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China's laughably overhyped quest to displace the dollar as a reserve currency, explained

Good for you!
Good for you!
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China this week received official status from the International Monetary Fund as the issuer of one of just five globally influential currencies that are used to peg the value of the IMF's Special Drawing Rights (SDR). If this sounds boring to you, Neil Irwin at the New York Times spices things up by suggesting that this "akin to what happened about a century ago, when the United States dollar was gradually supplanting the British pound as the predominant currency for global trade and finance," a move that "was a crucial piece of the nation’s rise to superpower status." Similarly, Matt O'Brien at Wonkblog raises the prospect that China "might be like the U.S. 100 years ago": poised to displace us as the world's financial hub, just as we were poised to displace Britain at the dawn of World War I.

The good news for those of you who don't know what any of this is about is that it's honestly not nearly as important as these stories are making it sound. I personally think the mechanics are interesting, but in terms of global economic conditions Paul Krugman rightly says, "This is not much more than a minor change in accounting, with trivial economic implications." Ben Bernanke compares it to an elementary school teacher putting a gold star on a piece of properly completed homework. He says it's a move that "confers no meaningful additional powers or privileges on China."

So honestly feel free to stop reading this article right now (though I would appreciate you sharing it on social media), unless you happen to be in the market for a detailed exploration of the nuances of something that isn't that important.

What's the slightly longer version?

Here are the key bullet points about this story:

  • The value of SDRs is specified in terms of a "basket" of internationally significant currencies.
  • Previously, the Chinese RMB was not in the basket. Now it will be.
  • SDRs are themselves not that important to the world economy.
  • Which currencies are in the basket is not that important to how SDRs work.
  • But membership in the SDR basket is symbolically important, serving as a kind of IMF seal of approval for foreign countries to hold your currency as a "reserve" instrument — a fancy finance term for when a country tries to save money by stockpiling foreign currency.
  • But it really is just symbolism, there is no particular indication that countries are about to start holding Chinese money as a major part of their reserves.
  • What's more, there's no particular economic significance to which currencies are used as international reserve currencies.
  • But there is arguably symbolic significance to being used in this way — it shows that foreign governments consider you credible and important.
  • So if this matters to the Chinese government, it matters either because they are misinformed or because they are primarily after a symbolic token of national prestige.
  • It is entirely possible that the Chinese government doesn't particularly care much about this whole issue, which would be sensible of them.

So what's an SDR?

At the heart of this unimportant story is a deservedly obscure economic instrument known as a Special Drawing Right.

IMF member states (which these days is basically all countries) hold SDRs that are allocated (i.e., created out of thin air) to member states in a manner proportionate to their payments to the IMF. The value of an SDR is determined in terms of a basket of currencies. Back in the early 1990s, for example, an SDR was 40 percent dollars, 21 percent German marks, 11 percent French francs, 17 percent Japanese yen, and 11 percent British pounds. More recently, SDRs have been 41.9 percent dollars, 37.4 percent euros, 9.4 percent yen, and 11.3 percent pounds. Now China is joining the club, and future SDRs will be 10.92 percent yuan, with the weight accorded to other currencies diminished accordingly.

You can't actually do anything with an SDR other than swap it for one of its component currencies. Consequently, countries generally don't do anything with their SDRs, and SDRs play no significant functional role in the economy.

The IMF does, however, use the SDR as its unit of account when scoring its own books. And a number of other international organizations — ranging from the Economic Community of West African States to the Islamic Development Bank — follow their lead in this regard. Actual business is conducted in local currencies, in dollars, or maybe in euros or yen or whatever else is convenient. But for accounting purposes, the SDR is a nice neutral choice.

If this doesn't sound important to you, then you are correct. As Berkeley economist Maurice Obstfeld recounts in his excellent overview of the SDR, they were created to solve a problem peculiar to the economic conditions of 1969. At the time, only gold or dollars — which were convertible to gold — could be used for international economic transfers. But there wasn't enough gold and dollars to go around. The idea was that "even though SDRs are not money, they could be used, like demonetized gold, to settle international claims between central banks." Could this have worked? Maybe. But the world will never know, because just a few years later Richard Nixon ended the convertibility of dollars into gold, and the entire gold-based system and the gold-related problem the SDR was supposed to solve went away.

