The Fate of the Dollar as Reserve Currency

Visiting Shenzhen now, a slick modern city, it is difficult to visualize what it was like in 1978 before these developments. It is, along with Shanghai and many other cities, the China miracle in shiny concrete, glass and steel.

The event that truly energized the China economic miracle is often traced to Deng Xiaoping’s “Southern Tour” in January 1992. Deng was 87 years old and no longer in a position of official political power. But he was still well-connected and influential. In the aftermath of the brutal Tiananmen Square crackdown in 1989 and the collapse of Soviet Union communist regimes, some Chinese planners believed the unrest was due to too much opening of markets and loss of discipline. But Deng thought that freer markets were essential for economic growth to continue.

He embarked on a public relations event. With an entourage of 17 people including his family, he set off by train from Beijing on a “family holiday.” He stopped at the Wuhan train station to lecture local officials on reform, then proceeded to Shenzhen and Zhuhai in the province of Guangdong where economic growth had been most vibrant due to market reforms. Says Fok, “Everywhere in Guangdong, Deng was greeted by adoring crowds, who were grateful for the improved livelihoods that his reforms had delivered to them.”

China’s paramount leader at the time, Jiang Zemin, “appeared to get the message. Two days later, he told fellow officials that China should speed up reforms.” The rest, as they say, is history.

Besides being enthralled by the fascinating and easy-to-read financial and economic histories, I was impressed by the fact that virtually all of Fok’s opinions that are lightly expressed from time to time in his narrative agreed with mine. For example, in Hong Kong, “An extremely judicious approach towards the application of the NSL [National Security Law required by Hong Kong’s Basic Law but imposed by Beijing in 2020] would help set international investors’ minds at ease. Equally, it would be in the interests of the West not to undermine Hong Kong's judicial system.”

The main thesis

But as important and engrossing as Fok’s historical account is, it is not the main thesis of his book. That, he expresses this way: “It is the first major argument of this book that the costs of a dollar-based global monetary system now outweigh its benefits to the world and even to the U.S. itself.” He then adds, “The principal American preoccupation will be to address the structural overvaluation of the dollar in order to help restore the competitiveness of U.S. industry.”

I have always struggled to understand the implications of the relative values of currencies. Years ago, I thought the relationship of one currency to another was simply a conversion factor, like feet to inches. How could that affect anything?

Because of that bewilderment, in 1985 I did for the first time something I would do a few times afterwards. I volunteered to teach a class on a subject I knew nothing about in order to learn it.

I called the nearby Colorado School of Mines, with which I’d had some familiarity because of international trips visiting mining projects, consulting on the possibility of applying solar energy to mining. I assumed it had no course on international finance but ought to have one.

I got connected to the head of the mineral economics department, John Cordes. (Land-grant colleges with mining specialties had to put “mineral” in front of the names of their economics departments to signify that they were confining themselves to their government-subsidized niche.)

He said, “I was going to teach that course, but I don’t feel like it, so why don’t you try it.”

I did, with a great deal of effort. They even paid me, though I didn’t expect it. But I calculated that my pay rate was about 25 cents an hour because I had to spend so much time on it.

I learned the subject better. (Curiously, three weeks into the course I had an idea for a Wall Street Journal op-ed and submitted it. To my astonishment the editors called me and said they wanted to publish it. But it was about how the dollar was soaring, and a day after they called it turned downward. They said they’d publish it when it went back up, but it never did.)

I still find the subject a little daunting. But Fok’s book moved my understanding up a sizable notch.

The roots of the overvaluation of the dollar

Fok spent a decade as senior executive at Hong Kong Exchanges and Clearing, the Hong Kong stock exchange. Before that he worked, among other things, on financing big projects in exotic countries. He is at least as intimately familiar with financial and currency relationships as I am with the mathematics of Brownian motion.

Therefore, it is enlightening to see through his eyes the history of the dollar and its relationships to other currencies. The roots of that, as of so many other global institutions, had their formation at the Mount Washington Hotel in Bretton Woods, New Hampshire, at the foot of the fabled Mount Washington, the summit of which held for 62 years the world’s record for the highest wind speed ever recorded until it was surpassed in 1996 by a gust at Barrow Island, Australia.

The most famous name remembered by economists from the Bretton Woods negotiations is John Maynard Keynes. But in Fok’s telling, another name that is not as well remembered is more important to the dollar’s story, Harry Dexter White, a senior U.S. Treasury Department official in the 1940s.

During World War II, the Englishman Keynes and the American White independently developed proposals for the post-war global monetary order. Both initially pegged a global unit of exchange to gold, and all other currencies to that global unit, but they were different in one crucial respect.

Keynes proposed that a new global reserve currency be created, called “bancor,” with a ”pegged but adjustable” currency system in which countries with persistent balance of payments deficits would be subject to automatic devaluations, while those with surpluses would be subject to upward adjustments.

White proposed that the dollar become the global unit of exchange instead of a new currency, and his proposal made currency devaluations and revaluations more difficult. Says Fok, “Compared with the Keynes plan, therefore, the White plan provided for a far more rigid system of global exchange rates.”

