CAMBRIDGE: The powerful US dollar continues to reign in world markets.
But greenback dominance may be more fragile than it looks, because expected future changes in China’s exchange rate regime are likely to trigger a significant shift in the international monetary order.
For many reasons, the Chinese authorities will probably one day stop linking the yuan to a basket of currencies and move to a modern inflation-oriented regime that will allow the exchange rate to flow much more freely, especially against the dollar.
When that happens, expect most of Asia to follow China. At the time, the dollar, currently the reference currency for about two-thirds of world GDP, could lose almost half of its weight.
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Given how much the United States relies on the special status of the dollar, or what the French finance minister, then Valery Giscard d’Estaing, famously called America’s “exorbitant privilege,” to finance a debt mass public and private, the impact of this change could be significant. .
Given that the United States has aggressively used deficit financing to combat the economic ravages of COVID-19, the sustainability of its debt could be called into question.
A MORE FLEXIBLE YUAN
The long-standing argument for a more flexible Chinese currency is that China is simply too big to let its economy dance to the beat of the U.S. Federal Reserve, even if Chinese capital controls provide some ‘isolation.
China’s GDP, measured at international prices, surpassed that of the United States in 2014 and continues to grow much faster than the United States and Europe, making the case for greater exchange rate flexibility more compelling. .
A more recent argument is that the centrality of the dollar gives the U.S. government too much access to global transaction information. This is also a major concern in Europe.
In principle, dollar transactions could be offset anywhere in the world, but U.S. banks and clearing houses have a significant natural advantage, as they can be implicitly or explicitly supported by the Fed, which has an unlimited capacity. · Limited to issuing currency in a crisis.
In comparison, any dollar clearing house outside the United States will always be more prone to a crisis of confidence, a problem with which even the eurozone has had problems.
LEGACY OF TRUMP’S POLITICS
In addition, former U.S. President Donald Trump’s policies to test China’s trade dominance will not go away anytime soon. This is one of the few issues that Democrats and Republicans broadly agree on, and there is no doubt that the deglobalization of trade is undermining the dollar.
Chinese policymakers face many obstacles in trying to get away from the current yuan pinion.
But, with a characteristic style, they have been slowly laying the foundations on many fronts. China has been gradually allowing foreign institutional investors to buy bonds in yuan, and in 2016, the International Monetary Fund added the yuan to the basket of major currencies that determines the value of special trading rights, the world reserve asset of the IMF.
In addition, the People’s Bank of China is well ahead of other major central banks in developing a central bank digital currency.
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Although currently exclusively for domestic use, the PBOC’s digital currency will ultimately facilitate the international use of the yuan, especially in countries gravitating toward China’s eventual currency bloc. This will give the Chinese government a window into the transactions of digital yuan users, just as the current system provides the US with a lot of similar information.
Will other Asian countries follow China? No doubt the United States will strive to keep the maximum number of savings around the dollar, but it will be an uphill battle. Just as the United States eclipsed Britain in the late 19th century as the largest trading country in the world, China long surpassed America by the same measure.
IT WILL NOT HAPPEN SOON
It is true that Japan and India can go their own way. But if China makes the yuan more flexible, they will likely give the currency a weight comparable to that of the dollar in its foreign exchange reserves.
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There are striking parallels between Asia’s close alignment with the current dollar and the situation in Europe in the 1960s and early 1970s. But that era ended with high inflation and the collapse of the post-war Bretton Woods fixed exchange rate system. Most of Europe then recognized that intra-European trade was more important than trade with the US.
This led to the emergence of a German Mark bloc that decades later was transformed into the single currency, the euro.
This is not to say that the Chinese yuan will become the world currency overnight. Transitions from one dominant currency to another can take a long time.
During the two decades between World War I and World War II, for example, the new entrant, the dollar, had about the same weight in central bank reserves as the British pound, which had been the dominant world currency for more than ‘a century after the Napoleonic Wars in the early 1800s.
So what about three world currencies (the euro, the yuan and the dollar) that share the spotlight? Nothing, except that neither markets nor policymakers seem remotely prepared for this transition.
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U.S. government debt rates are almost certain to be affected, although the really big impact could fall on business borrowers, especially small and medium-sized businesses.
Today, it seems to be an article of faith among American policymakers and many economists that the global appetite for dollar debt is virtually insatiable. But a modernization of China’s exchange rate agreements could make the state of the dollar a painful blow.
Kenneth Rogoff, a former chief economist at the International Monetary Fund, is a professor of economics and public policy at Harvard University.