by Sara Eisen
The real challenge for China’s leaders is that continuing the nation’s currency peg is not necessarily in the long-term interests of the Chinese people. As noted earlier, this strategy has worked while China has been shifting its labor force from agriculture to manufacturing. But it is likely to be less effective later, when growth becomes more innovation-intensive and China’s economy becomes more service-based.19 Furthermore, if the world economy is to avoid the deflationary impact of Chinese mercantilist strategy and the possibility of a continuing crisis or collapse, then the Chinese government will be called upon to rebalance and give away some of the advantage that its currency peg provides. The Chinese government could, for example, aid the transition to a consumer-based economy by increasing government expenditures on healthcare, pensions, and education, which would boost private- and public-sector demand and indirectly support consumption by reducing the precautionary motive for household saving in China.20
China also could move its currency peg higher to allow the RMB to appreciate, lowering the effective “tax” on consumers of the current peg while also easing deflationary pressures in developed countries. This approach would help solve both domestic problems and international imbalances. However, it also would require the Chinese government to be willing to undertake a deliberate, long-term plan of action that would directly reduce its own bureaucratic control domestically and internationally and would challenge the profit margins of powerful coastal interests.
If China wishes to develop the deep and liquid capital markets necessary for its currency to serve as a store of value that is widely used abroad, it will first have to develop a strict rule of law with transparent court systems, which is currently nonexistent. Well-developed property rights would also be a necessity, as would robust financial regulatory authorities. But as one professor of economics at China’s Beijing University has noted, “Almost everything [the Chinese government] has done, has been illegal” if it had strictly followed its own constitution. China’s government has often forged ahead without regard to technical legality and revised the laws after the fact.21 Foreign investors will be anxious about participating en masse in domestic Chinese currency markets if they lack confidence in the Chinese legal system. Yet, again, transforming the system to one of legal rules rather than bureaucratic discretion would mean a significant loss in political power for the Chinese government, and it is unclear whether the Chinese elites are willing or able to support that transformation.
To make matters even more complicated, there also are vested interests within the United States that resist RMB appreciation. The most notable advocates against Chinese currency reform are large U.S. corporations with direct investments in China that export their products back to the United States and low-cost American retailers like Walmart that benefit from the cheap labor that exists because of the pegged RMB. These companies are likely to oppose any attempt to get China’s currency to appreciate, since it would directly harm their quarterly profits if Chinese wages were to rise in dollar terms.
But the U.S. business community is hardly monolithic on this issue. Indeed, there also is considerable pressure building on China to liberalize its currency from Western financial institutions, which want this change for their own pecuniary benefit. Wall Street financiers see the opening of the Chinese currency market as a potential windfall, since it would open an enormous new market for currency trading and the provision of a whole array of financial services that are well developed in the United States, so they are likely to continue to push China to open and deepen its financial markets for the foreseeable future. One need only look to the leading Chinese universities in economics and business education, where the boards are replete with Western financiers who are hoping to entice the children of the Chinese elite into finance, to understand that Wall Street and big finance have serious interests in China’s financial deepening, which would be a precursor for currency convertibility. The result of this tug-of-war between Wall Street and multinational manufacturers and major retailers is likely to have a significant effect on U.S. policy regarding China in the future.
Despite Wall Street pressure, China is likely to avoid imitating the Western path of unbridled financialization and choose another road toward development. China is a country whose population is still about two-thirds rural—and in which 40 percent of the rural household budget is spent just on food.22 This makes China very vulnerable to fluctuations in the RMB emanating from global currency markets. With such a large percentage of its population still living at near-subsistence levels, China can’t afford to expose its population to the whims of volatile finance, especially given that the Communist Party’s legitimacy seems to be dependent on the country’s continued economic growth. China also is eminently aware of the lessons of the Japanese crash in the late 1980s and the ensuing lost decade that followed Japan’s acquiescence to the exchange-rate appreciation demanded by the Western economic orthodoxy. The recent experience of the 1997 Asian crisis only served to reinforce distrust of Western financialization. Therefore, for reasons of both general interest and elite self-interest, China is likely to resist full capital account liberalization.
China is walking on a knife’s edge between domestic imperatives and the impact that its size and policies have on the rest of the world. If China proves to be unwilling to change its current currency policy, its intransigence could well drive the world economy into a prolonged slump that worsens the credit crises in the United States and Europe. This could lead to financial and banking failures that could then spread the recession to the developing world—China included. European banks alone have extended credit of more than US$3 trillion to the emerging world. A drying up of that credit in debt deflation would weaken Eastern Europe, Latin America, the Middle East, and Asia. As the logic of the paradox of risk aversion suggests, by trying to insulate itself from risk, the Chinese government could well increase both its country’s and the world’s exposure to the risk of political and economic dysfunction.
