IN 2009, I had lunch in Hong Kong with a lawyer who was describing to me his many professional woes. We were sitting at the bar of an Italian restaurant in Pacific Place, a complex of tinted-glass office towers in the Admiralty District of the city with a cavernous shopping mall down below. Outside the restaurant, wealthy women flitted between the Chanel and Louis Vuitton stores, their high heels echoing on the marble floors. The set lunch of Caprese salad followed by linguine with crab was perfectly executed, but my lunch companion was not enjoying the meal. He launched into a lengthy whinge about how his business was all disappearing to Shanghai, which the Chinese central government wants to turn into the country’s main financial center. Companies were listing their shares in Shanghai, instead of Hong Kong, he complained. Multinationals were shifting their headquarters to Shanghai, and fund managers were also moving up there. Hong Kong was suffering the gradual erosion of its role as China’s conduit to the international financial world. “And another thing,” he said, almost without pausing for breath. “Our landlord wants to raise our rent by fifty percent.”
I have been traveling to Hong Kong regularly for much of the last decade, and on each visit I hear the same foreboding about the future of the city and the same fears about the lethal competition from Shanghai. It is the second-most-common complaint, after the pollution being blown down from the factories in southern China. Admittedly, Hong Kong did suffer two huge body blows, from the 1997 Asian financial crisis and the SARS outbreak in 2003, which possibly colors some of the grumpiness. Yet the soul-searching always seems out of place, a narrative that is rebuked by the constant bustle and progress. More than most other cities, Hong Kong adapts. To the visitor it always seems to be booming, with new high-rises, new malls, and new slivers of land reclaimed from Hong Kong Harbor. And the rents just keep going up.
The next new business opportunity for Hong Kong is already starting to take shape, and it could be a huge one. Beijing is putting in place an ambitious plan to allow the Chinese currency to play a larger role in the global economy, and Hong Kong is the launchpad. It is the first place where the Chinese currency, the renminbi, can be freely traded by Chinese and non-Chinese companies. There is also now a market in Hong Kong for corporate bonds issued in the Chinese currency, known as “dim sum bonds,” which allows people to put some of their savings into securities denominated in renminbi. (One of the first issuers was the McDonald’s Corporation, which must now sell Big Macs in China to repay the dim sum.) The financial world is abuzz with talk about the start of a momentous shift. HSBC predicts that by 2015 at least half of China’s trade with the developing world will be in renminbi, around $2 trillion. “We could be on the verge of a financial revolution of truly epic proportions,” says Qu Hongbin, HSBC’s China economist. “The world is slowly, but surely, moving from greenbacks to redbacks.” The Washington-based economist Arvind Subramanian predicts that the Chinese renminbi could become “the premier reserve currency by the end of this decade, or early next decade.” Hong Kong has found a new role. It could be the international hub for the world’s new global currency.
This might sound like arcane business-speak, the kind of thing that is of interest to financial professionals but not to anyone else. Yet, in reality, the question of whether the renminbi will supplant the dollar is one of the central contests that will determine the shift of power from West to East over the course of the next few decades, a delicate combination of high finance and geopolitics. The political influence of the U.S. dollar is the often overlooked anchor of American global influence. Just as the period of British pre-eminence from around 1850 to 1914 was sustained by the central role of sterling, American global reach in the post–World War II era has been underwritten by the pervasiveness of the U.S. dollar, which is used in 85 percent of cross-border business. The dollar’s position as the main reserve currency is both cause and effect of American power, a symbol of confidence in the world’s most productive economy and a manifestation of America’s position at the center of a series of economic, political, and military relationships at the heart of the international system. American politicians sometimes like to talk about the U.S. as the “indispensable” nation, a phrase that never fails to grate on foreign audiences, but in the case of the dollar it is quite apt. The dollar’s role in the world is a reflection of continuing trust in Washington as the guardian of the global order.
Washington is drowning in warnings about the end of the dollar era. Edward Luttwak, a hardheaded scholar of military strategy, downplays the military threat from China, but adds: “The real challenge to American and Western strategy is far more subtle: a slow, not uncomfortable slide into subordination in a China-centred world, with the renminbi as its currency.” The National Intelligence Council, which publishes the U.S. government’s official intelligence estimate, forecasts that “the fall of the dollar as the global reserve currency… would be one of the sharpest indications of a loss of U.S. global economic position, strongly undermining Washington’s political influence too.” If the dollar does start to lose that position to the renminbi, it would indicate that a real power shift was taking place and that China was assuming a central role in the world’s political and economic affairs. Since the financial crisis, there has been a lot of talk about a “currency war,” a somewhat faux dispute about U.S. and Chinese efforts to weaken the value of their currencies that was coined by the Brazilian finance minister. The real “currency war” for the next few decades is the contest for the title of global reserve currency.
