Monday, June 22, 2009

Zhou Xiaochuan and the Future of the International Monetary System

In March 2009, the Governor of the People’s Bank of China (China’s Central Bank), Zhou Xiaochuan, proposed an audacious reform for the international monetary system. Simply put, it was the most important development in international macroeconomics since Richard Nixon’s decision to abandon the Gold Standard in 1971.

As it happened, the story went relatively unreported in the U.S. mainstream media. That the proposal came from China is quite telling: as the largest foreign holder of U.S. debt, China publicly raised doubts about the solvency of the United States and the future value of the U.S. Dollar. In doing so, China called into question the prudence and sustainability of the international economic order.

Since the proposal, Russian President Dmitri Medvedev has joined the fray, calling into question the prudence of using the dollar as a reserve currency (see articles here and here), and the yield on U.S. Treasuries has increased - a sign that investors demand a higher return for higher risks. Reportedly, the leaders of the “BRIC” countries discussed the issue during their meeting in Yekaterinburg, Russia last week.

The Background for Zhou’s Proposal

Part of the background to Zhou’s proposal can be found in the Bretton Woods discussions following World War II. John Maynard Keynes feared that the reliance upon a reserve currency would lead to the “N-1 Problem,” wherein the world would become hostage to the international monetary policies of the United States. To avoid this, Keynes proposed an international currency - the Bancor - that would be linked to 30 internationally traded commodities. This was the fount of Governor Zhoul’s proposal.

Another part of the background to this proposal is China’s inordinate exposure to U.S. debt. As a result of the global financial crisis, the U.S. government has embarked upon expansive debt-financed stimulus programs to revive the U.S. and world economies. In addition, the Obama Administration’s budget proposal had the largest deficit in U.S. history, with forecasted deficits to increase throughout his term. For debt holders in Beijing, the U.S. government’s profligacy raises alarm bells, for not only does the likelihood of a U.S. default increase, but also the future value of the USD decreases with the prospects for future inflation. This ‘tough sell’ led Secretary of State Clinton to implore the Chinese to continue purchasing U.S. bonds during her trip to China in February. Indeed, in U.S. Treasury auctions, demand for the assets has softened, as evidenced by increased yields.

The Chinese are holding $1.35 Trillion of a sinking asset.

The final part of the background to Zhou’s proposal is the increasing internationalization of the Yuan-Renminbi (RMB). China has made overtures to ASEAN countries to invest in RMB-denominated government assets and to issue RMB-denominated debt. Additionally, the role of the RMB as a transaction currency is increasing. The Renminbi is now the settlement currency for Hong Kong-PRC trade, and the Bank of China has extended lines of credit to ASEAN countries to finance Chinese exports - an activity that used to rely upon the USD. Moreover, the Chinese government recently entered into currency swap agreements with Argentina.

What does this mean?

While the RMB’s likelihood of becoming a reserve currency in the near future is unlikely, the trend line is clear: the dominance of the USD is eroding. Certainly there are no substantive alternatives to the USD at present: the Euro area lacks a unified ministry of finance capable of issuing debt; China’s debt capital markets remain underdeveloped. Moreover, the United States has no incentive to forego the benefits of holding the reserve currency. It not only retains the benefits of seignorage, but it also benefits from lower borrowing costs.

Governor Zhou tapped into popular frustrations with the United States, and called into question the foundations of the international economic order. While it would be fanciful to think that a new version of the Bancor would supplant the USD as the world’s reserve currency in the near future, one must take Governor Zhou’s proposal seriously.

If something can’t continue forever, it won’t. The use of the USD as the world’s reserve currency will come to an end. Governor Zhou planted the seeds of what the future may hold in store. A world in which the USD is not the reserve currency will increase borrowing (and thus investment) costs for Americans, and it likely would increase the costs of certain commodities currently priced in U.S. Dollars, e.g. oil. Depending upon the monetary system that emerges, the ability of the United States to pursue an independent monetary policy could be constrained.

Granted, this outcome could help alleviate global macroeconomic imbalances, and a stable world currency could provide greater international financial stability. Yet a big question remains, whither U.S. influence when the dollar is no longer the currency of international commerce and finance?


  1. Great first entry.

    I do wonder, what will replace our current monetary system? Will the East Asian economies learn to love currency appreciation, and lose their self-made export-competitive edge? How will they reshape their economies?

    Similar questions can be posed for Europe. Whether or not the Asian currencies absorb some of the dollar's fall, the euro will surely strenghten as a result of the dollar's fall (the tight mandate of the ECB makes the currency somewhat analogous to gold). What then for Europe's sclerotic economies, and their export-led growth models? Surely Europe will have to look inward, to it's own single market.

    If Asia's economies become less competitive, and Europe grows more insular, who might grow more competitive because of a fall in the dollar? The US? But wouldn't a more competitive US economy lead to a stronger dollar, as was the case in the dot-com era?

    True, all macroeconomic fingers point to a fall in the dollar. But I struggle to construct a plausible post-dollar world.

  2. Nouriel Roubini comments on "The Chinese Proposal for a New Global Super Currency" on his website:


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