Thursday, April 9, 2009

The RMB as the Reserve Currency

I have a very curious sense at the moment of the world moving in slow motion. I had thought that the economic crisis would create dramatic moments, but in some respects it appears to be moving through a gradual shift.

One of the predictions that I have made, on two occasions, is the collapse of the $US and the end of the reserve status of the $US. However, it appears that the end of reserve status is being achieved with little drama, as it is apparent that the RMB is slowly but surely being positioned as a replacement of the $US as the reserve currency. We have this latest news from the China Daily:
Five major trading cities have got the nod from the central government to use the yuan in overseas trade settlement - seen as one more step in China's recent moves to expand the use of its currency globally.
The most interesting thing about the article is that the newspaper is part of the state run media, and therefore is careful to toe the party line. It is the following section that grabbed my attention:
Analysts said the experimental use of the yuan in trade settlement also reflects policymakers' rising concern over the shaky prospects of the US currency, of which China has large reserves from previous trade growth, and their willingness to gradually expand the yuan's use globally.

"The trial is the latest move toward making the yuan an international currency," Huang Weiping, professor of economics at Renmin University of China, said. "The prospect of a weaker US dollar is making the transition more imperative for China."
The method here is typical of the way that the Chinese government works. They use another person to make explicit an implicit policy, and thereby leave the situation open to later government denial. However, the idea is now 'out there', and that is their intention. The article also mentions several of the deals that I have discussed in past posts, and therefore offers a good summary of the progressive establishment of the RMB as a reserve currency to challenge the $US:
The mainland is trying to promote the use of the yuan among trade partners and, in the past four months, has signed 650 billion yuan (US95 billion) worth of swap agreements with Argentina, Indonesia, South Korea, Malaysia, Belarus and the Hong Kong Special Administrative Region. The agreements allow them to use their yuan reserves to directly trade with the Chinese mainland within a set limit in volume.
All the while this is going on, there is still chatter in the mainstream media about IMF Special Drawing Rights (SDR) developing into a new global currency. For example, Edmund Conway of the Telegraph points to a paper from the Governor of the People's Bank of China, in which there is a strong backing for SDRs as a global currency.
In fact, perhaps inadvertently the Geithner, Darling, Brown and Obama initiative has dramatically increased the odds of this happening [SDR as a reserve currency]. It will have increased the appetite of the Chinese, the Russians and the others who would like to depose the dollar as the world's reserve currency. Moreover, it has cemented the likelihood that they push for the deposition by trying to get the SDRs installed as the dollar's replacement. Quite how this would work remains to be seen. There appear to be plenty of obstacles and it is dubious that the SDR could be transposed to become a general unit of exchange.
I strongly recommend a read of the paper from the Chinese central bank governor. However, if you read it carefully, it might also be seen as much as an anti-$US statement, as much as a statement in favour of SDRs.

The problem for many analysts is that they are more likely to take an official paper as policy, rather than an article in the newspaper. However, a reading of Chinese history shows that a newspaper article is often used as a method of floating a new policy, often in contradiction to official policy. For example, the battle lines of the Cultural Revolution were heralded with People's Daily articles on the (apparently) innocuous subject of a Ming dynasty official called Hai Rui. I will not delve into details here, but this seemingly unimportant matter was exactly the opposite, and was later to be the precursor to a massive shift in government policy (for a full discussion of this you can find a good outline in 'The Search for Modern China' by Jonathon Spence, chapter 22 - which is one of the better studies of modern Chinese history).

Although the Hai Rui debate dates back to a different period of Chinese history, the methods of using the press, using proxy spokesman, and many other features of the case, can still be seen in use today. A more recent example that I discussed in a post many months ago was the indirect threat reported in a Telegraph article in which the Chinese obliquely threatened to destroy the $US if the US pressed further on trade disputes. As in this case, the idea was floated in such a way that allowed for later denials of this being an official policy. For those who may doubt that China might operate in such a way, I would suggest a reading of my post in which I discussed Chinese quasi-mercantilist policy in some depth.

In other words, China is now actively positioning itself as (at the least) a major issuer of reserve currency, but is doing so in a way in which - if their attempt were to meet resistance or fail - they can step back and point out that it was never their intention. They can therefore proceed with an official position of support for SDR, whilst acting to develop the RMB as a reserve, whilst never risking losing face. It is a very effective way of operating.

