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Will the Chinese renminbi replace the US dollar?
1 INTRODUCTION
This article makes three related points. First, for China to upend the dominance of the US dollar and replace it, even partially, with the renminbi would require major – and probably disruptive – changes in China’s financial markets and monetary policies. These would include Beijing giving up control of China’s current and capital accounts, abandoning the moral hazard that underpins the Chinese growth model, and accepting a governance system in which the decisions of a wide range of authorities would be subject to a transparent and predictable legal process. While Beijing and the People’s Bank of China (PBoC) often say they would like to see rising global use of the renminbi, they have also made clear that they are not willing to take any of these steps except in very limited and constrained ways.
Second, the end of US-dollar dominance would come about only after specific actions were taken by US policymakers to limit the ability of foreigners to use US financial markets as the absorber of last resort of global savings imbalances. It would require, in other words, a decision by Washington to undermine US-dollar dominance. That’s because the world doesn’t use the dollar because of American political pressure. The world uses the dollar because of the depth and flexibility of American financial markets, their superior governance, and, above all, the willingness and ability of the US to accommodate and absorb the savings imbalances of the rest of the world, or, which is the same thing, its willingness and ability to run large trade deficits. Unless Washington were to intervene to limit these conditions, the rest of the world would be extremely unlikely to want to give up these benefits.
This leads directly to the third point. The US economy and financial system absorbs nearly half of the world’s savings imbalances (with much of the rest absorbed by the other major Anglophone economies, for many of the same reasons). A global economy without the US dollar as the dominant currency would also likely be one without large, persistent trade and savings imbalances. This would force substantial and potentially disruptive structural changes on economies whose growth depends partly on their ability to externalize the costs associated with their international ‘competitiveness,’ which in turn depends on distortions in the distribution of income between households and businesses.
It is not just a coincidence that in economies that run large, persistent trade surpluses, whether high-income (Germany, Japan, the Netherlands, South Korea) or low-income (China, Malaysia, Vietnam), direct and indirect wages are lower relative to productivity than among their trading partners. This is because the various subsidies to manufacturing that underlie their international competitiveness must be paid for by the household sector, whether in the form of low wages, weak social safety nets, financial repression, depreciated currencies, environmental degradation, or some combination of these. Eliminating US trade deficits would require changes – with all the associated political implications – in the way income is distributed in these countries.
The irony is that the main beneficiary of the end of US-dollar dominance would be the US, and among the main losers China, along with other countries with large, persistent trade surpluses. In fact, more generally a world without US-dollar dominance would probably spell the end of the success of the Asian development model, even though it would be positive for the global economy overall.1 This is because it would spell the end of a global trading system in which countries compete internationally mainly by directly or indirectly reducing the share their households retain of domestic GDP, and, with that, reducing their contribution to global consumption. Eliminating the global dominance of the US dollar, in other words, would eliminate a mechanism by which trade competition can systematically depress aggregate global demand.
But with so many major economies locked into structural domestic demand deficiencies, any policy that forces an elimination or sharp reduction of global trade imbalances would in the short term also force deep institutional changes on the global economy. These changes would likely be economically and even politically disruptive for many countries, especially those, like China, whose economies have become structured around persistent trade surpluses and who have tried for many years, with almost no success, to rebalance domestic demand.
2 CAN THE RENMINBI BECOME AN ALTERNATIVE TO THE US DOLLAR?
The dollar is the most widely used currency in international trade not just because of network effects but for reasons that are even harder for other countries to replicate. The world uses the dollar because the United States has the deepest and most flexible financial markets, the clearest and most transparent corporate governance, and (in spite of recent sanctions on countries like Iran and Russia) the lowest amount of discrimination between domestic residents and foreigners.
These qualities attract the savings of foreigners, whether these are rich oligarchs who need to store money abroad, investment funds managing the savings of the wealthy and middle classes, central banks who want liquid, high-quality reserves, or even businesses and banks looking to diversify their operations by acquiring operations abroad. For another currency to compete with the US dollar, its home economy would have to provide similar conditions.
This further implies another, more important reason for the widespread use of the dollar. The global trading system is unbalanced, with several large economies – including those of China, Germany, Japan, Russia, and South Korea – locked into income distributions that reduce domestic consumption and force up savings rates. Weak consumption leads to weak investment from private businesses that depend mainly on local consumers to buy the goods they produce. These together lead to weak domestic demand. Because these economies suffer from deficient domestic demand, they must run large, persistent trade surpluses to absorb the production that drives their economies.