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The privilege of issuing the main reserve currency is more than just symbolism. The advantages are enormous. All governments borrow money, even in the very best-managed economies, and if a country does not have enough savings at home, the Finance Ministry will have to borrow abroad in someone else’s currency. When countries face economic problems, these overseas borrowings often become the weak link. If markets start to lose confidence in a government and its policies, it becomes much harder to roll those debts over, or to issue new bonds. The country’s currency also starts to weaken sharply as investors get cold feet. The government then faces a double whammy—it loses access to new international funding, and the cost of its existing debt suddenly shoots up, because its currency is now worth less. Imports also become more expensive, putting further pressure on dwindling sources of foreign currency. Many of the economic crises that developing countries have faced in recent decades have followed this pattern.
Yet America has been shielded from such troubles. The U.S. dollar is overwhelmingly the preferred unit for business and financial transactions around the world. Global trade is lubricated by dollars—99 percent of all foreign-exchange transactions in both South Korea and Chile, two big exporting nations, are sales of local currency for dollars. For the world’s central banks—the biggest, most conservative, and most influential investors on the planet—the U.S. dollar remains the principal anchor of their foreign-currency reserves. It is the same in the black market economy. When Somali pirates or Mexican drug lords demand payment, it is U.S. dollars they want to receive. Because the dollar is used so widely in commerce and investment, and because it is such a trusted store of value—it is “as good as gold,” as the saying goes—foreigners are only too happy to buy bonds from the American government that are issued in its own currency. As a result, the biggest and most liquid bond market in the world by far is the U.S. Treasury bond market. Even if the dollar suddenly gets weaker, this does not affect the American government in the same way it would affect other countries, because the U.S. repays foreign investors in the same currency it collects in tax revenues. That makes the position of the U.S. dollar a hugely powerful tool. It gives an important competitive advantage to American companies and banks, which get to do business in their own currency and avoid the vagaries of foreign-exchange markets. And it allows the U.S. government to live beyond its means without facing the punishment that other governments inevitably suffer. Washington can finance its global power projection with a credit card that has no limit. “Deficits don’t matter,” as Dick Cheney liked to say.
Except that, eventually, they do. Even for America, there are limits to the sorts of deficits it can run. At some stage, the credibility of the U.S. dollar will be called into question—and with it the underpinnings of America’s global position. To be fair, there have been many dollar scares in the past that proved to be unfounded. When I was studying in Washington in the 1990s, my dissertation supervisor was David Calleo, who was one of the leading voices in the school of thought sometimes called “imperial overstretch.” He wrote persuasively about the ructions caused by Lyndon Johnson’s budget deficits in the 1960s, which were needed to finance the Vietnam War, and the subsequent stresses the dollar came under in the 1970s, when Nixon eventually abandoned the convertibility of the dollar into gold. Yet the dollar’s primacy survived the episode. To Europeans who worried about the risk of inflation, then treasury secretary John Connally retorted: “It is our currency and your problem.”
The same pressures returned during the Reagan years and the arms race with the Soviet Union. The Soviets eventually blinked first, their economy imploding under the burden of heavy defense spending, but America’s finances also came under intense pressure, prompting a new bout of predictions that American dominance and the dollar era that financed it were coming to an end. Paul Kennedy had a massive publishing success at the time with his Rise and Fall of the Great Powers, a tome about imperial overstretch over the centuries which captured the prevailing mood. Again, the pessimism proved short-lived. The end of the Cold War and the supreme confidence of the early years of the George W. Bush administration made these sorts of predictions seem alarmist, almost foolish, and in the boom years of the mid-2000s they were brushed aside as a kind of intellectual defeatism. Yet, after a decade of two expensive wars and the biggest financial crisis since the 1930s, which forced the government to run a deficit of $1.1 trillion in 2012, America’s outstanding government debt is now almost as large as the economy itself—something that has not happened since the Second World War. The credibility of the dollar is once again being called into doubt, and the idea of “imperial overstretch” is very much back in vogue. In the financial world, some talk about when rather than if there will be a dollar crisis. It is precisely at this moment of uncertainty in the fate of the U.S. currency that China has chosen to start claiming a bigger role for the renminbi in the global economy.
THE DOLLAR TRAP
“How do you deal toughly with your banker?” Hillary Clinton asked, shortly after she became secretary of state. Since the start of the financial crisis, a new phantom has started to loom over U.S.-China relations: the massive amounts of American government debt that are now in China’s hands. China has the largest foreign-exchange reserves in the world, at around $3.3 trillion, and overtook Japan in 2008 to be the largest overseas holder of U.S. debt. Although the exact composition of China’s reserves is a state secret, analysts who have sifted through the available information estimate that around two-thirds of those reserves are in U.S. dollar assets. The likely result is that China owns around $2 trillion of U.S. government debt. “Never before has the United States relied on a single country’s government for so much financing,” as economist (and later White House official) Brad Setser put it. “Political might is often linked to financial might and a debtor’s capacity to project military power hinges on the support of its creditors.”
