Don’t Discount the Dollar Yet
China may want to displace the dollar with the yuan as the global reserve currency, but its actions are leading to the opposite.
If some stories are easier to tell than others, the decline of the U.S. dollar as a reserve currency is one of them. It’s not hard to see why. The cast of characters that avail themselves for the script includes international trade, financial architecture, great-power competition, cycles of history, and even parables from ancient Greece.
And on cue, the headlines are again churning out new versions of the familiar fable. New plot lines include the economic fallout of a global pandemic as well as a “capital war” between the United States and China, in which Washington usurps Beijing’s traditionally lonely role as the imposer of the restrictions on how capital can move between their two countries, frightening global investors, who then forsake the fallen dollar. Taken at face value, the headlines suggest that the dollar’s long-awaited dethroning may be here at last.
But the economic forces that thwarted any demise of the dollar in the past persist. They continue to render any end to the dollar’s reserve status today unlikely. In fact, there is a new player keeping it on its throne: the Chinese Communist Party. It’s the latest arrival to the motley crew of conspirators serving, unwittingly, to prevent the currency from leaving its seat.
The dollar can’t be displaced with nothing, and mainland China’s currency, the yuan, was once the most-viable something. Global banks planned for it to “inevitably” replace the dollar. Economists speculated about the timing. The country’s growing economy, after all, is the world’s second largest. And Beijing is keen to take steps intended to promote its currency’s use in international trade. Officials in the world’s third-largest economy, the European Union, may voice similar intentions. But Beijing is not dealing in the currency of a monetary union that, according to research at its own central bank, maybe shouldn’t even exist. “Overall economic structures in euro area countries,” economists at the European Central Bank concluded in 2019, “are still not fully commensurate with the requirements of a monetary union.”
Nonetheless, Beijing’s recent actions have eviscerated the yuan’s prospects as a real reserve currency.
For a currency to function as an international reserve, global businesses need safe places to put it when it’s not in use. After all, no one wants to sell stuff in exchange for money they’d struggle to safely store. Without safe storage options, like easy-to-access banks or at least low-risk bonds, a currency can become a costly thing with which to do business. The most natural home for these safe assets denominated in mainland China’s currency would be mainland China. But Beijing imposes capital controls on flows of money in and out of the mainland. These capital controls stymie the development of liquid, globally accessible capital markets that can offer safe assets. Hence any market for Chinese yuan consistent with a role as a global reserve currency would need to exist outside of mainland China.
The offshore Hong Kong market once seemed like it could facilitate the yuan’s rise as a reserve currency, much as the offshore “eurodollar” market that emerged in 1960s London once did for the dollar. But the market for U.S. dollars in London thrived in part because U.S. authorities resisted any desire to try to meddle in these offshore markets. Beijing’s recent changes in how it governs Hong Kong evince an atomically opposite approach. Even the financial institutions of Switzerland, traditionally paragons of political neutrality, are now poised to scale back operations in Hong Kong as a result.
Any offshore market for yuan, whether in Hong Kong or elsewhere, would require interfacing with mainland China’s financial system and ultimately its central bank. This necessarily leaves any offshore yuan market vulnerable to Beijing’s whims. And Beijing acts on its whims; last year, Chinese officials punished the NBA because of a tweet from an employee of the Houston Rockets basketball team. In this world, any new offshore market for yuan is unlikely to be perceived as much safer from Beijing’s political cudgel than onshore Chinese markets—and thus not that safe.
To be fair, officials in China never had much of a shot at displacing the dollar’s reserve status. Nor do governments anywhere. The reason: Market incentives and economic self-interest are what keep the dollar’s status as a reserve currency steady. And these market forces are largely impervious to the wishes of today’s governments, even if they do operate within structures created by past regimes.
To illustrate, imagine the world waking up with amnesia about the whole chain of events that culminated in the original arrival of the U.S. dollar as a global reserve currency after World War II. What would happen to the dollar as the world readjusted?
Virtually nothing. The post-amnesia equilibrium would be today’s equilibrium.
Managers of businesses with operations abroad would find that about 50 percent of existing international trade invoices, cross-border loans, and international bonds are in U.S. dollars. No other foreign currency would offer access to commercial and financial networks of this size; for as many businesses as before, the U.S. dollar would still be better than the alternatives. Foreign governments and central banks would see businesses within their jurisdictions accumulate this dollar exposure. In light of this exposure, to fulfill their domestic policy objectives, foreign officials would then stockpile U.S. dollars. The dollar’s share of official foreign exchange reserves would have no reason to deviate from the roughly 60 percent level it is at now.
This thought experiment captures the basic dynamic of the dollar’s genesis as the reserve currency. As the Bretton Woods conference in July 1944 unfolded, World War II was effectively purging the prewar monetary system from the rest of the world’s memory. There, allied governments decided that everyone would wake up to find themselves rebuilding a world in which the U.S. dollar had become the reserve currency. Whether everyone knew or cared about how or why this happened didn’t matter. Due to the strong network effects that operate in currency markets, dollars then begot more dollars. Even the suspension of the convertibility of U.S. dollars to gold in the 1970s failed to disrupt the self-perpetuating logic of the dollar’s reserve role.
Nonetheless, when it comes to the dollar’s reserve status, many observers seem to assume that its longevity remains a function of the factors relevant to the circumstances of birth, like geopolitical clout and agreements with allies. But this assumption has implications that are odds with observable features of reality.
For instance, by most accounts, the peak of U.S. geopolitical clout on the world stage came around 1990. The Iron Curtain fell. Even history itself felt like it ended. Yet the U.S. dollar’s role in international trade has increased since, even as its share of world trade and GDP have fallen. The dollar’s share of official foreign exchange reserves has also since gone up, undermining the common analogy between mid-20th-century Britain and 21st-century America.
Meanwhile, some of the allied nations present at Bretton Woods have themselves explicitly tried to loosen the dollar hegemony their own predecessor governments helped to design. But not even they can succeed. In 2019, a coalition of European governments unveiled an alternative currency payment mechanism intended to circumvent U.S. sanctions on Iran. In over a year, the European payment mechanism has now managed to facilitate all of a single transaction of 500,000 euros. The U.S. sanctions had induced European firms to cancel billions of dollars of planned investments in Iran.
Allies aside, currency markets have been an afterthought of Beijing’s policy in Hong Kong, but even China can’t quit the dollar when it tries to. Its steady trillions of dollars in official reserves reflect its decision to deal with the global economy as it exists, rather than any goodwill or foreign-policy intentions.
But unfettered envy for the United States would be premature.
If the U.S. dollar’s reserve status stays steady as the U.S. share of world GDP falls, the United States may find “exorbitant privilege” turning into exorbitant handcuffs. The resulting balance of payments trend would likely favor financiers on Wall Street at the expense of exporters on Main Street, widening the regional and income inequalities already dividing the United States. Americans could tolerate this as a price of privilege. Or they could look for escapes from it. One route could entail balancing the federal budget or regulating U.S. dollar debt. Another would entail restricting inflows of capital into the United States, much as mainland China does now. Only time, and perhaps the American voter, will tell.
Tales of the dethroning the dollar may be fun to talk about. And Chinese policymakers may have, alas, just removed the biggest risk to its health. But that doesn’t mean the next phase of its life won’t be just as interesting.