In the past two weeks we have been treated with a mostly positive but nonetheless mixed bag of economic data from China. There has been good news, bad news, good news with worrying underlying trends, and bad news with silver linings. Analysts have announced that things are getting worse and that things are getting better. There was, in other words, plenty to please or displease everyone.
I don’t have much to add to the voluminous analysis, especially since I don’t think anything has changed the underlying trend. Both the historical precedents and the arithmetic of rebalancing mean, in my opinion, that Chinese growth will continue to slow sharply for many years as a function of China’s economic rebalancing.
What’s more, without a significant – and politically difficult – change in the development model, only a renewal of investment growth, which itself only pushes off the rebalancing further and makes it ultimately more costly, can interrupt, albeit temporarily, the process of declining growth.
Rather than go through the data and explain why the latest numbers haven’t changed my opinion, I thought it might be more useful to cite and discuss in some detail a few interesting recent articles and commentary. This gives me a chance to dig a little deeper into the dynamics of China’s adjustment process and to illustrate some of the salient issues.
The first interesting commentary is a paper by Arvind Subramanian and Martin Kessler, both from the Peterson Institute, arguing that a RMB currency bloc is rising in Asia and is displacing the US dollar. According to the abstract:
A country’s rise to economic dominance tends to be accompanied by its currency becoming a reference point, with other currencies tracking it implicitly or explicitly. For a sample comprising emerging market economies, we show that in the last two years, the renminbi has increasingly become a reference currency which we define as one which exhibits a high degree of co-movement (CMC) with other currencies.
In East Asia, there is already a renminbi bloc, because the renminbi has become the dominant reference currency, eclipsing the dollar, which is a historic development. In this region, 7 currencies out of 10 co-move more closely with the renminbi than with the dollar, with the average value of the CMC relative to the renminbi being 40 percent greater than that for the dollar.
We find that co-movements with a reference currency, especially for the renminbi, are associated with trade integration. We draw some lessons for the prospects for the renminbi bloc to move beyond Asia based on a comparison of the renminbi’s situation today and that of the Japanese yen in the early 1990s. If trade were the sole driver, a more global renminbi bloc could emerge by the mid-2030s but complementary reforms of the financial and external sector could considerably expedite the process.
The RMB, the authors claim, is well on its way to eclipsing the US dollar as the dominant reserve currency. In an OpEd piece in the Financial Times the authors explain their reasoning a little more, going on to say:
In new research, we find that since the global financial crisis, as the US and Europe have struggled economically, the renminbi has increasingly become a reference currency (meaning emerging market exchange rates move closely with it). In fact, since June 2010 when the renminbi resumed floating, the number of currencies tracking it has increased compared with the earlier period of flexibility between July 2005 and 2008. Over the same period, the number tracking the euro and the dollar declined.
East Asia is now a renminbi bloc because the currencies of seven out of 10 countries in the region – including South Korea, Indonesia, Taiwan, Malaysia, Singapore and Thailand – track the renminbi more closely than the US dollar. For example, since the middle of 2010, the Korean won and the renminbi have appreciated by similar amounts against the dollar. Only three economies in the group – Hong Kong, Vietnam and Mongolia – still have currencies following the dollar more closely than the renminbi.
This is controversial stuff. I think anything that has to do with the supposed battle between the dollar and the RMB for reserve currency supremacy tends to get everyone’s juices flowing, and not surprisingly the piece has received a lot of commentary, for example in a recent issue ofThe Economist:
The greenback has in the past played a dominant role in East Asia. But if anything, the region is now on a yuan standard. Seven currencies in the region now follow the yuan, or redback, more closely than the green (see chart). When the dollar moves by 1%, East Asia’s currencies move in the same direction by 0.38% on average. When the yuan moves, they shift by 0.53%.
Reserve currency status?
I think there is a lot less to all this than meets the eye, however. I have many times expressed my deepest skepticism about much of what is said about reserve currency status, and especially about most of the arguments based on the claim that “history proves…” History almost never proves the many statements made about reserve currency status, especially when the history of shifts from one dominant reserve currency to another consists of a single case, the shift in the 1920s to 1940s from pound sterling to the US dollar.