The handover of global responsibilities from the U.K. to the U.S. was a long and drawn-out process, but the final blow was delivered because Britain owed too much money to Washington. In 1956, when the U.S. wanted to show its displeasure at the British invasion of the Suez Canal, Eisenhower refused to let the IMF issue an emergency loan which Britain needed to defend its currency. Fearing a complete financial collapse, Britain pulled out its soldiers from the Canal Zone. British influence in the world was never the same again. If China could turn this financial power into real political leverage, it would have dramatic consequences for both America’s economic policy and its ability to exert influence around the world. It would give Beijing the hold over Washington that the U.S. once held over its own great-power predecessor.
China is well aware of the potential significance. Every now and then, there have been comments from low-level Chinese officials raising the potential threat. In 2007, Xia Bin, who was then a leading economist at a government think tank called the Development Research Center, caused an international fuss when he suggested that China’s dollar holdings should be used as a “bargaining chip.” When the U.S. announced it would sell more arms to Taiwan in 2010, three senior PLA officers—Major General Zhu Chenghu, Major General Luo Yan, and Senior Colonel Ke Chunqiao—told the Xinhua News Agency that China should retaliate by selling U.S. government debt, which could lead to a sharp rise in U.S. interest rates. According to American diplomats, the threat to sell dollar assets has also occasionally hung over conversations about the Dalai Lama. The more nationalistic sections of the Chinese press call it “the nuclear option”—threatening to dump dollar bonds in order to change American policy. Or, as Gao Xiqing, the head of China’s sovereign-wealth fund, told the American journalist James Fallows: “I won’t say kowtow, but at least be nice to those countries that lend you money.”
In the U.S., this potential threat from China has now been a feature in two presidential elections. When he was running for the 2008 presidential nomination, then senator Joe Biden warned, in a Democratic debate, about the risks of having China finance U.S. debt. We need to “make sure that they no longer own the mortgage on our home.” Hillary Clinton, also then a senator and a presidential candidate, piped in: “I want to say ‘Amen!’ to Joe Biden, because he’s 100 percent right.” In 2012, the theme returned with a vengeance. In May, there was a standoff in Beijing over the blind activist Chen Guangcheng, who, having escaped house arrest and taken refuge in the U.S. Embassy in Beijing, announced that he wanted to leave China for the U.S. Paul Ryan was asked if the U.S. still had any influence over China in such a dispute. The Republican vice-presidential nominee answered: “When you depend on another country like China for the cash flow in your country and for your debt, there is not a lot you can do when you are asked to stand up to them on a principled matter such as this.” Ryan somewhat misread the situation: the next day Chen was given permission to move to New York.
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Paul Ryan was wrong for a reason. The supposed leverage that China derives from its dollar holdings is something of a myth—and China knows it. The curious thing about this discussion is that, although some Americans complain that the debt gives China excessive influence, China is increasingly angry at how little sway it has. In the years since the financial crisis, there has been a growing frustration in China that its U.S. bond holdings give it almost no leverage whatsoever. When the crisis broke, Beijing started to issue a series of warnings about American economic policy and its obligations to do right by China. “I request the U.S. to maintain its good credit, to honor its promises and to guarantee the safety of China’s assets,” Premier Wen Jiabao told a 2009 press conference. Beijing worried very loudly about the inflationary risks of the monetary expansion the U.S. Federal Reserve launched in response to the crisis. Chinese officials started to push for guarantees about repayment on their U.S. debt, especially in the troubled mortgage agencies Fannie Mae and Freddie Mac. It is possible that Chinese pressure had something to do with the timing of when the two mortgage agencies were brought under government control. But, by and large, China’s attempt to strong-arm the U.S. did not work. Beijing did not receive any formal guarantees, and it exerted no influence over American monetary or fiscal policy. The Fed has continued to do as it wishes. The Tea Party has more influence over the Fed than does the Chinese Communist Party.
Larry Summers, the former U.S. Treasury secretary, once described the situation between the two countries as “mutually assured economic destruction.” Beijing has come to realize that it is trapped—trapped by the size of its exposure to the U.S., trapped by the reality of financial markets, and trapped by the logic of its own policies. In any month when China exports more than it imports, this leads to an inflow of foreign currency into the country. In order to prevent the value of the renminbi from rising, which would hurt its exports, the Chinese central bank buys up the dollar excess. China’s foreign-currency reserves are the direct product of this policy of keeping its currency artificially cheap, in order to boost exports. This was a choice made by China, not by anyone else. Indeed, large parts of the world have called on China to change its approach and to allow its currency to become more expensive. Having built up such a stockpile, China’s official money managers are then faced with limited options. The U.S. Treasury market is by far the largest and most liquid in the world. It is also the only one with the size to absorb the sort of volumes of reserves that China has been accumulating. China therefore has little choice but to recycle a large portion of its surpluses into U.S. government bonds.
