Friday, July 3, 2015

The Impossibility of Renminbi Hegemony.

Most discussions on the renminbi replacing the dollar focus on how far the dollar has to fall, not on how high the renminbi has to climb. The obstacles to true renminbi hegemony are mathematic as much as they are political and economic.

As of the end of 2014, China had the largest foreign exchange reserve in the world. Part of the reason for that are China’s status as the world’s biggest exporter and the United States status as the world’s biggest external debtor. The simplest way for the renminbi to overtake the U.S. dollar as the world’s reserve currency would be for the United States to become the world’s biggest exporter and China to become the world’s biggest external debtor. Simple, but not likely. If it were to happen, we cannot be certain that most exports from the United States would be bought by holders of renminbi, nor could we be certain that China’s external debt would be in renminbi.

We can understand the likelihood of renminbi hegemony in two ways. The first would be to speculate on the renminbi rising to overtake the dollar. For this, a brief history lesson is required. The dollar did not become the world’s reserve currency because the United States made up a huge portion of world trade. China’s status as the world’s largest trading nation is one fact that many predictors of renminbi hegemony point to as a reason for the dollar’s replacement. For most of the United State’s history, it was a net exporter of goods. In that case, it should have been flooded with foreign currency, meaning dollars should have remained at home if reserve status was gained through trade. Instead, the dollar became dominant because it was the currency of choice for global debt markets. Starting with the Bretton Woods System, gold reserves could be used to issue dollar debt at multiples of the dollar’s gold price. That dollar debt could then be issued at multiples of the dollar’s foreign currency price. Not only is the U.S. dollar the currency of choice for New York City, the world’s largest financial market, it is also the currency of choice for London, Hong Kong, and Singapore debt markets. Although all three cities are vying for renminbi business, it is ridiculous to assume that they would give up on their dollar business. Dollars can be created outside America’s borders without the involvement of American institutions.

Progress has been made by the renminbi in international debt markets, but by the middle of 2015, the number of sovereign debt issues outside of China denominated in renminbi can be counted on the hand of a person with only two fingers. In October 2014, the United Kingdom became the first non-Chinese sovereign to issue renminbi-denominated debt. It issued ¥3 billion worth of three year bonds at a 2.70% yield. From a purely financial standpoint, this was an absurd move. On the same day that the three-year bond was sold for 2.70%, the yield on five-year British sovereign debt was 1.40%. The British government could have paid almost half as much in interest on British pounds borrowed for twice as long. Mongolia issued renminbi-denominated debt in June 2015, but paid about 100 basis points more than it was paying on its U.S. dollar-denominated debt. Mongolia may have given more momentum to a trend, but the last time Mongolia made an impact on the world, a well-fed horse was the most advanced weapon of war.

The second way to understand the likelihood of renminbi hegemony is the reasons the dollar would fall from grace. The rise of the renminbi is not simply a two-character story. The renminbi is not the first challenger to the U.S. dollar. In order to answer the question how the renminbi will surpass the U.S. dollar, proponents of coming renminbi hegemony must explain why others have failed. The International Monetary Fund compiles quarterly statistics on foreign exchange reserves. The figure for 2015 Q1 was US$11.4 trillion. Allocated reserves are reported broken down by currency, whereas unallocated reserves are only reported at their U.S. dollar equivalent. Of US$6.0 trillion worth of allocated reserves, U.S. dollars made up US$3.8 trillion, or 64.1%. Euros came in second place at US$1.2 trillion, or 20.7%. Japanese yen were a distant third at US$251 billion, or 4.1%. If unallocated reserves have the same composition, there were US$7.3 trillion worth of U.S. dollar-denominated foreign exchange reserves, US$2.3 trillion worth of euro-denominated foreign exchange reserves, and US$474 billion worth of yen-denominated foreign exchange reserves.

If China’s future role as the largest economy in the world will lead to renminbi hegemony, why has the euro been unable to surpass the dollar? The E.U., after all, is the world’s largest economic entity. Before the Global Financial Crisis, the euro was a likely successor to the dollar. If the European Central Bank had faced the Global Financial Crisis with higher interest rates to cleanse the financial system, that may have happened. Instead, it put internal, short-term economic considerations above long-term currency considerations. This made it no better than the Federal Reserve, but without the established brand. Fixing nominal interest rates in negative territory ended its chances of being taken seriously again. China’s status as the world’s second largest economy gives credence to the likelihood of renminbi hegemony, but Japan was the world’s second largest economy for 32 years. Today, all Japan has to show for its efforts is a huge pile of U.S. dollar-denominated foreign exchange reserves. The decision by the Bank of Japan to effectively nationalize the domestic bond market in 2015 ended the yen’s chances of being taken seriously again. As long as the U.S. dollar can keep winning the Least Ugly Contest, it will be on top of the fiat currency game.

China’s huge dollar holdings contribute to the dollar’s status as the world’s reserve currency. It is unlikely the renminbi could hold the title of world’s most common reserve currency while at the same time the country of issue holds the largest reserves of foreign currency. China could sell its dollars, but for what and to whom? If China were to sell one trillion dollars for some other asset, two issues arise. First, it would most likely have to find another foreign central bank to buy the dollars from it. In that case, the net change in the U.S. dollar’s reserve currency balance is zero. Second, if it were to buy non-currency assets with its dollars, it would still have to buy dollar-denominated assets, meaning its exposure to dollars is the same.

Realistically, the only way dollar hegemony would end is if the global fiat currency regime were to end. In that case, the renminbi is doomed, too. We cannot consider a loss for the dollar to be a win for the renminbi.

So far, the character absent from this story has been gold. The great irony of the central bank experiment is that while the entire world has accepted fiat currency, the institutions that issue fiat currency are the largest holders of gold. According to the World Gold Council, central banks held 31,977.6 metric tones of gold. At 2014 year-end prices, that was worth US$1.2 trillion. If gold were considered part of foreign exchange reserves, it would come in third, behind the U.S. dollar and the euro. If the value of gold were to increase six times over, gold would be back on top. During the last gold bull market, gold rose 662% from a low of $252.10 to a top of $1923.00, so it is not out of the realm of possibility. Unfortunately for China, it is on the short-end of the gold reserve stick. It has only invested 1.00% of its foreign exchange reserves in gold, putting it toward the very bottom of the list.

Although each move the renminbi makes in international currency markets makes headlines, we will probably never seen renminbi hegemony. How will the renminbi penetrate debt markets with higher yields than established currencies? How will the renminbi penetrate foreign exchange reserves if it exports much more than it imports? How will the renminbi survive a fiat currency shake up that would dethrone the dollar?