November 28, 2011
Global FX reserves are denominated in only a handful of currencies. For a currency to become a major reserve currency, it has to be underpinned by liquid, large and highly-rated bond markets. None of the BRIC can at present aspire to major reserve currency status given global FX reserves worth USD 10 tr. Only the RMB has the potential to become a major, albeit not the dominant, reserve currency by 2030. The USD will continue to benefit from incumbency, and is therefore unlikely to be displaced as the “dominant” reserve currency, assuming the government manages to put debt back on a sustainable path.
A reserve currency is, by definition, a currency in which the foreign assets held by central banks are denominated. Conceptually, this needs to be distinguished from a currency’s private international use (e.g. invoicing of trade), even if in practice the two are closely related. It is also important to distinguish between a major and a dominant reserve currency. A currency is a major and dominant reserve currency if 10% and 50% of global FX reserves are denominated in it, respectively.
Global FX reserves are denominated in only a handful of currencies (roughly: USD 60%, EUR 27%, JPY and GBP 4%, respectively). For a currency to become a major reserve currency, it has to be underpinned by liquid, large and highly-rated (ultimately: sovereign) bond markets. (After all, China dumped agencies and bank deposits in favour of US Treasuries during the 2008 financial crisis). None of the BRIC can at present aspire to major reserve currency status given global FX reserves worth USD 10 tr. Quite simply, none of the BRIC government bond markets has at present the required size and depth to absorb USD 1 tr (or 10% of total) global reserves.
There has been a lot of talk about the RMB replacing the USD as the “dominant” reserve currency. Government debt problems, potential inflation and depreciation are seen as undermining the USD. This fails to distinguish between the “store of value” and the “medium of exchange” function of a currency. Concern about the “store of value” has arisen not only due to rising US government debt and large current account deficits. It also has to do with the shift towards slightly more return-oriented behavior among central banks whose foreign asset holdings exceed pre-cautionary levels. “Excess reserves” allow central banks to invest in less liquid, higher-risk instruments.
A US sovereign default would naturally be a game-changer (but such an event is highly unlikely). It is very debatable whether a higher level of inflation and/or exchange rate volatility would undermine USD reserve status. It is noteworthy that the recent US sovereign downgrade was followed by a “flight” into US Treasuries. More importantly, medium-term depreciation won’t affect the dollar’s medium of exchange function, only possibly its store of value function. There is simply no high-grade bond market as liquid, deep and creditworthy as the US Treasury market.
The RMB, let alone the other BRIC currencies, will not emerge as a serious near-term contender for “dominant” reserve currency status in the next few years. First, size matters. Global FX reserves are almost USD 10 tr (a full 1/3 is accounted for by China). China’s government bond market is a mere USD 1.6 tr. Though comparable in size to Germany’s, it – leaving aside the issue of capital account convertibility – is not large enough to absorb even 10% of present global FX reserves. Second, even if global FX reserve growth slows from currently 15% to 5% and the Chinese bond market continues to grow 15%, the size of China’s government bond relative to global FX reserves by 2030 will still be smaller than the US government bond market relative to FX reserves today. None of the other BRIC bond markets will be sufficiently large by 2030 to absorb 10% of reserves assuming that foreigners will at most hold 50% of the market.
Third, and related, China’s role in international trade will lead to a greater share of trade being invoiced in RMB. Currently, the US remains the main source of final demand for Asian producers. But this will be changing rapidly, enhancing the incentives of central banks to increasingly manage their currencies against the RMB rather than the US and thus to hold greater RMB reserves. Demand for RMB reserve assets is driven not only by greater use in cross-border trade but, significantly more so, by private financial transactions. Greater private use on the back of RMB convertibility would also enhance the incentives to hold RMB.
Assuming that issues such as secondary market liquidity (China is far from having a deep and liquid bond market) and solvency (China is currently rated A by the major rating agencies) have ceased to present impediments by 2030, this leaves the issue of market access. China has recently taken steps very selectively opening up its on-shore bond market to foreign central banks, allowing them to reinvest their (mainly trade-related) RMB in local bonds. Complete capital-account convertibility would help further the international use of the RMB and increase the incentive for central banks to hold a rising share of their reserves in RMB. It will be interesting to see to what extent the Chinese authorities (perhaps other than the PBoC) are prepared to give up control over large parts of its financial system and its capital account and to potentially undermine the very foundation of its tried and tested economic development strategy!
All said, the RMB has the potential to become a major but not the dominant reserve currency by 2030. First and foremost, China itself will still be holding a significant share of global FX reserves by 2025. But a rising share of non-Chinese FX reserves may be invested in RMB-denominated assets, especially once China moves towards greater RMB convertibility. The off-shore RMB market would be too small to accommodate official demand for RMB. A more dominant position in terms of global trade and greater capital-account convertibility underpinned by a fully-developed domestic financial system will create greater incentives for other countries to manage their currencies vis-à-vis the RMB and thus to raise the share of RMB reserve holdings. Nonetheless, the USD will benefit from incumbency, and is therefore unlikely to be displaced as the “dominant” reserve currency, assuming the US government manages to put debt back on a sustainable path.
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