And this is where the US dollar matters. Surplus economies require deficit economies, which also means that surplus economies must acquire foreign assets in exchange for their surpluses. The United States – and to a lesser extent other Anglophone economies with similar markets and governance, like the United Kingdom – play their most important global trade role in providing these assets. The deficits that balance the surpluses of the surplus economies must automatically accrue in those countries in which the surplus economies acquire ownership of assets. It is in the US and the other Anglophone economies that they mostly choose to do so.2
3 CAN CENTRAL BANKS ACQUIRE OTHER ASSETS BESIDES US DOLLARS?
It helps in this context to consider the alternative assets surplus countries can accumulate. In principle, surplus-running economies can accumulate assets in other advanced economies besides the US, but with the exception of the European Union and perhaps Japan, none is big enough to balance more than a small share of the world’s accumulated trade surpluses.
More importantly, Japan and the European Union (EU), along with most advanced, non-Anglophone economies, run persistent surpluses themselves, so they must be net acquirers of assets abroad. If foreigners were to acquire large amounts of assets in either of these two countries, in other words, Japan and the EU would either have to allow the undermining of their powerful export sectors, or they would have to recycle the foreign inflows with even greater outflows and reserve accumulation, with all of the damaging monetary consequences this would imply.
If China, for example, were to accumulate large Japanese yen reserves instead of US dollar reserves, the Bank of Japan would either have to tolerate enough of a rise in the international value of the yen to undermine its export sector and force the country into running deficits, or it would have to accumulate an equal amount of foreign reserves to neutralize the net impact of Chinese inflows. In the latter case, higher Chinese purchases of Japanese reserves would be matched by higher Japanese purchases of foreign-currency reserves, which would almost inevitably mean buying dollars. It would also mean uncontrolled expansion in the domestic Japanese money supply.
That’s why, even as countries like China propose diversifying their reserves away from the USA, the most likely alternatives, the EU and Japan, will likely resist.3Some analysts argue that surplus-running countries can instead invest excess savings in the developing world, and while much of the developing world would welcome small persistent capital inflows, there are limits on their abilities to balance excess global savings. Developing economies currently absorb roughly a quarter to a fifth of global excess savings.4 They would not be able to increase their shares meaningfully without causing significant domestic dislocations to their financial markets, and these, in turn, would make repayment very difficult. In fact, China has in the past several years reduced its already limited exports of capital to developing countries as the risks have become evident (see Horn et al. 2022).
Some analysts have also recently argued that, as a consequence of the sanctions imposed on Russia, the world is likely to see a shift in global reserve accumulation toward commodities (see Pozsar 2022). This, too, is unlikely. Countries like Russia, Iran, and Venezuela are all primarily commodity exporters, and because commodity prices tend to be positively correlated, these countries would have to accumulate reserves most aggressively when prices are high and their surpluses are large, and they would most likely have to monetize their reserves when prices are low and their economies are struggling. Not only would their reserve accumulation thus exacerbate the volatility of commodity prices, which would be damaging for their economies, but, more worryingly, their reserves would be most valuable when they needed them least and least valuable when they needed them most. This is the opposite of what countries want from reserves.
China, of course, is the world’s largest commodity importer, so at first it might seem to be in the opposite position of commodity-exporting countries like Russia, in which case accumulating commodity reserves instead of foreign assets might seem to make a lot of sense for its central bank. However, as the world’s largest importer of commodities by far, especially industrial commodities, it turns out that China’s economic performance is correlated with commodity prices in the same way as that of commodity exporters, only with the direction of causality reversed.
Whereas high commodity prices allow commodity exporters to grow more rapidly, when the Chinese economy is growing rapidly, its commodity consumption is likely to rise sharply, and given its disproportionate role in commodity markets, rising Chinese consumption will drive up the prices of commodities. When the Chinese economy is growing slowly, on the other hand, commodity prices are likely to drop. Commodity acquisition as a reserve strategy would exacerbate economic volatility and leave China, like commodity exporters, with reserves that are most valuable when it least needs them and least valuable when it presumably most needs them.
