In the last month, Peoples Bank of China Governor Zhou Xiaochuan raised questions about the role of the dollar in the international monetary system and called for the replacement of the dollar with some type of global currency with the imprimatur of the IMF.
I share the Chinese concern over the role of the dollar and believe that it is a positive that China is starting to question the workings of the international financial system. It is my view articulated in these columns that the fundamental cause for the global boom bust that the world is now experiencing lies with faults in the international monetary system. The international monetary system as it currently functions has an inflationary bias. The US was able to run an inflationary monetary policy for years without suffering a currency crisis because of the special role of the dollar. No other country could have gotten away with what the U S did. Inflation occurred in the asset markets of equities and real estate. Consumer prices were held down by the good supply side deflation of globalization and the adding of Chinese and Indian workers to the global labor force. This supply side deflation simultaneously “hid” the monetary inflation that was occurring in the asset markets.
But in my view grandiose plans for a global IMF currency are the wrong way to go. The IMF is a politically driven organization whose past history is checkered to say the least. It hardly covered itself with glory during the Asian crisis when it in retrospect misunderstood what was happening. And even if the IMF were perfect, the US is not likely to cede the dollar’s role to a supranational organization so readily.
My advice to China would be to use its new economic power in the following way: Create the conditions for the renminbi to become fully convertible and allow it to do so. Then allow the currency to float. Given the size and importance of China’s economy, there is no reason why the renminbi cannot float in the currency markets just as the euro and the Japanese yen float. And China should stop worrying about the dollar. If China is worried about its dollar holdings, then going forward there is only one solution for China: Don’t buy any more dollars.
In recent years, as had the Germans in the 1960s and the Japanese in the 1980s, China had aided and abetted the US inflationary machine by buying huge amount of dollars to hold down the value of its own currency. In a recent article in China &World Economy, a journal published by the Chinese Academy of Social Sciences, respected international economists Ronald McKinnon and Gunther Schnabl argue that China has no choice. They state that “a free float would result in an indefinite upward spiral of the RMB against the dollar.” They argue that floating “presumes that a determinate market exchange rate, which could balance the demand and supply of dollars in terms of RMB, would actually exist if the PBC (Peoples Bank of China) were to exit the market.” China’s enormous savings surplus and the inability of its financial institutions to lend in their own currency to non-Chinese borrowers prevent the market from arriving at an equilibrium exchange rate.
The majority of economists would probably not agree with this. The consensus view including my own would probably be that the renminbi has been held at too low a level against the dollar. But assuming there is some truth to the McKinnon-Schnabl argument, the solution would be for China to allow its currency to become completely convertible. It is impossible to believe that the yen and the euro can find market equilibrium values against the dollar but that a freely convertible renminbi could not. Thus the renminbi could find its own level in the foreign exchange markets without China having to load up on unwanted dollars.
Moving to full convertibility for China will require continued banking reforms and further development of domestic financial markets. In this respect the recent huge increase in Chinese bank loans as a state directed part of its stimulus package is very worrisome and a step in the wrong direction.
Gold Isn’t the Answer Either
Recently released data show that China has significantly increased its gold holdings. China now owns 1054 metric tons of gold, up by 454 tons from 2003. Gold spiked at the release of the news and gold bugs everywhere took heart.
I don’t think the Chinese action is so significant. It may make sense for China and other countries to hold some of their reserves in gold but gold cannot resume anything remotely resembling the role it played in the Breton Woods system or the what now seems like the idyllic gold standard days of the pre -1914 world.
Let’s put the Chinese gold position in perspective. Current gold reserves valued at $900 per troy ounce equal about $30.5 billion. Assuming Chinese foreign reserve holdings have a value of approximately two trillion US dollars, then total Chinese gold holdings constitute 1.5% of total Chinese reserves. Big deal.
At current prices there isn’t enough gold in the world for gold to resume its role as the core global reserve asset. Gold would have to rise by some astronomical amount to replace the dollar. What central bank would want to put all its eggs in such a volatile basket?