The harsh reality for China is that it has too much at stake to turn its back completely on U.S. bond markets. Economic interdependence makes it hard for China to rock the boat. At best, China can gradually scale back the rate at which it buys new American debt. But if China were to try and sell a substantial chunk of its U.S. bond holdings, it would send the market into a tailspin, and bond prices—including China’s own investments—would plummet. Such action would also force down the value of the U.S. dollar, making China’s exports less competitive and threatening hundreds of thousands of factory jobs. It would be a huge self-inflicted wound. This formula does not make sense for a regime whose legitimacy is tightly wound up in delivering economic results. China’s holdings give it theoretical leverage over the U.S., but it is leverage that it is technically difficult and politically suicidal to exploit. Beijing knows as much. “We hate you guys …” Luo Ping, a senior Chinese banking official, admitted in 2009. “US Treasuries are the safe haven. For everyone, including China, it is the only option.” He continued: “Once you start issuing $1 trillion–$2 trillion… we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do.”
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Luo Ping was only half joking. His mock anger was politically important because that sentiment became one of the starting points for the campaign to take the Chinese currency global. Frustrated at its inability to influence American economic policy, Beijing has started to think much more seriously about finding ways to rein in the influence of the dollar and Washington’s ability to run endless deficits. Resentment at the “dollar trap” helped launch a much broader Chinese critique about the place of the U.S. dollar in the international economy. If China could not influence the way the U.S. managed its economy, it would try and reshape the international financial system instead, and make the dollar less indispensable. Hu Jintao called in 2008 for a “new international financial order that is fair, just, inclusive and orderly.”
The first sign that something was brewing in Beijing came from the governor of the Chinese central bank, Zhou Xiaochuan. Zhou is a chemical engineer by training but is considered one of the Communist Party’s intellectual heavyweights in the field of international economics. With his donnish air, he likes to tease journalists with the sort of delphic pronouncements that once made Alan Greenspan a cult figure—before the financial crisis, that is. In March 2009, six months after Lehman Brothers collapsed, the central bank started to put up on its Web site a series of long and detailed speeches and essays by Zhou that called for substantial reforms of the international financial system. Zhou had himself some fun at the expense of the Western investment banks, which had almost felled the global economy. He criticized the “herding phenomenon” among investors and the “inertia and sloppiness” that stopped executives from “asking tough questions.” But his broader message was aimed at the role of the U.S. currency. The international financial system, he said, needs a reserve currency “that is disconnected to individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies.” In between the technical language of international financial policy, the message was clear: the world needs to become less reliant on the dollar.
Zhou’s speech was the starting gun for China’s campaign to develop a more international currency. Since then, China has unveiled a steady series of reforms aimed at forging a bigger role for the renminbi. Using Hong Kong as a trial ground, the government in 2009 started to allow the use of the renminbi to settle international trade—the first stage in a plan to turn it into the main currency for trade in Asia and between developing countries. In 2011, it allowed renminbi bonds to be sold in Hong Kong, letting foreign investors buy assets denominated in the Chinese currency. Since then, Beijing has announced a slew of reform measures that will gradually make it easier to trade and invest in the Chinese currency. By the end of 2012, around 15 percent of China’s trade was being conducted in renminbi. The final stage would be to turn the renminbi into the sort of international safe haven that attracts the world’s central banks to park a substantial share of their reserves in the currency. That would be the real stamp of approval. In what was largely a symbolic gesture, Malaysia has already taken the first step, acquiring some renminbi bonds.
Chinese policy makers usually couch the project in technical terms, pointing out that it will reduce the costs of doing business for Chinese companies and expand the opportunities for Chinese banks. But they also do little to hide their broader political objective of forging a new international system that is not dominated by the U.S. dollar. Li Ruogu, head of the China Export-Import Bank, argues that “the financial crisis … let us clearly see how unreasonable the current international monetary system is.” Another official told me: “We have the second-biggest economy in the world, so we should have a currency that enjoys many of the privileges that the U.S. also gains.” According to Zha Xiaogang, a researcher at the Shanghai Institutes for International Studies: “The shortcomings of the current international monetary system pose a big threat to China’s economy. With more alternatives, the margin for the U.S. would be greatly narrowed, which will certainly weaken the power basis of the U.S.” One Chinese academic even goes so far as to say that ending the dominance of the dollar is as important for Beijing’s ability to project power as was “China becoming a nuclear power.”
