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.
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”.
Zhang Xiaohui, assistant governor of the PBoC, echoes the argument that the US has a self-interest in facilitating a multipolar reserve-currency world. “The [international reserve] issuance country faces the difficulty of ensuring reasonable inflation domestically and providing global liquidity,” she says. “The international monetary system is exhibiting many problems at the moment: the existing system is not perfect, but this is the only system that exists. If you can’t abolish it, maybe the only way is diversification.”
Subir Gokarn, former deputy governor of the Reserve Bank of India, where the pace of financial liberalization has slowed, in part, because of the speedy exodus of foreign investors amid the Fed taper-tantrum, agrees. “Anytime there is a sense of risk, money instinctively flows to US treasuries,” he says. “However, alternative reserves – which are high liquidity, low risk, and high volume – are badly needed. Until that asset class is created, the US dollar will be the ultimate reserve currency.”
He adds: “Each country attempts to feel safe from balance-of-payments shocks by accumulation of FX reserves, which is inefficient.”
The PBoC’s Zhang admits the RMB’s inclusion in the IMF’s basket of SDRs is “mainly” of symbolic value in the near-term, citing its limited use by markets, and its principal value as an accounting unit the policy lender uses in its own financial transactions. However, it could prove an anchor for financial reform in Beijing. The PBoC would actively promote the renminbi for trading and settlement purposes to reduce FX costs in cross-border trade, and the risk of liquidity traps amid dollar shortages, Zhang adds. Ultimately, however, the “internationalization of the RMB is driven by the market. It’s not the Chinese government or PBoC”.
The short-term need to reduce deflationary pressure in China, which justifies a weaker currency, has conflicted with the medium-term bid to promote the RMB globally. The unexpected move on August 11 to liberalize the RMB reference rate, which triggered large-scale market volatility and depreciation of the currency, exacerbated China’s impossible trinity problem, note Goldman Sachs analysts, who write: “Until market expectations for the RMB exchange rate stabilize, China will likely need to continue deploying its reserves to stem capital outflows or forego significant further monetary easing – constraints emblematic of the “impossible trinity”.”
By contrast, bouts of economic weakness – the current driver of capital outflows in China – in the US tend to draw in foreign capital amid a global flight-to-safety bid, a trend dubbed the ‘exorbitant privilege’ of the US in its capacity as the issuer of the world’s reserve currency.
At the current juncture then, China’s bid to cool economic headwinds and to liberalize its FX regime are opposing objectives. How China solves this policy headache will reshape the global monetary architecture, but, judging by the circumspect rhetoric of current and former Chinese policymakers, this could take decades.