There is plenty of history about major currencies generally, but this history too leads to few obvious lessons about any future shift away from the dollar. For example the first line in the abstract (”A country’s rise to economic dominance tends to be accompanied by its currency becoming a reference point, with other currencies tracking it implicitly or explicitly’) is not, as far as I can see, strongly supported by history except to the extent the statement is interpreted so vaguely so as to be almost meaningless.
The US was the dominant economic power in the world, and certainly among the dominant ones, pretty much by the mid-19th Century, for example, but except to the extent that it went onto the gold standard, it’s currency was not among the most closely tracked by other currencies for a very long time after. The Spanish (later Mexican) silver dollar, to take the opposite example, was one of the world’s dominant currencies (or tracking currencies) for hundreds of years up to the late 19th century, and yet it would be hard to argue that either Spain after the 16th Century or Mexico at any time was one of the world’s dominant economies. The history of currencies is a lot more complex than that, and anyway it seems to me that there is a big difference between the history of gold- or silver-based currencies and the history of fiat currencies.
But history aside, there is a much more important objection to the idea that the RMB is likely to become a dominant reserve currency. Reserve currency status involves substantial costs to the issuing country. In fact – and I will discuss this extensively in my upcoming book due February next year (Princeton University Press) – I do not think that the role of the dollar provides for the US any “exorbitant privilege”, contrary to what many suppose. Rather, I have argued, it creates an exorbitant burden for the US economy, one that forces the US to choose between higher debt and higher unemployment whenever a country takes steps to force up its savings rate or, which is pretty much the same thing, to force up its current account surplus
It is for this reason that I have never thought that the RMB would become an important reserve currency – precisely because Beijing has made it very clear that it will not accept any of the important costs that reserve currency status bring. Besides the fact that major reserve currency status would require complete liberalization of the capital account and a flexible financial system largely independent of government control, with clear and enforceable rules, it would put China’s economy at the mercy of countries that want to turbo-charge growth by running large trade surpluses. Beijing isn’t eager to accept any of these things.
But what about the advantages of reserve currency status – don’t they more than compensate the costs? The two most widely cited advantages in China of reserve currency status are first, that reserve currency status allows a country to borrow in its own currency and second, that it protects a country from accumulating too-large foreign currency reserves.
It turns out that the first “advantage”, however, has absolutely nothing to do with reserve currency status. Lots of countries, including China, borrow in their own currency. What matters is the quality of the balance sheet.
In fact in the case of China if the preconditions for reserve currency status were imposed there is a good chance that it would be harder, not easier, for China to borrow in its own currency. Why? Because at least part of the reason the Chinese government can borrow so easily in RMB has to do with restrictions on capital outflows and control of the domestic savings through the banking system. Relax both constraints, which are necessary if the RMB is ever going to become an important reserve currency, and domestic financing may very well be much more difficult.
The second “advantage” is mostly confused nonsense. For an example of this kind of claim, see this article in the current issue of Caixin, which was sent to me by Patrick Chovaneck of Tsinghua University – almost certainly to annoy me because he knows how absurd it is:
Some emerging economies, the theory goes, accumulate a large amount of foreign exchange as a result of trade surplus. They invest the forex in low-yielding U.S. Treasury bonds, while borrowing at high costs from developed countries in the form of foreign investments. One way to break this cycle would be to increase the global use of the yuan. At present, because it is not commonly accepted yet, China is bound to have huge forex storage and forced to invest heavily in the U.S. government debt.
This has “led to a currency mismatch and significant risk exposure to the forex reserve’s depreciation,” said Zhang Monan, research fellow at the State Information Center, a policy think tank under the nation’s top economic planner, the National Development and Reform Commission. By contrast, he said, Germany does not face similar pressure even though it is also a trade surplus country. This is because it does not need to keep a large forex reserve since the euro is a reserve currency.
This is absolutely wrong. Aside from the fact that no country can accumulate its own currency in its foreign currency reserves, the size of foreign currency reserves has nothing to do with whether or not others accept your currency as a reserve currency. Reserve accumulation is fully explained by the sum of the current account and the capital account.
Any country that runs a surplus on both accounts must accumulate foreign currency reserves, and the reason Germany has a large current account surplus and no foreign currency reserves is simply because it runs a large capital account deficit. Instead of recycling its current account surplus by having the central bank lend to foreign governments, as the PBoC does, it recycles its current account surplus by having German banks lend to other European countries.