Attacking the power of the U.S. dollar is not a new form of geopolitical sparring. In the 1960s, General Charles de Gaulle sought to challenge American leadership of the West and to position himself in the middle ground between Washington and Moscow. One of his tactics was to withdraw France from the military arm of NATO. The other was to take aim at the dollar. Throughout the mid-1960s, as America became bogged down in Vietnam and its public finances came under pressure, de Gaulle gave a series of press conferences in which he called for an end to the primacy of the dollar and urged other countries to convert their holdings of U.S. currency into gold. And it was a French finance minister (and later president), Valéry Giscard d’Estaing, who famously complained in the 1970s that the benefits America derived from the dollar were “an exorbitant privilege.” “There was no doubting de Gaulle’s intention: to promote his drive to reduce US economic, military and cultural influence,” Time magazine said of his campaign. (As part of his effort to demonstrate independence from Washington, de Gaulle recognized the People’s Republic of China in 1964, a full seven years before Nixon and Kissinger made their celebrated opening to Beijing.) China sees a global role for its currency in a similar light to de Gaulle’s, as both good business and good power politics. Even though Beijing knows it will be a long process that could take several decades, some officials see it as a central part of a broader struggle to place limits on American power and to increase China’s own room for maneuver. In their minds, it is a rather nerdy, pointy-headed proxy war for influence.
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When then U.S. treasury secretary Tim Geithner spoke to a group of students at Peking University in 2009, he was asked if China’s holdings of U.S. government debt were safe. Of course they are, he responded. The audience laughed. It is not just the Chinese elite who frets about the dollar. One of the surprising aspects of the Chinese reaction to the financial crisis has been the way in which seemingly technical issues about the international financial system have seeped into public debate. The U.S. dollar has become a flashpoint for some of the broader nationalist tensions that have been boiling up within China. In 2012, the car of the U.S. ambassador to China, Gary Locke, was surrounded by an angry mob of around fifty people who had been protesting at the nearby Japanese Embassy. One demonstrator grabbed the flag off the front of the car. Then the crowd shouted: “Give us back our money.”
In Song Hongbing, China’s currency nationalists have found an unlikely cheerleader. A few years ago, Song was an unknown economist at a Chinese government think tank. But his 2007 book Currency Wars turned him into an unlikely star of the publishing world, selling half a million copies, and making him the spokesman for popular resentment at the dollar-based world. The book aims to be a sort of financial history, but it is really a hodgepodge of dubious stories about financial conspiracies down the ages, arguing that the Rothschild banking dynasty has been pulling the strings in the international financial system ever since the nineteenth century, when it made a fortune speculating on the outcome of the Napoleonic wars. He claims the Rothschild family wealth is now a hundred times greater than that of Bill Gates. One of his main targets is the fact that the regional U.S. Federal Reserve banks are technically owned by the private banks rather than the government. But Song also manages to recycle some ugly myths about the prominence of Jews in the financial sector and their alleged role in events ranging from Waterloo to the Asian financial crisis. Such insinuations did not prevent the book from generating buzz in some surprising places—two different sources told me that Premier Wen Jiabao had asked to read a copy of Currency Wars.
Song’s background does not make him an obvious critic of American financial excess. While he was living in the U.S., he did some work creating financial-risk models for Fannie Mae and Freddie Mac, the two mortgage finance institutions at the center of the housing bubble. But the book seems to have tapped into popular suspicions that international finance is rigged against China and that the U.S. will debase its currency. His timing was impeccable: Currency Wars came out just before a massive financial crisis which was caused in part by the arrogance of a U.S.-based international financial elite. That has helped turn Song into an often quoted authority on the links between finance and politics. In the process, he has also helped popularize a certain strain of victim nationalism that sees the dominance of the dollar as one of the tools used to curtail China’s rise. “Before my book, people thought currencies were really an academic issue, but now they see it as a political issue, as a struggle for power,” Song told me. “The big power is the one who issues the money, who can define what money is. The currency war is a struggle, a fight for who controls the money and who can issue it.”
One of the peculiar aspects of Song’s writings is that he shares many of his concerns with a section of the right wing in America. He has not only an intense aversion to the investor George Soros, but also a deep suspicion of the powers of the U.S. Federal Reserve. “Congress should have the power to issue money, not the Fed,” he told me. “No one audits the books of the Fed.” He added: “Ron Paul has very much the same view. Why is money issued by a small group of unelected people?” When I asked him why he was so obsessed about Jews in finance, such as Soros, he smiled a little uncomfortably and attempted the sort of compliment that runs its own risks of stereotyping. “I personally admire the Jews,” said Song. “They were prohibited from doing anything else, they could not own land, so money was the only way to succeed.”
A bespectacled forty-something in a starched shirt with personalized cuff links, Song was clearly enjoying his success when I met him. He had opened a new consulting business, called the Global Business and Finance Institute, to give advice on international financial issues. A sequel to his book, Currency Wars 2, which describes plans by a small group of bankers to launch a new global currency, had been published, and a third volume is in the works. He had also just rented a suite of offices in Beijing near Dongzhimen Avenue, modern China’s new power center, which houses the imposing and slick headquarters of many of China’s largest state-owned companies. One side of the office was taken up by a new side business: a group of young computer programmers were designing a video game based on Currency Wars. Song described to me the outline for the game. The early stages would involve starting your own business and building up capital. If a gamer managed to reach the final stage, he would get to become a big hedge-fund speculator who could launch an attack on the U.S. dollar. “You can become the sort of financial big guy who has the resources to start a currency war,” he said. “Someone like George Soros.”