For many of the countries most determined to escape from the US dollar’s dominance, in other words, investing in commodity reserves is likely to lock them into acquiring assets when prices are high and selling them when prices are low. Only smaller economies that are net importers of commodities are likely to benefit from investing a significant portion of their reserves in commodities, and even these have to worry about the positive correlation between global growth and commodity prices. The value of reserves should be either stable or inversely correlated with the performance of the underlying economy, and most global commodities are unlikely to satisfy this condition.5
4 FOREIGN DOLLAR ACCUMULATION DISTORTS THE US ECONOMY
As long as the global economy tolerates and encourages large, persistent imbalances, it is stuck, at least for now, with recycling a small share of excess global savings to developing countries and the rest to the US and other Anglophone economies.6 And because of their open capital accounts and status as safe-haven investment destinations, the US and other Anglophone economies are stuck with persistent capital-account surpluses and the accommodating trade and current-account deficits, and must pay for the deficits with the export of ownership of domestic assets. They are the only stable, mature economies that are both willing and able to allow foreigners unfettered access to the acquisition of local assets or, which is the same thing, the only major economies willing and able to run the permanent trade deficits that accommodate the needs of foreign-surplus-running countries to acquire foreign assets.
This suggests something that many economists may find counter-intuitive. They assume that the US imports foreign capital because it needs foreign savings to bridge the gap between its own domestic savings and domestic investment, but this has the causality backwards. For years American businesses have had access to enormous amounts of cheap liquidity, with little desire to convert their easy access to global savings into productive investment. The investment constraint for American businesses does not seem to be scarce, expensive savings but rather weak expected demand, as I will explain later in this article.
This matters a great deal. For economies whose domestic investment needs are not constrained by scarce savings and the high cost of capital, there is a cost to exporting ownership of domestic assets. This cost, as I will discuss below, effectively requires that the deficit economies must either allow unemployment to rise as net imports undermine local manufacturers, or, which is far more likely, they must create assets by encouraging a rise in household debt or in the fiscal deficit to counteract the domestic impact of their persistent deficits.
Before explaining the consequences, a brief digression. Some analysts have suggested that the issuer of a major reserve currency does not need to run persistent deficits, and in support they point to the current-account surpluses that the UK ran for much of the period when sterling was the world’s leading currency (see, for example, Jones 2022). But, aside from the fact that a major currency under the gold standard exists under completely different circumstances than does the US dollar today (its main virtue being the credibility of its commitment to gold), the world didn’t need sterling to be used to absorb excess savings at the time.
On the contrary, because investment in most countries at the time was constrained by scarce domestic savings, during much of the nineteenth century developing economies like the US, Canada, and Australia needed foreign savings to boost domestic investment. Rather than import savings, they wanted other economies to export them, which the UK duly did. In fact, the United States too was a net exporter of savings (it ran persistent surpluses) in the five decades ending in the 1970s, during a time when the world was rebuilding itself from two world wars and urgently needed to import savings.
The relevant point is not that the issuer of the global currency must run permanent deficits, but rather that it must run surpluses when the world wants to import scarce savings and must run deficits when the world wants to export excess savings. This is what it means to say that the issuer of the global currency must effectively give up control of its capital account to balance whatever the rest of the world requires.
5 WILL CHINA ABANDON CAPITAL CONTROLS?
Because the widespread global use of a currency is determined by the benefits that global households, businesses, and governments can obtain from the use of that currency, for the renminbi to replace the US dollar, a number of conditions have to be met that accommodate the needs of the global economy. The first and most obvious is that China would have to give up control of its capital account, allowing foreigners unfettered entry or exit into the Chinese financial markets as their own domestic needs dictated.
For example the Chinese financial system would have to accommodate a substantial reduction in net capital inflows during times of global confidence and growth, as capital flows into risky foreign ventures and economies. It would have to accommodate a substantial increase in net capital inflows during times of global economic or political uncertainty, when capital is looking for a safe haven.
What is more, whether or not the investment needs of Chinese businesses matched the change in inflows would be irrelevant. With an open capital account, the inflows would be driven by foreign considerations, not domestic; and without one, renminbi assets could not fulfill one of the fundamental roles of a dominant global currency, which is to allow non-residents to store excess savings as a form of insurance that is freely available to the investor in times of need.
But unfettered entry and exit of foreign capital requires that China’s financial system accommodate these flows – which means absorbing the consequent currency volatility, the changes in interest rates, and the domestic money supply, or all three – regardless of whether or not Beijing’s financial and monetary authorities approve of these changes. This is just a restatement of the impossible trinity, also called the Mundell–Fleming model, which posits that if an economy allows the free inflow and outflow of capital, it cannot simultaneously maintain a fixed exchange rate and independent monetary policy (Mundell 1963).
