On April 16, Zhou Xiaochuan, the governor of China’s central bank, the People’s Bank of China, once again set off alarm bells during a speech at the International Monetary Fund (IMF). “Starting from this April,” he announced, “China has released foreign exchange reserve data denominated in the SDR in addition to the USD.” He went on to say: “We will also explore issuing SDR-denominated bonds in the domestic market.” After many years of announcing monthly the value of its foreign currency reserves only in dollars and renminbi, the Chinese currency, the People’s Bank has begun to announce their value in Special Drawing Rights (SDRs), a weighted index set by the IMF consisting of the dollar, euro, Japanese yen, pound sterling, and, beginning in October, the renminbi. This, according to a People’s Bank statement, “would also help enhance the role of the SDR as a unit of account.”
The announcement raised eyebrows among many central bank watchers. Within days, Hong Kong’s South China Morning Post warned that the bank’s latest move confirmed its strategic goal to “end the US dollar’s hegemony” and “forge a new global financial order.” In an article for the financial publicationMarketWatch, research analyst David Marsh tried to suggest a wider strategy: “The world’s second-largest economy is embarking, pragmatically but steadily, toward enshrining a multicurrency reserve system at the heart of the world’s financial order.”
Marsh, like many other analysts who have repeated the popular but confused story about the rise of the renminbi and the decline of the dollar, may have misunderstood the role of reserve currencies within the global balance of payments. Whatever Beijing may think it is doing, its economic policies since the 1990s have, in fact, enhanced the reserve role of the dollar. To do otherwise would have undermined China’s economic development. A reduced reserve role for the dollar would, in fact, make China’s already difficult economic rebalancing — shifting its economy away from investment and toward domestic consumption — costlier than ever.
The dubious privilege of hegemony
While many complain about the “exorbitant privilege” Washington enjoys from the dollar’s hegemonic status, the U.S. government actually receives very little economic benefit and pays a substantial economic cost for having the dollar as the world’s reserve currency. These costs have become that much greater as a result of the June 23 Brexit vote, which saw the dollar strengthening as frightened money poured into the United States.
Before discussing the costs, it might be useful to consider the purported benefits. These four are the most widely discussed:
Lowering U.S. government borrowing costs. An otherwise excellent 2009 report by the McKinsey Global Institute claims “the United States can raise capital more cheaply due to large purchases of US Treasury securities by foreign governments and government agencies.” This seems reasonable at first: More demand for government bonds should drive prices up. But, as we will see, foreign purchases also automatically increase the supply of dollar debt. Were this not so, we would have to conclude absurdly that driving up a country’s current account deficit, the obverse of its capital account surplus, would automatically lower that country’s borrowing cost.
Allowing Americans to consume beyond their means. This interpretation implies, as the St. Louis Federal Reserve Bank erroneously explains in a 2016 paper, that “the United States has become a net borrower from the rest of the world because it has run a persistent current account deficit.” Here is how Yale University professor Stephen Roach puts it: “America has made its own bed. The culprit is a large saving deficit; [t]he country has been living beyond its means for decades and drawing freely on surplus saving from abroad to fund the greatest consumption binge in history.”
This is almost exactly backward. Yes, developing countries are usually unable to save enough to fund their investment needs and so run current account deficits. This was true with the United States in the 19th century, whose deficits were financed mainly by the United Kingdom — which also supplied the U.S. shortage of investment and consumer goods with a British current account surplus. But U.S. investments have long ceased to be constrained by a lack of savings. Today, the United States runs a current account deficit only because foreign money flows into the country and pushes up the dollar.
This need not be just a U.S. problem. Any country with a credible currency will “consume beyond its means” whenever foreign central banks or foreign institutions try to stockpile its currency. However, most countries refuse the privilege, often indignantly, because it unfairly forces up their currencies or otherwise compels them to “consume beyond their means.”
Providing seigniorage benefits. Currency notes are effectively interest-free loans to the issuing government. The value of this benefit, however, is almost negligible and has nothing to do with reserve status. Any credible currency can enjoy the benefits of seigniorage — the profit a government makes by issuing currency. For example, the 2002 creation of the 500 euro note caused a significant shift in seigniorage benefits to the European Central Bank, as money launderers, drug dealers, and others trying to hide their wealth switched from hoarding $100 bills.
Allowing the United States to sell economic insurance. As the United States intermediates low-risk, high-quality inflows into riskier outflows during times of stability, it effectively earns a risk premium for which it pays out during periods of instability. This creates real value both for the United States and for countries that choose to buy this insurance. However, this value does not depend on reserve currency status at all, but on the perceived stability of the U.S. economy as a safe haven.
