Literature Review: Dollar Hegemony & RMB Internationalization
Research Question: In recent years, the RMB has been slowly gaining viability as a cross-border currency. What are the primary motivations behind the gradual internationalization of the RMB?
The majority of this paper will be a comprehensive literature review on currency dominance and the potential for RMB internationalization.
Pages 2-4.5 will focus on the evolution of dollar internationalization and dollar hegemony. In conjunction with this, I will explain what currency internationalization is. I will discuss the benefits this system accrues to the US and why other countries want to reform the order. It is important to understand dollar dominance and hegemony to understand what RMB internationalization might look like and why China may or may not want to pursue it.
Pages 4.5-6.5 will discuss about China’s intermittent appeals for and actions in regard to lessening its own reliance on the dollar and boosting the RMB. Next, I will outline the various reasons that have been put forth as to why China has been incapable—to now—of breaking dollar dominance in any significant way.
Pages 6.5-10 will explain some key hypotheses from the literature as to why the RMB has been internationalizing and provide some of my own thoughts on these analyses.
A History of Dollar Dominance
The US dollar is used in 40% of global transactions (Swift, 2018). The US Dollar accounts for 61% of all foreign currency reserves (Amadeo, 2018). The dollar is used to price more than 2/3 of the world’s oil (Jegarajah, 2017). This means there are trillions of dollars circulating around the world. This is true, even though US GDP is only 24.03% of world GDP, a number that has been in decline for years (World Bank, 2018) and Americans represent only 4.4% of the world population (Washington Post, 2018).
The concept of widespread use of a single currency is not new. The role has been held by various governments over the years—Rome during the Roman empire, the Dutch in the 17thcentury (as the Dutch East India Company dominated global trade). (Pisani-Ferry, Posen, 2009) More recently the British pound was the world’s preeminent currency, due to the vast reach of the British empire and London’s function as the global financial and insurance hub throughout the 19thand early 20thcenturies. (Pisani-Ferry, Posen, 2009). The US Dollar has been the world’s dominant currency for nearly a century now (Wightman, 1994). Its role was solidified and accelerated during the post-WWII Bretton Woods conference, when the US government agreed to back its currency with gold. At that time, $35 paid to the US government could redeem one ounce of gold (Best, 2018). The US later abandoned the Gold Standard in 1971 when demand for gold became too high and the fixed price of $35 untenable (Best, 2018). The dollar has since remained the world’s reserve currency. However, now, instead of being backed by gold, it is backed by “confidence.” This means that countries around the world are “confident” that the US dollar will not fluctuate wildly in valuation and, as such, that it is a safe “store of value.” They are also confident that the US is able to pay back its debt—massive American borrowing is a consequence of currency dominance, as I will discuss later.
The most fundamental points to understand when discussing dollar dominance are 1). It causes the dollar to be in high demand. 2). The dollar’s value is of extreme importance to almost every state actor around the world. 3). It is almost impossible to conduct global business without interacting with the US dollar.
The dollar, however, can only be issued by the United States. This is also true of United States treasuries (US debt)—an instrument that often functions as a place for dollar holders to store their dollars. These elements come together to provide what former French President Valéry Giscard d’Estaing termed an “exorbitant privilege” for the USA (Chey, 2012). It means that the rest of the world—because they hold so many dollars, because the United States economy is a massive consumer of the world’s products, and because, for many countries, the United States is their principal military protector—is keenly interested in the stability of the US. This has fueled a system in which the US debt has grown to historically unprecedented portions, yet there has yet to be a commensurate change in the monetary order, save for an increase in the international importance of the Euro and a still small but growing use of the RMB.
Currency Dominance: Good or Bad?
