China and the Reserve Currency

As mentioned in Part 2 of The Global Strategy of the Dragon, in late March, China raised the heated debate of substituting the dominant currency status of the U.S. dollar with a new reserve currency. China’s central bank governor, Zhou Xiaochuan, called for moving toward a super-sovereign reserve currency, or one that doesn’t belong to any particular country, by expanding the Special Drawing Rights (SDR) – a kind of synthetic currency whose value is determined by a basket of major currencies – of the International Monetary Fund by including the Chinese yuan and currencies from other economies. This debate mainly revolves around China, Russia and the U.S., illustrating their concerns from multiple dimensions.

It began in March 2009, when Chinese Premier Wen Jiabao voiced his concern on the fact that China was holding about $2 trillion U.S. Treasury in its foreign reserves. China bought so much U.S. debt without diversifying its foreign reserve because of the low default rate of the liquid U.S. Treasury market. However, since the U.S. government has been printing and pumping money into its economy in this financial crisis, an economic recovery will inevitably generate inflation, which will depreciate the value of the dollar. As a result, holding too much U.S. Treasury will be detrimental to its value, and thus China’s foreign reserve. Therefore, according to Zhou, moving to a reserve currency that belongs to no individual nation would make it easier for all nations to manage their economies better because it would give the reserve-currency nations more freedom to shift monetary policy and exchange rates.

The proposal also allows China to regain face, especially in response to U.S. Treasury Secretary Timothy Geithner’s criticism of currency manipulation, or the notion that China artificially keeps the yuan weak against the dollar (even after Mr. Geithner declined to cite China as the currency manipulator in April). Peter Gries’s book, China’s New Nationalism, states that “face is fundamentally political, involving a contest over power” (Gries 26). Currently, the SDR is only composed of four major currencies in the world (G4): the U.S. dollar, the euro, the Japanese yen, and the British pound. If the IMF SDR program includes the Chinese yuan, it will certainly enhance national pride in China.

As a consequence of rising Chinese nationalism, the Chinese will “altercast the relationship between China and the U.S. as teacher and student, respectively” (Gries 33). The U.S. government (as the student) is busy implementing different economic stimulus solutions to rescue its economy, while China (as the teacher) is slowly preparing itself to teach the student a lesson by attempting to overtake the U.S., the single economic superpower. According to The Economist, “the crisis would severely weaken the economic, political, military and diplomatic power of developed countries. This would create a “historic opportunity” for China to strengthen its position. To do this, China should export capital to South-East Asian countries to strengthen their economies. Doing this would help prevent political turmoil and win strategic influence in the region (The Economist 28).

On the other hand, China has been continuously opening up its economy to the world since Deng Xiaoping became the leader of China in 1978. After Deng set up four Special Economic Zones in China, namely Shenzhen, Shantou, Zhuhai and Xiamen, China underwent rapid economic development. When Jiang Zemin became the new Chinese leader in the 90s, he greatly favored Shanghai and the Yangtze River Delta to become the next big economic regions in China. When Hu Jintao became president in 2002, he led China to increase its participation in developing the domestic front such as the “Open up the West” policy, the completion of the Three Gorges Dam, and the international economics affairs. Consequently, these actions would contribute more to the Chinese economy during his tenure.

If China wants to expand the international use of the yuan, in addition to having a low inflation rate in its economy and a huge GDP and export figures, China still needs to broaden its financial markets by increasing the yuan’s usability and convertibility. Due to this, China has been taking great steps to strengthen the importance of yuan in the foreign exchange market, even though China is still proposing a reserve currency under the IMF. China has not only set up tens of billions of dollars in currency swaps with Hong Kong, Malaysia and South Korea, which enabled those regions to settle their trade accounts with China in yuan, but in late March 2009, China also entered a 70 billion yuan currency swap deal with Argentina. This deal effectively allowed China to settle the trades with yuan, which further enhanced China’s influence in Argentina’s economy while strengthening China and Argentina’s geopolitical relationship. Hence, we can see China is slowly bypassing the dollar to settle its bills on the international trade platform.

