An internationally accepted ‘redback’ and financial institutions under Beijing give China the requisite arsenal to project economic influence and craft the Belt & Road Initiative.
This is the fortieth part in the series The China Chronicles.
Read all the articles here.
“Uneasy lies the head that wears a crown” best characterises America’s position as the hegemon in global finance. The global financial system that we have today is the result of the combination of international monetary cooperation, diverse economic ideologies and collective financial innovation. The United States (US) for the last half a century has controlled the financial order via prudent macroeconomic management and shrewd statecraft. The relative political stability of the US and the way it designed the global economy in the post-war era makes American economic institutions best suited to handle global financial rubrics. Additionally, the International Monetary Fund (IMF), which monitors trade flows, and the World Bank, which helps provide financing for developing nations, are both headquartered in Washington, effectively making United States the de facto leader of the global economy. The currency instrument that realises all of this is the US Dollar (USD) — the primus inter pares of the international monetary system.
The rise of the People’s Republic of China (PRC) has initiated a change in this longstanding international monetary order. The absenteeism of the US in reorganising the existing system of global economic governance has compelled policymakers in Beijing to pursue their own strategies to achieve economic leverage. The objective of traditional economic statecraft is to shore up a country’s foreign policy objectives via the use of economic resources. China’s use of economic instruments to shore up its position as a global economic power is one that supplements the broader idea of the rejuvenation of the Chinese nation. The incentive for the PRC is the ability to wield power beyond its immediate shores. There are three comprehensive strategies that the Chinese have employed to this effect. The first and most visible amongst them is the internationalisation of the Renminbi (RMB). The second, is the establishment of Beijing based financial lending institutions for developmental funding. The third, is the advocacy of free trade, and positioning itself a leader of globalisation in the aftermath of the election of a protectionist leader in the US. These strategies provide Beijing a wide range of tools with which it can pursue economic statecraft and exercise power abroad. These measures might not change the fundamentals of global economics, but there is enough potential to institute a parallel system of monetary cooperation.
The incentive for the PRC is the ability to wield power beyond its immediate shores.
The issue of the ‘redback’ (an informal term for RMB) is central to China’s quest for global recognition. Zhou Xiaochuan’s paper for the People’s Bank of China (PBoC) titled ‘Reform the International Monetary System’, put forth a nuanced plan for the world to move away from the USD. Xiaochuan demanded a more responsible US economic policy to protect the value of China’s dollar-denominated assets and proposed measures to encourage the use of the Special Drawing Rights (SDR) issued by the International Monetary Fund (IMF) as a partial substitute to the ‘greenback’ (informal term for USD). In 2016, the PRC finally followed up on this and published its foreign reserves total in SDRs. David Marsh observed that this was a clear signal that the PRC was, “embarking, pragmatically but steadily, toward enshrining a multicurrency reserve system at the heart of the world’s financial order.” This move from the PRC was a natural follow-on from its plans to create a parallel financial lending system via the Asian Infrastructure Investment Bank (AIIB) and the New Development Bank (NDB). These two tools — an internationally accepted ‘redback’ and financial institutions under Beijing, give it the requisite arsenal to project economic influence and craft China’s version of the crown — The Belt & Road Initiative (BRI).
In October 2016, China achieved a breakthrough in its attempts to internationalise the RMB when the IMF included the ‘redback’ in its basket of reserve currencies. The RMB joined the USD, the euro, the yen and the pound in the organisation’s SDR basket. The SDR essentially controls which currencies countries can receive as part of the loans granted by the IMF. The PBoC immediately released a statement, hailing the inclusion of the RMB as, “affirmation of the success of China’s economic development and results of the reform in its financial sector.” This measure came on the back of an extremely vocal campaign from one of the candidates of the US presidential election, wherein he formally announced that he would label China a ‘currency manipulator’ if he came to power. As things stood, China’s currency regime was under completely under state control, and therefore lacked the basic tenets required of an international reserve currency. Multiple restrictions on capital accounts in China limited investment options for foreign investors in the country and make it difficult for them to acquire financial assets inside China. As earlier attempts to internationalise the currency were only limited to establishment of off-shore financial markets, currency swap agreements with foreign central banks and the liberalisation of the current account, policymakers reached a juncture where they had to make a crucial sacrifice if they wanted to internationalise the RMB.
China’s currency regime was completely under state control, and therefore lacked the basic tenets required of an international reserve currency. Multiple restrictions on capital accounts in China limited investment options for foreign investors in the country and make it difficult for them to acquire financial assets inside China.
Basic international economics is based on the principles of the Mundell-Fleming model, and provides policymakers the option to choose two out of three: free capital flows, a fixed exchange rate and monetary policy autonomy. This “impossible trinity” made it impossible for China to exert control over both domestic interest rates and the exchange rate of the RMB at a time when their capital account restrictions were getting porous. The PBoC announced a move away from fixing the value of the RMB to let it be decided, “in conjunction with demand and supply condition in the foreign exchange market and exchange rate movement of the major currencies.” This move was in direct contrast to earlier policies of controlling the value of the RMB to support the export oriented trade regime. This did however, give RMB the requisites for inclusion in the SDR, but resulted in a downward pressure on the currency. This led the PBoC to further reform the currency regime with the introduction of ‘counter-cyclical adjustment factor’ and tighten capital controls to address capital flight, as raising interest rates was considered too risky a move.