The literature is somewhat split on its opinion of how beneficial/detrimental dollar dominance is for the United States and the rest of the world. The general consensus to be gleaned from the literature is that the currency’s prominence is a short-term positive for American consumers but a long-term negative (“negative” may even be too soft a phrase) for American society. (Bergsten, 2009) In the short term, American consumers are able to live beyond their means. Because there are so many dollars in circulation, countries have a near-limitless appetite for US debt—one of the safest places for countries to “store” their dollars and still make a return. This means that, even though American debt is already dangerously high—$17.8 trillion total and $6.06 trillion held by foreigners (U.S. Treasury, 2018) and 104. 1% of GDP (St. Louis Fed, 2018)—trade deficits are historically high, and household savings are low, America is still able to borrow from foreign investors at low interest rates (Cohen, 2008). The benefit for the US is that Americans can live beyond their means. The US had a trade deficit of $566 billion in 2017 (Amadeo, 2018). The American government is able to run a $600 billion budget deficit (Bergsten, 2009). Americans are spending more than they are earning. Yet, countries still keep lending the US money. This has allowed the US to enact overstretched pension and social welfare policies. It also finances the massive US military budget ($596 billion) (Stockholm International Peace Research Institute, 2015). The “exorbitant privilege” of dollar dominance is responsible for, most economists and policy makers argue, a global military overreach on a scale that no other “normal” country of the US’s size would be able to replicate given the debt levels. Essentially, the wars in Iraq and Afghanistan would have been nearly impossible ($2.4 trillion) (Daggett, 2010) without the position of the dollar.
Many of the global complaints about dollar hegemony/dominance focus on this privilege. The dollar gives the US an unfair advantage to be fiscally irresponsible. To use an extreme case, when Venezuela, for example, is fiscally irresponsible, its citizens starve. When the US is fiscally irresponsible, it borrows more money. Many countries—particularly America’s largest competitors—are no longer comfortable supporting this privilege. Many have been keen to decrease their dollar reserves. Putin’s Russia is a notable example (Johnson, 2008). Some academics theorize that George W. Bush’s proclamation of the Axis of Evil of Iran, Iraq, and North Korea in 2002 had less to do with authoritarian regimes and more to do with the fact that each of those country’s moved away from the dollar (Hensman, Correggia, 2005). In late 2000, Saddam Hussein converted Iraq’s $10 billion reserve fund to Euros. Iran converted over half of its own reserves to Euros in 2002. North Korea officially shifted its own trade to Euro’s in 2002 as well. (Hensman, Correggia, 2005). The international use of the dollar also allows the US government to overreach in its sanctions imposition (Swift, 2018). Because the US government is able to track dollar transactions, the treasury is able to track sanctions-violations when payments are transacted in US dollars. Governments often have no choice but to comply with sanctions—as avoiding the dollar in cross-border transactions is extremely difficult. This recently led European governments to create an alternative payment scheme to get around US sanctions on Iran—a major step in de-dollarization (Kientz, 2018).
It should be noted that the US’s position of currency hegemon has also long provided foreign states with 1). An interest-bearing place to stash their currency reserves (US treasuries) 2). A stable and prosperous economy for which to export their own products and 3). A reliable and safe conduit for cross-border exchange—overseen by the world’s most robust financial system. So, despite (often legitimate) claims of American privilege, the rest of the world does also benefit from the system. Similarly, English is the world’s lingua franca. This is beneficial to native English speakers because they don’t have to learn a second language. However, the rest of the world also benefits from this standardization.
On the other side, however, most researchers argue that dollar hegemony is not a sustainable long-term reality. (Coy, 2018) Reliance on debt has put the United States in a long-term hole that will be very painful to emerge from. American standards of living will have to come back to reality—something that will be politically very difficult in a democracy, especially a highly polarized one. The high demand for the dollar also strengthens it, which makes US exports less competitive than they should be, which increases the American trade deficit, which in turn leads to higher demand for the dollar because there are more dollars in circulation. Many countries—Germany, Japan, Switzerland, and, most notably, China—have long encouraged a strong dollar and, thus, a weaker Euro, Yen, Franc, and RMB, so that their own exports will be more competitive. US GDP is 70% consumption. That number is 53% in Germany, 39% in China, and 56% in Japan (CIA, 2018). Most experts agree that the US needs to be more competitive in the international marketplace and that Americans need to live within their means. It is very difficult to envision this message being well-received by American voters.
Roadblocks to RMB Replacing the Dollar
There are also a few reasons why China specifically has been unable or unwilling to break dollar hegemony in any meaningful way. The underlying reality is that it is just not time (Bulloch, 2018). China is still a very export heavy economy and any weakening of the dollar would likely hurt Chinese exports on both ends—their price would be less competitive vs. American exports and the largest buyer of their exports (the US) would have less buying power. China is also by far the world’s largest foreign holder of dollar reserves. A weakening of the dollar immediately makes those reserves less valuable. China also does not want to challenge the US too overtly. Dollar hegemony is a great source of American power. Substantially threatening this source of power is still not something Beijing is interested in. It is much more likely to endorse a slow approach to any change in the monetary order. Further, China’s economy is still far behind the US’s in terms of openness. Many countries are wary of putting so much trust in a country that still has relatively strict capital controls and whose currency is still not in free float.
