The Titillating And Terrifying Collapse Of The Dollar Again

Foreign perceptions about the Chinese economy are far more volatile than the economy itself, and are spread across a fantastic array of forecasts. On one extreme there are still many who hold the view that overwhelmingly dominated the consensus just four of five years ago, with a book by Martin Jacques,When China Rules the World, titillating or terrifying many with a subtitle that promised the end of the Western world and the birth of a new global order. Although few within this camp still believe in their earlier forecasts of 8-9 percent annual growth for another one or two decades, many among them still think China will manage to double its GDP in ten to twelve years.

On the other extreme are those who expect the economy to collapse well before the end of the decade. Although he himself does not expect an economic collapse but rather a political one, among the deeply pessimistic is George Washington University’s David Shambaugh, who published an article in the Wall Street Journal last year about “The Coming Chinese Crackup”. His article set off an intense debate among China watchers that still continues and indeed has been made more intense by a number of recent measures that seem aimed at limiting economic discussion and analysis.

Shambaugh warns that Beijing’s policies, aimed at staving off imminent political collapse, are instead “bringing it closer to a breaking point.” This seemed to mark a sharp change from his earlier views, all the more noteworthy given that his credentials as a knowledgeable and sympathetic observer of China had been reinforced just two months earlier when the prestigious China Foreign Affairs University, “the only institution of higher learning under the guidance of the Ministry of Foreign Affairs”, according to its website, named him the second-most influential China expert in the United States.

While political whispering and gossip about political instability have undoubtedly surged during the past year, I have no ability to judge China’s complex power struggle and its mysterious political maneuverings. No one I know, even the most plugged-in of my friends and former students, seems to have much sense of the political direction in which we are going, and the only thing with which everyone agrees is that they are all a lot less certain than they used to be.

In my opinion, however, there is no question that the days of rapid growth, which powered the inexorable economic rise on which Jacques relies for the future described in his book, are well and truly over. There is no way that growth won’t drop to below 2-3% well before the end of this decade, although if it manages the adjustment well and doesn’t put off too much longer an intelligent plant to resolve its debt burden, Beijing could keep the annual growth in household income from dropping much below 5% during this period.

This doesn’t mean that I think China is likely to experience an economic or financial crisis, let alone political collapse, however, although historical precedents make it very clear that as a country’s balance sheet becomes increasingly fragile, it takes a smaller and smaller adverse shock to set off a financial unraveling. There is nonetheless absolutely no question in my mind that its GDP growth rate will continue to drop sharply – either by 1-2 percentage points a year, or a lot more steeply after two or three years in which it maintains growth rates above 6 percent.

But titillation and terror continue in various forms. For many analysts who don’t understand why continued rapid slowdown is inevitable and why, therefore, it makes sense to tone down some of the rhetoric, recent statements made by Zhou Xiaochuan, Governor of the People’s Bank of China (PBoC), set off some very loud alarm bells. In his statement on April 16 to the IMF’s International Monetary and Financial Committee meeting in Washington, D.C., the head of China’s central bank closed with two sentences that caught the eyes of a number of analysts:

Starting from this April, China has released foreign exchange reserve data denominated in the SDR in addition to the USD. We will also explore issuing SDR-denominated bonds in the domestic market.

A concurrent release by the central bank on the PBoC website emphasized the first of these two statements: “starting from April 2016, the People’s Bank of China is releasing foreign exchange reserve data denominated in the SDR, in addition to the USD currently used.”

A little bit of context is in order here. Every month the PBoC announces the value of its foreign currency reserves in renminbi and in US dollars. Beginning in April, it plans also to announce the value of the PBoC’s reserves in Special Drawing Rights (SDRs).

The PBoC correctly points out that because the SDR is necessarily less volatile than any of the constituent currencies – US dollar, euro, the Japanese yen, pound sterling, and, in October of this year, the renminbi – using the SDR “would help reduce valuation changes caused by frequent and volatile fluctuations of major currencies.” We saw how this works Sunday, in an article in the South China Morning Post that opened with this:

China’s foreign exchange reserves rose, albeit marginally, for a second consecutive month in April, indicating easing in capital outflows, according to data released by the People’s Bank of China on Saturday. The US$7.1 billion rise beat the market forecast of a drop and took outstanding forex reserves to US$3.22 trillion at the end of last month. In March, the reserves rose US$10.2 billion, ending a five-month decline.

At the bottom of the article, the SCMP gave us the SDR figures released by the PBoC:

In terms of SDR, the country’s foreign exchange reserves were 2.27 trillion at the end of last month, down from 2.28 trillion at the end of March.

A $7.1 billion increase in reserves when quoted in US dollars turned into a SDR 0.1 decrease when quoted in SDRs. The dollar declined against most major currencies in April and this weakness showed up in the form of an increase in the dollar value of the PBoC’s non-dollar reserves. Because the US dollar share of PBoC reserves is around 1.5 times its share of SDR, this same weakness showed up in the form of a decline in the SDR value.

Aside from reducing volatility, the PBoC also claims that using the SDR to report foreign exchange reserve data will help “provide a more objective measurement of the overall value of the reserve”. Here the PBoC is mistaken; there is no additional information in the new number. Indeed anyone who preferred to keep track of the SDR value of PBoC reserves could have done so all along simply by converting each monthly US dollar value into SDRs – or euros, yen, sterling, or any other currency for that matter – at the then-prevailing exchange rate. There is no special trick here.