This may explain why, despite China’s resistance to exchange-rate adjustments, there are some recent signs pointing to an awareness of the dangers posed by its currency policy. In a strategy very similar to the one employed by the United States in the early twentieth century, China appears to be running experiments and exploring the benefits of the eventual use of its currency as an international reserve currency. The emergence of the RMB as an international reserve currency would enable Chinese firms and investors to limit their foreign exchange exposures as a result of being able to carry out international transactions in their own currency. Chinese banks would be better able to compete for international business, helping to develop Shanghai as an international financial center by bringing its banks a substantial share of the global foreign exchange market.23 And China’s central bank would be able to follow a nonpegged monetary policy that could help foster further domestic growth.24 These benefits are ample, and it appears that China may be starting to become interested in pursuing them.
Since 2009, China has suggested that it will slowly begin to move in a new direction, demonstrating its intention to internationalize the RMB, supposedly within a decade. While this may seem unlikely today, it is worth remembering that in the early twentieth century, the U.S. dollar went from a complete nonfactor to dominance in global currency markets in only 10 years.25 China has begun allowing the RMB to be used in trade-related transactions and has entered into bilateral agreements with other countries, the largest being Brazil, to allow the RMB to be used in trade there. More than 70,000 companies are now doing cross-border settlements in RMB.26 In 2004, banks in Hong Kong were allowed to accept RMB deposits. In January 2011, the Bank of China was allowed to provide RMB deposit accounts in New York and to use the RMB in bilateral U.S.-China trade.
But despite these modest efforts, China is still a long way from having full currency convertibility and deep and liquid RMB markets. While China has played with allowing the RMB to serve as a medium of exchange, as
well as its existing role as a unit of account, in the short term, China seems to be unwilling to allow its currency to become a store of value similar to the dollar. And, as noted earlier, the country does not yet have the deep and liquid financial markets or the robust courts and financial regulation that are prerequisites for full currency convertibility. Change on either of these fronts will require the Chinese government to give up considerable control. So progress will probably be very slow.
The reality facing the West is that China is already one of the major powers in the global economy. In the near future, it is certain to share the world stage with the United States. It is possible that within a few decades, China’s RMB will emerge as an international currency. This could happen even sooner if the Chinese government truly commits itself to the project of currency liberalization. In the 1920s, the United States was able to achieve the transformation in just a decade largely because the recently created Federal Reserve Bank backed the market in bank acceptances, providing liquidity for the market even though the Fed often lost money on the transactions.27 So now it’s China’s turn to put its foot forward.
Perhaps the most important question facing society today is: What will this new world look like as China’s presence on the global stage grows? It is theoretically possible that China’s RMB could take over as the leading global reserve currency, replacing the U.S. dollar altogether, if the United States proves to be unable to address its growing domestic tensions and problems. But this is unlikely to happen, and it isn’t a particularly desirable outcome for the global economy. The benefits to the network from having a single global reserve currency are probably not sufficient to keep one currency dominant. This logic suggests that there is room for more than one global currency. Indeed, historically there has typically been more than one reserve currency. For example, the U.S. dollar and the U.K. pound sterling shared this precise role for several decades until the mid-twentieth century.28
Replacing the dollar with the RMB would not solve the problems that the current system faces. It would do little to correct the global imbalances that such single-reserve systems cause. Further, it is not clear that central banks would want one dominant reserve currency because diversification to a multipolar approach could lead to enhanced stability in global foreign exchange markets compared to the current structure, which features substantial dollar-denominated overhangs. This approach would not have the control of a centralized world currency the way a retooled Special Drawing Right (SDR) created by the International Monetary Fund (IMF) would. But it would have the advantage of being politically feasible. SDRs or some other global unit of account would be unlikely to gain international approval. Historically, international institutions like the IMF have been deliberately restricted from carrying out precisely the functions that would be required of them if they were to maintain an international currency, and currently there are no other institutions available to fill this role.29
Of course, this points to the fundamental problem in the global economy: the world’s major powers are unlikely to grant to any truly international institution the kind of control necessary for maintaining a global currency. This reticence is visible in the struggles of the European Union, where many member nations—particularly the surplus nations like Germany—were hesitant to give the European Community and the European Central Bank full control over fiscal and monetary policy. (And lest we forget, China, the world’s biggest surplus nation, would probably act no differently in similar circumstances.) Therefore, it is unlikely that an even more creative understanding could be reached by an even larger collection of countries with fewer cultural, historical, or political ties.