Recently, on April 9, 2009, China picked five cities (Shanghai, Shenzhen, Guangzhou, Zhuhai, Dongguan) for the yuan settlement program. This program allows foreign trades to be conducted wholly in yuan rather than in conventional U.S. dollars in those cities. This is an innovative move, as the yuan settlement program not only reduces the risks of exchange-rate fluctuations for the Chinese companies, but also promotes the development of China’s currency investments products.

From China’s view, all these recent currency policies have shown that even if the Chinese yuan failed to be included in the reserve currency by the IMF, China’s new currency policies and political positioning are preparing the yuan to become an increasingly important global currency with implications for reducing the use of the U.S. dollar in the future.

Russia’s reaction may be a good implication on the strategic importance of China’s recent decisions. Once China released its reserve currency proposal, Russia echoed its terms and proposal change. Before the G20 meeting, Russia’s President Dmitri Medvedev supported the creation of strong regional currencies as a basis for a new reserve currency and the consideration of backing this currency by gold. According to Reuters, Russia said that the new international reserve currency, which dislodges the dollar, could curb the volatility of foreign exchange markets. In April 2009, the Kremlin’s chief economic adviser Arkady Dvorkovich also asked the IMF to study the risks and possibilities of the new global currency. These actions reflect how anxious Russia is to remove the primacy of the U.S. dollar.

In comparison to China, Russia’s economy is less export-oriented and Russia’s currency, the ruble, has been devalued by more than 35% since the commodity bubble burst in the summer of 2008. If the U.S. dollar is no longer a dominant currency, the ruble should appreciate against the dollar, which will increase its currency reserve.

In addition to Russia’s own benefits, Russia supports China because of their geopolitical relationship, since Russia and China share the same border and both countries have serious currency concerns over the potential depreciation in the value of the U.S. dollar that they are currently holding. In addition, Russia and China have important economic relations. China has been invested in Russia’s natural resources, such as the deal with the China Development Bank in February 2009, which I have mentioned in Part 1 of The Global Strategy of the Dragon.

From the U.S. standpoint, the U.S. does not want to lose the dominant status of its currency. The use of a country’s currency as an international store of value allows the country issuing it to benefit from seigniorage (the net revenue derived from the issuing of currency), and lower borrowing costs. In response to the reserve currency proposal, the U.S. President Barack Obama said the U.S. dollar still remains the primary global currency and there is no need for a new global currency. At the same time, since many commodities are denominated in dollars globally, changing the current system would take a lot of effort and time for a worldwide adaptation to occur.

On the other hand, even though a move towards global currency reform may detract from the dominance of the U.S. dollar in the foreign exchange market, it may not necessarily be a bad thing. Since China is an export-oriented country, if the U.S. dollar is no longer a dominant currency, the Chinese yuan will surely appreciate against the dollar and make Chinese exports relatively more expensive than those in other emerging markets. Moreover, as most of the Chinese exports are shipped to the U.S., Chinese goods will become more expensive than U.S.’s goods, which the U.S. will import less from China and consume more domestic goods. If this were to occur, it will hurt China’s economy while benefiting US’s domestic economy by reducing its trade imbalance and trade deficit.

From a global perspective, in the recent G20 meeting, the G20 leaders have announced plans under Point 19 of the communiqué to replace the role of U.S. dollar as the world reserve currency, which stated to support a general SDR allocation into the world economy and increase liquidity, which is not under the control of any sovereign body. The G20 leaders have activated the IMF’s power to create money and begin global ‘quantitative easing.’ The global leaders also agreed to increase IMF’s financial capacity to $1 trillion commitment.

Moreover, it is possible for China to first create a common currency among the East Asian countries that mirrors the euro, which was established in 1999 by the European Union. The euro’s position has becoming increasingly important since then. As of today, the euro is even more expensive than a dollar. However, critics argue that this process would require a tight trade agreement among the East Asian countries, which will potentially take a long time to become stabilized.

While it is still early to draw conclusions about whether the switch to a new reserve currency is technically feasible, it would take a long time for this global currency reform to take effect. We can also see that this new global currency proposal is a two-edge sword to China. However, this currency debate will surely mark the beginning of a new era when emerging markets, especially China, are developing the capabilities to lead major reforms in the international monetary system.