Economic turmoil in the United States and Europe is both signalling, and helping to accelerate, a deeper, long-run development. After three centuries of economic dominance, the West is about to be eclipsed by a rising Asian power: China. The Chinese economy may soon be larger than America’s, if measured at prices that reflect purchasing power. And the renminbi could even displace the dollar as the premier reserve currency within the next decade or soon thereafter.
Sceptics will scoff at this prediction for two reasons. First, even if China’s economy overtakes America’s, historical evidence suggests the renminbi’s rise will be delayed because of persistence in currency use. For example, the United States economy surpassed Great Britain’s in the early 1870s, but the dollar displaced sterling decisively only around World War II. That implies there could be a lag of about 70 years between economic dominance and currency ascendancy.
Second, China is far from creating the policy and market environment for the renminbi to become a reserve currency. China’s capital account is still largely closed and the renminbi still not convertible and freely available to foreigners; its financial system is financially repressed and is government controlled; and its financial markets lack depth and sophistication to provide liquidity critical to make a currency attractive to hold and trade. In these circumstances, how could foreign governments or private players make payments in renminbi, hold renminbi assets, or denominate economic transactions in renminbi?
In other words, loyalty to the dollar and the absence of the policy prerequisites seem to make the renminbi’s rise a very distant possibility. How wrong that is.
My research shows that persistence in history has been exaggerated. Great Britain ceded its economic dominance much later, and sterling its dominance much earlier, than is believed. Economic dominance, in the sense of the factors that determine reserve currency status, is affected not just by the size of an economy but also by its trade and external financial strength. On this broader metric, the United States overtook Great Britain not in the 1870s but only around World War I: in fact, Great Britain was the world’s largest exporter and net financier until the 1920s.
Moreover, the dollar became dominant in the mid-1920s and would have remained so had special political factors not intervened to shore up sterling. As a result of political decisions that strengthened economic ties within the British empire – including granting trade preferences and creating the sterling bloc – the then colonies continued to hold sterling rather than switch to the dollar. Thus, the real lag between economic and currency dominance was not 70 years, but more like ten years.
Today, China has essentially caught up with the United States as an economic power. Its economy is about as large (measured in purchasing power), while its exports and overseas assets are substantially larger. If one were to apply the lag actually suggested by history, the renminbi’s potential eclipse of the dollar is no more than a decade away. In other words, the fundamentals of broad Chinese economic strength create the conditions for the imminent rise of its currency.
This is not inevitable, of course. China still has to undertake major policy reforms. But internationalising the renminbi has been set in irreversible motion in a distinctively Chinese manner. The process is micro-managed, interventionist, and enclave-based: not a day seems to pass without some foreign transaction, entity, or country being granted greater but selective access to the renminbi. Just last week an initiative was launched to promote London as a possible offshore renminbi trading centre to complement similar plans for Shanghai and Hong Kong. Extending this experiment to the rest of China will presumably depend on its success.
Why might China be interested in turning the renminbi into a reserve currency? The answer is that the Chinese authorities have been searching for an exit from the country’s decades-old and controversial growth strategy based on keeping the currency undervalued and the economy closed to foreign capital. Internationalising the renminbi offers one such exit.
As China moves away from mercantilism, and as the renminbi appreciates, there will be stiff opposition from the tradable sector that has benefited most from currency undervaluation. To overcome that opposition, the Chinese authorities can play up the benefits of international reserve status of the renminbi. The argument will be that the economic losses and dislocation costs from currency appreciation will be outweighed by the gains to national prestige from encouraging the renminbi to rise to reserve currency status and overtake the dollar as the world's economic standard. “Renminbi Rules” could prove to be the slogan of, even a lifeline for, China’s policy makers as they seek their difficult but desired exit from the mercantilist status quo. And, sooner than almost anyone thinks, that slogan within China could also become the reality.
The author is Senior Fellow, Peterson Institute for International Economics and Centre for Global Development
This piece, based on his book, Eclipse: Living in the Shadow of China’s Economic Dominance, is an elaborated version of an op-ed published in Financial Times on September 12, 2011
