Friday, May 15, 2009

Rise of the dragon currency

Nouriel Roibini is warning how financial power is currently transferring at a rapid pace towards China, as a result of US need to fund its deficit.

China is a creditor country with large current account surpluses, a small budget deficit, much lower public debt as a share of G.D.P. than the United States, and solid growth. And it is already taking steps toward challenging the supremacy of the dollar. Beijing has called for a new international reserve currency in the form of the International Monetary Fund’s special drawing rights (a basket of dollars, euros, pounds and yen). China will soon want to see its own currency included in the basket, as well as the renminbi used as a means of payment in bilateral trade.

Brad Setser
explains why China will want to do so.

China’s basic problem is not that it is running a large current account surplus and accumulating financial claims on the world. Rather, its problem is that those financial claims are denominated in dollars and euros rather than in China’s own currency. If China was lending to the US – and Europe – in renminbi, China could continue to run large current account surpluses without taking on as much financial risk as it is now. If the US was required to pay China RMB, not dollars, China wouldn’t need to worry about about of inflation in the US that led the dollar to depreciate – or for that matter a dollar depreciation that wasn’t the product of a rise in US inflation.

Roubini further warns.. Now, imagine a world in which China could borrow and lend internationally in its own currency. The renminbi, rather than the dollar, could eventually become a means of payment in trade and a unit of account in pricing imports and exports, as well as a store of value for wealth by international investors. Americans would pay the price. We would have to shell out more for imported goods, and interest rates on both private and public debt would rise. The higher private cost of borrowing could lead to weaker consumption and investment, and slower growth.

We have reaped significant financial benefits from having the dollar as the reserve currency. In particular, the strong market for the dollar allows Americans to borrow at better rates. We have thus been able to finance larger deficits for longer and at lower interest rates, as foreign demand has kept Treasury yields low. We have been able to issue debt in our own currency rather than a foreign one, thus shifting the losses of a fall in the value of the dollar to our creditors. Having commodities priced in dollars has also meant that a fall in the dollar’s value doesn’t lead to a rise in the price of imports.

Brad again: The problem of course is that is that China’s own choices more than anything else constrain the renminbi’s ability to serve as a global reserve currency. China’s currency isn’t freely convertible and its capital account is heavily managed. And China’s government doesn’t exactly welcome foreign inflows of any sort — and it certainly doesn’t want to increase its dollar holdings to allow other countries to increase their stock of renminbi denominated reserves. Letting other central banks hold RMB means letting other central banks speculate on RMB appreciation …

The US shouldn’t welcome a world where Asian countries try to maintain undervalued currencies – and thus run large, sustained external surpluses – while minimizing their risk by running up renminbi and yen denominated claims on the US, Europe and potentially a host of emerging economies.

China should allow its currency to appreciate, offset the drag from slower growth of exports with aggressive policies to stimulate domestic demand (including the rapid implementation of a broad social safety net, even if this produces sustained budget deficits) and bring its current account surplus down. China’s government would no longer steadily accumulate large quantities of dollar reserves. More balanced trade flows would allow the RMB to eventually float – allowing China to direct domestic monetary policy toward stabilizing China’s own economy rather than stabilizing its exchange rate.

But for as long as the US will remains a debtor without choice, and China its primary creditor, how could this alternative be possible?

* Both articles are must-reads to understand the dynamics of the possible China-US currency standoff.

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