Neil Irwin ponders the long-run effects of financial liberalization in China. Now that China is the primary trade partner with more countries than America, wonks can’t help but wonder the Renminbi’s role in tomorrow’s economy:
The answer has all kinds of consequences: From a U.S. perspective, that includes the question of whether the dollar will remain the bedrock of the world financial center in the decades ahead, or if the renminbi will become a rival for global trade, particularly within Asia.
China reminds us that liberal democracy is no necessary condition for a free market economy. But the financial system is different. In the long-run there are few things more important for deep and liquid bond markets than a free, voting people with strong Constitutional limits on arbitrary power. It’s also important to note that changes in the preferred reserve usually emerge after currency crises. Further, the geopolitics of oil will play a critical role in the Dollar’s future. China’s unwillingness to accept responsibility today will undermine its market position tomorrow.
Let’s consider the two primary risks entailed by coupons; full default or inflation. The Americans, and British before them, can credibly promise not to cheat creditors. Default or debasement is moderated by a democratic electorate that will throw officials out at any hint of default. America’s commitment to liberal democracy is what kept markets calm during the 2011 and 2013 debt ceiling debacle.
This is easily explained by simple public choice or game theory. Rapid devaluation as a means towards greater export-led growth and hence short-run prosperity is a subgame perfect strategy for Chinese leaders. They will be rewarded lavishly by the business community, as they have been for the past decade. America can never credibly threaten to inflation or default because the the majority of debt is owned by voting citizens and pensioners. Further, a strongly independent Federal Reserve is a powerful drag on inflationary politics.
International markets have no faith in the democratic accountability of the National People’s Congress or the independence of the People’s Bank of China. But there are other important reasons involving our friends in the Middle East. For all the sins of America’s adventurous foreign policy, the quid pro quo relationship with major oil exporting countries adds an important dimension to the Dollar’s mandate. Indeed, certain dictators failed to move oil to a “Euro standard” and China’s restrained Middle Eastern diplomacy will earn it no favors.
Even a grand scale increase in China’s trade cannot improve the Renminbi’s position. Here’s why:
- Financial liberalization will if anything decrease net exports and hence demand for the Renminbi.
- Deepening Chinese exchange markets will allow traders to hold Dollars and exchange as and when needed.
- Today, countries with a bad fiscal position borrow in Dollars (the “original sin”) to benefit from lower rates, as inflation risk is negated. There is no chance that the Renminbi will ever play this role.
Shadows Can’t Hide Forever
The not-so-secret truth is China’s shadow banking system is a known unknown unknown. We know it could be dangerous, but we have no idea how dangerous it might be and how rapt China’s economy is thereof. Institutions are, clearly, more important than trade. Consider the Swiss Franc, a currency of outsized importance relative to trade. But international confidence in the highly stable Swiss banking institutions (did I just say that?) keep it alive.
I might even venture to guess that holding Renminbi will become less important as it liquifies. China’s exports are, no doubt, crucial. If I know I can immediately trade on the exchange market as and when needed, it’s not nearly as important I keep it as Reserve.
There’s also a Keynesian Beauty Contest at play. Confidence in America is, in no small extent, aided by confidence in America. Therefore, as I noted, it is unlikely any tectonic shifts on the international finance arena will take place without a massive currency crisis.
To the extent we discuss vast improbabilities – like a successor to the United States Dollar – it’s worth noting the Indian Rupee is more likely an eventual reserve than the Renminbi. Firmly rooted democratic institutions will build faith in the Rupee. Conditionally:
- Indian debt will have to be equitably held and, hence, Indians in general will need to become far richer.
- India will need to handle supply-side issues of financial liberalization and inflation.
- India will need to become a main trading partner across Asia.
Given its size and commitment to fantastic economic leadership (Kaushik Basu… Raghuram Rajan…) it is not impossible that this will happen before I die. If it does, remember I said this before it went mainstream.