Zhou Xiaochuan & International Monetary Reform
That is, roughly, the troubled state of dollar hegemony. So, how does China fit in to this equation? In 2009 Chinese central banker Zhou Xiaochuan wrote an essay titled “Reform the International Monetary System.” (Zhou, 2009). In his essay, Zhou called for a new global monetary order. He discussed the oft cited “Triffin Dilemma” that states that it is not possible for countries to maintain the value of their reserve currency and provide currency liquidity to the world (Zhou, 2009). This is essentially a comment on the demand created by the dollar’s position. Countries demand the dollar and, subsequently, US dollar-denominated assets like US debt, even when the US economy is not feasibly able to service all of that debt. But, it keeps issuing debt because there is an international demand for liquidity. Zhou does not, like many other leaders, outwardly attack the United States as “tyrannical” or a “hegemon” for its dollar practices, but rather points out that the system has also put the United States (whom he does not mention by name) in an impossible position. Zhou notes that the system is unsustainable and calls on the international community to advance the use of the IMF’s Special Drawing Rights (SDRs)—a basket of prominent global currencies—in international transactions and as proxy for a reserve currency. When the Bretton Woods system was first devised in 1944, John Maynard Keynes argued for a similar mechanism called the “bancor” to serve as the unit of account for world trade (not a currency, but rather a way to keep international trade more balanced). Zhou cited Keynes in his essay and called the bancor plan “farsighted.” Zhou’s words read less like a Chinese politician’s and more like a typical economist’s.
From Zhou’s essay, it can be extrapolated that a move to a more internationalized global currency regime is something Chinese policymakers would like to see. It also seems to suggest that China is not looking to replace the United States as global currency hegemon. A healthy majority of economists see the flaw in the current system and understand the reality behind the façade of the “exorbitant privilege.”
However, until now, very little progress has been made on this front. SDRs remain essentially unused internationally. There are a few reasons for this. First of all, the legacy of the dollar is strong. The literature’s general consensus is that the process of replacing dollar hegemony will be one that takes place over many years. (Luft, 2017). Secondly, as is true of many international agreements, the legitimacy of SDRs is tied to the legitimacy of a multilateral international institution (the IMF). The SDR system, to many observers (myself included), puts an unprecedented amount of global responsibility in the hands of a multilateral institution. One can imagine the efficiency and regulatory issues that would accompany this system. Lastly, it’s complicated. While the current system is far from perfect, its pitfalls and benefits are now, after 70 years, clearly illuminated and understood by international actors.
This brings me to my principal question. In recent years, the RMB has been slowly gaining viability as a cross-border currency. What are the primary motivations behind the gradual internationalization of the RMB?
The Growing RMB: Numbers & Outlook
The prominence of the RMB has increased markedly in the last few years. There are now a total of 57 countries using the RMB for more than 10% of their transactions with Hong Kong and mainland China (Swift, 2018). In 2016, the IMF added the RMB to the aforementioned SDR basket—which also includes the dollar, the pound, the euro, and the yen. The European Central Bank converted $557 million reserve dollars into RMB in 2017, making Europe one of the first developed economies to signal “trust” in the RMB as a reserve currency (Swift, 2018). However, this $557 million total, is still only 0.7% of Europe’s reserve portfolio. The RMB is the 8thmost actively traded currency in the world in forex markets. (Swift, 2018). Such a positioning is, of course, quite low for the world’s second largest economy.Today, fully 80.47% of payments made to China or Hong Kong are still made in USD (Swift, 2018).
The literature notes many potential avenues for the proliferation of RMB internationalization. Many note that the Belt and Road Initiative is a prime method with which to inject RMB into foreign markets. Some have gone as far as to suggest that this may be one of the primary motivations behind the project (Dhaka Tribune, Swift, 2018). The spread of WeChat and Alipay—which can now be used in many locations outside China, including New York taxis (Surane, Cannon 2018)—is another. These transactions take place in RMB. There is also the recent denomination of oil futures contracts in RMB, heralding the potential rise of the so-called “petroyuan.” China is the world’s largest oil importer and would prefer to begin paying for this oil in its own currency. This move will put yet more RMB in international circulation. Iran and Russia are already accepting energy payments in RMB as a result of US sanctions (Mathews, Selden, 2018). More RMB in the system means more need for a place to store the RMB—Chinese products and/or Chinese debt are logical avenues. Thus begins a cycle by which the RMB starts to take on some of the characteristics of the dollar’s international role.
