2023.06 The Taiwan Banker NO.162 / By David Stinson
What's different about this round of de-dollarization chatter?Banker's Digest
Few countries want the responsibilities that come with being a superpower. These include the management of a global reserve currency, which requires a dual deficit in the trade account and capital position. Even China lacks this ambition, despite its constant “renminbi internationalization” rhetoric. It has always viewed international capital flows with suspicion, and its recent actions against corporate due diligence make it an even more difficult investment destination for outsiders. Shaky local government finances would make the financial system vulnerable to instability. Yet if anything, a trade deficit would be an even bigger challenge. “The number of fresh college graduates this year was a record 11.58 million, up 820,000 year-on-year,” wrote Shen Guobing, deputy director of the Institute of World Economy at Fudan University, and Liu Weiping, researcher at the China Development Bank, in a recent China Daily feature on de-dollarization. “To ensure their employment, China needs to achieve sustainable and rapid economic growth, a goal which can be met through massive exports and foreign direct investment [as opposed to ‘hot money’]. The internationalization of the renminbi being a long-term process could make achieving that goal a bit difficult.” They advise caution on further opening. Bad look The US has meanwhile held unquestioned monetary dominance for decades, but this role has imposed a variety of costs, of both concrete and abstract. One example of the latter is the lack of market feedback on its national debt, which may explain why Congressional Republicans are now leveraging the possibility of national default in order to negotiate budget cuts. The US is highly unlikely to default, even if congressional negotiations fail. The 14thAmendment of the Constitution, which states that “the validity of the public debt of the United States…shall not be questioned,” overrides any congressional legislation. Furthermore, even in the off chance this protection were somehow ineffective, a default would be technical in nature only, because the US is still fundamentally solvent. Even though the way the debt sustainability question is being raised is not ideal, however, the underlying debate is valid. The Peter G. Peterson foundation projected earlier this year that government interest payments will reach a record post-war high of 3.3% of GDP by 2030 as interest rates rise. Neither the Democrats nor Republicans have a plan to reduce the deficit. This ultimately undermines the credibility of dollar. Meanwhile, the US dollar has steadily declined to 58% of global reserves from 63% in 2018. Will the US lose its privileged place in the global financial system? The question has been asked for many decades, and the answer appears no different than it ever was. Notably, the change in reserve allocation largely reflects a significant increase in the total size of global reserves from a low of 20% up to 30% during that time. That answer however conceals some changes in the underlying role of the reserve currency – or perhaps a reversion to its past role. A splitting of currency functions Money in general has three functions: as a store of value, unit of account, and medium of exchange. The first function gives the US government access to international capital as a safe haven security issuer. The third function allows it to impose controls over international financial flows, a capability of which it has made increasing use in recent years, to increasing alarm by many middle powers who wish not to be drawn into factional struggles between the US, Russia, and China. Those two functions are traditionally thought to be connected. When the US creates a pool of assets for overseas trading, lenders using such assets as collateral for further lending also prefer to use dollars in order to eliminate currency risk, feeding additional cycles of dollar adoption and creating an entire dollar ecosystem. But what if the two functions could be separated? The ability of the US to impose financial sanctions could gradually be eroded. Russia’s response to international sanctions provides a model. It has been reportedly selling its renminbi holdings earned through export to China, unable to find suitable investments in China’s capital markets. It is hoping to avoid currency risk from holding the renminbi for too long. The buyers of those renminbi can in turn use them to purchase imports from China, forming a closed loop even though China retains an overall surplus. Currency for financing trade in the short term thus plays a different role from long-term holdings of reserves. The latter is essentially all under the control of the US, to one degree or another. Even if savings are invested in a variety of smaller curries, the US maintains strong ties with most such countries through monetary swap arrangements. Moreover, if China or others were to park too much capital there, they would be forced to invest in the US if they hoped to avoid currency appreciation and a trade deficit, creating an investment in the US by proxy. Such countries could perhaps provide a check on abuse of sanctions by the US, but would not do for an act of common concern, like the outright invasion of another country. For shorter-term transactions on something approaching a barter model, however, China still has room to grow. Even though China accounts for 13% of global trade, the renminbi only accounts for 2% of global transactions, in distant fifth place following the yen and pound, and particularly the euro and dollar. Because of China’s sustained surplus, however, that figure is misleading. China makes up 11% of global imports, which constitutes a reasonable ceiling on RMB usage as a portion of global transactions. The remaining money earned from its surplus will end up overseas. Politicization of payments That benchmark however still disregards the ecosystem advantages of the dollar. In the past, any marginal difference in transaction cost would be enough to give one currency near-absolute dominance. Emerging political factors could however change that calculation. Here, it is important to note that recent calls for de-dollarization are not only coming from China, or even from countries politically aligned against the US. Over a dozen Asian countries have discussed de-dollarization in some form. In January, Brazil and Argentina announced plans for a common currency. On a superficial level, it is the increase in Fed rates and the recent difficulty of dollar financing which is causing this increased interest in the old concept of de-dollarization. Behind that business cycle consideration however lies some structural changes. The US is no longer an energy importer. This tightening cycle is unique in that the dollar has gone up at the same time as commodity prices, according to April analysis by the Bank of International Settlements (BIS), creating a stagflationary squeeze on both the current and capital accounts of many emerging economies. Beyond the material impacts, energy importers may feel uneasy that some elements of the US economy profit from sanctions. A further effect of American energy self-sufficiency, meanwhile, is ironically to undermine the deficits originally responsible for the reserve status of the dollar. This is a critical part of the reason that Saudi Arabia is moving closer to China; it used to be a critical player in the “petrodollar” model of recycled export earnings. Going after the endpoints That minor change notwithstanding, however, the role of the US as the destination for the world’s excess capital is not in question. Even if its current debt ceiling debacle is not a great look, the question is what other market could possibly provide the same function. Europe, Japan, and China all have even more severe demographic crunches on the horizon, which the US has avoided through robust immigration. At the same time, the reserve status of the dollar should not be confused with the ability of the US to implement sanction trade using finance. China’s Cross-Border Interbank Payment System (CIPS) could eventually grow into an alternative to SWIFT, which implemented many aspects of the current sanctions on Russia. A system like CIPS shows strong economies of scale: the more it is used, the lower its costs. There are no insurmountable technical obstacles to its adoption, but if your counterparty bank does not use it, then you will find another method. Many countries therefore aim to set up alternative payment networks bypassing the dollar system before they might need to be used. Such infrastructure would only work for the balanced portion of trade, and not reserves; any country that accumulates long-term investments overseas through surpluses must either accept holding non-mainstream currencies as cash, or else some degree of US control. This is not to say that the US has no options to sanction China on trade, but that any broad-based sanctions will likely be economic rather than financial in nature. Rather than engaging intermediaries, the US would simply need to ask other countries to stop trading with China – or else physically disrupt delivery of goods. The Strait of Malacca remains the most potent chokepoint for China’s economy.