by Arvind Subramanian, Peterson Institute for International Economics
Op-ed in the Financial Times
September 11, 2011
© Financial Times
Economic turmoil in the United States and Europe is helping to accelerate a deeper, long term development. After three centuries of economic dominance, the West is about to be eclipsed by a rising Asian power: China. Not only may the Chinese economy soon be larger than America's—if measured in purchasing power—but the renminbi could displace the dollar as the premier reserve currency within the next decade or soon thereafter.
Skeptics will scoff for two reasons. First, even if China's economy overtakes America's, the renminbi's rise could be delayed. America's economy surpassed Great Britain's in the early 1870s, but the dollar displaced sterling decisively only around World War II. That implies there could be a lag of about 70 years between economic dominance and currency ascendancy.
Second, China is far from creating the policy and market environment for the renminbi to become a reserve currency. China's capital account is still largely closed and the renminbi still not convertible and freely available to foreigners; its financial system is government controlled; and its markets lack the depth to provide the liquidity critical to make a currency attractive to hold and trade. In these circumstances, how could foreign governments or private players make payments in renminbi, hold renminbi assets, or denominate economic transactions in renminbi?
In other words, loyalty to the dollar and China's lack of policy prerequisites seem to make the renminbi's rise a distant possibility. How wrong that is. First, the usual historical analogy is misleading. Great Britain ceded its economic dominance much later, and sterling its dominance much earlier, than is believed. Economic dominance, in the sense of the factors that determine reserve currency status, is affected not just by the size of an economy but by its trade and external financial strength. On this metric, the United States overtook the United Kingdom not in the 1870s but only around World War I: In fact, the United Kingdom was the world's largest exporter and net financier until the 1920s.
Second, China has all but caught up with the United States as an economic power. Its economy is about as large, in purchasing power, while its exports and overseas assets are much larger. If one were to draw the correct historical analogy, the potential eclipse of the dollar is just a decade away. Chinese economic strength creates the conditions for the rise of its currency.
This is not inevitable, of course. China still has to undertake major policy reforms. But internationalizing the renminbi has been set in irreversible motion in a distinctively Chinese manner. The process is micromanaged, interventionist, and enclave-based. Not a day seems to pass without some foreign entity or country being granted greater but selective access to the renminbi: Just last week an initiative was launched to promote London as a possible offshore renminbi trading center to complement similar plans for Shanghai and Hong Kong. Extending this experiment will presumably depend on its success.
Why might China want to turn the renminbi into a reserve currency? The answer is that the Chinese authorities have been searching for an exit from the decades-old and controversial growth strategy based on keeping the currency undervalued and the economy closed to foreign capital. Internationalizing the renminbi offers one such exit.
As China moves away from mercantilism, and as the renminbi appreciates, there will be stiff opposition from the tradable sector that has benefited most from currency undervaluation. To overcome that opposition, China's authorities can play up the benefits of the renminbi having international reserve status. The argument will be that the economic losses and dislocation from currency appreciation will be outweighed by the gains to national prestige from encouraging the renminbi to rise to reserve currency status and overtake the dollar. “Renminbi Rules” could be the slogan of, even a lifeline for, China's policymakers as they seek their difficult but desired exit from the mercantilist status quo. Sooner than almost anyone thinks, that slogan within China could also become the reality without.
Arvind Subramanian is author of Eclipse: Living in the Shadow of China's Economic Dominance. See also a technical version of this op-ed: Working Paper 11-14: Renminbi Rules: The Conditional Imminence of the Reserve Currency Transition.
Book: Eclipse: Living in the Shadow of China's Economic Dominance September 2011
Working Paper 11-14: Renminbi Rules: The Conditional Imminence of the Reserve Currency Transition September 2011
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Working Paper 12-19: The Renminbi Bloc Is Here: Asia Down, Rest of the World to Go?
Revised August 2013
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Testimony: Correcting the Chinese Exchange Rate September 15, 2010
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Testimony: China's Exchange Rate Policy and Trade Imbalances April 22, 2010
Policy Brief 10-7: The Sustainability of China's Recovery from the Global Recession March 2010
Testimony: Correcting the Chinese Exchange Rate: An Action Plan March 24, 2010
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