Can China accommodate the unfettered entry and exit of foreign capital in the same way as the US does? Almost certainly not, and this has to do with the very different structures of their respective economies and financial systems. There are at least three important such differences. First, the export and tradable goods sectors represent a greater share of the Chinese economy than they do of the American economy. According to the World Bank, exports comprise 19 percent of the Chinese economy, versus 10 percent of the US. This means, among other things, that the Chinese economy is more vulnerable to currency volatility than is the US economy. A period of rapid strengthening of the renminbi would consequently be more damaging to the Chinese economy than an equivalent strengthening of the US dollar would be to the US economy, especially given that Chinese growth is dependent on its trade imbalance in a way in which the US isn’t.
If the PBoC wanted to control currency volatility, it could only do so while giving up control of domestic monetary policy, and the greater the extent and volatility of capital inflows, the harder it would be for Beijing to manage domestic monetary conditions.7 That’s where we see the second major difference between the two economies. The Chinese financial system is dominated by commercial banks, unlike in the US and the other Anglophone economies where stock and bond markets play a much larger role in financing businesses, households, and governments. More importantly, Chinese financial and monetary authorities exercise control of the banks administratively – similar to Japan’s ‘window guidance’ in the 1980s – and not through traditional monetary policy.
The result is that China has a more rigid financial sector than the US, with bank credit serving policy objectives directly, and credit allocation determined from the top. An administrative system of this nature also requires that the financial system be underpinned by widespread moral hazard. None of this is consistent with the flexibility needed to accommodate large and unplanned changes in net capital inflows. An administratively controlled banking system is one that cannot simply expand and contract according to external conditions.
Finally, and this is perhaps the least appreciated of the major differences, Chinese households retain the lowest share of their country’s GDP of any major economy in history. This is the reason that the consumption share of China’s GDP is also among the lowest in history, and, what is the same thing, the savings share is the highest.8 It is the low household share of GDP that locks countries like China into structural trade surpluses and, as I will explain later in this article, it is difficult for such countries to reverse the high savings rates that drive their trade surpluses.
6 BEIJING IS NOT MOVING IN THE RIGHT DIRECTION
What may surprise observers is that, for all their talk of a rising global role for the renminbi, it is clear that the PBoC understands the risks associated with an open capital account and has done the necessary to protect the domestic Chinese economy from potential consequences. In spite of nearly two decades of claiming to want to boost the renminbi’s international role, the PBoC and China’s State Council have never been willing to allow unfettered inflows or outflows. This is mainly because these might disrupt domestic financial markets and undermine the ability of regulators to control the financial system administratively.
This has been especially true in recent years, as China’s financial system has become increasingly fragile, its debt burden has soared, and the banking system’s dependence on moral hazard to maintain stability has increased. In fact it is worth noting that during much of 2021 and early 2022, as China saw an acceleration of foreign financial inflows – albeit to levels in which the share of domestic bonds and equity owned by foreigners was still a fraction of what is typical for other large developing economies – the central bank several times expressed its concern about the risks these foreign inflows posed to the financial system (see, for example, Horta e Costa and Curran 2021; Tang 2021). PBoC officials warned repeatedly against the risks associated with a sharp rise in foreign inflows and outflows – an inexorable consequence of greater capital-account openness and wider global use of the renminbi.
What is more, as the Beijing monetary authorities also recognize, it’s not just the capital account that matters. Giving up control of the country’s capital account also effectively means giving up control of the country’s trade account. As I discussed earlier, for the renminbi to become a major global currency, China, like the United States, would have to accommodate the desire of other countries to run trade surpluses and to balance these with the acquisition of renminbi assets. The Chinese financial system would have to absorb an increasing share of the rest of the world’s excess savings as these countries acquire Chinese assets in exchange for their trade surpluses.
But China’s trade surplus is structural, and based on a highly unbalanced distribution of income between households and local governments. For its economy to shift towards deficits requires very substantial changes in the structure of the domestic economy, and this in turn would require, as I explain later in this article, either a surge in unemployment, rising household debt, an increase in (unwanted) infrastructure and property investment, or a major – and politically difficult – redistribution of wealth.
Aside from giving up control of its capital account and its trade account, there is at least one other major change Beijing would have to make before the renminbi could become a major global currency. For the renminbi assets to be widely held and traded by foreign investors and central banks, Beijing would have to implement significant governance reforms.