Meanwhile Back on the Potomac
The US currently is the world’s number one holder of gold reserves with some 8133.5 metric tons. That works out to some $ 235 billion, again assuming a gold price of $900 per ounce. Treasury Secretary Geithner could spend that in an afternoon. If the news coming out of Washington is correct, the US is going to be looking at trillion dollar deficits for years to come.
A consistent hope of the gold bugs and a consistent fear of economists is that US, British and other governments’ Keynesian based fiscal profligacy will inspire a run out of paper currencies into gold. The ability to issue fiat money is one of the key powers that modern governments have and one that in my opinion they will defend at all costs.
In 1933 there were stirrings of a flight to gold. President Roosevelt responded by forbidding US citizens to hold gold. Were there to a be a major flight out of dollars into gold, it is inconceivable to me that the current US Administration would not take measures to stop it. Statistics are not available on the demographics of American gold holders. But a likely guess would be that they would fit an older, middle class conservative profile – not Obama supporters. They would be regarded as politically expendable.
It has been suggested that the US might want to sell its gold holdings to China. However, at current prices the amount received would hardly make a dent in prospective American financing needs. And the real cost might be higher than the amount received. The US acquired its gold hoard in the nineteen twenties. Selling the family “heirlooms” would hardly enhance the stature of the dollar. Such a sale in my opinion would not survive a rational cost benefit analysis.
I just attended a conference in Vietnam. Anyone doubting the value to the US of having the world’s international currency should visit Vietnam. The Vietnamese currency (the dong) is worth roughly 17,800 to the dollar. At least in Ho Chi Minh City ( aka Saigon) you can use dollars to pay for just about anything and you will get your change in dollars. By using the dollar for daily transactions, Vietnam is essentially making the US an interest free loan.
A Freely Convertible Renminbi Would Be a Bonanza for Hong Kong
Since 1983 Hong Kong has had a quasi currency board system and has pegged its currency to the dollar at 7.80 Hong Kong dollars to one US dollar. At the time of the Handover of Hong Kong back to China in 1997, the US dollar peg was regarded as a political and economic necessity for Hong Kong. There was no greater symbol of Hong Kong’s political and economic autonomy than the dollar peg and it has been a symbol respected since then by China and Hong Kong’s governments.
But times have changed. In the eleven years since the Handover China has emerged as an economic heavyweight and, although more progress needs to be made, has evidenced a certain degree of political maturity. On the other hand the US – at least temporarily – has fallen from its pedestal of perceived omnipotence. At the same time Hong Kong’s economy has become ever more inextricably linked to that of China’s. Commentators and even government officials in Hong Kong have started referring to an inevitable day when the Hong Kong dollar might be pegged to the renminbi rather than the US dollar.
Such an event however awaits the full convertibility of the renminbi which is currently partly blocked on capital account. Hong Kong cannot peg its dollar to a currency which is not convertible.
Once full convertibility occurs, however, Hong Kong will have a shot at becoming China’s principal financial center. Without capital barriers, Chinese investors will be able to invest in Hong Kong stocks and IPOs. The Shanghai A/H share valuation discrepancy will disappear. The legendary Chinese saver, hitherto legally off limits, will be available to the Hong Kong market. Hong Kong’s superior British derived legal structure, reputation for honesty and extensive knowledge based economy will then give it a comparative advantage within the Chinese market. And for the same reasons Hong Kong will retain its current role of attracting external financing for China. Throw in the new punitive personal tax rates being levied in New York and London, and Hong Kong will have a shot at becoming the world’s number one financial center.
It of course follows that if China does not unblock its capital account that this will be to Hong Kong’s disadvantage. Shanghai – Hong Kong’s major competitor for Chinese business – would have pretty much unchallenged access to the Chinese saver. From Hong Kong’s perspective, the blocked Chinese capital account is a protectionist barrier.