Deep Dive

The New Triumvirate

Sayonara yen. By 2025, the renminbi, dollar, and euro will control the international currency system.

History has a strange way of repeating itself on the global stage, not only in terms of economic cycles, but also in the eruption of momentous global events. In the 1930s, the world's monetary system was dominated by three powers -- Britain, France, and the United States -- whose currencies, along with gold, served as the main international reserve assets. In the 1980s, the U.S. dollar, Deutsche mark, and Japanese yen ruled the international monetary system. Although the dollar has since become the unquestioned principal international currency, even through the global financial crisis, another iteration of the global currency triumvirate is on the horizon. Fast-forward to 2025, and a system centered on the dollar, the euro, and the renminbi is likely to have emerged.

Much can be said about why only a few national currencies have historically topped the international currency hierarchy and how a country's economic power and political clout can elevate a currency's status. And there's certainly debate swirling around the fate of the euro with the deep debt crisis currently engulfing eurozone sovereign borrowers. But clearly the big story behind the emerging multicurrency monetary system is the internationalization of the renminbi -- and how it will alter the international monetary landscape and the dynamics of the U.S.-China bilateral economic relationship.

But what's required for a new currency to take on an international role? For one, it must be capable of attracting foreign private and official players active in cross-border trade, investment, and financial transactions. An international currency must also serve the usual functions of money -- invoicing trade, anchoring exchange rates, denominating international claims, and holding official reserves -- in both its home country and on the global stage. While a currency may perform such functions in sequence en route to achieving global status, it is through the collective impact of all four functions that economies of scale are created -- sufficiently lowering transaction costs and propelling a currency into widespread use. This doesn't happen overnight: The international monetary system's use of particular currencies exhibits considerable inertia, explaining why a few currencies tend to dominate for a number of years or decades. Transformation within the international monetary system simply takes time.

At the current juncture, the U.S. dollar remains the most important international currency, crowned as such in the postwar environment of the mid-20th century, when the global economic order became reliant on a complementary set of tacit economic and security arrangements between the United States and its core partners. In exchange for the United States assuming the responsibilities of system maintenance, serving as the open market of last resort, and issuing the most widely used international reserve currency, its key partners -- Western European countries and Japan -- acquiesced to the special privileges enjoyed by the United States: seigniorage gains, domestic macroeconomic policy autonomy, and balance of payments flexibility.

The benefits of these privileges are potent. Estimates of seigniorage -- the revenues arising from the difference in the cost of printing dollars and the face value of dollars -- for the United States arising from foreign residents' holdings of dollar notes, for example, have averaged $15 billion per year since the early 1990s, and the United States is estimated to have benefited from a discount of $80 billion on its borrowing costs in 2010 alone, as a result of the dollar's international status.

Broadly, the global economic order revolving around the dollar remains intact, though hints of its erosion have emerged over the past decade. For the United States, the dollar's international reserve status and its safe haven characteristics, coupled with the country's large and deep capital markets and developed legal institutions, have allowed it to successfully sell huge amounts of government and corporate bonds to foreign investors. This success, however, does not remove credit risk or the risk that an abrupt loss of investor confidence could trigger a disorderly adjustment in U.S. asset prices and the value of the dollar. The downgrading of the U.S. credit rating by Standard & Poor's is a warning sign.

As of the end of 2010, foreign investors' exposure to the U.S. economy amounted to $22.8 trillion, close to half of the aggregate GDP of the rest of the world. Changes in U.S. monetary policy thus have a direct wealth impact on foreign residents, independent of how U.S. monetary policy affects global financial market conditions. A whopping 95 percent of foreign exposure to U.S. assets is denominated in dollars, which poses a difficult dilemma for foreign investors. Collectively, there's a strong incentive to maintain the value of their holdings by avoiding the risk of dollar depreciation that could undermine their investments -- despite the incentive individual investors have to diversify their portfolios as a matter of prudent risk management.

In the near term, the euro represents the strongest rival to the dollar, assuming the eurozone is able -- through bailouts and longer-term institutional reforms -- to successfully navigate a path out of the sovereign debt crisis currently plaguing it. But in the long term, the size and dynamism of China's economy and the rapid globalization of its corporations and banks put the renminbi in a position to take on a more important international role.

