The Demise of Dollar Diplomacy?
Pundits have been saying last rites for the dollar’s global dominance since the 1960s – that is, for more than half a century now. But the pundits may finally be right, because the greenback's dominance has been sustained by geopolitical alliances that are now fraying badly.
WASHINGTON, DC – Mark Twain never actually said “Reports of my death have been greatly exaggerated.” But the misquote is too delicious to die a natural death of its own. And nowhere is the idea behind it more relevant than in discussions of the dollar’s international role.
Pundits have been saying last rites for the dollar’s global dominance since the 1960s – that is, for more than a half-century now. The point can be shown by occurrences of the phrase “demise of the dollar” in all English-language publications catalogued by Google.
The frequency of such mentions, adjusted for the number of printed pages per year, first jumped in 1969, following the collapse of the London Gold Pool, an arrangement in which eight central banks cooperated to support the dollar’s peg to gold. Use of the phrase soared in the 1970s, following the collapse of the Bretton Woods system, of which the dollar was the linchpin, and in response to the high inflation that accompanied the presidencies of Richard Nixon, Gerald Ford, and Jimmy Carter in the 1970s.
But even that spike was dwarfed by the increase in mentions and corresponding worries about the dollar starting in 2001, reflecting the shock of the terrorist attacks that September, the mushrooming growth of the US trade deficit, and then the global financial crisis of 2008.
Yet through all of this, the dollar’s international role has endured. As my coauthors and I show in a new book, the share of dollars in the foreign-currency reserves held by central banks and governments worldwide hardly budged in the face of these events. The greenback remains the dominant currency traded in foreign-exchange markets. It is still the unit in which petroleum is priced and traded worldwide, Venezuelan leaders’ complaints about the “tyranny of the dollar” notwithstanding.
To the consternation of many currency traders, the value of the dollar fluctuates widely, as its rise, fall, and recovery in the course of the last year have shown. But this does little to erode the attractiveness of the dollar in international markets.
Central banks still hold US Treasury bonds because the market for them is the single most liquid financial market in the world. And Treasury bonds are secure: the federal government has not fallen into arrears on its debt since the disastrous War of 1812.
In addition, US diplomatic and military links encourage America’s allies to hold dollars. States with their own nuclear weapons hold fewer dollars than countries that depend on the US for their security needs. Being in a military alliance with a reserve-currency-issuing country boosts the share of the partner’s foreign-exchange reserves held in that currency by roughly 30 percentage points. The evidence thus suggests that the share of reserves held in dollars would fall appreciably in the absence of this effect.
This under-appreciated link between geopolitical alliances and international currency choice reflects a combination of factors. Governments have reason to be confident that the reserve-currency country will make servicing debt held by its allies a high priority. In return, those allies, by holding its liabilities, can help to lower the issuer’s borrowing costs.
Here, then, and not in another imbroglio over the federal debt ceiling this coming December, is where the real threat to the dollar’s international dominance lies. As one anonymous US State Department official put it, President Donald Trump “does not seem to care about alliances and therefore does not care about diplomacy.”
South Korea and Japan are thought to hold about 80% of their international reserves in dollars. One can imagine that the financial behavior of these and other countries would change dramatically, with adverse implications for the dollar’s exchange rate and US borrowing costs, were America’s close military alliances with its allies to fray.
Nor is it hard to imagine how this fraying could come about. President Donald Trump has painted himself into a strategic corner: he needs a concession from North Korea on the nuclear-weapons issue in order to save face with his base, not to mention with the global community. And, for all of Trump’s aggressive rhetoric and posturing, the only feasible way to secure such a concession is through negotiation. Ironically, the most plausible outcome of that process is an inspections regime not unlike the one negotiated by Barack Obama’s administration with Iran.
To get there, Trump’s administration will have to offer something in return. The most obvious bargaining chip that could be offered to make the North Korean regime feel more secure is a reduction in US troop levels on the Korean Peninsula and in Asia in general, With that, the US security guarantee for Asia will weaken, in turn providing China an opportunity to step into the geopolitical breach.
