the world's primary reserve currency, many think a 'redback world', in which the renminbi enjoys premier status, is increasingly a possibility.

The Economist’s Banyan columnist has written: “Some 18% of China’s foreign trade is now settled in yuan, a proportion the Hong Kong Monetary Authority expects to reach 30% next year. Some central banks already hold a small chunk of their countries’ foreign-exchange reserves in yuan. Economists even talk of an emerging “yuan bloc”, encompassing China, Hong Kong, Taiwan and the ten members of the Association of South-East Asian Nations. The globalisation of the yuan seems remorseless and unstoppable.

Eswar Prasad, an economist and author of a new book on the global monetary system, “The Dollar Trap”, is less sure. He points out that the internationalisation of a currency has three essential aspects. In the first, its use in settling trade and financial deals, the yuan is well advanced. But it has barely started on the second, the liberalisation of China’s capital account so that the yuan can be freely converted with other currencies at market rates. Without that convertibility, much deeper domestic financial markets and a floating exchange-rate, the yuan will not achieve the third essential—becoming a global reserve currency, such as the dollar, euro, yen, sterling or Swiss franc. For now, the yuan’s exchange rate is tightly managed, to the irritation of trading partners, which believe it is kept artificially cheap.

In an interview with the New York Times, Prasad argued: “I expected the dollar to weaken because the crisis exposed problems in the U.S. financial system. Moreover, the U.S. racked up a lot of government debt and the Fed began flooding the global financial system with dollars. The more dollars there are out there, the less value they should have. But the exact opposite happened. The dollar, if anything, gained slightly in value.

Contrary to all expectations, the U.S. dollar’s position as the world’s dominant reserve currency has been strengthened by the crisis. The world became even more dependent on the dollar than it had been before the crisis.

What the renminbi debate ignores is that substituting one reserve currency for another simply changes the evil. It does not transform the evil. Only a gold standard can do that.