The troubled euro

The euro's current predicament is attributable, in a broad sense, to the global financial crisis and the 2008-2009 Great Recession. European economies have shouldered huge levels of public debt and growing government borrowing requirements during the episode, giving rise to mounting concerns about sovereign risk. Despite the general consensus that deterioration in public finances is of a cyclical nature, the scale of private risk transferred to the public sector, along with projections of growing long-term government outlays for health care and old-age entitlements, point to enduring structural budget gaps and growing levels of public debt to income. Thus according to OECD estimates, public debt in European countries has expanded considerably, with total OECD central government debt rising from 50.6 percent of GDP in 2007 to 71.7 percent in 2011; gross borrowing requirements are expected to reach a record $19 trillion in 2011, almost twice that of 2007. Successfully issuing such large volumes of debt would be challenging in the best of circumstances.

Given anemic growth prospects and uncertainty about the course of monetary policy in major global financial centers, capital markets have reacted by repricing European sovereign debt in a fragmented manner: Fear and anxiety now grip public debt issuance in eurozone periphery countries, while positive sentiment continues to drive trading in core eurozone sovereign debt. Peripheral countries like Greece and Ireland have been all but locked out of private markets, even though both groups of countries have issued debt in euros and are operating in a common monetary policy framework. The crisis has led the European Union to take several extraordinary steps toward remediation, such as the European Central Bank's Securities Markets Program, which purchases government debt of troubled countries through secondary markets, and the European Financial Stability Facility, which provides country-level guarantees to temporarily assist countries with budgetary needs and supports the financial stability of the eurozone as a whole.

Beyond the troubles in the eurozone, today's dollar-based international monetary system and the likely multicurrency system of the future share a number of systemic defects. The fundamental problem is an asymmetric distribution of the costs and benefits of balance-of-payments adjustment and financing. Countries whose currencies are key in the international monetary system benefit from domestic macroeconomic policy autonomy, seigniorage revenues, relatively low borrowing costs, a competitive edge in financial markets, and little pressure to adjust their external accounts. Meanwhile, countries without key currencies operate within constrained balance-of-payment positions and bear much of the external adjustment costs of changing global financial and economic conditions.

The dollar-based monetary system, though, is also associated with significant shortcomings that would be unlikely to be so prevalent in a multicurrency system, most notably the asymmetric distribution of the cost of adjustment to external conditions. It is precisely this scenario that has contributed to a dramatic widening of global current account imbalances in recent years. It has also produced a potentially destabilizing situation in which the world's leading economy, the United States, is the largest debtor; meanwhile, the world's largest creditor, China, assumes a massive currency mismatch risk in the process of financing U.S. debt. Another shortcoming of the dollar-based international monetary system is that global liquidity is created primarily as the result of the monetary policy decisions that best suit the United States, rather than with the intention of fully accommodating global demand for liquidity.

The rise of the renminbi?

In another instance of history repeating itself, the measures introduced by the People's Bank of China in July 2010 to stimulate the internationalization of its currency through the development of an offshore renminbi market in Hong Kong are considered landmark events in the financial community, in much the same way as the July 1963 issuance of a $15 million bond by the Italian highway concession company, Autostrade, was a groundbreaking transaction in the development of the offshore Eurodollar market. But the headline news misses the underlying economic forces and regulatory factors that shape the evolution of an offshore financial and trading market.

China already satisfies the underlying trade and macroeconomic criteria required for currency internationalization in some respects: a dominant role in global trade, a diversified merchandise trade pattern, and a macroeconomic framework geared to low and stable inflation. From a historical perspective, China's current position in global manufacturing exports is similar to that of the United States in the interwar period, when Britain's lead in manufacturing exports was steadily declining. On the other hand, China's lack of open, deep, and broad financial markets means that the renminbi falls far short of being a truly international currency at present. Limitations on currency convertibility in China also constrain the use of the renminbi as an international currency -- though the renminbi is convertible for current account transactions (that is, payments for goods and services), capital account inflows and outflows are subject to tight restrictions, making liquidity a problem.

Chinese authorities are adopting a novel approach in developing an offshore renminbi market while maintaining capital controls, one distinguished by pragmatism and a gradual pace. This strategy of "managed internationalization" involves actions on two fronts: the development of an offshore renminbi market, and encouraging the use of the renminbi in trade invoicing and settlement. Beijing's actions thus far suggest that authorities' initial focus is regional, starting with promoting the renminbi's role in cross-border trade between China and its neighbors. To that end, China began a pilot arrangement of cross-border settlement of current account transactions in renminbi in July 2009, focusing on transactions between five Chinese cities and Hong Kong, Macao, and the Association of Southeast Asian Nations (ASEAN) countries. This arrangement was extended in July 2010 to include all ASEAN countries and 20 provinces inside China. Currently, about 6 percent of China's international trade (roughly RMB 360 billion, or about $55.4 billion) is denominated in and settled in renminbi. This looks to be the start of a rapid upward trend. Renminbi-denominated trade settlement is expected to reach $1.3 trillion by 2015, providing a major source of offshore liquidity and capital market business.  

