By Arvind Subramanian
Economic turmoil in the US 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.
Sceptics 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 the policy prerequisities 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 US overtook the UK not in the 1870s but only around World War I: in fact, the UK was the world’s largest exporter and net financier until the 1920s.
Second, China has all but caught up with the US 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 internationalising the renminbi has been set in irreversible motion in a distinctively Chinese manner. The process is micro-managed, 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 centre 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. Internationalising 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.
The writer is a senior fellow at the Peterson Institute for International Economics. His new book, ‘Eclipse: Living in the Shadow of China’s Economic Dominance,’ is published this month.