In his new book, "Eclipse: Living in the Shadow of China’s Economic Dominance", Arvind Subramanian, Senior Fellow at the Peterson Institute for International Economics, Washington D.C., presents the following possibilities: "What if, contrary to common belief, China's economic dominance is a present-day reality rather than a faraway possibility? What if the renminbi's takeover of the dollar as the world's reserve currency is not decades, but mere years, away? And what if the United States's economic pre-eminence is not, as many economists and policymakers would like to believe, in its own hands, but China's to determine?", according to the Peterson Institute website.
The Peterson Institute website explains,
"Subramanian's analysis is based on a new index of economic dominance grounded in a historical perspective. His examination makes use of real-world examples, comparing China's rise with the past hegemonies of Great Britain and the United States. His attempt to quantify and project economic and currency dominance leads him to the conclusion that China's dominance is not only more imminent, but also broader in scope, and much larger in magnitude, than is currently imagined. He explores the profound effect this might have on the United States, as well as on the global financial and trade system. Subramanian concludes with a series of policy proposals for other nations to reconcile China's rise with continued openness in the global economic order, and to insure against China becoming a malign hegemon". Click here
Subramanian's prognosis is based on detailed econometric and regression analyses, supported by robustness verifications, which find a rising degree of distinctive currency movement coefficient (CMC) of the RMB as an international reference currency, compared with the dollar and other leading currencies. The Abstract of a Peterson Institute joint working paper (WP 12-19) dated October 2012 by Subramanian and his colleague Martin Kessler states -
"In East Asia, there is already a RMB bloc, because the RMB has become the dominant reference currency, eclipsing the dollar, which is a historical development. In this region, 7 currencies out of 10 co-move more closely with the RMB than with the dollar, with the average value of the CMC relative to the RMB being 40% greater than for the dollar. We find that co-movement with a reference currency, especially for the RMB, are associated with trade integration. We draw some lessons for the prospects of the RMB bloc to move beyond Asia based on a comparison of the RMB situation today and that of the Japanese yen in the early 1990s. If trade were the sole driver, a more global RMB bloc could emerge in the mid-2030s, but complementary reforms of the financial and external sector could considerably expedite the process."
What is tale-telling in these findings is that "the yen at the peak of the Japanese miracle was not a significant reference currency at all even in neighbouring East Asia and the dollar reigned supreme; in contrast, today, the RMB has eclipsed the dollar as the dominant reference currency."
Click here for "Turning from green to red", an article in The Economist dated 20 October 2012 on the same topic.
Subramanian's claim of China's emerging economic dominance seems to be lent credence by South China Morning Post columnist Tom Holland in his article of 10th September, 2012 - "What 'pivot'? Real US-China war will be over money" Click here
Holland refers to the latest book "Paper Promises" by author and Economist columnist Philip Coggan, who "describes economic history as an endless struggle between borrowers and lenders over the irreconcilable difference in their interests".
"For the last 40 years, ever since the US government severed the link between the US dollar and gold, creditors have had the upper hand". "With the anchor cast loose, the US financial system embarked on a credit creation binge that saw total debt, both public and private, explode from 150 per cent of gross domestic product to almost 400 per cent in 2009". "In Europe, too, debt levels soared, assisted by the continent's monetary union". It couldn't last, says Coggan. "They created more claims on wealth than they created wealth itself."
Holland continues, "The result, believes Coggan, will be a major overhaul of the international financial system, with China, as the biggest creditor, writing the rules to suit itself, just as in 1944 the US wrote the rules for the post-second world war monetary system".
"Naturally this new system will be created in China's image, with exchange rates confined to narrow trading bands, controls on the free flow of capital across international borders, and debtor economies obliged to accept strict limits on the size of their fiscal deficits". "In short, this is a war China will win".
Holland, however, seems to have forgotten about what he wrote in the South China Morning Post on the "Five reasons yuan is no threat to dollar as reserve currency" on 10 February 2012. Click here
There, he invoked important pre-conditions before the yuan could become a major reserve currency as outlined in a new paper by economists Professor Eswar Prasad and Professor Lei Ye of Cornell University in the US. "China's economy must first be big. Second, it must be open, especially to capital flows. Third, it must have a flexible exchange rate. Fourth, it must have broad, deep and liquid financial markets. And finally, China must follow economic policies that inspire confidence in the rest of the world".
Holland deduced that "for the time being, China only fulfils one of the five conditions required of the issuers of major reserve currencies: sheer size".
He went on to conclude that "even if China meets the other four criteria, there is another reason why the yuan will not displace the US dollar as the world's leading reserve currency: sheer arithmetic".
"At the moment, China holds around 30 per cent of all the world's foreign reserves, and China has to hold those reserves in foreign currencies, which for practical purposes means the US dollar and the euro. That means if China were to hold its reserves half in US dollars and half in euros, Europe to hold half US dollars and half yuan, and the US to hold half euros and half yuan, with the rest of the world holding US dollars, euros and yuan equally, then the sheer size of China's reserves would ensure the US dollar remained the dominant currency by a considerable margin, with the euro second and the yuan a distant third".
"So unless China runs down its own foreign reserves by running massive trade deficits over the coming years, the US dollar will remain the world's reserve currency of choice for the foreseeable future."
The above arithmetic, however, is predicated upon the premise that currency preferences would remain static forever. As China's economy is growing to be bigger than the U.S. in the coming decade(s), an internationalized Chinese yuan of the world's largest economy supported by a robust foreign currency reserve is likely to gain preference as a reserve currency. This is even more likely as China is trying to extricate herself from being locked in what Paul Krugman calls China's "Dollar Trap".
What is preventing the Chinese yuan to attain this level of global dominance, however, remains its continuing non-convertibility on the capital account, which has proved to have served China remarkably well in times of global financial crisis. There is yet no sign that China is likely to take on the risks of unwelcome capital flows by giving up this protection on the capital acount any time soon.
This is explained in a commissioned paper "Is the Renminbi the New Dollar? Chinese Monetary Policy and the Global Reserve Currency System" in a Chartered Insurance Institute report in April 2012, which was published to mark the CII’s centenary year as a chartered professional body. Click here
So, what is the upshot of all of the above arguments?
Well, there is little doubt that the U.S and most European economies remain infected with structural malaise which are unlikely to be cured quickly. Meanwhile, the EAGLES (Emerging and Growth Leading Economies) are soaring, of which China dwarfs the rest as the centre of a global supply and production hub to which the other EAGLEs become increasingly linked. In these circumstances, China stands a fair chance of overtaking the United States as a dominant economy sooner rather than later. Click here
However, as Holland cautioned in his earlier article,
"Although .... over the last five years the value of China's foreign assets and liabilities has doubled to more than US$6 trillion .... that's tiny by the standards of the US, or even Britain. China's gross external position is now roughly the same size as that of Switzerland, whose currency the franc, according to the International Monetary Fund, makes up only about 0.1 per cent of the world's foreign reserves. Clearly China still has a long way to go on opening up to capital flows".
So unless the world's confidence in the greenback quickly plummets to a tipping point before there is a credible substitute, it is unlikely to be able to take over the leading role of the dollar only years away, as Subramanian may fear. However, if his prognosis on the global ascendancy of the RMB as the leading reference currency materializes, the Chinese yuan may well become one of several major world reserve currencies much sooner than people expect.
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