These four “privileges,” in other words, are at best weak and usually confused. In the 1960s, Valéry Giscard d’Estaing, later France’s president, accused the United States of exacting “exorbitant privilege” after the dollar shortage of the 1940s and 1950s, which was only resolved by the massive dollar grants under the Marshall Plan and a political decision during the Cold War to allow Europe to earn dollars through protective measures. What makes the continued intellectual obtuseness of many Europeans extraordinary is that it is only the private sector analog of exorbitant privilege — unconstrained foreign capital inflows into the United States — that has permitted Germany to continue policies that have crippled German demand, which, after devastating peripheral Europe, are now resolved within the United States as European capital pours into the country.
Open and flexible financial markets in the United States allow Germany to pursue policies that are among the most irresponsible in modern history. This is what exorbitant privilege brings, and this is why the dollar will continue to be the dominant reserve currency for the next several decades (unless the U.S. government itself decides to prevent or limit foreign accumulation of dollar reserves).
It is also why the SDR, and even more so the renminbi, cannot become important reserve currencies. Many in Beijing may not understand that the cost of reserve currency status is foreign appropriation of domestic demand. Despite small-scale policies to increase renminbi holdings among foreign central banks, Beijing’s economic policies prevent foreigners from appropriating China’s already-too-weak domestic demand and so make it impossible for the SDR or the renminbi to ever become more than a minor reserve currency.
The dollar rules everything
To see why, we only have to go through the balance of payments exercise. The SDR is a constructed currency. If a central bank buys an SDR-denominated bond issued by the IMF, and the IMF hedges it by buying the requisite amount of bonds in dollars, euros, yen, sterling, and, soon enough, renminbi, this is no different than if the original central bank simply bought the requisite amount of bonds in dollars, euros, yen, sterling, and renminbi. In 2009, the People’s Bank website published a famous essay by Zhou in which he asked, “[W]hat kind of international reserve currency do we need to secure global financial stability and facilitate world economic growth?” His answer suggested a significantly enhanced role for the SDR and was widely interpreted as an assault on U.S. dollar hegemony. Strangely enough, if the People’s Bank really wanted SDR exposure, it could easily get it by buying those currencies separately according to the formula set out by the IMF.
But it never did. Instead, it mostly bought dollars. When a central bank chooses which currency to buy, it is also determining the direction of net trade flows. If the People’s Bank had bought other currencies, those related countries would have had to match the inflows on the capital account with larger current account deficits, or smaller surpluses, which would have triggered resistance in those countries.
This resistance, of course, is the problem. Given their much more limited economic flexibility and less ebullient financial systems, few other countries could have sustained the consequent trade deficits, and they would have almost certainly moved aggressively against China to limit the development of unfavorable trade balances. China, in other words, chose to buy dollars not because it had to, but because if it did not export capital, its domestic unemployment would have soared. And no other country besides the United States was willing or able to run deficits of the necessary magnitude.
It may be useful to consider an actual case. When the People’s Bank tried to accumulate yen in 2011, rather than welcome the chance to steal away some of the dollar’s exorbitant privilege, Tokyo demanded that the People’s Bank stop buying its currency and aggressively bought dollars, effectively trying to ensure that its increased share of “exorbitant privilege” was immediately passed on to the United States.
Because a current account surplus is by definition equal to the excess of savings over investment, the gap between the two in Japan would have had to narrow by an amount exactly equal to People’s Bank purchases. Here is where the exorbitant privilege breaks down: If Japan needed foreign capital because it had productive investments at home that it couldn’t finance for lack of savings, it might have welcomed Chinese purchases. But like any other advanced economy, Japan did not need foreign capital to fund productive domestic investment.
If People’s Bank yen purchases couldn’t force up Japanese investment, by necessity Japanese savings had to decline in line with its current account surplus. There are only two ways the inflows could cause Japanese savings to decline. First, a domestic consumption boom could cause the Japanese debt burden to rise, which Tokyo clearly didn’t want. Second, Japanese unemployment could rise, which Tokyo even more clearly didn’t want.
There is, in short, no way Japan could have benefited from People’s Bank purchases of its yen bonds. Only the United States permits unlimited purchases of government bonds by foreign central banks — not because, however, it is immune to the problems Japan and other advanced countries face. Like them, the United States can easily fund productive domestic investments without foreign capital, and so rather than cause productive investment to rise, foreign investment causes domestic savings to fall, which can only happen with a rising debt burden or rising unemployment.
