In Arvind Subramanian book, Eclipse: Living in the Shadow of China’s Economic Dominance, Arvind Subramanian argued that the renminbi could overtake the dollar as the world’s premier reserve currency sometime during the next decade. His prediction was based on an econometric analysis of the fundamental economic determinants of a reserve currency (chapter 3) and applying the lessons from the sterling-dollar transition.
At the time, his prediction elicited three criticisms:
1) It took nearly 60 years after the US economy overtook the UK economy for the sterling-dollar transition to occur. This was said to imply that even if the fundamentals were moving in China’s favor, the renminbi’s ascendancy was some long way off.
2) deep and liquid financial markets, and especially an open capital account were essential for maintaining a reserve currency, and China did not fulfill these requirements.
3) Perhaps most important, even if China fulfilled them, reserve currency status for the renminbi was nowhere close to imminence because that status is fundamentally based on trust—and not just any trust, but the trust of foreign investors and traders that China would not misbehave, especially in hard times, by expropriating or defaulting on its obligations to foreigners
The sterling-dollar transition was effectively only 10 to 15 years even without the United Kingdom inflicting demonstrably self-destructive costs as the United States is today. Moreover, in the last three years, the renminbi has displaced the dollar as the dominant reference currency in Asia.
China today looks more likely to fulfill the requirements for running a reserve currency. The creation of Shanghai as a free trade zone with full renminbi convertibility and the designation of London as an offshore renminbi center attest to China’s intentions to gradually open the capital account. While the financial system is still neither liberalized nor developed, policies to move in that direction may well be announced at the Third Plenary Session of the Communist Party later this year.
China needs to make the necessary changes not immediately but over the next five years or so to create the conditions for a reserve currency.
A reserve currency does not need an American-style, turbo-charged and sophisticated financial sector. It needs a reasonably open, reasonably transparent, reasonably liquid, and reasonably well-regulated financial system. China can also achieve that over the next decade.
The Simon Johnson critique that the United States has unusual trust among investors has been turned on its head. Can investors now trust the United States not to default on its obligations (and thereby on the very instrument that provides the financial plumbing for the depth and liquidity important for a reserve currency)? Will this new distrust persist beyond the bad times, even in normal times?
Making matters worse, the US problem leading to investor uncertainty and mistrust is not a one-off breakdown but a structural problem of ongoing dysfunctional politics.
As Michael Clasey, arguing for a downgrade of the US credit rating, put it: “Triple-A credits do not behave like this.” Only a change in the underlying politics can restore the attribute that China does not currently have but that the United States is squandering away.