In order to encourage foreigners to acquire Chinese assets, in other words, either to pay for their trade surpluses or as financial insurance, Beijing would have to allow foreign investors access to a wide variety of domestic assets, foreigners would have to be able easily to accumulate or liquidate these assets in a transparent and rules-based process, and there would have to be minimum discrimination between assets held by Chinese residents and assets held by foreigners. Among other things, this would require an independent judiciary and a transparent legal system that takes precedence over all other agents, including local and central-government entities.
To date China has not moved to fulfill any of the required conditions listed above: an open capital account and the associated financial reforms, an open trade account and the elimination of structural surpluses, and a radical reform in governance. There is, furthermore, little evidence that Beijing even wants to move in any of these directions, especially as the economy slows and the country’s debt burden becomes increasingly hard to manage.
7 WILL THE UNITED STATES FORCE OTHERS TO STOP USING THE DOLLAR?
Much of the discussion about whether or not the US dollar can maintain its global dominance assumes as a matter of course that it is non-Americans who want to constrain the global use of the dollar, and it is Americans who will fiercely resist this process. This only indicates how confused much of this discussion has been. As Matthew Klein and I discussed in our 2020 book, the structure of international trade and capital flows does not pit the interests of nation against nation so much as it pits the interests of certain economic sectors against other economic sectors (Klein and Pettis 2020).
Among other things, this means that it is not the United States as a whole that benefits from the global dominance of the US dollar but rather certain constituencies within the United States (and similar constituencies in the rest of the world), in contrast to other constituencies in the US that pay the price for the dominance of the US dollar. The beneficiaries of US-dollar dominance include two major, and politically powerful, groups: Wall Street and the Washington foreign affairs and defense establishments. Other beneficiaries are global banks linked to the dollar system, large global businesses, and wealthy owners of movable capital, both American and non-American.
By contrast, it is American workers, farmers, producers, and small businesses that pay what amounts to a significant economic cost, along with workers in the rest of the world. The reason is because as long as other countries can easily accumulate US assets to balance their structural trade surpluses, the US must be a net importer of foreign savings – that is, it must have a capital-account surplus – whether or not it needs foreign savings for its own domestic investment.
If the US runs a capital-account surplus, however, this necessarily creates a gap between domestic investment and domestic savings – which is just another name for a current-account deficit. This has at least one obvious, but little noticed, implication. As long as the US maintains an open capital account and does not control the net inflow of capital, by definition it cannot control the gap between investment and savings. This means that either investment levels or savings levels are at least partly determined by external conditions that drive net capital inflows.
So which is it? It turns out that the answer depends on the underlying conditions at the time. When the US was a developing nation whose high investment needs were constrained by low domestic savings, as it was during much of the nineteenth century, the country’s capital-account surplus was balanced by higher investment. In that case, the US economy benefitted from trade deficits and the associated capital inflows because these led to or accommodated higher investment and, consequently, higher growth.
In the past several decades, however, in a world of weak demand and excess savings, there has been no savings constraint on US investment. In fact, for years US companies have sat on enormous cash hoards for which they have found few productive investment opportunities at home. Much of these cash hoards have been used to pay dividends, buy back stocks, and acquire other companies, but not to increase investment in domestic production facilities.
In that case, increasing the amount of savings available to US businesses – by increasing the amount of savings foreigners export to the US – will not cause an increase in the amount of American business investment. But whether or not net capital inflows cause investment to increase, they nonetheless require domestic investment to exceed domestic savings, and so if they do not cause investment to rise, they must cause savings to fall.
This is perhaps the implication of US-dollar supremacy that is least understood by most economists, who tend automatically to assume that US savings are an independent variable that affect, but aren’t affected by, the current-account deficit. As Klein and I show, however, foreign inflows can force down US savings in a number of ways, the net result of which is either higher unemployment, higher household debt, or higher fiscal deficits.
What is more, there is evidence that surplus-running countries benefit from their net absorption of foreign demand with a rising share of global manufacturing and the accumulation of foreign assets (Atkinson et al. 2012). This rising share comes at the expense of the declining share of global manufacturing retained by deficit-running countries like the United States.