As mentioned, another reason for China’s proclivity to expedite the internationalisation process was the concern among Chinese policymakers over their dependence on US monetary policy. The centrality of the USD gives the US the ability to run skyrocketing trade deficitswithout any disciplinary constraints, as it can finance the difference through open market operations. The USD and T-bills are readily lapped by international investors, as they consider it to be the safest form of investment. As the 2007 financial crisis demonstrated, after multiple rounds of quantitative easing by the US Federal Reserve, capital flowed into US as investors sought protection from market volatility. The foreign exchange reserves of almost every country is denominated via the greenback. Consequently, these banks must also engage in open market operations to keep their currency values stable if the Federal Reserve changes its interest rates, effectuating a global dependence on US monetary policy. In this respect, China has accrued 3.08 trillion USD of central bank reserves, from balancing its massive trade surpluses in the current account. This phenomenon also labelled the ‘dollar trap’, forces China to accumulate or lose reserves to adjust the money supply of the RMB to match supply and demand in the market in which the RMB and USD are exchanged. The move to internationalise the RMB and denote its foreign exchange reserves in SDR, thus fulfills the desire of Beijing to move away from their dependence on the USD. American scholars like Krugman have seen Zhou’s article calling for a super-sovereign reserve currency to replace the dollar as a plea that someone rescue China from the consequences of its own investment mistakes.
Most importantly, a widely circulated RMB helps China achieve independence in its pursuit of economic statecraft. Policymakers in Beijing eventually want development banks backed by them to issue financial assets in local currency to international partners. The establishment of new multilateral financial institutions — the AIIB and the NDB, serve to project Beijing’s growing economic clout. As The Economist posited back in 2014, “China will use the new bank to expand its influence at the expense of America and Japan, Asia’s established powers. China’s decision to fund a new multilateral bank rather than give more to existing ones reflects its exasperation with the glacial pace of global economic governance reform.” These institutions carry with them the support of many western nations, and can be used to issue financial assets that will then provide the biggest avenue of RMB circulation in the international market. The success of dim sum bonds over the past decade is a testament to the growing demand for the currency.
A widely circulated RMB helps China achieve independence in its pursuit of economic statecraft. Policymakers in Beijing eventually want development banks backed by them to issue financial assets in local currency to international partners.
The final stroke in Beijing’s grand plans for its currency is the Belt and Road Initiative, through which it’s sponsoring some 900 projects in 65 different countries. The China Development Bank has already earmarked 890 billion USD for this purpose. The economic strategy to spread the use of the RMB to the developing world through development assistance programmes and trade settlements will further enhance the role of the Chinese currency, subsequently raising China’s profile in the rest of the world. Then Beijing can efficiently deploy a range of economic instruments to further its foreign policy agenda. These instruments can be anything from limiting investments to imposing trade restrictions, freezing financial assets, or shifting foreign currency holdings. These further leads to enshrinement of Chinese influence in the domestic policies of these countries. The goal to global power seems less rocky when backed by the economic goodwill emanating from a strong, stable and widely used currency. The BRI also ensures the establishment of a Chinese led infrastructure network that will serve neighboring regions for a long time to come. Xi Jinping’s speech at the World Economic Forum made the world notice that the consequence of a protectionist US was the ascendance of China as the advocate of global trade. As the conversation in the US shifts to trader barriers, the trend in China is free-trade agreements. This paradox of political ideologies in sync with economic considerations has created an air of uncertainty that the Chinese are savoring. They will do their best to take advantage of this vacuum in global economic leadership to further their interests.
So far, China’s economic statecraft has been executed with remarkable proficiency. However, there are multiple roadblocks to the RMB’s acceptance as a global reserve currency leaving Beijing with limited avenues. China is yet to achieve the ‘indispensable’ status in global economics like the US, and has weaker financial fundamentals when compared to the current hegemon. The restrictions and controls on China’s economy means that it is unable to offer the liquidity required of a colossal financial system that transacts 5.1 trillion USD every day. The contentious nature with which it has operated controls on capital and fixed its exchange rate mechanism do not provide stability to the system. In a system that is tied to the idea of a free and open global economy, Beijing’s multiple territorial disputes, authoritarian regime and lack of government transparency pales in comparison to the American system of meritocracy and liberal democracy. Moreover, economic ties with Beijing has not always resulted in the best outcome for some countries. The terms and conditions associated with the BRI, and the lack of sustainable investment standards, cast doubt on a future global economy that revolves around China.
The day is not far off, when an alternative currency will be used for global transactions of oil and gold. The idea of a super sovereign currency is novel, whether it be IMF’s SDR or a new crypto-currency of the Information Age, as these currencies gain more traction, the world’s dependency on the dollar will decrease. Yet, as things stand, the USD is world’s negotiated currency, and if countries can acquire it in near-unlimited amounts, and the US can bear the brunt of an ever-widening fiscal deficit, the crown as heavy as it may seem, will firmly be with the United States.
The views expressed above belong to the author(s).