From a policy perspective, foreign currency exposure in China's external balance sheet provides a powerful incentive for Chinese authorities to promote renminbi internationalization. As of the end of 2010, China had borrowed less than one-quarter of its $630 billion of outstanding foreign debt in renminbi. The share of China's international lending denominated in renminbi has been negligible -- only 3.2 percent of the total -- partly due to the fact that foreign bonds could be issued only in foreign currency until mid-2007, when official and commercial borrowers were allowed to issue renminbi-denominated bonds in Hong Kong. Internationalization of the renminbi would help mitigate this tremendous currency mismatch in China's asset/liability position vis-à-vis the rest of the world.

Although international use of the renminbi has the potential to expand, the task ahead remains challenging. Expanding domestic debt markets, increasing the convertibility of the renminbi, reinforcing financial sector supervision, and establishing a more transparent framework for monetary policy are all necessary for the renminbi to become an attractive international (not just regional) currency. And these processes take considerable time to complete. Moreover, prospects for the renminbi also depend on the direction of East Asian monetary integration in addition to how quickly the inertia present in the current international monetary order can be overcome.

Implicit in any discussion of prospects for internationalization of the renminbi is consideration of the unmatched scope of bilateral economic interdependency between the United States and China. The United States accounts for a greater share of Chinese exports than any other country, while China is the largest foreign investor in U.S. government debt. At the same time, the massive global payment imbalances between the two economies have placed the U.S.-China bilateral relationship at the center of policy discussions regarding the need to reduce imbalances and rebalance global demand.

For the past four years, the U.S.-China relationship has been managed under the framework of the Strategic and Economic Dialogue, a series of high-level biannual meetings. This structure has provided an effective forum for engagement, negotiation, and strategic planning between the two countries on key bilateral issues ranging from currency regime to energy policy to the environment. But China's management of its exchange rate has been a reoccurring focus of this relationship, rendering it testy at times. This could change with the internationalization of the renminbi -- and it is in the interest of the United States, indeed the world, to encourage the process. With the renminbi increasingly serving as an international trading, funding, and eventual reserve currency, it would behoove China to be seen as acting on its own initiative rather than yielding under foreign pressure.

A more stable union

Defects of any international monetary system aside, policymakers would do well to recognize that moving toward a new iteration of the multicurrency monetary system offers the prospect of greater stability than under the present dollar-centered system. More even distribution of lender-of-last-resort responsibility and better provision of liquidity during times of distressed market conditions would be two major benefits of a multicurrency system. At the same time, diversifying the source of foreign exchange reserve supply may permit developing countries to meet their reserve accumulation objectives more easily and render stocks of reserves less exposed to the risk of depreciation. A multicurrency regime also has the potential to command greater legitimacy than a dollar-based system, particularly if countries issuing the main international currencies manage global liquidity consistently with global growth and investment, stabilize their bilateral exchange rates, and devise mechanisms for sharing the benefits of international currency status with other countries. And there is geopolitical advantage in expanding the benefits of an international currency to aid additional countries. While change may not yet be imminent, it is certainly in the air.

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Deep Dive

The Buck Stays Here

Why the dollar isn't going anywhere anytime soon.

Five years ago, questioning the dollar's status as the world's reserve currency was confined to abstruse think-tank musings. How times have changed. The 2008 financial meltdown of the U.S. subprime mortgage market pushed debates about the dollar into the public eye. In September 2009, World Bank President Robert Zoellick warned, "The United States would be mistaken to take for granted the dollar's place as the world's predominant reserve currency. Looking forward, there will increasingly be other options to the dollar." This year's political meltdown in Washington has only exacerbated the issue. HSBC now predicts that China's currency will rival the dollar sometime this decade.  

The obstacles to a shift away from the dollar are still formidable. A useful global currency provides three necessary functions: It should serve as a medium of exchange for cross-border transactions, a unit of account to determine prices, and a store of value for those wishing to hold liquid assets. Measures like official currency reserves, invoiced international transactions, and international debt securities confirm that the dollar still surpasses any other currency in providing a unit of account and a medium of exchange. As a store of value, however, the dollar has become more suspect. Gyrations in the price of gold and the exchange rates of the Australian dollar and Swiss franc suggest at least a modest effort to diversify away from the greenback.

About a year ago, I argued in International Relations of the Asia-Pacific that "neither the opportunity nor the willingness to shift away from the dollar is particularly strong." That was before a global economic slowdown and a downgrade of U.S. debt by Standard & Poor's, however. So has the world changed enough to require me to retract that conclusion? Not really.

