Monday, May 22, 2023

Future Prospects for the Global Reserve Dollar, Part 4: Longer Term for the Dollar and the RMB

Click here to read the original Cautious Optimism Facebook post with comments

6 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff closes out recent events surrounding the global reserve dollar with a few words on its longer term prospects and China’s counter strategy.

With stress in the U.S. banking system, federal spending and debt reaching new records, and inflation still lingering like a dark cloud over the economy several headlines have hit the media in recent weeks predicting the imminent collapse of the U.S. dollar’s reserve currency status, soon to be replaced by the Chinese RMB (aka yuan) or a new BRICS gold-backed reserve currency.

The Economics Correspondent is skeptical about these gloom and doom scenarios although he sees a tiny sliver of a chance that the BRICS concept might pose a real challenge to the reserve dollar in the next several years.

To read the Correspondent’s recently posted case for the dollar keeping its leading reserve status for the near-to-mid future check out links in the comments section.

However, all while defending the dollar's chances for remaining the world’s leading reserve currency for a while longer the Economics Correspondent has consistently said that over the longer term the dollar’s share of global reserve holdings and international payments will continue on a slow, steady path of decline that began as far back as the 1960’s. Hence the dollar won’t dominate the international currency reserves and payments stage forever, but the process will be gradual.

For those who know what precursors must exist for a currency to be selected by world central banks and governments to serve as a global reserve this forecast might seem self-evident.

One of the many key traits currencies must exhibit to serve as a global reserve is they must be usable in a large economic zone. Swiss francs might have a laudable reputation, but with Switzerland's GDP at about $800 billion the world’s central banks won’t be willing to hold trillions of dollars in francs that they can’t really use (collectively they hold about $6.5 trillion in dollars today).

Thus it’s no surprise that the dollar has been number one since the end of World War II since the United States has been the world's largest economy going back to the 1880’s.

Even today, when comparing national GDPs on the more meaningful nominal basis (not purchasing power parity or PPP) the USA still generates the world’s largest GDP even as China slowly closes in.

USA est. nominal GDP: $26.8 trillion (2023)
China est. nominal GDP: $19.4 trillion (2023)
Eurozone est. nominal GDP: $17.82 trillion (2023)
Source: IMF

However, just having the world’s largest economic zone isn’t good enough. The issuing country’s GDP must not be so much the largest as much as "large enough" on an absolute basis for its currency to support global trade.

Today that’s not a problem as international reserve dollar holdings are estimated at $6.5 trillion for a $26.8 trillion U.S. economy.

The longer-term problem for the dollar is the trend of the last few decades has clearly been one of many other countries’ economies growing faster than the United States—particularly India and China. Or more succinctly, U.S. GDP as a share of world GDP is on a steady path of decline even as the U.S. economy itself continues to grow.

In 1960 U.S. GDP enjoyed a 40% share of world output.
By 1985 it was 34%.
By 2000 it was 31%.
For 2023 the IMF estimates nominal U.S. GDP will represent 25.4% of world output.

Over those sixty-plus years the U.S. economy has been growing. In real terms it’s 6.2 times larger than in 1960. But over that same period the rest of the world has been growing even faster.

As the growth rate of the rest of the world’s economies continues to outpace that of the United States, the dollar’s ability to support the planet’s trade needs will inevitably be eroded. This mathematical reality has been reflected in the dollar’s slow decline as a share of international reserve holdings for some time: from 83% in 1970 to 71% in 2000 to 60% today.

And the Economics Correspondent doesn’t see that trend reversing.

As for what will fill the gap left by the dollar’s shrinking role, that’s been the subject of debate among international monetary  economists for quite some time with no real consensus winner. Probably the largest opinion bloc believes a basket of global currencies will serve as the global reserve—a combination of dollars, euros, yen, francs, SDR’s, possibly an unanticipated emerging economy, and/or a new BRICS regional currency.

Another faction of economists has called for John Maynard Keynes’ plan for a supranational currency, the old bancor proposal from the 1944 Bretton Woods monetary conference, to be resurrected and for the bancor to take on a leading role in settling international transactions.

An even smaller group of economists suggests returning to gold to settle balance of trade payments although their proposal probably stands the least chance of success for political reasons.

And what of China? According to many media headlines of late the Chinese yuan is in position to catapult to world's leading reserve currency any moment now.

The Economics Correspondent has written repeatedly that, despite China’s large GDP, its autocratic political system makes the yuan unsuitable to serve as a global reserve currency. Some of the yuan’s many problems include the immaturity and opaqueness of Chinese securities markets, the CCP’s regular imposition of capital controls, its manipulation of currency exchange rates, its insistence on running constant trade surpluses, the arbitrary power of its government and shaky confidence in its commitment to rule of law and property rights, and questions about the Chinese Navy’s ability and willingness to keep merchant sea lanes open for all nations.

Not only do world central banks not want to hold large balances of Chinese RMB in reserve, but the CCP itself knows the yuan has little chance of dethroning the dollar and holds no such global reserve ambitions.

However China’s geopolitical goals don’t require the yuan to take away the dollar's number one spot. And even though the CCP would certainly like to weaken the dollar’s share of reserve holdings, that’s not their primary objective either.

China’s goal, first and foremost, is to insulate its own import/export and investment activities from the dollar as much as possible so that it can achieve its geopolitical ambitions without worrying about U.S. dollar-imposed punishments.

Beijing has seen the economic pain the U.S. has been able to inflict on Russia for the invasion of Ukraine–cutting it off from the international dollar network and kneecapping much of its import, export, and financial business. The PRC worries that if one day it decides to invade Taiwan, the USA’s dollar leverage will allow Washington to impose similar pain on the Chinese economy. And Chinese officials fear any economic decline that might stir unrest among its own population, a problem that has brought down many dynasties throughout history long before the CCP dynasty.

So although China would love for the yuan to replace the dollar, something it knows is unlikely, it would still accept its own import and export business being conducted in some other currency so long as it's issued by a country that isn’t likely to punish Beijing for bad behavior... or which at least can be intimidated into abstaining.

Obviously convincing trading partners to use RMB would be ideal since Beijing controls its own currency. But even settling with its trading partners in rubles, rupees, or the recently proposed BRICS currency would be acceptable since, if one day the CCP decides to behave very badly on the world stage, the effects of a US-imposed dollar retaliation would be greatly reduced.

Thus China is working to wean itself—not necessarily the whole world, just itself—off the dollar as much as possible. Beijing couldn’t care less if the dollar retained its current 60% share of global reserve holdings and 50% share of all international transactions, so long as China itself isn't part of those numbers.

For all those reasons, the Economics Correspondent believes Chinese officials will be patient about invading Taiwan and not move until they feel enough of China's international trade is safely conducted in non-dollar currencies. Beijing will probably also first divest more of its dollar-denominated assets like U.S. Treasury bonds.

The Correspondent doesn’t guarantee China will take its time, but exercising patience while moving away from the dollar first is its most logical preparatory move if planning for a military action that could provoke a negative response from the U.S.

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