By Andrew Sheng
(Caijing Magazine) I always find it strange when people debate whether the yuan should be an international reserve currency while officially still under exchange control. We still remember that, as late as 1993, China used foreign exchange certificates.
As we have seen from the experience of the yen and euro, which I discussed in previous columns, using a national currency as a reserve currency has both advantages and disadvantages. The obvious advantage is seigniorage, although in a world of near-zero interest rates, this benefit is very small indeed. The second is an increase in financial services and commercial business that comes from global use of the reserve currency. New York and London benefit considerably as international financial centers that trade financial products denominated in global currencies. The third advantage is the prestige that goes along with having a nation's currency elevated to reserve currency status.
There are also disadvantages. A country that allows its national currency to become a reserve currency is also letting foreigners hold large amounts, and letting the currency move freely in and out. Hence, one pre-condition for any reserve currency is the ability of an issuing central bank to control the currency's value through appropriate monetary policy. This implies a stable exchange rate as well as low level of inflation.
This is precisely the problem facing the U.S. dollar. It's called the Triffin Dilemma – a tension between national monetary policy and global monetary policy. In 1998, when the U.S. Federal Reserve realized the world was plunging into a global crisis, it lowered interest rates and reflated not only the U.S. economy, but also the global economy. The United States could do that because it was fundamentally strong and U.S. consumption was the real engine of global growth.
But constant deficits add up to excessive borrowing, which is unsustainable. The dilemma is that, in a world of freely flowing capital, any central bank that raises interest rates to control domestic borrowing will invite a ton of hot capital, creating asset bubbles. A country that maintains flexible exchange rates will not only have exchange rate appreciation that encourages imports, but also worsen a current account deficit funded by short-term capital inflows.
In other words, the Triffin Dilemma imposes high costs on a reserve currency country, which must run a deficit to increase global money supply when the world demands greater liquidity. But if a reserve country runs a deficit that's too large, a financial crisis is inevitable. There is no free lunch.
Can we resolve the problem by creating a global central bank and a global super-regulator? The answer is no. If we have global monetary policy, some regions and sectors will be winners and some will be losers. Thus, a pre-condition for a global central bank is a global fiscal mechanism that can tax winning sectors to compensate losing sectors. Without such a fiscal compensatory mechanism, no sovereign country will be willing to cede its monetary policy to a global central bank without assurance of at least some fiscal assistance. The euro can work with the European Central Bank because such a fiscal mechanism exists within the European Union.
A further issue when weighing the pros and cons of reserve currency status is that the decision is not a policy issue, but really a market decision. Ultimately, the market decides whether a currency becomes a reserve currency. The yen experience shows that a highly volatile exchange rate turns the market away from a particular currency's use as a reserve currency. A central bank with a zero-interest rate policy cannot use interest rates as a tool to stabilize the exchange rate. So, in the case of the yen, the exchange rate is moved by speculative forces, dominated by the yen carry trade.
This is why a recent decision to establish several pilot yuan clearing centers in Hong Kong and mainland border cities was a pragmatic move that facilitates market needs. Foreign trade in the border areas is facilitated when traders are willing to use yuan as a convenient medium of exchange. Yuan swap arrangements with various central banks are also trade-facilitating moves to encourage the use of domestic currencies on a bilateral basis.
Some think large foreign exchange reserves are a pre-condition for reserve currency status. Central banks used to measure foreign exchange reserves in terms of months of imports. But this is an outdated measure. Annual world merchandise exports amounted to US$ 15.8 trillion in 2008, whereas daily foreign exchange transactions amount to US$ 3.2 trillion, or roughly US$ 800 trillion annually. This means global exchange rates are determined, not by physical trade, but by market capital flows.
In other words, one condition for opening the yuan is that its exchange rate maintains long-term stability. This requires skillful monetary policymaking that sterilizes speculative flows, with support from strong fiscal conditions tied to resilient and strong domestic financial systems that can absorb external shocks. In an era of global zero interest rates and highly leveraged speculative flows, it will not be easy to manage market stability. With interest rates near zero, speculation costs are exceedingly low. But, for any economy, destabilization costs are exceedingly high.
So, now that we clearly understand what's involved, who wants theirs to be a reserve currency?
Andrew Sheng is the author of a forthcoming book published by Cambridge University Press, From Asian to Global Financial Crisis.
Full article in Chinese: http://magazine.caijing.com.cn/2009-09-27/110266188.html