Tuesday, July 7, 2009

The RMB as a reserve currency - an update

I have been discussing the steady progress of China in setting up the RMB as the reserve currency for a long while, and have proposed that it is fast moving towards success (though success is not guaranteed). Economists like Nouriel Roubini have suggested that this is going to be a long term process:
This decline of the dollar might take more than a decade, but it could happen even sooner if we do not get our financial house in order. The United States must rein in spending and borrowing, and pursue growth that is not based on asset and credit bubbles. For the last two decades America has been spending more than its income, increasing its foreign liabilities and amassing debts that have become unsustainable. A system where the dollar was the major global currency allowed us to prolong reckless borrowing.
Roubini is seeing a long term decline in the $US, and sees the RMB as being unready to take the place of the $US. In an update to his article, he has this to say:
So the process that will lead - in the medium-long term - to a challenge of the US dollar as the major global reserve currency has started. The US creditors - the BRICs, the Gulf states and others - are becoming increasingly alarmed that the US will deal with its unsustainable fiscal path via inflation and debasement of the value of the dollar via depreciation. So they will not sit idly waiting for this to happen: they are already diversifying into gold, into resources (as China purchases mines and energy, mineral and commodity resources all over the world) and into shorter term maturity US Treasuries that have less market risk than longer term Treasuries. With two-thirds of US Treasuries, being held by non-residents and the average maturity of such government debt down to 4.5 years, the risk of a refinancing crisis and disorderly fall in the dollar will increase over time unless the US presents a credible plan for medium term fiscal consolidation.
Even the Chinese are approaching the issue of the shift in reserve currency with some considerable caution, so Roubini's view is mirrored by the official view of the $US replacement in China:
Yet even Chinese officials pour cold water on the idea that this might happen fast. China Vice Foreign Minister He Yafei, who is traveling with China President Hu Jintao this week to attend the G8 meeting, said Sunday night in Rome that the creation of a supranational reserve currency has been discussed “among academic circles” but that any proposal outlined “is not the position of the Chinese government,” according to China’s state-run Xinhua news agency (in Chinese here). And, at the Global Think Tank Summit in Beijing on Saturday, Li Yang, a former adviser to the PBOC and a prominent academic, said that the transition to a multi-reserve currency system could take 20-30 years or longer.
In some respects I have no argument with Roubini. I have long argued that the US deficits will eventually see the $US decline in value. However, I would argue that his implication of an orderly decline is far too optimistic. The fragility of the $US is becoming increasingly evident as each day passes. Just one example can be found in a recent article from Reuters on 26th June:

NEW YORK (Reuters) - The U.S. dollar fell broadly on Friday after China renewed its call for a super-sovereign reserve currency and as improving appetite for risk dented the greenback's safe-haven allure.

China's central bank on Friday did not mention the dollar by name but said it was a serious defect in the international monetary system that one currency should dominate.

Whilst such negative news dents confidence, it is still not enough to finally pull the rug out from under treasuries, as more recent news reports a rally in the face of poor stock market performance:
Treasuries rose, with the 10-year yield touching the lowest in more than a month, as investors speculated the worst recession in 50 years has further to run, tempering concern record U.S. borrowing may outstrip demand. U.S. debt gained as the U.S. sold $35 billion of three-year notes at the lowest yield since May. The auction is the second of a record four this week totaling $73 billion and stocks fell.
What we are seeing in these two reports is a process that I described in a recent article in the TFR magazine, which is that fear is driving markets, and that there is an oscillation from one place of risk to another place of risk. The problem is that there is no safety in any of the traditional safe havens. As each day passes, the underlying reality of the weakness of the $US is gaining traction, as ever more analysts are coming to realise that the current fiscal policy can no longer be sustained. An interesting example can be found in the Telegraph, which reports the analysis from the Federal Reserve's senior economist:

He added: “Similarly, a percentage point increase in the projected debt-to-GDP ratio raises future interest rates by about 4 to 5 basis points.” Economists are predicting a wide range of ratios but Mr Congdon said it was “not unreasonable” to assume debt doubling to 140pc. At that level, Mr Laubach’s calculations would see long-term rates rise by 3.5 percentage points.

The study is damning because Mr Laubach was the Fed’s economist at the time, going on to become its senior economist between 2005 and 2008, when he stepped down. As a result, the doubling in rates is the US central bank’s own prediction.