So then what's a reserve currency?

Countries sometimes want to stockpile foreign currency — or financial assets that are denominated in foreign currency — for a variety of reasons.

One, as Obstfeld recounts, is as a form of "self-insurance" against financial crisis. The IMF itself is supposed to be able to help crisis-stricken countries with loans, but getting an IMF loan requires agreeing to an IMF-written structural adjustment program. Keeping a few billion dollars under the pillowcase is a small price to pay for national sovereignty.

Another is genuinely as a savings device. Intelligently managed oil exporting countries, for example, know that spending 100 percent of any given year's oil revenue would be a mistake. The global price of oil goes up and down from year to year, and the reserves generally don't last forever. So oil-rich countries generally stockpile a bunch of foreign currency during good times to have something to help ride out the lean years.

Last, a country can amass foreign currency reserves as a kind of accident. For years, Americans were buying tons of stuff that was made in China, and the Chinese government didn't want this to drive up the price of Chinese currency. Consequently, China needed to buy and hold some dollar-denominated financial assets. That's how it wound up buying so many US government bonds, leading to a lot of misinformed commentary about the existence of some kind of Chinese debt bomb.

When it comes to foreign currency reserves, in principle any currency would work. In practice, you want a currency that is widely used so that if you need to sell your currency in the middle of a panic you will find customers. You would also like the currency to be tied to a credible legal system, a transparent political system, and open financial markets. Basically you want American dollars, and then you might want to hedge a bit with euros and yen and British pounds especially if you happen to do a lot of business with those countries. The main thing, though, is that you want a currency that other people will want — it's a basic coordination game. So for a long time the currency that everyone wanted was the British pound. Then after Britain's financial resources were exhausted by two gigantic global military conflicts, the main default global reserve currency became the US dollar.

In theory, the dollar could be supplanted by Chinese money someday. But not only would a lot of institutional, legal, economic, and political changes need to happen in China for this to make sense but you would also need some equivalent of the world wars to erode the United States from its current position.

What does this have to do with SDRs?

Nothing. There is literally no causal relationship between inclusion in the SDR basket and emergence as a dominant global reserve currency. The SDRs themselves are counted as a form of foreign currency reserve, but that's an unrelated issue to whether anyone really uses the SDR's component currencies as a reserve asset. The euro has been in the SDR basket since its inception, and it's not all that widely used as a reserve currency because there's just no reason for anyone to switch.

Okay, but being used as a reserve currency must be awesome, right?

You often hear this, generally from Europeans, who sometimes complain that the United States enjoys an "exorbitant privilege" from the dollar's reserve currency status that allows us to get away with running large trade deficits.

But this is not true. Australia has run bigger trade deficits for longer than the United States, nobody holds Australian dollars as a reserve currency, and Australian governments are not wasting their time trying to convince anyone to do it.

The reason Australia can always run trade deficits is ultimately not that mysterious. Australia is a rich country with a credible legal system and a stable political order that also — thanks to immigration — has a substantially higher population growth rate than other advanced economies. That makes Australia well-suited to receive a net inflow of private investment money from the rest of the world. All this also applies to the United States, though to a lesser extent, and so we also can sustain large trade deficits.

Meanwhile, even if it really were true that being a global reserve currency made it easier for you to run a trade deficit, it's clear that the Chinese government doesn't want to run a trade deficit. On the contrary, it rather infamously intervenes in foreign exchange markets to try to ensure it runs a trade surplus to bolster its exporting industries.

So why the hype?

China has an ongoing and active program to send people to the moon.

Once upon a time, the United States and the Soviet Union were engaged in a high-profile "space race" to accomplish precisely this. It is not entirely clear to me why the superpowers became fixated on this moon goal, since there was never any indication that anything of value was on the moon. But it happened. And the US won. And then we sent a few more astronauts to the moon. And then having proved our point (whatever the point was), we stopped bothering. China is a large and important country whose large population and middling income combine to make it a major power on the world stage.

Consequently, the Chinese government is doing a bunch of "major power on the world stage" type of things. One of those is trying to send people to the moon. Lobbying the IMF to get into the SDR basket is a lot cheaper than sending people to the moon.

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