In the global schoolyard there are many ways to pick on someone (i.e. some country) based on how much you want to embarrass them or piss them off. There’s the annoying North Korean spitball: I’ll hack into your government websites and then duck behind the tetherball pole before the playground monitor notices. There’s the Iranian virtual wedgie: I’ll tell Hezbollah to fire some rockets into a few of your neighborhoods then watch from the swings with a smile on my face as you chase them around. And then there’s the more sophisticated and subtle hijinks reserved for the older mean girls to promulgate against a Jan Brady like target as part of a broader strategy of complete playground hegemony. A prime example of this is China’s call for the end of the U.S. dollar as the world’s default reserve currency.
Far from an easy poke at the lone superpower when it just fell off the economic monkey bars (OK, I’m done with playground metaphors), the recent rhetoric from several senior Chinese officials suggesting that a non-national currency or form of reserve replace the dollar as the go-to global standard is a subtle sign of longer term Chinese ambitions.
So why care? From an economic and financial standpoint, thou who controls the world’s reserve currency controls much of the playground (whoops). And it’s not just a financial advantage. A country can use the liquidity and flexibility of its dominant currency to build a war chest and finance other ambitions cheaper than its rivals.
The way foreign exchange reserves and reserve currencies work is made complicated because it’s usually explained by economists. Here’s the shade tree 160 word deep dive on the subject:
In order to buy and sell things with other countries you need to convert your currency into theirs and vice-versa. In the old days, currency was issued literally as gold and silver certificates. Theoretically you could take a dollar bill to the Federal Reserve and get a dollar’s worth of gold in return. For many reasons (most of them due to economists paid to explain currency and exchange rates) you can’t do that anymore. So you can hold all kinds of currency reserves in your national bank hoping that you have it right when the Andorrans (no, they’re not aliens, Andorra is a small country wedged in the Pyrenees between Spain and France) show up to buy a 777, or you can use a fiat currency. After WWII the U.S. dollar became the world’s fiat currency, enabling you to buy oil from Russia in dollars, Lawn Darts from China in dollars, and finance yourself silly because everybody else uses dollars.
Now the Chinese and other emerging economic players want to change the status of the dollar. From an international finance view they make a good point. As The Economist magazine puts it “China has particular cause to worry that America’s massive printing of money in response to the financial crisis will undermine the value of its (China’s) dollar reserves”. China and others hold massive amounts of dollars in their banks in order to lubricate trade with the U.S. and with each other. If the world becomes awash in dollars, they have to give up more of their reserves to play and they lose money. On the other hand, finding a new reserve is not easy. It could take decades and wild swings in currency valuations to come up with a new standard.
So the Chinese have begun to slow their purchase of dollar denominated U.S. government securities and increase the support of their currency, the Yuan, to settle international trades. There’s nothing illegal about this but it is risky. If the dollar were to fall because of this the massive amounts of dollars held by China (and others) would be worth less. But the Celestial Kingdom looks like it’s willing to take that risk because there are additional payoffs, the most prominent being the lower use of the dollar as the world’s fiat currency will lessen the power of the U.S. while seemingly increasing China’s.
So what’s wrong with China trying to flex a little muscle? It’s China. The reason the dollar has worked well as a global currency is largely due to America’s advanced, transparent, and liquid capital markets. No one who has looked at China’s capital markets would use those adjectives to describe it. Yes, the financial crisis resulting from American mismanagement of monetary policy and bizarre regulatory environment deserves criticism and questioning. However, putting China in the driver’s seat would be like letting the Tasmanian Devil take the wheel from Mr. Magoo.