Civid 19, the dollar, and the renmembi

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But there is one place where US leadership is quietly working on overdrive: the Federal Reserve. While investors have sought refuge in Chinese government bonds to a greater extent than ever before, they have also scrambled to buy dollars and US Treasury bonds – the world’s traditional ‘safe haven’ assets.

Since January, around $96 billion has flowed out of emerging markets, according to data from the Institute for International Finance. This is more than triple the $26 billion outflow during the financial crisis of a decade ago. This “sudden stop” in dollar funding has caused currencies to plummet and borrowing costs to rise in many developing countries. Combined with a collapse in commodity prices and fragile healthcare systems, this has left many countries dangerously exposed to the pandemic.

This rush to safety has also created a global shortage of dollars which, if allowed to continue, could leave many countries unable to obtain the currency they need to meet their dollar denominated liabilities. As in 2008, the Fed has responded aggressively by reopening swap lines, including to selected emerging market economies such as Mexico and Brazil. It has also gone further by introducing a repurchase agreement facility for foreign central banks. In doing so, it has once again demonstrated its unparalleled power and reach – and exposed the global financial system’s deep reliance on the dollar.

But there is one major central bank that does not have a specific arrangement in place to access dollars at the Federal Reserve: the People’s Bank of China. Given the frosty relations between the two powers, this is perhaps unsurprising. But this blockage in the global financial plumbing could have significant consequences.

In recent years Chinese businesses have amassed large debts denominated in dollars. Crucially, many of the sectors hardest hit by the coronavirus outbreak, such as airlines and real-estate development, are also among the most likely to have high dollar-denominated debt burdens. If these companies find themselves in difficulty, it could spark a scramble for dollar funding in China. Without access to a dollar swap line, the People’s Bank of China may be forced to play its trump card.

The prospect of China suddenly deciding to sell its vast $1 trillion holding of US Treasury bonds has haunted markets for over a decade. Up until now, it has not been in China’s interests to try and destabilise the dollar based global financial system. But some believe that the rising tensions from the coronavirus pandemic, combined with the erosion of US soft power, could mean that things are about to change.

Benjamin Braun, a political economist at the Max Planck Institute for the Study of Societies, notes that it would be naïve to assume that China is content to live under dollar dominance forever. “The question is not whether China would like to wean itself off its dollar dependency, but whether its leaders can do so without causing harm to the Chinese economy”, Braun notes. While the future is inherently unpredictable, Braun believes there are a number of variables that could change the political calculus in Beijing.

One of these is if the People’s Bank of China is forced to start selling its vast stock of Treasury bonds, which experts including Credit Suisse’s Zoltan Pozsar believe is no longer inconceivable. Flooding the market with US Treasury bonds would be akin to setting off a financial nuclear bomb, causing bond yields to spike and wreaking havoc in financial markets, while also undermining the ability of the Federal Reserve to control monetary policy. Such instability could end up generating blowback that would harm China’s economy, so most analysts believe that a rapid fire sale is unlikely. However, even a controlled sell-off would likely cause a major headache for Washington, and push the relationship between the White House and Beijing into unchartered waters.

Such a move would satisfy hawks in China, who have long argued that China should cut holdings of dollar-denominated assets and instead seek to strengthen the international standing of the renminbi. Xiao Gang, the former chairman of the China Securities Regulatory Commission, has accused the US of “turning on the dollar printing machine” and misusing its “dollar hegemony to pass its own crisis to the rest of the world”.

Braun notes that China has already built the foundations for a renminbi trade area in the form of the Belt and Road project. And if Chinese leaders believe they can achieve their goal of achieving supremacy in key strategic technologies, the need to accumulate dollars may eventually wane. “When China starts to sell its advanced products to the rest of the world, will they want to be paid in dollars? Or will there come a point when they want to be paid in renminbi?”, Braun asks.

There are also other long term trends that could reduce the dollar’s importance in the global financial system. One is decarbonisation: one of the dollar’s key strengths is that it is the currency of the global oil trade. But as countries increasingly switch away from fossil fuels towards clean energy, global demand for dollars will likely decline as countries source their energy from more local sources.

“The global trend towards decarbonisation definitely increases opportunity for non-dollar denominated trade relationships”, explains Braun.

Whether the renminbi can challenge the dollar in practice is another matter, however. Daniela Gabor, a professor of economics and macrofinance at UWE Bristol, points out that China has been developing the architecture to promote the internationalisation of the renminbi for many years, but faces a recurring problem: becoming a global reserve currency would necessarily involve opening up China’s tightly controlled financial system to the rest of the world. “In practice, China would need to reorganise its financial system so that it resembles something that looks more like the US financial system”, Gabor explains. So far, this is a risk that Chinese leaders have not been willing to take.