For the dollar's reserve currency status to fundamentally change, both public and private actors would need to prefer alternatives to holding and using dollars. Yet there remains no attractive alternative to the dollar as a reserve currency. In terms of currency reserves, the closest peer competitor to the dollar is the euro. The eurozone, however, has achieved the signal feat of making the United States look relatively stable by comparison. Furthermore, the European Central Bank (ECB) doesn't seem to want the euro to become the new reserve currency. It has placed high barriers on any country joining the eurozone and seems more intrigued by the idea of kicking out some of the periphery countries than expanding the euro's use overseas. In January 2009, ECB President Jean-Claude Trichet flatly stated, "I strongly disagree with those who say that the euro has been created to compete with the U.S. dollar. Let's be clear: The ECB is not campaigning for the international use of the euro."

The other long-standing alternatives have even greater problems. The yen, pound, Swiss franc, and Australian dollar are all based in markets too small to sustain the inflows that would come from reserve currency status. A return to the gold standard in this day and age would be completely infeasible. Economist Barry Eichengreen recently detailed in the National Interest the domestic deflationary costs if the United States alone went back onto gold. And a global gold standard would have the same problem -- the liquidity of the global economy would be held hostage to the vagaries of the gold supply.

There is, of course, the Chinese renminbi. China's currency remains inconvertible for now. For the past few years, however, authorities in Beijing have taken incremental but appreciable steps to promote the international use of the renminbi to settle accounts in international trade. With the intention of turning Shanghai into a global financial center by 2020, Chinese authorities are even tinkering with the idea of liberalizing the capital account as well. The only bet speculators are making on the renminbi these days is that it will appreciate in value. Surely it will be a worthy challenger to the dollar?

Despite these steps, turning the renminbi into a convertible reserve currency would require a fundamental and costly transformation of China's domestic political economy. For the renminbi to be a truly global currency, Beijing would have to allow the following to happen: full currency convertibility combined with a dramatic appreciation in the value of the renminbi, greater liberalization and transparency in the domestic financial sector, and a dramatic decline in the book value of its dollar holdings.

Each of these steps requires a rupture of the current rules of the game in China. A convertible, appreciating renminbi will hit the country's export sector hard. Leaders in Beijing will also be extremely reluctant to cede their control over the country's financial sector. Indeed, if the 2008 financial crisis taught them anything, it was that direct control over the banks was the best way to pump up China's economy during a downturn. Turning the renminbi into a serious international currency weakens a key policy lever. To be sure, there would be some compensating benefits: imports would be cheaper for Chinese consumers, for one thing. But as the good folks at Eurasia Group have recently observed, China's political class is far too risk-averse to contemplate such a drastic sea change in their domestic political economy. Even Beijing's baby steps toward internationalizing the renminbi have led to domestic criticism.


Despite these roadblocks, it would be possible for a concert of countries to decide, for geopolitical and economic reasons, that they would be willing to bear the temporary burden of switching reserve currencies. According to former U.S. Treasury Secretary Henry Paulson's memoir, Russia seemed particularly eager to attempt this feat as the 2008 financial crisis started.

If anything, however, the shifts in the geopolitical winds have made this possibility even less likely than it was three years ago. China would have to be the de facto leader of such a concert. Its foreign-policy belligerency in 2009 and 2010, however, raised threat perceptions across the Asia-Pacific region about Beijing's martial intentions. Beijing might view fishing boat skirmishes, rare-earths embargoes, and territorial claims in the South China Sea as simply a rising power trying to punch its weight. To the rest of the region, however, these actions require a hedging strategy against China's ambitions -- which means not antagonizing the United States. The very countries that China would need to cooperate with on currency matters are the ones that are warier than they were three years ago.

The dollar is not going anywhere -- unless, of course, the United States political system were to torpedo it through repeated acts of self-sabotage. Given how the debt debacle played out this summer, that now seems possible. It is equally possible, however, that in witnessing the wild market reactions to political shenanigans, both sides of the partisan divide will recoil from brinkmanship.

Despite the popularity of bashing America's trade deficit, few politicians have made the connection between it and the dollar's reserve currency status. As long as other countries need to buy dollars as part of their reserves, its exchange rate value will be higher than it otherwise would be, rendering some sectors uncompetitive. A December 2009 McKinsey report argued that, over time, the benefits of the dollar's status would decline compared with its costs. To give up the dollar's status, however, would be a tacit acknowledgment about the decline in American power -- and no politician wants to make that claim.

If current economic trends continue, there will come a time when the dollar's reign will end. Every major political actor in the global political economy, however, has strong incentives to forestall that day -- until they are no longer in office.

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