In the meantime, in the face of increasing uncertainties, one of the few remaining props for the $US is the purchase of treasuries by the Federal Reserve:
TOKYO, June 29 (Reuters) - U.S. Treasuries edged down in Asia on Monday as traders took profits after a rally pushed benchmark yields to their lowest in nearly four weeks, while the prospect of the Federal Reserve buying bonds this week underpinned prices.
It is clear that the process of printing money to purchase bonds can not continue forever. Whilst the process is currently supporting the bond market, the process of itself weakens the bond market, as it generates inflationary expectations. As such, having started the process, the Federal Reserve is now locked into the process. The more bonds that they buy, the less confidence in the $US, and the less confidence in the $US, the more bonds the Fed must buy. They are now locked into a cycle that must eventually end with the destruction of the value of the $US.

Whilst all of this is taking place, the Chinese continue to promote the idea of SDRs as a replacement for the $US:

The Special Drawing Right (SDR), a unit of account used by the International Monetary Fund, presents a viable alternative to the dollar as a global reserve currency, said Li Ruogu, chairman of the Export-Import Bank of China, a major state-run bank.

"It is a feasible plan to reform the present SDR and make it into a real settlement currency, a universally accepted 'currency basket' that would replace the dollar at the heart of the monetary system," Li was cited as saying in Financial News, a newspaper published by the central bank.

I have long argued that China is using the idea of an SDR reserve currency as a stalking horse. I positioning the SDR as the replacement for the $US, China can engage the support of other countries like Russia, India and Brazil, who might blanch at the prospect of the RMB as the reserve currency (e.g. see here for discussion of support for the SDR in relation to India and Russia).

The underlying reality behind the challenge for reserve supremacy is that China is increasingly the linchpin in the global financial system. Whatever China does with its massive reserves quite literally shapes the world financial system. China quite literally has the power to make or break any asset or any market, as can be seen in the attention paid to every utterance from China regarding the $US. When a country has such economic firepower, it is puzzling that anyone might suggest that it is not ready to take on the role of a reserve currency. I can only assume that many analysts are taking the SDR stalking horse seriously, and are not considering the vacuum that will be left when the $US finally collapses under the weight of quantitative easing and fiscal profligacy.

One argument I have read (sorry, I forget where) is that China would not want the RMB to become a reserve currency, as it would mean that the RMB would strengthen. There is some merit to this argument, as the fall of the $US against the RMB would make a serious dent in China's trade. However, the problem that underpins the current fragility is that China is currently subsidising US consumption at the expense of Chinese people.

At present, China is funding the US deficits and consumption in return for treasuries. Those treasuries are a promise of payment in $US, and yet the issuance of $US is massively expanding even as output is falling in the US. With each $US a representation of the output of the US economy, such issuance of $US currency and debt means that each currency unit is representing a smaller amount of output (I explain this in more detail here). As such, one way or another, China must eventually shift its reliance on a large US export market, and start to gain the full value of their economic output. They can not continue to literally give away a proportion of their output to the US, which is what the purchase of treasuries represents.

The only question marks that remains over the RMB as a reserve currency are largely to do with whether China can continue the present economic momentum, and the timing and nature of the collapse of the $US. When I first wrote about China for the blog in July 2008, I highlighted the risks for China, but concluded that on balance I favoured the view that China would emerge in the ascendant in the economic crisis. Whilst still issuing a note of caution, the developments since that time are even more favourable for China. With regards to the collapse of the $US, it is quite astounding that it has defied gravity this long.

As the current situation stands, the RMB is looking very much like the new reserve currency, and it is not going to become the reserve currency in ten or twenty years time, but in the near future. It may be that SDRs will be implemented as a reserve on a temporary basis during the transition, for long enough for China to satisfy the aspirations of the other supporters of the SDR. However, unless China's ascent is halted (e.g. through civil unrest), it is almost certainly going to succeed in the ambitions for the RMB.

Note 1: I have recently seen an article which agrees with my view that the SDR is a stalking horse, though he is using the expression 'smoke screen'.

Note 2: I have had some negative feedback on the new comments system. More feedback would be welcome, as I am starting to think that I need to revert to the old system (which might be a bit tricky to actually do, but I will work it out if necessary).