Math is math
But let’s leave all of this aside. The paper by Arvind Subramanian and Martin Kessler argues that, regardless of what people like me believe ought to happen, in fact the RMB is actually displacing the dollar, whether or not we think it can or should. The proof?
In East Asia, there is already a renminbi bloc, because the renminbi has become the dominant reference currency, eclipsing the dollar, which is a historic development. In this region, 7 currencies out of 10 co-move more closely with the renminbi than with the dollar, with the average value of the CMC relative to the renminbi being 40 percent greater than that for the dollar.
You can’t argue with the math, can you? As The Economist put it in their review of the article, “Seven currencies in the region now follow the yuan, or redback, more closely than the green.” Since this only leaves three recalcitrant currencies, sheer arithmetic shows that the dollar is being displaced by the RMB.
Well actually you can argue with the math, or at least you can argue with the interpretation of the math. There are alternative – and much simpler, I think – explanations for the increased “co-movement”, and these do a much better job, I think, of explaining what is happening than reserve currency displacement.
Assume for a moment a global scenario in which the largest exporter of manufactured goods in the world has a significantly undervalued currency. Assume further that many of its competitors also have undervalued currencies, and would like to revalue in order better to manage their domestic monetary policies. Assume finally that the world is in crisis, and exporting nations are having trouble maintaining the necessary growth rate of their exports, so they cannot allow their currencies to rise faster than that of their main export competitors.
In this scenario which currency would the currencies of the smaller exporting countries track, the US dollar, or the undervalued currency of the largest and most competitive exporter of manufactured goods in the world? Almost certainly the latter, right? The smaller exporters would want their currencies to rise, but the rise in their currencies would be limited by the rise in the currency of their largest competitor. This would happen not because they are tracking a new reserve currency but only because they are in export competition with that currency.
Is my scenario a plausible description of the world today? I think it very clearly is. The world certainly is growing slowly, exporters are having real trouble, countries are engaged in currency war, and one can very easily argue that the RMB is seriously undervalued and acting as a constraint on other Asian currencies. In fact over the past several years many Asian finance ministers have said exactly that – they cannot appreciate their currencies as much as they would wish until the RMB appreciates more. The conclusion, then, might be not that there is a RMB bloc, but rather that the appreciation of the RMB against the dollar is a kind of cap against which other currencies are constrained.
Or let’s take another scenario. Assume the world is in crisis and the US dollar is seen widely as the “safe” asset. In this world, perhaps when risk perceptions rise, investors and traders move generally out of riskier currencies into the dollar, and when risk perceptions decline, traders move out of the dollar into riskier currencies. Perhaps we could even call these trades “risk-on” and “risk-off” trades.
In this case it would be natural to see an increase in the correlation among riskier currencies. Would this be a sign of an emergent currency bloc? No. It would just be a sign that the dollar is the dominant reserve currency and that everyone is treating it as such, buying and selling it is response to changes in risk perception. Is my second scenario a plausible description of the world? Again, it almost certainly is.
I am not saying that Subramanian and Kessler are necessarily wrong. I am just suggesting that there are alternative, and in my opinion far more plausible, explanations for the greater correlation between the RMB and these other currencies than the RMB bloc hypothesis. Of course if the RMB were a freely floating currency and there was no longer PBoC currency intervention, and the correlations that the authors find still hold, then perhaps this could be a more powerful argument about the rise of the RMB. Until then, it is almost wholly irrelevant.
The authors go on to make a further point in their Financial Times piece that, I think, explains where the real differences in opinion are:
This development has two implications. First, it is one more important marker in the shift of economic dominance away from the US and towards China. Not only is China, by some measures, the world’s largest economy in purchasing power parity terms, the world’s largest exporter and the world’s largest net creditor (for more than a decade), but the renminbi bloc has now displaced the dollar bloc in Asia. The symbolism and its historic significance cannot be understated because east Asia, despite physical distance, has always been part of the dollar backyard.
America optimists invoke the rise and fall of Japan over the past few decades to suggest that China’s rise today will go Japan’s way, ensuring the continuation of Pax Americana. But they should take note that even during the heady days of the Japanese miracle, the yen never came close to rivalling the dollar as a reference currency. There was never anything close to a yen bloc in east Asia.