And where China leads geopolitically, its currency, the renminbi, is likely to follow.
Why the Renminbi Won’t Rule
As the US retreats from the world stage and a multipolar global order emerges, the international monetary system may well be transformed – but probably not into a renminbi-led system. Indeed, not even China expects the age of renminbi diplomacy to arrive anytime soon.
TOKYO – In the dystopian fantasy Blade Runner 2049, Los Angeles 32 years from now looks a lot like China’s megacities today: grey, polluted, and dominated by tall towers emblazoned with flashing neon advertisements. The viewer never learns much about the outside world, much less in what currency the advertised goods are traded. Is the US dollar still dominant, has the Chinese renminbi taken over, or has some other currency surged to global preeminence?
US President Donald Trump seems intent on ensuring that America retreats, at least partly, from its global leadership role. But, as was the case with the British pound in the interwar period, a currency can remain globally dominant even after its issuing country loses its economic, financial, and geopolitical hegemony. Today, too, the world should expect the US dollar to remain the key reserve currency, used to invoice and settle international trade, for a long time to come.
But, in terms of international financial diplomacy, the dollar’s position may not be as secure. The question is whether the end of “dollar diplomacy,” which the economist Barry Eichengreen predicts, will necessarily mean the rise of renminbi diplomacy.
Chinese policymakers have been hoping to develop the renminbi’s role in international finance, in order to strengthen China’s geopolitical standing, since the 1990s. And, in recent years, the Chinese leadership has led a concerted effort to fulfill that ambition, especially by internationalizing China’s currency.
Yet renminbi-denominated finance is nowhere near ready to compete with – let alone rival – dollar finance. In fact, the renminbi still trails other reserve currencies (the US dollar, the euro, the Japanese yen, and the British pound) in international finance by so much that a renminbi-led international monetary system by mid-century seems about as likely as a Blade Runner 2049-style dystopia.
One reason for the renminbi’s continued weakness in international finance is that, despite considerable progress since 2010, it remains a half-baked international currency. The renminbi is illiquid and unconvertible outside designated offshore markets. As a result, its weight in international investors’ portfolios is miniscule.
Even China itself uses the renminbi in only about a quarter of its international trade, and its international finance remains dollar-denominated. China’s blue-chip firms – Alibaba, Baidu, and Tencent – are listed in New York or Hong Kong, where they are priced either in US or Hong Kong dollars. And most of China’s fast-expanding loans and overseas investments are in dollars.
But the most compelling reason why one should not expect a renminbi-dominated international finance system to arise anytime soon is that China’s leaders have never shown any sustained commitment to developing the renminbi as a true alternative to the dollar. Instead, they have pursued a cooperative approach to reform of the international monetary system, which they argue should not be dependent on any one currency.
For the Chinese, the future of the international monetary system should be one in which multiple national currencies provide choice – in terms of invoicing, payments, and asset allocation – thereby reducing the system’s exposure to national politics. Moreover, with more central banks creating liquidity, and international financial centers offering pools of it, such a system would entail a lower risk of cash crunches. Already, China has been experimenting with the development of offshore renminbi markets in key financial centers, as a way to overcome its currency’s limited liquidity.
In order to build such a multi-currency system, however, the world would need to undertake far-reaching reforms of the international institutions. This was precisely the point that Zhou Xiaochuan, the governor of the People’s Bank of China, made in a 2009 speech challenging the view that only the US, through the dollar, could guarantee the functioning of the international monetary system.
As Zhou pointed out, the US dollar’s monetary dominance is underpinned by the Bretton Woods institutions, created after World War II. Reforming the international monetary system, therefore, means reforming the governance of the multilateral financial institutions – an argument that China emphasized during its G20 presidency last year.
As the US retreats from the world stage and a multipolar global order emerges, the international monetary system may well be transformed – but probably not into a renminbi-led system. Whether because of the intrinsic weakness of China’s international finance or an understanding that a truly international currency must be more market-driven than the government-controlled renminbi could be, not even China expects the age of renminbi diplomacy to arrive anytime soon.