The most likely outcome, then, is a world in which several global currencies exist at once, probably the RMB, the dollar, and the euro, if Europe can save itself from itself. Under this scenario, the main challenge for the United States would be whether it can fix its domestic problems. Can America rebuild its crumbling domestic infrastructure and education system and correct the extreme imbalances in income and wealth distribution? If it can’t, it is unlikely that the United States will be able to continue its dominant role on the global stage. The United States still enjoys large advantages in key areas, such as high-tech development and global cultural influence. But suddenly they are America’s to lose.
For China, the main challenge is to get the world to accommodate its success. If China is not economically dominant in 30 years, it will probably be because it could not achieve a cooperative understanding for a system that works with both the developed and the emerging worlds. This outcome is not desirable to anyone involved because it would cause the global economy to operate at a much lower level of per capita income, employment, and wealth than would otherwise be possible.30 In the near future, the growth of the world economy is likely to be driven by China. Therefore, limiting China’s growth will have substantial adverse feedback effects on everyone else. It is in the entire world’s long-term best interest that China’s economy continues to grow and develop at a healthy rate. But China also must be sensitive to the exigencies of international politics because potential trade and currency wars are likely to lead down this road as well.
In the short term, China is not likely to make its currency fully convertible (freely exchangeable without government restriction). The Japanese collapse, the 1997 Asian crisis, and the 2008 financial crisis have demonstrated the potential calamities that await a system based on unfettered short-term capital mobility. But China is likely to begin to change its currency peg, slowly moving it up to allow the RMB to appreciate against the dollar. The hope is that China will do this at a rate that will produce positive effects for struggling developed nations and keep China’s economy growing and stable. In the long term, this move in China’s currency regime also is necessary if China is to make the transition to a more service- and high-tech-oriented economy.
What the world is facing, ultimately, is what Mohamad El-Erian, the head of the asset management firm PIMCO, has called a “non-cooperative cooperative game.” It is unlikely that implementing any sweeping global financial architecture like a true world currency will be politically feasible in the near future. Therefore, countries must continue to try to generate better cooperative outcomes in an ad hoc manner, often without working together directly. The potential pitfalls of this situation are demonstrated in the paradox of risk aversion, where a country that pursues only its own short-term interest in an attempt to insulate itself from risk can actually hurt its own economy after the repercussions that its actions impose on other economies affect the home country. The world’s leading countries, China in particular, must heighten the weight they give to how their domestic interests affect other nations. They must begin to realize that their own long-term economic health is contingent upon the success of the worldwide economy.
The vast web of global trade and commerce that exists today and that benefits people the world over evolved through just such an uncooperative game. But it also is instructive to remember the catastrophes that the current system has produced. China is, perhaps rightly, leery of Western economic and political policies that historically have been used to promote the short-term interests of Western financial elites at the expense of the well-being of those in developing (and, often enough, also developed) countries. In many ways, the current Chinese currency peg and buildup of substantial foreign currency reserves can be seen as a direct reaction to the disasters that those Western policies brought upon the East. Going forward, it will be important to keep in mind who benefits from these policies. One must ask not only, “What does it do?” but also, “Who is it for?”
It also will be important to keep an eye on the competing forces of national governments, local populations, domestic manufacturing interests, and global financial elites. To some degree, the debate must shift from economics to politics. As the economist Michael Pettis does well to note, “The process of adjustment is a political one.”31 The changes that are taking place both in the
world economy and in China’s domestic economy are happening and will happen. The real question is, who will bear the burdens of these changes—and who will benefit from them? This, first and foremost, is a political question and a question of political power.
In practice, the route forward will not be decided simply by technocratic questions about the best possible results. Any look at future outcomes in the global economic system must keep in mind the realities of political economy. This is as true in Europe and the United States as it is in China. Whose interests win out will ultimately determine the path that we take. In this light, the challenges ahead for China and the rest of the world are considerable. Whether or not we succeed will depend on how the constellation of interests that is at play in the global economic system forges ahead. For things to work out well, the microinterests that have led to the current colossal imbalances will need to move in a constructive direction. It is possible that we will find success. But it is also possible that the entire system will deteriorate under the weight of its own contradictions. There is a way. We will find out if there is the will.
REFERENCES
Chapter 3
Baldwin, R. “In or Out: Does It Matter? An Evidence-Based Analysis of the Euro’s Trade Effects.” Centre for Economic Policy Research, London, 2006.
Bénassy-Quéré, A., and J. Pisani-Ferry. “What International Monetary System for a Fast-Changing World Economy?” Working Paper 2011–04b, CEPII Research Center, Paris, 2011.