The literature is decidedly split on China’s motives, which makes this an intriguing research question.
Motivation 1: China Wants to Become a Currency Hegemon
Some writers go as far as to assumethat China wants to replace the dollar. Kimberly Amadeo of “The Balance” states this plainly in her post “How the Yuan Could Transition from a Reserve to a Global Currency.” Others like Nomura analysts Chan and Teo highlight China’s “strong desire” to push forward with RMB internationalization. (Teo, Chan 2018)
This assumption seems to extrapolate and take the characterization of currency hegemony as “exorbitant privilege” at face value. This is inappropriate. The literature and information on dollar hegemony convincingly show that this position is not a clear-cut privilege and that any rational state—particularly a non-democratic, long-term entity like the Chinese government—would be wary of taking on this role. The issues with dollar hegemony that have been listed above like massive trade deficits and historical budget imbalances are not policies characteristic of the Chinese government. Further, sacrificing control over domestic monetary policy and the value of the RMB—a side-effect of hegemony—is utterly inconsistent with PBoC policy today.
Motivation 2: China Wants the US to be less of a Currency Hegemon
Simultaneously, there is what I’ll call the “addition by subtraction” approach on the part of Chinese policymakers. This is the case most frequently argued in the literature. Economist Jeffrey Sachs notes that “Trump’s tariffs and his broader affinity for upending trade agreements and multilateral treaties could diminish the US’s role on the world stage.” (Smith, 2018). The dollar gives the United States a great deal of unilateral power—not everyone thinks that’s a good thing.
The international dollar order allows the US the power to unilaterally impose sanctions and punish sanctions violators. The recent Huawei case is a prime example. The Euro provides an alternative. However, in many cases sanctions imposed by the US may also be imposed by the European Union. If more transactions are carried out in the RMB, US sanctions regimes will have less unilateral power. This gives China more autonomy in global affairs. It is my opinion that the concept of Chinese “autonomy” is often improperly conflated with the idea of Chinese “domination.” Further, as Zhou Xiaochuan discussed in his landmark essay, the current system is unhealthy and unbalanced for the global financial order. Injecting more RMB—or any other currency—into the system would hedge against global dollar risk.
In this scenario, the world sees many different currencies sharing the role as international leader. This is the scenario that Zhou Xiaochuan (and Keynes before him) pushed. It is the concept at the heart of the IMF’s SDR system.
Motivation 3: Renminbi Internationalization is a Way to Inch China Toward Financial Reform
Callan Windsor and David Halperin of the Reserve Bank of Australia argue that China would not have decided to begin internationalizating its currency if it did not ultimately seek to reform and further open its financial system. There is a chicken-egg situation at work here. Does internationalization lead to reforms or do reforms lead to internationalization? Windsor and Halperin and Robert McCauley argue that both are true. There is a compounding effect. Internationalization, which started in Hong Kong in 2009 with the CNH, is something like a pilot project for the People’s Bank of China (PBoC) to better understand what an internationalized RMB might look like and to gauge foreign demand. It is a signal that the government wants to make reforms but is not yet ready to do so on the mainland. By internationalizing the RMB, even on a small scale, China is opening up its currency to market forces.
The literature widely states that perhaps the largest barrier to RMB internationalization is global wariness of the PBoC’s strict control of the RMB float. Claudio Cardozo of the Foundation for Economic Education notes concisely that “In order for the yuan be the next international currency, perhaps the Chinese Communist Party would have to reduce power… International banks and institutional investors will only want to accumulate yuan if they can move their money into and out of China freely and if banks are strong enough to keep up with the waves of a market-driven economy.” (Cardozo 2018) In essence, as long as currency controls are in place, there is a ceiling on how internationalized the RMB can become.
At this point I am convinced by arguments made by those like Windsor/Halperin and McCauley. China is using the offshore market in Hong Kong as a way to test what a market floating currency looks like and if and when they will be ready for it.
I tentatively disagree with the latter near-consensus that an internationalized currency must be that of a fully free market, transparent economy. Currency usage is about the best option. If the US economy begins to breakdown and the Eurozone continues to be unstable, the RMB is the next best option. Traders, businesspeople, and countries will weigh the pros and cons and it is not an axiomatic certainty that a controlled currency cannot be an international currency. Like in many other areas—trade, market access, human rights complaints—the Chinese currency may be too big to ignore on the basis of small misgivings. The dollar, after all, is far from perfect. Yet, it has been the key global currency for a century.