JEKYLL ISLAND
In November 1910, a group of the great and the good from America’s financial elite assembled after dark in a railway car at a quiet siding in Hoboken, just across the river from Manhattan. They used only their first names in front of the porters. When they reached Brunswick, Georgia, two days later, they took a boat to Jekyll Island and checked in at the private club partly owned by J. P. Morgan. They told people they were going duck hunting, and one of the party even carried a shotgun onto the train to keep up the pretense, although he had never used one in his life. But their real purpose was to draft legislation to completely shake up the country’s banking system. In the process, they also revolutionized the role of the U.S. dollar.
The men at the secret meeting on Jekyll Island included Benjamin Strong, head of Bankers Trust; Henry Davison, who was J. P. Morgan’s right-hand man; Paul Warburg of Kuhn, Loeb; and Frank Vanderlip, a former journalist who was by then the boss of what became Citibank. They were joined by Senator Nelson Aldrich of Rhode Island, head of the Senate Finance Committee, whose daughter was married to John Rockefeller, son of the richest man in the country, and Abraham Piatt Andrew, assistant secretary of the Treasury Department. The most famous consequence of the meeting was the bill that created the Federal Reserve, America’s central bank. The 1907 financial crisis had exposed the vulnerabilities of the economy to such an extent that the government effectively had to rely on J. P. Morgan to broker a solution—he called leading bankers to his Manhattan town house and would not let them leave until they had devised a rescue plan. As a result of the legislation they wrote, the Federal Reserve System took over that role of regulating and managing credit conditions in the country. Every modern economy in the world now has a central bank that plays the role of lender of last resort. But, given that sections of the American right believe the Fed is an example of excessive government interference, the Jekyll Island meeting is, to this day, viewed by some as an elite conspiracy against the interests of ordinary Americans. In 2010, the libertarian politician Ron Paul was the headline guest at a conference on Jekyll Island about the misdeeds of the Fed. “People are demanding that we not put up with a secretive organization like the Fed that prints all this money and causes all this mischief,” the former presidential candidate told the audience.
Establishing the Fed was only one part of the 1910 Jekyll Island plan, however. The legislation they developed also created the legal instruments for the dollar to become an international currency—as it happens, a plan quite similar to the one China is now pursuing. They started by establishing procedures so that trade could be settled using U.S. dollars. Then they created the legal framework for the issuance of international U.S. dollar bonds. The impact was dramatic. According to the financial historian Barry Eichengreen, just one decade after the bill was passed in 1913, the U.S. dollar already accounted for a larger share of central-bank reserves than the British pound. It was also used in more bond issues and exceeded sterling in loans linked to trade by a factor of two to one. Even before the Jekyll Island plan was implemented, the American economy had the scale for the dollar to play a larger role in the global economy, but lacked the legal instruments and market infrastructure. Within just a decade of its approval, the status of the U.S. dollar had been transformed and sterling’s diminished.
Just as Americans should not be surprised by China’s urge to build a grand navy, they should also not be blindsided by Beijing’s ambitious plans to turn the renminbi into a global currency. After all, this is precisely what America did at a similar stage in its development, when it wanted to start turning its economic scale into greater international influence. Whereas America’s plan was written by an elite band of Wall Street and Washington figures, China’s global-currency push has been orchestrated by a small group of the Communist Party elite. (The party’s senior officials also often plot new strategies at its own beachside retreat, Beidaihe, a few hours east of Beijing.) Given America’s current troubles and China’s inexorable growth, it is tempting to think that something similar might happen again over the coming decade or two, when it is quite likely that China will become the biggest economy in the world. But for history to repeat itself, and for the renminbi to eclipse the dollar, two very substantial conditions will need to be met. China will have to tear up its economic model, and America will need to let it happen. Both are possible, but neither is inevitable.
GRIDLOCK
As to the second condition, there certainly is no shortage of reasons for thinking that the U.S. could be heading for the sort of crisis that would shake the foundations of the dollar era. The litany is a familiar one—high debt levels, chronic budget deficits, political gridlock, spiraling entitlement spending, and crumbling infrastructure. In some ways, the status of the dollar is actually making things worse. The U.S. government’s ability to keep borrowing from abroad allows it to put off taking some of the tough decisions that will eventually need to be taken. Some Americans worry that having a reserve currency is the equivalent of a “resource curse,” the sort of natural advantage that leads to indulgent, ineffectual government.