This is why the global dominance of the US dollar imposes an exorbitant burden on the US economy, rather than the exorbitant privilege of French nightmares. It forces the US to balance net capital inflows either with higher unemployment or – more likely – with higher household debt and/or higher fiscal deficits; it reduces the US share of global manufacturing; and it puts downward pressure on wages if US-based manufacturers are to remain competitive.
8 WILL WASHINGTON IMPLEMENT CAPITAL CONTROLS?
As global trade imbalances rise and the American share of global GDP declines, the United States will eventually have to reject this exorbitant burden. For all the geopolitical power that control of the global currency system confers on Washington and Wall Street, it comes at a substantial economic cost to American producers, workers, farmers, and businesses, and as the rest of the world grows relative to the United States, this cost can only rise.
If the United States at some point refuses to run the permanently rising deficits that are needed to accommodate weak demand and excess savings in the rest of the world, in what form might that ‘refusal’ take? Tariffs and other forms of direct trade intervention cannot work because they are largely ineffective in shifting the global savings imbalances that drive the US trade deficit. The Trump administration’s tariffs on Chinese goods, for example, may have shifted bilateral trade, but they did not reduce China’s overall surplus, which is a function of its domestic savings imbalance, and they did not reduce the overall American deficit, which is a function of the US role in absorbing excess savings in the rest of the world.
This suggests that the only way for the United States to be relieved of trade deficits is for measures that interrupt the unfettered global flow of international capital into the US financial system. There are basically three ways in which this is most likely to happen. One way would be for the current system to be maintained until the United States is no longer able to carry the economic burden. In that case, amid a collapse in the credibility of the US dollar, the world would abandon the currency. This would force the United States and other economies to adjust in chaotic and disorderly ways.
A second way would be for the United States unilaterally to opt out of the current system by constraining foreigners’ ability to dump excess savings into the US economy. One means of doing this would be to tax all financial inflows that do not lead directly to productive investment in the US economy. There have already been such proposals in the US Congress, and while as of yet they have been rejected, there are likely to be many more (Baldwin 2019).
This would of course entail a substantial reduction in US financial power abroad and in the power of Wall Street, and it would be painful and in some cases even destabilizing for countries – such as China, Germany, Japan, Russia, and Saudi Arabia – that would likely prove unable to resolve domestic demand and savings imbalances quickly enough. It would, however, boost US manufacturing, raise domestic wages, and force US businesses once again to rely on raising productivity rather than lowering wages to achieve international competitiveness.
A third and final way would be for the United States and the world’s other major economies to organize a new global trade and capital regime, based perhaps on ideas similar to those originally proposed by John Maynard Keynes at Bretton Woods, which, among other things, relied on a global synthetic currency (which he called the bancor) designed to absorb temporary global imbalances and spread out their consequences across the major economies. Washington and its allies could do this by negotiating a new set of trade agreements that would force members to resolve their domestic demand imbalances at home, rather than force their trade partners to absorb them. By requiring countries with temporary surpluses to exchange these surpluses for bonds denominated in the new synthetic currency, it would also spread more widely the adverse consequences of those surpluses.
While either of the last two options would ultimately benefit the US economy, the second of the two would be the least disruptive for the global economy and the one most likely to allow the United States and its allies to continue maintaining some degree of control over global trade and capital flows. But one way or another, Washington should take the lead in steering the global trade and capital regime away from its excessive reliance on the US dollar. For all the excited discussions about foreign antagonists forcing the US dollar to lose its global dominance, this will never happen because no other country is willing to take on the exorbitant burden that the US dollar places on the US economy. Washington itself must end the age of the US dollar’s dominance for the benefit of the American economy.
9 HOW WOULD CHINA BE AFFECTED BY A REDUCED ROLE FOR THE DOLLAR?
If the United States – and presumably the other Anglophone economies – were to take steps that eliminated the role of their domestic financial markets as the net absorbers of foreign savings, by definition they would also no longer run large and persistent current-account and trade deficits. But because these countries account for 75–85 percent of the world’s current-account deficits (with the developing world accounting for most of the rest), this would also mean that, unless some other large economy were willing to convert its surpluses into massive deficits, the world would have to reduce its collective trade surpluses by 75–85 percent.9
For countries that are structurally reliant on trade surpluses, this could be extremely painful. To understand the implications, assume a country that runs persistent trade surpluses, like China, is forced to adapt to a world of much lower trade deficits, and hence of much lower trade surpluses. Domestic savings exceed domestic investment in countries that run persistent surpluses, and domestic savings are high in these countries mainly because ordinary households, who consume most of their income, receive a very low share of the GDP they produce – compared to the shares of businesses, the government, and the very rich.