In fact, foreign investment is only good for an economy if it brings needed technological or managerial innovation or if that economy cannot otherwise raise funding for domestic productive investment. If neither holds — and they hold in developing economies only, not advanced countries like the United States — foreign investment always forces the recipient country to choose between a higher debt burden and higher unemployment.
This is the great irony of the aftermath of the global financial crisis. China, Russia, and France want to lead the charge to strip the United States of its exorbitant privilege, and Washington resists. And yet, if Washington were to take steps to prevent foreigners from accumulating U.S. assets, the result would be a sharp contraction in international trade. Surplus countries, like Germany and China, would be devastated, but the U.S. current account deficit would fall with the reduction in net capital inflows. As it did, by definition the excess of U.S. investment over savings would have to contract. Because U.S. investment wouldn’t fall, and in fact would most likely rise, savings would automatically rise as lower unemployment caused GDP to grow faster than the rise in consumption.
The savings slip-up
But what about the United States’ extremely low savings rate? Doesn’t it consume beyond its means, as Roach wrote, leaving it savings-deficient and reliant on Chinese and European savings to fund the U.S. fiscal deficit? “[T]he real reason the US has such a massive multilateral trade deficit,” Roach wrotein April, “is that Americans don’t save.”
This is one of the fundamental failures in understanding the balance of payments. As counterintuitive as it may seem at first, it is not low U.S. savings that suck in foreign capital, which then forces foreigners to run current account surpluses. On the contrary, the U.S. savings rate is low precisely because it must balance foreign capital inflows.
This is an arithmetical necessity. If foreigners increase capital exports to the United States, the excess of investment over savings must necessarily rise to balance the import of foreign savings. This is a requirement of the balance of payments, and the money pouring into the United States following the shock of the Brexit vote, for example, will push U.S. savings down further, probably partially as the consequence of a rise in unemployment. Productive investments in the United States are not constrained by a lack of capital — and have not been since the late 19th century — and so the excess savings foreigners export to the United States cannot result in higher U.S. investment. U.S. savings must necessarily fall, and they do through only one of two mechanisms.
The first mechanism occurs during economic booms, including, most famously, in the United States and peripheral Europe before the 2008-2009 crisis, wherein foreign capital inflows drive up asset prices, making households feel richer. This encourages increased consumption funded by rising debt. Monetary authorities usually gladly accommodate rising debt because higher domestic consumption generates jobs that replace those lost by workers producing the tradable goods displaced by the rising current account deficit.
During the subsequent contraction, set off once asset prices and debt levels rise too high, the second mechanism comes into play. High debt and declining asset prices force households to cut back on consumption so that businesses lay off workers. Rising unemployment forces down savings as unemployed workers continue to consume.
As long as the United States is the only country willing and able to run the current account deficits that result from foreign accumulation of dollars, the dollar will be the only important global reserve currency. And as long as other economies try to goose domestic growth or reduce domestic unemployment by forcing up exports relative to imports, either U.S. debt will be higher or U.S. growth will be lower and unemployment higher. This is why the United States will eventually limit foreigners from accumulating dollars for their reserves.
If central banks were forced to accumulate SDR, the United States would absorb just under 42 percent of central bank capital exports, equal to the dollar’s share of the SDR, as opposed to the roughly two-thirds it currently must absorb. Europe would be forced to absorb almost 31 percent and China, Japan, and the United Kingdom between 6 and 11 percent.
Even this is too much, however. It would be far better if countries that allowed domestic policy distortions to create domestic demand deficiencies were prevented from forcing these distortions onto their trading partners. It is surprising that Washington has not yet taken the lead in doing so — not so much by forcing cumbersome changes in the rules governing international trade, but by taxing or otherwise limiting foreign access to U.S. government bonds when purchases are driven primarily for trade advantage.
The logic is inexorable. As the global economy grows relative to that of the United States, it is only a matter of time before Washington is forced into defensive action. The only question is how much economic pain and domestic unemployment the United States is willing to accept before it acts. As long as the dollar is easy to acquire in near-unlimited amounts, foreign countries with weak domestic demand can simply buy dollars and force their domestic demand deficiencies onto their trading partners. Until then, it doesn’t matter whether or not the People’s Bank tries to improve the SDR’s visibility. It is entirely against China’s economic interests for the SDR to replace the dollar — let alone for the renminbi to do so.