Yet, despite all these problems, the fate of the U.S. dollar still lies largely within the control of the U.S. government. Big shifts in the international monetary system take place rarely, and then usually only in response to dramatic events. Once gained, the position of reserve currency is not easily lost. The system is a reflection of the collective confidence and force of habit of millions of economic agents around the world and only changes from one anchor to another when there is little alternative. The loss of influence suffered by the British pound is one example. The decade starting in 1914, which was the period in which the U.S. dollar began to stake its claim at the heart of the international monetary system, was also the decade that included the First World War, an event which all but bankrupted Great Britain. With the value of sterling plummeting from 1915, all of a sudden Brazilian coffee traders started pricing their goods in dollars, and Dutch tulip-bulb farmers wanted export credits to be issued in dollars. The Second World War finished the job on Britain’s finances and completed the process of transition from sterling to the dollar. The ascendance of the dollar required not only the decisive plan that was devised on Jekyll Island, but also a collapse of confidence in sterling.
Now, admittedly, it is not completely out of the question that the U.S. will suffer a similar financial convulsion. In the summer of 2011, some members of the U.S. Congress seemed quite happy to use the threat of default as a short-term political tactic. The subsequent downgrading of U.S. government debt by Standard & Poor’s was a stark warning about the potential erosion of confidence in the dollar. Ever since then, Washington has been living from one budget crisis to another. Yet even this 2011 mini-crisis served to demonstrate the unique position that America holds in the international financial system. In such moments of nervousness, investors seek a safe haven, and the place they looked to was, ironically, the U.S. Treasury bond market. In the very week when America’s credit rating was downgraded, the price of American debt actually rose by near-record levels. There are huge incumbent advantages to being the principal reserve currency that are not easily dismantled. If the U.S. can muddle through its current troubles and present a coherent long-term plan for bringing its debts under control, the U.S. dollar will retain a central role, if for no other reason than inertia. That is politically easier said than done, of course, but the correct response to the Chinese challenge to the dollar is nothing more and nothing less than good housekeeping. The U.S. holds its fate in its own hands.
The China model of economic management had its finest moment in November 2008. Lehman Brothers had collapsed two months earlier, sending the Western economic world into the sort of panic not seen since the 1930s. Over the next few weeks, the brutal consequences for China started to mount. In southern and eastern China, the areas where most of the export factories are concentrated, tens of thousands of migrant workers would line up every day at railway stations to return home to their villages, their jobs having disappeared almost overnight. Seeing a potential threat to its legitimacy, the Chinese party-state snapped into action. In November, Beijing announced a massive economic stimulus plan with a headline figure of $586 billion to backstop the collapsing economy. The Chinese government’s main planning agency—the National Reform and Development Commission—is based in the northwest of the city, in a neighborhood that has three or four modest hotels. For several weeks after the government announced the stimulus plan, every conference room in these hotels was booked by local government officials from around the country who came to present their best “shovel-ready” projects. From dawn to dusk, planning officials surveyed the plans for construction and infrastructure, giving a quick yes or no. The state-owned banks then provided the initial financing, and work began as quickly as possible. Roads, bridges, airports, and tunnels were built in record time. It was probably the biggest-ever emergency public-works program.
It turns out that China had the perfect “model” to respond to the sort of economic crisis that seems to happen every eighty years. When foreign analysts talk about Chinese “state capitalism,” they are usually referring to the presence of state-owned businesses in many areas of the economy. But the real key to the system is the way the financial system works. China was able to respond so quickly to the crisis because of the control the state has over the big four banks, which are responsible for between a third and a half of new credit in the country. The government was able to use its direct influence over the banks to funnel credit quickly to infrastructure projects. In the U.S., when the crisis hit, bank lending all but seized up as uncertainty took hold of economic decisions. In China, bank lending exploded. In 2009, the country’s banks issued twice as many new loans as they had written the year before. These banks had spent the previous five years getting stock-exchange listings, attracting foreign shareholders, and publishing ambitious statements about corporate governance. But, for all the talk that they were becoming more independent, when it came to the crunch they took a political order from the top and opened the credit floodgates. As China rebounded much more quickly from the global financial crisis than any other major economy, the normally disciplined Premier Wen Jiabao let slip a somewhat triumphalist note. China’s economic model, he said, allowed the government to “make decisions efficiently, to organize effectively, and to concentrate resources to accomplish a large undertaking.”
Yet this same brand of state capitalism is also the main obstacle to China’s developing a major global currency. The project to take the renminbi global is actually a pivotal moment in modern China, because it presents the leaders with an almost existential choice. For the renminbi to become an internationally accepted currency and a trusted store of value, China will need to make the sort of root-and-branch economic and financial reforms that would transform the way the economy is run. The scale of the changes that China would need to implement to achieve this goal makes the problems facing the U.S. at the moment look modest in comparison.
At the moment, Beijing is trying to square an economic circle. Although China is now the biggest exporter of manufactured goods in the world, the reason few people use the renminbi to settle trade transactions is that Beijing maintains a high wall of capital controls that protect its economy from the fickleness of international financial markets. As a result, it is still very hard to take Chinese currency in and out of the country, and for foreigners to invest money in China’s financial markets. This is where Hong Kong comes in—it is a perfect halfway house, an offshore laboratory where Beijing can experiment with allowing its currency to be widely held without the risk of a destabilizing financial blowback. But the offshore market in Hong Kong can only take the renminbi so far, because the volumes will always be limited. To turn the renminbi into a currency that even the world’s deeply conservative and cautious central banks would feel comfortable holding, China would need to tear down some of those barriers, allowing money to move freely in and out of the country. In other words, to boost the credibility of its currency, China would need to open itself up to international capital in just the way that New York does. This would not be a simple technical change: it would mean a revolution in how China runs its economic affairs.