The real question is whether they might succeed in this ambition. Can the RMB become the world reserve currency? As I have pointed out in previous posts, they are already using their financial power to bolster their position and influence in developing countries (e.g. a recent loan to Mauritius). At the same time, despite my predictions of the demise of the $US still not coming to fruition, the actions of the US government, the irresponsible fiscal and monetary policy, continue to erode faith in the $US. However, the real key to reserve status is when trade is more broadly conducted in the RMB, such as move to trading oil in RMB. Perhaps Venezuela will offer such an opportunity? An article here suggests that Venezuela may need to turn to China for financial support, and this may well present an opportunity for China to start this process:
In Latin America, the external funding situation remains relatively stable but in the case of further deterioration of capital flows, the solid economies would be able to tap the IMF or the Inter-American Development Bank (IADB) for non-conditional lines of credit, while the economies with less sound macroeconomic frameworks such as Ecuador, Argentina and Venezuela would most likely only be able to obtain funds through more formal conditionality or by turning to lenders like China.
Returning to the question of whether it is possible, I see no reason to prevent the RMB from taking on this role. There has been talk about the RMB not being 'liquid' enough, the lack of depth of their financial markets. However, I take a fairly simplistic view, which is to ask whether a currency has the underlying strength of being able to be used to purchase goods and services. The answer to this question is, of course, 'yes'.

The remaining question is whether the Chinese government would want to have the RMB as the reserve currency. If it were to become the reserve currency, then it would surely dampen their export led growth, would it not? The RMB would appreciate in value and that would hurt the Chinese economy? There is some logic in this argument. The greater demand for the RMB, the more that it will appreciate - in principle. However, they would be able to hold down the value by expanding supply of the currency, though avoiding the level of expansion that has been the case with the $US. They will have surely learnt the lesson of the $US, which has seen the abuse of reserve status to finance massive deficits in government spending. Provided that they increase supply to provide sufficient to meet demand for the currency for trading usage, they will avoid the problems of the $US.

This point is critical. If a currency expands as a unit of exchange, rather than as a method of financing borrowing, the supply might expand without negative impacts and the value of the currency might remain stable. A currency is, in the end, a unit which promises to be utilised for exchange of goods and services and therefore needs to have the backing of an economy capable of honouring that promise. When a currency becomes a reserve currency, it might exceed that capability from the issuing economy, but still remain a currency in which there is confidence. Provided that confidence remains, there is little likelihood of the promise being called in all at once. In this respect, it mirrors fractional reserve banking in which the assumption is that it is safe to loan depositor money on the basis that not all depositors will want their money at the same time.

In other words, provided the currency continues in circulation, without a sustained call on the promise of the currency to provide goods and services from the issuing economy, it can hold and store value. My prediction of the (not yet arrived?) demise of the $US is that the underlying weakness of the $US is resultant from the abuse of the reserve status to build up a debt mountain, and the use of the reserve status to finance that debt. It can only service that debt through new currency issuance. There is no reason to see why China might follow such a course as a major creditor nation, and this is why it is so well positioned as a reserve currency. They only need to expand the money supply such that they provide sufficient units for exchange, not to finance debt. This is the inherent strength in the RMB, and why it might replace the $US.

I am sure that some will suggest that this is a simplistic approach. There are many other factors that are involved, some of which are psychological, or concerned with 'belief'. Whilst I can acknowledge these factors, indeed have to acknowledge them when viewing the continuing position of the $US, I do not believe that the underlying reality can be avoided for ever. In the end, as the situation becomes increasingly transparent and plain before the eyes of people, the underlying reality will become self-evident. In this case, the RMB as a unit of exchange for real goods and services is solidly backed up with the capacity to service the implicit promise of the currency.

On the other hand, the $US is expanding in volume to finance yet more consumption, the output of the economy is in decline, and the units in circulation are expanding beyond what is needed for exchange - whether for internal use or for use as a medium of exchange outside the US. Where is the underlying ability to service the promise?

The big question in my mind is when belief will end, and when will reality reassert itself?

Note 1: A regular commentator on the blog, Lord Keynes (a pen name) will be contributing an article in the future. Lord Keynes is a critic of many of the ideas in this blog, but I believe in open debate, such that I believe this will be a positive contribution. MattinShanghai - I would welcome an article on CDSs, an area I am aware you have both a strong point of view, and have evidently researched in some depth.

Note 2: I have had another article published in the Trade and Forfaiting Review, and you may wish to read this here. The article discusses the Japanese experience of quantitative easing (printing money).

Note 3: There is an interesting article here that I did not manage to integrate into this post. It is an essay on savings by the Chinese central bank governor, and makes interesting reading.


  1. I think you're missing an important factor in all the geopolitics: which currency would you rather hold, the dollar, issued by a stable democratic government, or the yuan, issued by a Communist dictatorship?

    When it comes down to it, there is independent rule of law in the USA, something that the Chinese can only dream of. At any moment the Chinese government could unilaterally dissolve the yuan and turn it into something new, and you would have no recourse whatsoever.

    When the traders in Cuba, Zimbabwe and souks all over the world want yuan rather than dollars, then the dollar will have lost its reserve currency status.

  2. CE said "I do not believe that the underlying reality can be avoided for ever. In the end, as the situation becomes increasingly transparent and plain before the eyes of people, the underlying reality will become self-evident.

