Are there any domestic or external political circumstances in which China may ‘drop the nuclear bomb’ — that is, dump the dollar?
You can’t really do it. Let’s go through the different games — China can exchange dollars for commodities, which would probably have some impact on the dollar, but would cause commodity prices to surge. A lot of the commodities-exporting countries would end up recycling that money back into the US. So, it would only have a small impact on the dollar.
Or China could diversify into other foreign currencies. Let’s say China dumps dollars and buys euro. The value of the euro would shoot up against the dollar, the European export manufacturing sector would collapse; there will be disruptions in the US in the short term, but there would be an uproar in Europe. That would lead to trade sanctions, so they can’t do that either.Alternatively, China could dump dollars against the renminbi; in other words, invest all this money back in China. But the PBoC is the only net buyer of dollars. If it becomes a net seller, the dollar has to collapse against the renminbi — which means the renminbi will soar against all currencies, wiping out China’s export sector.I keep hearing about this ‘nuclear threat’. Politicians and ordinary people get very nervous about this. But I cannot figure out how you go about doing it in a way that benefits China and disrupts the US. Almost anything you do would cause either trade war, a collapse in China’s export sector and/or a massive transfer of wealth from China to the US, in exchange for some fairly short-term disruptions in the US. It could be a very difficult six months or a year. But at the end of the day, I don’t think it will make such a huge impact on the US. It’s one of the things that keep us awake at night unnecessarily.
Is the ‘nuclear bomb’ a dud?
Yeah, it looks like an atom bomb, but there’s nothing in it.
What are the merits and demerits of having SDRs as the alternative ‘super sovereign reserve currency’ that China wants?
I’d argue that if we were to switch to the SDR, it would have a couple of consequences. One would be that the US would no longer be able to run massive current account deficits. But the flip side is that countries that have generated growth by running massive current account surpluses — China and the Asian Tigers — would no longer be able to do that. If I were an Asian Tiger or an Asian exporter, I’m not sure I’d be in a great hurry to see that.
The other problem is: how do you actually make the transfer? There are two ways. Let’s say China says to the International Monetary Fund: “Here’s 2 trillion in dollars, give me the equivalent in SDR”.
The IMF can do it one of two ways. It can take the dollars and give out SDRs, but it would run a massive balance-sheet mismatch that would bankrupt it in a week. Or it can sell the dollar and buy euro, yen, pound and Swiss franc to create the SDRs that it gives to China. That would be the same thing as China selling the dollar, which would mean that the value of the dollar would drop significantly against the euro, yen, pound and Swiss franc. And all of those countries would find themselves running very large trade deficits while the US may actually run a trade surplus; so they would be absorbing the Chinese trade surplus — and possibly a US trade surplus too. I don’t think they will permit it.
We’ve seen some baby steps towards greater internationalisation of the yuan. Does this accelerate the timetable for making it fully convertible?
It does accelerate the process of making it convertible, but these are, as you say, just baby steps: we’re going from tiny to a little less tiny. We’re in a world where demand has the upper hand. There’s plenty of supply. China is the world champion of supply: it’s got this massive overcapacity that it must export. The world has said it prefers to denominate trade in dollars. China has said that it would like to denominate trade in renminbi…I don’t see how in a world with excess capacity and deficient demand, the world champion of excessive capacity can redenominate international trade.
When is the earliest the RMB can become fully convertible?
It could happen at the earliest in 3-4 years, but will probably take a lot longer. But that doesn’t make it a reserve currency. In the 1980s, everybody thought the yen would be the dominant reserve currency by 2000, but that didn’t happen. I think it’s much easier for the yen to become the dominant reserve currency than for the renminbi — because among other things, we’d need a much more independent banking system and a much more independent financial system. Financial sector reforms are political before they are economic: it needs a significant political change.
If China’s demands for a “super sovereign reserve currency” are ignored, does it increase the risk of a disorderly unwinding of the reserve currency mechanism?
No. These discussions, about doing away with the dollar as the reserve currency, have occurred every decade or so. After 2-3 years we’re not going to be talking about this. One reason we talk about this so much is the massive accumulation of central bank reserves.
But that’s the flip side of the massive US trade deficit. That’s contracting very quickly. In fact, some people believe that in 2-3 years, the US will be running a small current account surplus. If that happens, the rest of the world will be losing dollars. All this feverish speculation about ‘What happens if China has $4 trillion or $5 trillion’… it’s unlikely to happen. Ultimately, we’re going to work our way out of this issue, and my prediction is that in three years we won’t be talking about it.
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