At the Bretton Woods meeting in 1944, the United States, having played such a large role in the battles against Germany and Japan, was in the strongest negotiating position. White’s plan substantially won out. Fok’s comment is, “History would later vindicate Keynes’ reservations about the White plan.”

Implications of the global dollar

In the post-war period, Europe and Japan were devastated and needed to import from the United States. The Marshall Plan, and similar aid to Japan, injected billions of dollars into those economies to enable them to pay for U.S. goods.

As the dollar assumed its role as the global reserve currency, demand for dollars extended throughout the world. Traders needed dollars to pay for oil and other global goods. The Asian financial crisis in 1997-1998, in which dollar-denominated loans were not rolled over when several countries had difficulty repaying in dollars, caused many countries, especially China, to stock up on dollar reserves to buffer themselves against another crisis.

Excess demand for something causes it to be overvalued. The dollar became overvalued, and there was no mechanism for devaluing it.

The world flattened and economic globalization overtook it. Economic activities, particularly manufacturing, shifted from the United States to China (and other then-third world countries). People in those countries, being much poorer than the United States, were willing to work for much lower wages since that would still be an improvement on their previously impoverished state.

But it was also about currencies.

When consumers in the United States buy goods from China, the Chinese worker who produces those goods is paid in renminbi. Of course, the dollars used to pay for the goods have to be converted to renminbi. If the exchange rate is highly beneficial to the U.S. consumer – if the dollar is overvalued – the goods are very cheap.

Hence, the overvaluation of the dollar can be blamed at least in part for the loss of manufacturing jobs in Middle America to China. If Keynes’ plan had been in effect, the dollar would have been automatically devalued (or the dollar might not have been the global currency).

And this shift of manufacturing jobs to China has increased wealth inequality in both the U.S. and China too; in the U.S. because it hollowed out the middle class while the rich benefited from globalization, and in China because as Deng Xiaoping foresaw in calling for more open markets, “some will get rich first.”

Fok says this situation cannot persist for long. He writes that “the costs of a dollar-based monetary system now outweigh its benefits to the world and even to the U.S. itself.” He believes the structurally overvalued dollar is harmful to the U.S. because it has to provide dollar liquidity to the rest of the world, and thus must run persistent deficits.

He says it will take many years before the dollar’s central role in the global monetary system can be altered. It could be replaced by a non-country-specific currency like the International Monetary Fund’s special drawing rights (SDR) or Keynes’ bancor, but the most likely replacement would be the Chinese renminbi, due to China’s role as the center of global trade networks and its rise toward being the leading economic power.

The renminbi, though, is nowhere near ready to be a global currency, or even to be used widely in global trade, due to the difficulty of investing the RMB proceeds outside of China and other constraints. However, its transition to a global currency, if it is to transition, highlights Hong Kong’s crucial role as a financial center, and bridge between China’s renminbi and other currencies, as well as between China’s thriving economy and the more familiar and independent legal systems and protections of the West. This crucial role will persist for a long time.

He sees several possible paths by which the dollar will gradually relinquish its central role. One is beginning to occur, because of the U.S.’s overweening financial sanctions. The U.S. imposed sanctions on Iran after the Trump administration pulled out of the Iran nuclear deal, but countries in Europe didn’t. To get around those sanctions, Fok says that Britain, France and Germany set up the Instrument in Support of Trade Exchanges (INSTEX) to provide a non-dollar channel for international companies to trade with Iran. China has launched its national digital currency and has set up the Cross-Border Interbank Payment System (CIPS), its own system to standardize payment instructions between financial institutions, as an alternative to the dollar-centric Society for Worldwide Interbank Financial Telecommunication (SWIFT).

But Fok thinks that greater competition for the lead role in the global financial system can cause problems. It increases inefficiencies, it could lead to a reduction in global trade and investment, and China’s efforts to create a competing international financial system are perceived as a threat by the U.S. Instead of two (or more) systems competing to play the role of anchor of the global financial order, it would be better for the two to deepen their financial interdependencies “in a way that would make it unthinkable for either the U.S. or China to wield their financial arsenals against each other in capital markets.”

There is something I want to ask Fok the next time we meet. (He lives in Hong Kong and we have had lunch twice, accompanied by lively conversation, since I discovered that his book was going to be published.) Why isn’t there an “efficient market” solution to this? The dollar is not pegged, for example by international agreement, to the renminbi. Foreign exchange traders, could, in theory, trade the dollar lower, much like George Soros forced the pound sterling lower in 1991 even though it was supposed to be pegged to the deutsche mark – though to do that he had to secure an enormous amount of capital to back up his trade. But if most nations, or at least the nations most prominent in international commerce, did not try to prevent it, why could not the dollar float to a less “overvalued” exchange rate?

This is, to my amazement, only Fok’s first book. I recommend reading it, and I look forward to more.

Economist and mathematician Michael Edesess is adjunct associate professor and visiting faculty at the Hong Kong University of Science and Technology, managing partner and special advisor at M1K LLC, and a research associate of the Edhec-Risk Institute. In 2007, he authored a book about the investment services industry titled The Big Investment Lie, published by Berrett-Koehler. His new book, The Three Simple Rules of Investing, co-authored with Kwok L. Tsui, Carol Fabbri and George Peacock, was published by Berrett-Koehler in June 2014.

Read more articles by Michael Edesess