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CAMBRIDGE: The mighty US dollar continues to reign supreme in global markets.
But the dollar’s dominance may well be more fragile than it appears, because expected future shifts in China’s exchange rate regime are likely to trigger a significant shift in the international monetary order.
For many reasons, the Chinese authorities will likely one day stop pegging the yuan to a basket of currencies and switch to a modern inflation targeting regime under which they will allow the exchange rate to fluctuate much more freely, especially against the dollar.
When that happens, expect most of Asia to follow China. In due course, the dollar, which is currently the anchor currency of about two-thirds of world GDP, could lose almost half its weight.
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Considering how much the United States depends on the special status of the dollar, or what the then French Finance Minister Valéry Giscard d’Estaing called the famous “exorbitant privilege” of the United States, to finance massive public and private loans, the impact of such change could be significant. .
Given that the United States has been aggressively using deficit financing to combat the economic ravages of COVID-19, the sustainability of its debt could be called into question.
A MORE FLEXIBLE YUAN
The long-standing argument in favor of a more flexible Chinese currency is that China is simply too big to allow its economy to dance to the rhythm of the US Federal Reserve, even if Chinese capital controls provide some measure of isolation.
China’s GDP, measured at international prices, surpassed that of the US in 2014 and is still growing much faster than the US and Europe, making the case for greater exchange rate flexibility become more and more convincing.
US Treasury Secretary Steven Mnuchin said China has made ‘enforceable commitments’ not to devalue its currency to gain a competitive commercial advantage AFP / Nicholas Kamm
A more recent argument is that the centrality of the dollar gives the US government too much access to global transaction information. This is also a major concern in Europe.
In principle, dollar transactions could be cleared anywhere in the world, but US banks and clearinghouses have a significant natural advantage, as they may be implicitly or explicitly backed by the Fed, which has a capacity unlimited to issue currency in case of crisis.
By comparison, any dollar clearinghouse outside of the US will always be more subject to a crisis of confidence, a problem that even the eurozone has struggled with.
TRUMP POLICY LEGACY
Furthermore, the policies of former US President Donald Trump to control China’s commercial dominance will not go away anytime soon. This is one of the few issues on which Democrats and Republicans generally agree, and there is little doubt that the deglobalization of trade undermines the dollar.
Chinese lawmakers face many obstacles in trying to break the current yuan peg.
One hundred US dollar bills are seen in this photo illustration taken in Seoul on February 7, 2011. (Photo: REUTERS / Lee Jae-Won)
But, with a characteristic style, little by little they have been laying the foundations on many fronts. China has been gradually allowing foreign institutional investors to buy yuan bonds, and in 2016, the International Monetary Fund added the yuan to the basket of major currencies that determines the value of Special Drawing Rights, the IMF’s global reserve asset. .
Furthermore, the People’s Bank of China is far ahead of other large central banks in developing a central bank digital currency.
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Although it is currently purely for domestic use, the People’s Bank of China digital currency will ultimately facilitate the international use of the yuan, especially in countries that gravitate towards China’s eventual currency bloc. This will give the Chinese government a window into digital yuan user transactions, just as the current system provides the US with a wealth of similar information.
Will other Asian countries actually follow China? Certainly, the United States will push hard to keep as many economies as possible orbiting the dollar, but it will be an uphill battle. Just as the United States eclipsed Great Britain in the late 1800s as the world’s largest trading country, China long ago surpassed the United States by the same measure.
IT WILL NOT HAPPEN SO SOON
It is true that Japan and India can go their own way. But if China eases the yuan, it is likely to at least give the currency a comparable weight to the dollar in its foreign exchange reserves.
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There are striking parallels between Asia’s close alignment with the dollar today and the situation in Europe in the 1960s and early 1970s. But that era ended with high inflation and the collapse of the postwar Bretton Woods system of fixed exchange rates. Most of Europe then recognized that intra-European trade was more important than trade with the US.
An American dollar bill with American founding father Benjamin Franklin and a Chinese yuan bill with the late Chinese President Mao Zedong are seen between the flags of the United States and China in this illustrated image taken on May 20, 2019 (Photo: REUTERS / Jason Lee / File Photo).
This led to the emergence of a block of German marks that decades later became the single currency, the euro.
This does not mean that the Chinese yuan will become the world currency overnight. Transitions from one dominant currency to another can take a long time.
During the two decades between World War I and World War II, for example, the new entrant, the dollar, had roughly the same weight in central bank reserves as the British pound, which had been the dominant world currency for more than a century after the crisis. Napoleonic wars in the early 19th century.
So what’s wrong with the three world currencies, the euro, the yuan and the dollar, sharing the spotlight? Nothing, except that neither markets nor politicians seem remotely prepared for such a transition.
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The borrowing rates of the US government will almost certainly be affected, although the really big hit could fall on corporate borrowers, especially small and medium-sized businesses.
Today, it seems to be an article of faith among American politicians and many economists that the world’s appetite for dollar debt is virtually insatiable. But a modernization of China’s currency arrangements could deal a painful blow to the state of the dollar.
Kenneth Rogoff, former chief economist at the International Monetary Fund, is Professor of Economics and Public Policy at Harvard University.