The problem is that if some external event were to force a sharp contraction in the country’s trade and current-account surpluses, like constraints on its ability to acquire US assets to balance its surpluses, and if it were not able to acquire an equivalent amount of assets in some other country, by definition the gap between its savings and its investments would shrink. There are broadly speaking five ways (or some combination thereof) by which an economy locked into structural trade surpluses can adjust to bring savings and investment back in line.
The first way is a surge in unemployment. Without an appropriate policy response the collapse in its trade surplus would most likely come about through a collapse in exports, and this would cause manufacturing unemployment to surge. Unemployed workers, of course, have negative savings, and a surge in unemployment would be one means, albeit an extremely painful means, of closing the gap between savings and investment. If a brutal enough export shock also caused domestic business investment to contract, as is likely, the rise in unemployment would have to be much greater since the decline in savings would have to accelerate to catch up to a decline in investment. This downward spiral is what happened in the US in the early 1930s, and this is obviously something Beijing would want very much to avoid.
The second way is a boost in consumer lending to spur domestic demand. China’s savings would also decline, but much less disruptively, if the central bank, in response to a collapse in exports, quickly forced banks to increase consumer lending dramatically so as to replace foreign demand with domestic demand. Even if it were possible to do this efficiently, rising household debt would eventually be unsustainable. Consumer debt in China has already risen very rapidly in recent years, and as a share of household income it already exceeds that of the US and most other major economies. Not surprisingly Beijing has recently been trying to implement policies to bring household debt levels down.
The third way is a jump in government deficit spending to spur demand. Savings would decline if Beijing, in response to a collapse in exports, quickly expanded the fiscal deficit so as to replace foreign demand with domestic demand. Higher fiscal spending, for example, could be aimed at boosting indirect consumption. With a trade surplus of currently around 5 percent of GDP and growing, this would require a substantial increase every year in the fiscal deficit. Again, even if it were possible to do this efficiently and productively, rising fiscal deficits would eventually be unsustainable, especially given China’s already dangerously high debt levels.
The fourth way is a surge in government and state-owned-enterprise investment. The most obvious form in which Beijing could engineer a sufficiently rapid expansion in fiscal spending – as it did, for example, in 2009–2010 – is with a massive increase in investment. The private sector is unlikely to respond to a collapse in exports by increasing investment, and indeed private firms would probably reduce investment, which means that more than 100 percent of the increase in investment would have to occur in the form of government and government-backed expansion. Normally Beijing would rely on a rapid expansion in property development and in infrastructure spending to balance any sharp contraction in the trade surplus, but as we saw with the clamping-down on the property sector in 2021, there is a growing sense that much if not most property development and infrastructure spending has become non-productive and leads only to a surge in the country’s debt burden. Large and sustained increases in infrastructure investment from levels that are already too high, in other words, are unsustainable and would only worsen the overall adjustment cost, albeit by spreading it out over a longer period.
The fifth way is income redistribution. China’s savings would decline in a healthy manner if the government were able to engineer a substantial redistribution of income from governments, who consume a very small share of their income, to ordinary households, who consume most of it. This would be sustainable and by far the best long-term outcome for both China and the world, but any substantial redistribution of income would be a slow and difficult process, and it would almost certainly be politically disruptive. China has been trying to engineer an increase in the household income and consumption shares of GDP since at least 2007, with very little success (IMF 2007).
The point is that there are only a limited number of ways in which a country that runs large, persistent surpluses, like China, can adjust to a global contraction in aggregate trade deficits. All of these adjustments except the last one – a major redistribution of domestic income – are unsustainable and can only be temporary. But this last is an extremely difficult adjustment that no country has been able to make successfully except over the very long term, perhaps because it implies politically disruptive changes in a number of domestic institutions.
This just reinforces how it is the willingness and ability of the United States to run large, persistent deficits that underpins the role of the US dollar as the world’s dominant currency, and how these deficits benefit, directly or indirectly, the countries that claim to be most eager to dethrone the US dollar. Ironically these are also the countries – especially China – whose domestic economic policies make this all but impossible.
10 WHAT NEXT?
The world is stuck with the US dollar, not because it creates an exorbitant privilege for the US economy over which Washington will fight. It uses the dollar because this allows many of the world’s largest economies to use a portion of American demand to resolve deficient domestic demand and fuel domestic growth, for which the US economy must then make up by increasing its household or fiscal debt.
