Observations: 12 September
Recent developments show a rising threat to the dollar
A reserve currency is a global bias of foreigners to hold that nation’s assets as means to save in and conduct international trade in. This bias lowers $ interest rates and enables the U.S. government to run larger fiscal deficits than it would be able to do otherwise due to balance-of-payment constraints — a so-called “exorbitant privilege”.
There are three main sets of challenges.
The first is that America’s import partners, its creditors, already own a lot of U.S. Treasuries. The graph below shows a time-series of these nations’ FX reserves relative to their cost of imports.
Aggregates FX reserves relative to imports for: Japan, Singapore, Malaysia, S. Korea, Taiwan, India, China (from 1977), HK (from 1990), and Vietnam (from 1995). Sources: World Bank, IMF, various national statistics agencies; own calculations.
Reserve holdings in dollars are also high relative to the economic weight of the U.S.
Sources: Maddison Project Database; IMF; Eichengreen-Mehl-Chuti data; Own Calculations. Full citation below.
Secondly, there is also less incentive to hold US Treasuries relative to history given (1) negative real interest rates (2) and an increasing ability to pay for imports in their own currency. This latter point is becoming increasingly relevant.
This week marked the completion of the Nord Stream II pipeline directly linking Russian gas to Continental Europe, which can potentially supply c. 15% of European gas needs. This is relevant because for the first time European can pay for these imports in euros.
“The euro is completely acceptable for us in terms of gas payments. This can be done, of course, and probably should be done” - Vladimir Putin Saint Petersburg International Economic Forum; 5 June 2021.
This comes at at time where China is building out its infrastructure for yuan-denominated futures contracts in core commodities (copper, oil, iron ore, gold, silver, etc), with a further expansion in the past week to shipping contracts.
Thirdly, there is the growing potential for alternatives. Currently, because China effectively runs a closed capital account, the Yuan makes up a very small share of international payments. Only 2-3% of world trade uses the RMB, and this is mostly between HK and the Mainland.
Source: SWIFT
In July, the PBOC released a white paper on the development of its digital currency. It noted:
“The third objective is to echo the international initiative and explore the improvement of cross-border payments…the PBOC will explore pilot cross-border payment programs”
Linked to this, the Chinese Securities Journal reported in late August that e-CNY had been used for the first time for transactions in the Dalian Commodity Exchange, albeit only domestically for the payment of storage fees.
But what if China was to extend credit in it’s Belt & Road initiative in Chinese yuan rather than dollars? China has announced c. $300bn in such loans since 2013. Can China design the e-CNY to segregate such funds from the rest of the currency in circulation and thus maintain its control over the capital account? It is an open question but one that may have large implications ahead.
References:
Eichengreen-Mehl-Chuti data on the currency composition of international reserves in the long run. Annual data for eight currencies as in Eichengreen, Mehl and Chitu, "How Global Currencies Work." September 2020.
Maddison Project Database, version 2020. Bolt, Jutta and Jan Luiten van Zanden (2020), “Maddison style estimates of the evolution of the world economy. A new 2020 update ”.