Undermining dollar hegemony

It was the last sentence in the PBoC release that raised eyebrows among many analysts, and this is where the titillation and terror come in. Reporting the value of foreign exchange reserves in SDRs, according to the PBoC release, “would also help enhance the role of the SDR as a unit of account.”

Why is the PBoC so concerned about enhancing the role of the SDR, an “international reserve asset” that until now has had little practical use and into which the renminbi has only recently entered? Shortly after the release, an article in the South China Morning Post provided one possible answer. It warned that the PBoC’s use of the SDR was aimed at achieving Beijing’s “longstanding strategic aim of dethroning the US dollar in the international monetary system.” According to the article “Beijing‘s renewed passion for the awkwardly phrased reserve asset is all part of its strategic goal – led by the central bank’s veteran governor Zhou Xiaochuan – to end the US dollar’s hegemony; the world’s second-largest economy wants to forge a new global financial order.”

In an article for MarketWatch, David Marsh, managing director of a London-based research company called Official Monetary and Financial Institutions Forum, explained in greater, slightly fawning, detail why this latest move is all part of a grander, carefully-thought-out strategy:

China’s utterances over the years on the International Monetary Fund’s special drawing rights confirm the Beijing authorities’ reputation for long-term thinking as well their ability to create riddles on what the goals actually are. The mystery is starting to look little less obscure. 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.

Although it accepts that many years will elapse before the dollar can be dethroned from its No. 1 role, Beijing favors a “4 plus 1” system: the euro, sterling, yen, and yuan coexisting with the dollar. These are the five constituents of the SDR, which the yuan formally enters in October, following a U.S. Treasury-endorsed IMF decision in November. As part of this thinking, China for some years has been showing less interest in purchasing U.S. Treasurys — a trend that is likely to continue.

Beijing has upgraded the role of the IMF’s composite currency unit by starting to publish its foreign reserves total (the world’s biggest) in SDRs in addition to its long-standing practice of publishing them in dollars.

Marsh, like many other analysts who have repeated the popular but confused story about the rise of the renminbi and the decline of the US dollar, has probably misunderstood the way reserve currencies work within the global balance of payments. Whatever some people in Beijing might think about enshrining a multicurrency reserve system, in fact Beijing’s economic policies in the past two decades have done the opposite. They have systematically enhanced the reserve role of the US dollar. Had Beijing done otherwise, it would either have undermined China’s economic development or it would have created significantly higher domestic political pressures in the past two decades.

This is truer now than ever. Regardless of the stated intentions of certain political figures, Chine’s economic adjustment requires that Beijing continue supporting the dollar’s reserve-currency role. A reduced role for the US dollar would actually make China’s already difficult economic rebalancing costlier than ever.

As an aside there is of course no question that US dollars account for most central bank reserves, and have for seven decades, in spite of occasional periods in which many believed its role would be significantly reduced as another currency rose to take on a much greater presence – for example the D-mark was seen as a potential rival in the 1970s and 1980s, the yen in the 1980s and early 1990s, and the yen in fact widely expected to supplant the dollar altogether by the beginning of the last decade, and even the ruble in the 1950s. Nomura’s Stuart Oakley explained the current breakdown three years ago:

According to IMF data there is currently approximately $11 trillion of foreign exchange reserves sitting in the coffers of the world’s central banks. $6 trillion of this is referred to as “allocated reserves” where the currency composition is known. Most of the remaining $4-5 trillion “unallocated reserves” are owned by China who choose not to divulge the currency composition of their foreign loot. 

We know roughly 62 percent of “allocated reserves” are held in U.S. dollars, 23 percent in euros, 4 percent in yen, 4 percent in sterling with the Swiss franc, the Aussie and Canadian dollars making up the tiny remaining balance.

I will get back to this later, but I want to follow up on one of the other points Marsh made in his piece. He claimed that it was no coincidence that only a few days before his Washington statement, Zhou Xiaochuan had been in Paris: “The French capital is the traditional venue for plans (mainly fruitless) to unseat the dollar. These date back to the maneuverings of Jacques Rueff, the legendary pre-World War II French economist, and the ill-fated 1960s rebellion against the greenback’s exorbitant privilege.”

In fact the whole theory of the exorbitant privilege – first articulated by Valery Giscard D’Estaing, later France’s president, and referring to the tremendous economic benefits that the US supposedly receives because of the primacy of the US dollar among reserve currencies – came out of very special post-War circumstances. In the late 1940s, as the US ran trade surpluses with war-torn Europe, the Bretton Woods institutions were unable to recycle enough dollars to Europe to allow it to pay for consumption as well as fund the necessary rebuilding of infrastructure and manufacturing. The notorious “dollar shortage” was so severe that it threatened to derail any hope of European and Japanese economic recovery.

The large US dollar grants provided by the US under the Marshall Plan partially resolved the problem, but even this wasn’t enough. By the 1950s, as Cold War tensions rose, in order to rebuild European economies the US permitted protectionist policies in Europe without retaliating, so that its allies could reduce their current account deficits and eventually convert them into surpluses.[1] This would permit European employment to rise quickly enough that the concurrent increase in savings could fund faster increases in domestic investment.