Motivation 4: The Renminbi’s Internationalization is less Push (by China) and more Pull (from other countries)
It is also worth remembering that the dollar didn’t necessarily ask to be the world’s reserve currency. A unipolar world, a strong, dynamic, and free American economy, the robust American financial system, the collapse of the USSR, and the lack of a unified European currency until 1999 in many ways crowned the dollar king by default. Also, once dollars were entrenched in the system, countries the world over had and still have incentives to keep their value high. Similar macroeconomic and political forces may leave certain parts of the world hungry for RMB. In essence, the boom may just as likely come from the demand, as opposed to the supply side. A recent HSBC report Renminbi Internationalization and the BRI explained that “it just makes sense” for BRI countries to trade in RMB to “avoid exchange rate risk and increase the ease of transacting.” (HSBC, 2018) As Juliet Johnson discusses in “Russia’s Uneasy Relationship with the Dollar,” the Kremlin has long wanted to decouple from the dollar’s overly influential place in its economy and, thus, the US’s ability to impose sanctions and multilateral actions. The Ruble, however, is not a very attractive international currency. With the emergence of an international RMB the choice, for countries like Russia, need not be binary.
For countries like Pakistan, whose companies have been subject to US sanctions in the past and who do a great deal of business with China, increased use of RMB is doubly reasonable. (HSBC, 2018)
Motivation 5: Realignment
Many experts, like the University of California’s Hyoung-kyu Chey, think that the RMB will partly serve the role of reconstituting the world order. Instead of being a fully international currency, it will first be an Asian regional currency and maybe a BRI-country/African currency. As noted by Chey, 13 of the first 19 countries to undergo currency swaps with China were in Asia or Asia-Pacific. The massive amount of money pouring into the BRI and into projects in Africa and the political goodwill that follows it may also bring simultaneous monetary and political realignment.
Monetary spheres of influence will reflect emerging political spheres of influence—the dawn of a multipolar world. The current trade war—and the policies of the Trump administration in general—will probably have the effect of accelerating this process. Currency may be the ultimate determinant—or, more likely, result—of political alignment. There is another chicken-egg phenomenon at work that I hope my research can partly illuminate. For this reason, I imagine countries like Japan or Vietnam may be wary to adopt the RMB as reserve/transactional currency, whereas countries like Iran—long marginalized by United States policy—may be more than happy to.
A Consensus of Sorts: Slow, if at all
One theme that is mentioned over and over again in the literature regarding heavy RMB internationalization is that it will be slow. Those that believe it is inevitable think it will be slow. Those that believe it is unlikely think, in the off chance that it does happen, it will be slow. Gal Luft of the Institute for the Analysis of Global Security said of the petroyuan, “Game-changer it is not… but it is an indication of the glacial… I emphasize glacial decline of the dollar.” (Luft, 2017).
There are two broad factors cited. First, there is the legacy of the dollar, the Euro, and the other international currencies—but, particularly the dollar. It will take a long time administratively to dislodge the dollar. This has been discussed at length above. On the other side, China is not yet ready. Last year, for example, as noted by Xu Yanzhuo, the RMB actually decreased from being used in 2.09% to 1.98% in international trade (Xu, 2018). However, this is widely assumed to be because of the central government’s limits on capital flight instituted last year. Nonetheless, this illustrates the key point. There are still artificial, non-market barriers to the RMB which for now should limit its global presence.
My take from my preliminary research is that this consensus skews to long-term or at least neglects the possibility of a much more rapid RMB adoption. The fact is, the channels for RMB internationalization are already in place. China is the world’s number one trader. Projects like the BRI are worth trillions of RMB. China is the world’s largest oil importer. And, these numbers are not going to decrease. China also has one of the world’s most sophisticated financial centers in Hong Kong. I do not necessarily see why, if the PBoC willed it to be so, the process could not be completed rapidly.
I’m not saying I believe this will happen. I hypothesize that the central government is far from ready for a heavily internationalized currency. But I do believe the infrastructure is in place.
The Big Picture
While I don’t agree with Motivation 1—that China wants to become a global currency hegemon a la the US—I to think the other four motivations for RMB internationalization all hold validity. At this stage, I hypothesize that the growing cross-border use of the RMB is part demand, part-rebalancing of the US’s hegemony, part path toward financial reform, and part politics.
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