In 1928, with the future of the pound sterling uncertain, France was concerned about its sizable sterling deposit with the Bank of England. “To avoid trouble for the City of London”, British Foreign Secretary Sir Austen Chamberlain entreated French Prime Minister M Poincaré not to ask for gold, which France could do under the gold exchange standard. France partially acceded to the request. Eventually in 1931, when Britain abandoned the gold exchange standard, France lost substantial amounts.
France saw a repeat of the problem in the 1960s. That was the height of the Vietnam War. Substantial US current account deficits raised doubts about the continued convertibility of the US dollar for a troy ounce of gold at $35. France started converting some of its US balances for gold, and on February 4, 1965, President de Gaulle created a stir by announcing the demise of the monopoly of the US dollar as a reserve currency. The US dollar went off the $35 parity in August 1971, but remained the dominant reserve currency.
With roughly two-thirds of over $2.2 trillion reserves in dollar assets, including over $750 billion in US treasury bills, China faces a currency problem much more severe than France did in the past. These reserves lose value according to the US inflation and dollar depreciation rates less interest earned on these assets. Rising fiscal deficit and public debt in the US and the fear of the US deflating away its debt have made many analysts deeply apprehensive about the US dollar’s future. The fear of a falling dollar is at the root of China’s currency problem. The dilemma is: Inaction implies suffering losses passively, while switching from dollars hastens the fall of the dollar.
China’s reserves are mostly its accumulated large current account surpluses vis-à-vis the US in the current decade. Consumers in the US had been living beyond their means, borrowing money to buy houses and funding their other spending. The US government was doing the same, and so it incurred large fiscal deficits. The excess of expenditure over savings in the US as reflected in large current account deficits reached a peak of $811.5 billion, equivalent of 6.2 per cent of GDP in 2006. The deficit was financed largely by China.
China sold goods to the US in exchange for IOUs, which means “I owe you”. The US paid for its excessive imports in dollars which the Chinese invested in US securities despite fears about a “hard landing” of the US economy. For example, in 2005, Paul Volker predicted a brutal correction to the exchange value of the US dollar. But macroeconomic imbalances continued to build up, until the bubble burst in late 2007. The US dollar, vis-à-vis the Japanese Yen, for example, depreciated from a high of ¥124.09 per dollar on June 22, 2007 to a low of ¥ 93.28 on October 27, 2008. China has allowed the renminbi to appreciate from RMB 8.27 per US dollar in 2005 to RMB 6.82 in May 2009. Some argue it is not enough.
What worries China about an appreciation of the renminbi is its adverse effect on exports and hence on its economic growth. Like a high tide covers the swimmers in a beach, in political economy, high growth forgives a lot of sins. As Warren Buffet has said, “Until the tide goes, you don’t know who’s swimming naked.” Exports and investment have been the main engines of growth, and China does not want to take any chances with its growth.
Sale on credit is always risky. What price China will ultimately realise on its goods sold to the US will depend on what happens to the value of these IOUs. It is not the risk of not realising the promised dollars, but the uncertainty of how much purchasing power those dollars would command. A 30 per cent appreciation of the renminbi vis-à-vis the dollar on $1.5 trillion can be a sizable $500 per capita! Such a wealth effect on a $2-trillion economy can be substantial. Albeit, the fixed assets that China has built in terms of productive capacity embodied in factories and physical infrastructure will remain. In retrospect, perhaps purely from an economic perspective, the strategy of export-led growth nevertheless would seem to be a justified one. But, the political fallout from such a large wealth effect is difficult to predict.
China’s response to the currency dilemma is a three-part action plan:
With attractive company valuations in the midst of the crisis, China transferred a part of its reserves to a sovereign wealth fund, the China Investment Corporation (CIC), to acquire stakes in about 50 large companies abroad, mainly in the natural resources sector. Modelled on Singapore’s Temasek, the CIC, established in 2007 and funded by issue of special treasury bonds, already has assets worth about $300 billion. This spate of acquisitions and investment overseas is a part of what Premier Wen Jiabao calls the “going out strategy”.
At the heart of the talk on international macroeconomic rebalancing is the question of how to promote more savings in the US and more consumption in China. Promoting consumption in China will inevitably involve increasing the wage rate, reducing corporate profits and introducing an effective social security cover for the population. This, undoubtedly, is an agenda for the medium term.
By completing a series of currency swaps — providing yuan to other central banks for use in trade with China — with, for example, Argentina, Indonesia, Malaysia and South Korea, China is encouraging the use of the renminbi as a reserve currency. There seems to be a good chance that the renminbi will be increasingly used as an international currency for current account purposes such as trade and tourism. But its use for capital account transactions will have to await capital account convertibility in China. The US dollar’s role as a reserve currency in the post-War period was facilitated by the existence of a large pool of claims on the US, including the US government, which the other countries could hold. The use of renminbi as a reserve currency will suffer unless the Chinese can create a large pool of marketable claims on itself. It is unlikely that governments such as the US would like to issue bonds denominated in renminbi.
The US has had a virtual monopoly of issuing paper claims for real goods and services. In the 1960s, the French complained of the “exorbitant privilege” that the US enjoyed because of the dollar’s dominance as a reserve currency. The monopoly is again under threat. At stake is the large seigniorage income that comes from the use of a currency as reserves by the world at large. The Chinese have staked a claim to a part of this “exorbitant privilege”.
The author is an executive director, Asian Development Bank (ADB), Manila. The views expressed here are personal and do not reflect those of ADB
