Same bank, different dreams

The term “print money” translates easily and directly into Chinese, and it is among the first words heard in any conversation in Beijing about Washington’s current approach to the financial crisis. The news that the Federal Reserve would support the market for Treasury bills by making purchases on its own account has not been greeted with wild enthusiasm. While no one is certain whether the “flight to safety” that has supported the US currency for the last several months will sustain or unwind, the long-term impact of current Treasury policy is almost certain to be negative for China, as the US’s major creditor nation.

Knowledgeable Chinese officials are forthright in arguing this approach shows the US has not learned the lesson of the post-NASDAQ bubble years – namely that it cannot buy its way out of trouble by stacking up more cheap debt-driven liquidity. Some see the Federal Reserve’s decision to buy government paper as the third reenactment of just such an effort, and they fear it will result in a deepening of the financial sector crisis, not a resolution of it.

Displace the dollar?

So it is not surprising that discussions of the US dollar, and the risks associated with it, have gathered momentum. Premier Wen Jiabao called upon the US Treasury to assure large foreign investors that the value of their dollar holdings would be maintained. Meanwhile, Zhou Xiaochuan, governor of China’s central bank, has floated the idea of a global weaning from the dollar as the reserve and settlement currency, substituting instead a world currency based on the IMF’s special drawing rights (SDR).

Food for thought here is that China has perhaps the largest stake in the stability of the US dollar, yet it is Chinese leaders who are making the loudest warnings on the world stage about its potential instability, and thus potentially contributing to it.

This coincides – and it is surely no “mere coincidence” – with steps to establish the renminbi as a regional settlement currency and even as something of a reserve currency. The renminbi has already carved itself a life outside China, in Vietnam, Central Asia, Russia and Pakistan, for example. Beijing has watched the evolution of that “informal” practice and is subsequently moving to codify it, providing currency swap facilities to a number of trade partners, principally in Asia but most recently with Argentina.  In fact, in contrast to the US$40 billion pledge to support the SDR program, China has extended renminbi credits worth nearly US$100 billion on a bilateral basis. These credits both enable and bind trade partners to import from China. More offshore renminbi will appear through mechanisms like renminbi-denominated corporate bond issuance in Hong Kong.

The push for the renminbi as a trade settlement currency was officially permitted first for Yunnan province and the Guangxi region before all ASEAN counterparts. It is also promoted for mainland-Hong Kong trade, which could mean the rest of the world through the Hong Kong window. While it is uncertain when the mechanics of these arrangements will be worked out, Shanghai, Guangzhou, Shenzhen, Zhuhai and Dongguan have since been named as pilots for renminbi settlement of cross-border trade.

Uncertain future

But constrained by convertibility limits and capital account controls, the renminbi still faces an uncertain future even as a regional currency. South Korea recently raised just these issues – in word and in deed. While publicly expressing doubts that current regulations and infrastructure will enable the renminbi to be a significant currency outside China, Korea’s central bank began negotiations to convert its swap agreement with China into US dollars.

Looking ahead, it is difficult to predict how quickly and durably the renminbi will trend as a regional currency, but a few things are clear. The renminbi to a certain extent is secured by the US dollar, with China’s massive foreign exchange holdings. But at the same time, the renminbi looks set to grow as a regional currency at the expense of the US dollar, by reducing the regional demand for the American currency.

Accordingly, the two currencies will remain tightly linked, but in an oddly paradoxical way – directly linked by China’s dollar holdings and inversely linked in terms of prestige and influence as the primary holding and settlement currency for a broad swath of Asian economies, among them, some of the world’s fastest growing.