The Dollar Dilemma

Russia's reserve diversification is one thing, but reserve diversification by China is another matter. Informed guesses put China’s official dollar assets at roughly eight times Russia’s as of May 2009. Thus reserve diversification by China would be a very big deal.

It is not surprising that the issue has become a flashpoint domestically since China’s foreign currency reserves amount to $2,000 per Chinese resident. That said, Chinese officials are aware that they are trapped. The prices of treasuries would tank if the People’s Bank of China sold them in sufficient quantities to significantly alter the currency composition of its reserve portfolio. To the extent that dollars still comprised a significant portion of its reserves, the People’s Bank would incur costly losses. One is reminded of Keynes’s aphorism: “When you owe your bank manager a thousand pounds you are at his mercy. When you owe him a million pounds, he is at your mercy.”

The sensible strategy in such circumstances would be to make a series of small adjustments in portfolio proportions, which is essentially what China’s reserve managers are doing. This is yet another reason why the declining dominance of the dollar in reserve portfolios is more likely to be gradual than sudden.

Finding itself in this bind, China has, not unreasonably, begun exploring other options. In March 2009 its central bank governor made a splash by arguing that the IMF’s Special Drawing Rights (SDRs) should replace the dollar as the world’s reserve currency.

The obstacles to making this happen are formidable. Reserves, as noted above, are only attractive if they can be used. Making the SDR attractive would thus require developing markets on which SDR claims can be bought and sold. It would be necessary to build a market on which governments could issue SDR bonds at a competitive cost. Banks would have to find it attractive to take SDR deposits and make SDR loans. It would be necessary to restructure foreign exchange markets so that traders went through the SDR.

Making this happen would require significant investments over an extended period. To start with, if China were serious about elevating the SDR to reserve-currency status, it should then take steps to create a liquid market in SDR claims. For example, it could issue SDR-denominated bonds. This would be a much more meaningful step than buying SDR bonds from the IMF, as it has indicated it will do.

Then there is the question of who would be on the demand side of the market. Government bonds are held by pension funds and insurance companies since the maturity of the bonds matches the maturity of these buyers’ liabilities. If the dollar depreciated against the euro, a European insurance company holding SDR-denominated bonds and euro denominated liabilities would find itself in deep trouble. Potential investors would need markets on which to hedge SDR currency risk—markets that can only be created at a cost.

Finally, for the SDR to become an attractive form of reserves, the IMF would have to be able to issue additional SDRs in periods of shortage, much as the U.S. Federal Reserve provided dollar swaps to ensure adequate dollar liquidity in the second half of 2008. In other words, for the SDR to become a true international currency, the IMF would have to become more like a global central bank. Again, this is unlikely to happen overnight.

An international Chinese currency?

Perhaps the most fundamental reason for discounting the SDR proposal is that China has a preferred alternative: establishing the renminbi as an international currency. If the renminbi were to be widely used in international transactions, China itself would no longer need to hold foreign currencies to smooth its balance of payments. It could simply print more or less of its own currency, as necessary, like the United States.

But for now the renminbi remains unconvertible. Foreigners can only use it to purchase goods from China. It is used in cross-border trade only with China’s immediate neighbors. Brazil and China recently announced the intention to explore ways of using their own currencies in their bilateral trade. But this agreement is mainly useful for advertizing Chinese-Brazilian trade. A Brazilian firm will take renminbi in payment for its exports only to the extent that it imports from China—not your typical case.

Similarly, China’s recently concluded swap agreements with Argentina, Belarus, Hong Kong, Indonesia, South Korea and Malaysia are mainly a way of signaling its global ambitions. These countries cannot use renminbi to intervene in foreign exchange markets. They cannot use it to import merchandise from third countries or to pay foreign banks and bondholders.

In time, China can strengthen the international role of the renminbi by developing liquid financial markets and liberalizing foreigners’ access to these markets. Over time, it can also make its currency convertible for financial as well as merchandise transactions. The question is: how much time? Reconciling financial stability with capital account convertibility has formidable prerequisites. Markets must first become more transparent. Banks must be commercialized. Supervision and regulation must be strengthened, and the exchange rate must be made more flexible to accommodate a larger volume of capital flows.

China, in other words, must first move away from a growth model in which bank lending and a pegged currency have been two of the pillars of its development policy. This is easier said than done. Witness how the Chinese authorities’ reaction to the crisis was in fact to move in the other direction, relying more on directed lending to boost investment and hardening the renminbi’s peg to the dollar to sustain exports.

The year 2020 is the authorities’ target date for transforming Shanghai into an international financial center and thus, de facto, for the capital account convertibility that is a prerequisite for a reserve-currency role for the renminbi. But even if China grows at a 7 percent annual rate for the next decade (slower than in the past, reflecting less favorable demographics, but still exceptional), its GDP in 2020 will still be considerably smaller than that of the U.S. at market exchange rates. The renminbi will still have a smaller domestic platform than the dollar. In turn this means that its market liquidity will not be comparable.

Under these circumstances, the attractiveness of holding reserves in renminbi will be limited. It will be most attractive to countries conducting the majority of their trade with China and doing their international financial business in Shanghai. This suggests that the market for renminbi reserves will, at least initially, be concentrated in Asia, much as the market for euro reserves is concentrated in Europe.

The resilient dollar

I conclude, by process of elimination, that the dollar will remain the principal form of international reserves for the foreseeable future. It will not be as dominant as in the past, for the same reasons that the United States will not be as dominant economically as in the past. In the short run the euro will continue to gain market share, especially in Greater Europe. In the longer run there will be a role for the renminbi, especially in Greater Asia. But as far into the future as I personally am able to see, the dollar will remain first among equals.

Barry Eichengreen is George C. Pardee and Helen N. Pardee Professor of Economics and Political Science at the University of California, Berkeley.