These economies, in other words, can increase their international competitiveness by lowering the relative share households retain of what they produce, and can then run the large surpluses needed to balance their domestic demand deficiencies while keeping growth high. This is the form of beggar-thy-neighbor trade policy that Keynes most urgently warned against. Global dollar dominance accommodates this process by allowing surplus countries to exchange excess production for ownership of real assets – American real estate, factories, stocks, bonds, farmland, mines, and real businesses – that other countries would be unwilling (and largely unable) to give up.
The point is that while the US dollar may create an exorbitant privilege for certain American constituencies, this status creates an exorbitant burden for the US economy overall, especially for the vast majority of Americans who must pay for the corresponding trade deficits either with higher unemployment, more household debt, or greater fiscal deficits. This is also why the end of the US dollar’s dominance has little to do with the political desires of countries like Russia, China, Venezuela, and Iran, and everything to do with the political decisions of Americans.
Once Washington understands the cost of this exorbitant privilege – although this may unfortunately take many more years – US leaders will take steps, either unilaterally or collectively, that force the world off its dependence on the US dollar. But that will have an enormous side effect. It will force the rest of the world, and especially countries like China with low domestic demand and structural surpluses, into a very difficult adjustment as global imbalances shrink sharply. Without the widespread use of the US dollar as the mechanism that allows global imbalances to be absorbed by the US economy, these imbalances cannot exist.
1 In the two to three decades after 1945, in a world of capital controls and limited trade imbalances, capital-importing Latin American economies were generally considered to be the most successful developing economies, and the ones most likely to converge to Western levels of income, while the East Asian economies struggled to achieve growth. By the 1970s and 1980s, the tables had turned completely and it was the high-savings capital-exporting East Asian economies that had vastly outperformed, while Latin America became bogged down in surging debt and unsustainable trade deficits. While the possible reasons for this are beyond the scope of this essay, it may have to do with important monetary and financial shifts in the 1970s and 1980s that saw huge increases in global trade imbalances and in the global export and import of capital.
2 See Klein and Pettis (2020). For this reason, the US has no control at all over its capital account. This lack of control explains a phenomenon that many economists find puzzling. If foreign capital is ‘pulled’ into the US economy for domestic reasons, as many assume, the size of the US trade or current-account deficits should be positively correlated with US interest rates. The fact that they are either uncorrelated or, in certain periods, negatively correlated suggests that foreign capital isn’t pulled into the US to respond to the needs of domestic American users of capital. Instead, it is ‘pushed’ into the US in response to the needs of foreign savers. But whether it is pulled or pushed, it must be balanced by a trade deficit.
3 In the past few years, the Chinese press has made a great deal of noise about reductions in the portion of PBoC reserves held in US dollars, but there is much less here than meets the eye. First, the recorded decline is less than a few percentage points. Second, and more importantly, since 2017 the PBoC has largely stopped intervening in the currency. Instead, state-owned banks have acquired roughly $1 trillion in net foreign-exchange (FX) purchases on behalf of the PBoC. Without a breakdown in the composition of these ‘hidden’ reserves, we have no idea whether or not the PBoC has reduced or actually increased its direct and indirect exposure to US-dollar reserves but, given large surpluses in recent years and rising net financial inflows, it is almost certainly the case that its total exposure has increased.
4 Benn Steil and Benjamin Della Rocca, Global Imbalances Tracker, Greenberg Center for Geoeconomic Studies, Council on Foreign Relations.
5 The US dollar of course behaves in the opposite way. Its value tends to rise when global conditions are at their most unsettled, as we saw in the first half of 2022.
6 Benn Steil and Benjamin Della Rocca, ibid. footnote 4.
7 As the PBoC buys (sells) foreign currency to manage the foreign-currency value on the renminbi, it would have to create (destroy) renminbi, or money equivalents, whether or not domestic monetary management called for an expansion or contraction of the money supply.
8 Because most consumption is household consumption (businesses don’t consume any of their profits and governments consume a very low share of their revenues), the lower the household share of GDP, the lower the consumption share tends to be, and, by definition, the higher the savings share. It is not just coincidence that in high-savings countries like China, Germany, and Japan, households retain a lower share of GDP than among their trading partners.
9 Benn Steil and Benjamin Della Rocca, ibid. footnote 4.
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