Economists sombre on China monetary trap

Sid Verma
Published on:

Dollar dominance continues; RMB inclusion in IMF reserve basket symbolic.


Zhou Xiaochuan, PBoC: seeking FX diversification

The past few months have exposed the fault lines in the international monetary system. Emerging markets, despite weakening real economies, have been forced to engage in pro-cyclical monetary tightening to stabilize currencies amid capital outflows as the US Federal Reserve prepares to tighten monetary policy. 

The dollar’s status as the global reserve currency means the central flaw in the international monetary landscape – the inevitable conflict between the US’s domestic aims and global policy objectives, known as the Triffin dilemma – has taken centre stage. 

The JPMorgan EM currency index hit a 15-year low in July and is down 13.5% against the dollar, while emerging market equities have shed a further 10% year-to-date, respectively. 

The market rout in emerging markets over the past month, in part, reflects the fear that tighter dollar liquidity will roil the foreign-debt-servicing capacity of emerging market borrowers. By contrast, private-sector borrowers face fewer challenges servicing local-currency liabilities given the ability of the home central bank to print unlimited currency, in theory.

Impossible trinity

What’s more, emerging markets are unable to exert full control over domestic monetary conditions thanks to the economic policy conundrum known as the impossible trinity – the challenge of managing exchange rates, allowing the free movement of capital and boasting an independent monetary policy all at the same time. 

In a nod to the lessons of the 1997 crisis, some emerging Asian nations, led by China, have relied on a combination of relatively-managed exchange rates, and large dollar foreign exchange reserves, in a bid to self-insure against the risk of a sudden exodus of foreign capital. But the resultant stockpile of low-yielding dollar reserves imposes large opportunity costs compared with domestic investments.

Post-crisis plans to fix the holes in the international monetary order have failed to get off the ground, including the People’s Bank of China (PBoC) governor Zhou Xiaochuan’s call to transform the IMF’s Special Drawing Rights (SDR) into a truly global reserve currency in 2009, and the IMF’s bid, also that year, to become a de facto global central bank by pooling foreign exchange reserves. 

Frustrated by the western-centric monetary order, in recent years, Asian nations and the Brics have plotted regional liquidity arrangements, but these are far too modest in scale to serve as effective liquidity backstops or to help undercut the dependence on the dollar.

In recent months, emerging market policymakers have grumbled that many exchange rate values have fallen out of line with economic fundamentals while FX volatility imposes real economic costs. But they have largely fallen short of proposing grand fixes to the global financial architecture, aside from calls for the Fed to be mindful of the negative spill-over effects of its policies and for the IMF to be more innovative in its policy instruments, while moderating the pace of their own financial-liberalization efforts. 

Against this backdrop, leading economists and Chinese policymakers, at the Boao Forum for Asia-Europe Co-operation in London in November, struck a sombre note over the prospects of improving the dollar-driven monetary order in the near-term, and the ability of the Chinese authorities to speed up financial reforms to facilitate RMB internationalization to rival the dollar. At the same time, participants agreed that the limited stock of assets considered safe and liquid remains a source of systemic risk for the global economy, as the 2008 crisis laid bare. 

Wu Xiaoling, former PBoC vice-governor and vice-chair of the financial and economic affairs committee of China’s national legislature, sums up the global monetary conflict and argues it is also in the US’s interest to see change, saying: "The biggest conflict [for monetary stability] is relying on a single currency and we now encounter the Triffin dilemma. The Fed is faced with a difficulty: it cares about the US domestic economy but it needs to care about its impact on other countries." 


Beijing would actively promote the RMB for trade settlement and capital-market transactions but domestic economic and capital-market reforms are a prerequisite for boosting confidence in, and demand for, RMB-denominated assets, according to Wu, who adds: "We can do more bilateral swap lines, and seek multiple currency settlement options. But within a short period of time, it [the dollar-led monetary architecture] can’t change dramatically".