Opening the economy to financial flows would put huge strains on the Chinese economic model. Beijing would have to dismantle many of the tools that allow it to funnel huge volumes of cheap credit to its favored investment projects. One reason the state banks have such a stranglehold on the financial system is that Chinese citizens have little choice but to put a large part of their savings into the banks. To a large extent, they are captive bank-depositors. But in a more open financial system, Chinese citizens would have many more options about how and where to invest their money. Banks would have to compete for deposits by offering higher returns, which would slash the profits they made from lending. And in order to retain the confidence of depositors, they would also have to be much more transparent about the risks they were taking with loans to pet government projects.
The Chinese authorities also use the tight control they have over the banking system to effectively set interest rates in the economy—another powerful tool that allows them to shape macroeconomic policy and keep credit cheap. But the power of the banks would be diminished by another necessary change. If foreign investors are going to hold a significant share of their assets in renminbi, they will need access to a large, liquid, and credible Chinese bond market. The global role of the dollar is underpinned by the huge U.S. government bond market, which gives investors an easy way to buy and sell large volumes of securities. It is that liquidity that makes it such a reliable store of value. Yet, in a large and transparent bond market, the price of credit is set by the market, not by government fiat. In essence, the decision to open up the economy to foreign capital would transform the position of the big state-owned banks. They would need to be run on much more stringent commercial principles and could no longer be used as piggy banks for other state-owned companies. And in the process, the Communist Party would lose a vital element of its current political control over the economy.
China would also need to transform the way it manages its exchange rate—another revolution in economic policy making. If China were to allow capital to flow more easily in and out of the country, it would have to adopt a much more flexible exchange rate in order to manage the volatility. China would probably end up floating its currency, at least partially. That means it would become much harder for Beijing to depress the value of its currency artificially to help its exporters—another central element of the economic model of the last few decades.
The implications do not end there. If foreign investors are going to park large sums of money in the Chinese financial system, then China would also need a much more independent legal system. Why invest in a Chinese security if a Communist Party official can tell a court what to decide in any legal disputes that might arise? The system of making economic policy would also need to be much more transparent. At present, it is not clear who actually makes decisions about interest rates in China, let alone why they are made. The central bank almost certainly does not make these decisions. But is it the premier? The Finance and Economics Leading Small Group? The Politburo? Or the Communist Party Standing Committee? If the world’s central banks are going to put a large part of their reserves into Chinese government bonds, they will want to know more about the key economic decisions.
Over time, the Chinese renminbi will doubtless increase in importance and is likely to rank alongside the euro, the yen, and the British pound as one of the second-string reserve currencies, accounting for 10 to 20 percent of global reserves. But if it is to supplant the U.S. dollar and establish itself as the principal safe-haven currency, the harsh reality for China is that it has two options. It can keep its particular model of state capitalism. Or it can have a global reserve currency. But it cannot have both.
And that is, of course, the central irony of this whole discussion. The project to make the renminbi into an international force has been dressed up in the geopolitics of dethroning the U.S. dollar, a reflection of both the frustrations of the economic elite and the popular resentment of the U.S. Yet this project requires precisely the economic and political reforms that U.S. leaders have been calling for in China over the last couple of decades. Many of the frictions over economic issues that have built up between the U.S. and China in recent years would disappear if Beijing introduced these policies. The exchange-rate controversy would evaporate as China adopted a more market-based currency policy. And Beijing would be much less able to use its banks to subsidize its own companies with cheap loans—one of the core issues behind the current fears about a new wave of “state capitalism.”
Indeed, some believe this has been the hidden agenda all along of Zhou Xiaochuan, the central-bank boss. Along with a group of other reform-minded officials, he has been trying for much of the last decade to get China to gradually open its financial system, which he thinks is essential for improving the efficiency of investment in China and maintaining high growth over the coming decades. But at almost every stage, he has been frustrated by the caution and conservatism of his Communist Party bosses, some of whom have legitimate complaints about financial capitalism, and some of whom fear an American conspiracy to weaken the Chinese economy. The push to take the Chinese currency global could end up as Zhou’s Trojan Horse—a policy proposal which appears at first sight to have a nationalist, anti-American agenda but which, if followed through, will actually involve groundbreaking liberalization of the economy, the sort of things that American Treasury secretaries want to see happen. In its bid to end the dominance of the dollar, China could end up taking down its great financial wall much more quickly than Beijing would like. Challenging America’s exorbitant economic privileges brings its own very high costs.