Needless to say at its peak the Japanese yen was a far more important reserve currency than the RMB currently is, and sustained just as many anxious or triumphant claims for the inevitability of its rise to dominance. The same constraints however that prevented the yen from ever being more than a minor reserve currency will, I suspect, prevent the RMB, along with the currency of any country that requires external demand to resolve domestic imbalances, from ever playing the role of the US dollar.
What is more, Japan’s long and difficult adjustment, clearly has implications for China and future growth prospects. I have discussed many times before why I strongly disagree with the claim that China is “by some measures, the world’s largest economy in purchasing power parity terms.” Since PPP measures simply take the current nominal GDP and adjust them for price differences between the referent country and the US, this can only be a meaningful measure if China’s GDP is not significantly overstated. If it is, the PPP estimate is also overestimated.
When I first proposed this argument many years ago, I think few people would have agreed that China’s GDP is significantly overstated, but today, with nearly everyone recognizing the extent of Chinese overinvestment, the extent of environmental degradation (one professor at Renmin University estimates that because of the failure to recognize environmental degradation China’s GDP is overstated by 10-20%), and the large but unrecognized amount of NPLs in the banking system, it is hard to believe that anyone still doubts that China’s real GDP might not be quite as high as claimed.
Who is top dog?
But where I have a real difference of opinion is the claim that “American optimists” somehow don’t want the RMB to become the dominant reserve currency and want the US dollar to retain the title. This suggest to me that the argument here is really not about the whether or not the RMB is likely to become a reserve currency but rather about whether or not you expect this to be the “China Century”, and if the RMB becomes the reserve currency Chinese dominance will inevitably follow.
But this doesn’t make sense to me. I think, and have argued may times, that reserve currency status hurts the US.
This is not just some wild opinion of mine. John Maynard Keynes effectively argued many years ago that the current system had deep flaws, and would force an unbearable burden onto the reserve currency country (the US) unless there were strict rules preventing surplus countries from failing to adjust when surpluses got too high (there aren’t). I was at a conference in Tokyo last week with the estimable Brad DeLong, and he made the same point – that the current reserve system is a mistake, and one that Keynes warned us against making.
In fact I have also argued many times that if the US does not take steps to prevent foreign countries from acquiring unlimited amounts of US dollar reserves, for example by forcing, as Keynes wanted, reserve accumulation to be more evenly divided amount all the major currencies, it will force the US into a very difficult position and can actually hasten the coming of the China Century. As I see it, “American optimists” or at least those who want the US to remain the only “indispensible country”, should actively encourage a greater role for the RMB and a lesser role for the dollar.
Unfortunately what should be a technical discussion about the merits for and preconditions of reserve currency status has been completely subsumed into the idiotic argument about whether you are “for” China or “against” China. But anyone who conflates his opinion about which country should be top dog with his analysis of the rise of the RMB as the dominant reserve currency is, I think, engaged in bad economics.
There are of course plenty of generals, journalists, and policymakers in China who believe that dominant reserve currency status is desirable and inevitable, but very few Chinese monetary economists, even among those blessed few that do not believe China is going to have a very difficult adjustment, think reserve currency status is likely to happen soon. Among economists, it seems that only foreigners, and based mainly abroad, seem to believe that this process is happening.
This is because anyone who follows the Chinese financial system closely knows that China is decades away from having the kind of financial system that is consistent with important – let alone dominant – reserve status. For example, here is the influential Yu Yongding, a senior fellow at the Institute of World Economics and Politics of Chinese Academy of Social Sciences, in a July 1021 paper for the Asian Development Bank:
The process of yuan internationalization essentially is a process of capital account liberalization. Due to the unprecedented and complex global financial crisis and the PRC’s huge imbalances, capital account liberalization has to be pursued in a cautious way. As a result, the internationalization of the yuan is bound to be a long-drawn process.
The PRC’s road map for the internationalization of the yuan is flawed with many missing links and wishful thinking. Yuan internationalization guided by the current road map may be proven counterproductive.
In fact many people in Beijing argue that the reason the PBoC and other monetary economists are pushing so hard for increasing internationalization of the RMB is not because they think it is good, or inevitable, but rather because they are despondent about the pace of financial sector reform and think that only a risky move, like opening up the capital account, can force faster domestic financial reform. This is certainly not a confidence booster in the RMB’s prospects.
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