Future Prospects for the Global Reserve Dollar, Part 1: The Chinese Yuan is Still Not About to Replace the Dollar

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“China might become the major economic power, but if they want their currency to be the [global] reserve currency, as we know they have to have flexible exchange rates, they have to have elimination of capital controls, they have to have a deep and liquid market for their own currency—domestic and foreign—and they have to liberalize their financial system and make it safer and so on so on, and right now they're going in the other direction."

-Nouriel Roubini, aka. "Doctor Doom"

5 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff finds himself in the unusual position of defending the US fiat dollar—which he’s simultaneously a critic of—from the recent barrage of news opinions predicting its global reserve currency status is on the brink of collapse.

With a salvo of bad news for the U.S. dollar—high inflation, soaring fiscal deficits, and several countries signing limited bilateral currency agreements with China—a flurry of opinion pieces have hit the news predicting that the imminent collapse of the global reserve dollar is right around the corner.

While none of the recent developments can be considered positive for the dollar the Economics Correspondent believes that:

1) The dollar’s status as leading global reserve currency isn’t going away anytime soon

2) The dollar’s share of foreign reserve holdings has long been on a slow, nonlinear, multi-decade decline (73% in 1965 to 60% today) for a very different set of reasons and that gradual decline will continue.

3) Most predictions of imminent dollar collapse are being made by people with poor understanding of what reserve currencies are and how they are chosen, and many of the same people have predicted the immediate death of the dollar every day for at least the last fifteen years and/or been selling gold or Bitcoin for nearly as long.

The question of what makes a global reserve currency the most popular medium of exchange between nations is more complicated than “the petrodollar is holding the whole thing up” or “Russia is going to trade in Chinese yuan now.” 

An adequate understanding requires an explanation that might require, oh… twelve minutes of reading.

That’s not much of an investment to gain an underlying understanding of global reserve currencies is it?

Well it happens the Economics Correspondent posted just such a writeup three years ago right here at Cautious Optimism. Anyone who wants to make only a small time investment can’t do much better for a brief education on reserve currencies at:

http://www.cautiouseconomics.com/2019/05/inflation-currencies03.html

http://www.cautiouseconomics.com/2019/05/inflation-currencies04.html

To whet readers’ appetites with just a few teasers (much more in the linked articles), the ideal and most sought-after global reserve currency will exhibit at least eleven traits:

1. Incumbency and the largest network effect

2. A large economic zone

3. Large, developed, liquid securities markets

4. Trusted, transparent, and regulated securities markets

5. A commitment to low inflation

6. No capital controls

7. Free/floating exchange rates

8. Consistent trade deficits

9. Democracy or at minimum some political liberalization

10. Military superpower status

11. A lender of last resort central bank

The U.S. dollar with all its warts has done a better job, a far better job, of offering all eleven for over forty years. The next closest competitor has been the euro which still has problems with trade surpluses, military superpower status, incumbency, and doubts about government securities issued by periphery states like Greece, Spain, Portugal, and Italy.

And how about recent events?

Anyone who hasn’t been in a coma the last two years knows the dollar has stumbled on one requirement—low inflation—and the threat of the world’s central banks scoffing over inflation is just one more reason the Fed has taken getting it under control so seriously.

However where the dollar has gotten lucky is that nearly all other western central banks, plus a few eastern ones, have made the same inflation mistake with their own currencies, leveling the playing field.

The dollar’s continued acceptance has truly been a case of remaining the least dirty shirt in the laundry basket—even with all of the Biden administration’s recent unforced policy errors.

And what about China? Isn’t the Chinese renminbi (RMB aka. yuan) moving in to replace the dollar by the end of the year?

Well not only does the RMB fail miserably in the trustworthiness and transparency of its still-developing securities markets, not only does China still impose capital controls on investment flows, not only does the CCP insist on running consistent trade surpluses, and not only does Beijing still manipulate the RMB’s exchange rate—insurmountable problems all—but China’s political system also sows sufficient distrust for nations to avoid holding large balances of reserves in RMB or RMB-denominated assets.

Despite all the talk about Russia, Saudi Arabia, and BRICS countries discussing or agreeing to some level of bilateral trade using Chinese RMB, no one is going to convert the greater part of their hard-earned foreign reserves into Chinese currency other than symbolic balances used to make pointed political criticisms of the United States.

Consider that China’s dictatorship already stops western movies, western companies, and western investment from freely flowing into its markets if any company or a single sports league owner criticizes just one aspect of the regime. And if the Taiwan flag isn’t digitally removed from Tom Cruise’s bomber jacket, Top Gun Maverick is banned from Chinese theaters.

Now imagine you’re a central banker, finance minister, or sovereign wealth fund manager responsible for hundreds of billions of dollars in global reserves that your citizens have sweated for years to earn by producing and selling real goods and services for export.

Will you trust converting those reserves to RMB and parking them in Chinese securities markets? Where a corruption scandal can wipe out their value overnight? Where the CCP can slap down capital controls and lock down your money anytime they please? Where Beijing can intervene in foreign exchange markets and devalue you into a 10% of 15% haircut overnight? Or Xi Jinping can arbitrarily seize your financial assets if he wakes up one morning in a bad mood?

China is already in the habit of using its economic power to punish western companies and even small countries for the tiniest perceived sleight. So are they going to become less aggressive one day when they're the world’s largest economy and control the premier reserve currency? 

It doesn’t take much imagination to predict what will happen to your country’s hundreds of billions of dollars—or trillion-plus RMB—in foreign reserves if you displease the CCP.

Foreign governments, even those who publicly talk about friendly alliances with China, already know this. Even fellow autocracies that publicly broadcast their "limitless" friendship with China are smart enough to know when it comes to their money there will definitely be limits.

The US by contrast, while not angelic in its application of reserve dollar power, is far more trusted by world central banks. A perfect example is China itself whose relations with the USA are now more acrimonious than at any time since Mao Zedong. Yet even Beijing still trusts the USA enough to hold well over  $1 trillion in dollar reserves and assets, even after unleashing Covid upon America and angering Washington with its spy balloons.

If the shoe was on the other foot can anyone really see countries that offend China trusting the RMB in case their relationship goes south?

This explains in part why the Chinese yuan, despite being issued by the world’s second largest economy, maintains a 3% share of global reserve holdings compared to 60% for the dollar and 20% for the euro.

It's also why the Economics Correspondent predicts that while non-aligned countries like Saudi Arabia and Brazil announce agreements to trade in RMB, they will likely accept only enough RMB as payment for exports to meet their immediate purchasing/import needs from China and perhaps a tiny/symbolic amount in reserve—the rest being held in more trustworthy currencies like the pound, Swiss franc, yen, Canadian and Australian dollar, and mostly still the US dollar.

And yes, all this even as the Biden administration’s weak foreign policy, deficit-bloating fiscal policy, and Federal Reserve screwups nudge more countries slightly further away from the dollar—but not nearly enough to compensate for the glaring deficiencies of other competing currencies.

Anyway the Economics Correspondent highly recommends reading his 2019 columns on how the world chooses a currency to serve as its preferred reserve holding. In fact he wishes many of the columnists who have been predicting the imminent collapse of the global reserve dollar every day for the last fifteen years, some of whom he usually agrees with, would learn some of those basics themselves.

Another column or two will follow to address a few more recent global reserve dollar issues: the always-mentioned “petrodollar,” the role of the U.S. military, the prospect of competing gold-backed currencies, and the much longer-term.