    The human ability to ignore 'underlying reality' is astoundingly resilient. A look at any addict or alcoholic will show that underlying realities can be ignored for years or decades with a little help from *friends*.

    For example most people, media pundits and politicians believe that the G20 summit was a riproaring successs.

    A problem with your analysis MIGHT be that you apply logic to a world where illogic (presently) holds sway: as greed and fear. You make it seem a minor point, but I think its huge. Why should we expect more rational behvaiour and outcomes from currency exchanges than we get from the stock-market etc? As a supporter of A. Smith might not your racit belief in the rationality delivered by undistorted (mythtical?) free-martkets apply to macroeconomic areas?

    I don't doubt that there will be comeuppances, but I am sceptical of all predictions about who will finally win or lose.

    Hugh Hendry - who I find interesting - does not think the dollar will collapse:
    ("Hugh's outlook on the dollar (26th MArch 2009)").

  3. If you can put aside one 1-20mins of your valuable time here's a professor's take on the the Worlds's financial crisis.

    It is entitled The Crisis in Global Capitalism.

  4. Hi, the following article may be of interest :-

  5. Lord Sidcup: Many thanks for an insightful comment. I agree with the point that perhaps 'logic' is my weakness. I do sometimes wonder whether 'logic' means that I expect others to see the world as I do, and then puzzle that they do not. i.e. I expect them to see what I see.

    This may be a problem.

    However, I still believe that, one way or another, the logic of the situation will win out. We can deny and hide reality, but only for so long. This perhaps is my weakness. I expect reality to intrude faster than it actually does. I expect that others will see the underlying situation more quickly. It appears that they do not.

    I took a look at the video that you linked to. I could not help but feel that the Hendry had a fundamental disconnect with reality. In particular, he honestly believes that money can be divorced from actual value. He talks of the massive losses in the abstract, but does not connect them with the actuality of the 'real' economy. Perhaps he is the perfect example of the point I have made regarding the seeing of reality.

    Essentially, Hendry imagines that money and asset prices are both distanced from underlying value creation. It may sound 'clever', but it is the delusion that got us into this mess.

    In my simplistic world, the only thing that matters is the sale of goods and services, and this is the underlying foundation of economics. If you buy more value than you sell.....nothing will save your economy in the end. You must pay back the value, or you are bankrupt. People will only lend if they think that they will get greater value in return.

    Yes, there are politics involved. Yes there is belief involved. However, at some point, the situation must resolve itself according to some sense of value.

    It is just a question of when, and how.

  6. Coshbrew: Thanks for the link. I have reproduced it here:

    It is a brief but interesting article, that grabs a little slice of the reality of the situation. I am trying to be modest on the matter of the fall of the $US (having been wrong on the matter of the demise of the $US), but think he is looking too far into the future. Otherwise, I can not help but agree.

    Sobers: Interesting point, but at any time the US might print any amount of new $US - and they are already doing so.....I am not sure the rule of law helps where the law allows such policy.

  7. Interesting article. However, a reserve currency is not chosen. It just happens to be used. And although the dollar is regarded as the sole reserve currency, this is only because it is the biggest. Governments do hold reserves massive reserves of Euro and to a lesser extent Sterling and Yen.

    It is highly unikely that the RMB will be regarded as a currency to hold in reserve for the foreseeable future. China is highly unstable, and it is a communist country.

    There is no other altrnative to either the Dollar or the Euro as sound reserve currencies. They are highly accountable, transparent and democratic countries with huge economies.

    The GDP of EU is $18.8m and the US is $14.3m. China has a GDP of $4.2m. It is minnow despite its size.

  8. Had a look at that Hendry video, and I agree with it.

    There may be a disconnect from underlying value, but I think debt denomination and the "we're fcuked, but the rest of the world is fcuked even more" scenario are the two factors that keep the $ as a safe store of value.

  9. Would a small expansion of the RMB money supply suffice for it to become a - or the - reserve currency? Wouldn't it have to expand hugely to do the trick, to the point where China's GDP was dwarfed by the sum in circulation worldwide? At that point, its ability to store value would depend on the confidence placed in it, not on the capacity of the Chinese economy to honour the promise to supply goods & services.
    And would China's rulers really prove better and wiser than those of any other empire for very long, or would they too eventually start to borrow more than they should because they could?

  10. The actual sizes of the economies in question are very hard to measure, especially now. GE was a great industrial company that created real wealth, but it got overwhelmed by GE capital, which created substantial amount of paper wealth. By such measures, how much of the $14.3 trillion US GDP were of the paper kind?

    UK probably had a very respectable GDP pre-crash, but does it produce any tradable goods/services except for financial services?

  11. Whatever happens, I don't think the US will take it laying down.

    Pentagon preps for economic warfare

  12. I think this article in the telegraph may be on to something:

  13. Nice blogging, My review is very good example.
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