The price to pay for reserve currency status

PUBLISHED : Tuesday, 02 June, 2009, 12:00am
UPDATED : Tuesday, 02 June, 2009, 12:00am

Ten weeks ago, Chief Executive Donald Tsang Yam-kuen, speaking at an Asian investment conference, discussed the possibility that the Hong Kong dollar might end its peg to the US dollar. He said it would only happen after the yuan had become fully convertible. And that, he said, would be 'many, many, many, many years down the road'.

Yet, only two days later came the news that the State Council had issued a directive to develop Shanghai into a global financial centre by 2020, something that would only be possible if the yuan were fully convertible. That is to say, full yuan convertibility has to be achieved before then.

That's not such a long time. Hong Kong obviously was not in the loop and had no idea that this was going to happen. In fact, once Beijing let it be known that Shanghai was going to be an international financial centre, there was something akin to panic in certain circles in Hong Kong, fearful that it would be overtaken by Shanghai.

As it is, in the past few weeks, it has become increasingly clear that China has big plans for its currency, even though it is unlikely to replace the US dollar.

The arrival of the global financial crisis was an unexpected boon, presenting an opportunity to accelerate the process of China's rise. The way the rest of the world treated China made it clear that the international community wanted it to play a more important role and agreed that it should have a bigger voice in world affairs, including financial ones.

Signs that China was preparing to play this new role were plentiful in the weeks leading up to the Group of 20 meeting in London in April, and beyond.

A new assertiveness was on display, with Premier Wen Jiabao voicing concern about China's investments in the US and calling on Washington to look after China's interests. Not long after that, Zhou Xiaochuan , governor of the People's Bank of China, suggested a reform of the international monetary system and called for a new international reserve currency.

This was followed by similar sentiments by Finance Minister Xie Xuren and Vice-Premier Wang Qishan. There was no doubt that Beijing had embarked on a new policy.

The coming out of the yuan is being managed in stages, beginning with yuan-denominated settlement of trade deals between Hong Kong and the mainland. Then the way was paved for expanding trade in yuan with some Asian and African nations.

But China has few illusions that its currency can replace the dollar. It is not aiming that high. In late May, for example, Zhang Guangping, vice-head of the Shanghai branch of the China Banking Regulatory Commission, was quoted as saying that, hypothetically at least, there was no reason why the yuan could not account for 3 per cent of global reserves by 2020.

However, China should understand that, to do so, it must be willing to suffer extensive trade deficits, the very opposite of what it has been doing.

Economist Michael Pettis recently wrote: 'One of the necessary conditions for currency reserve status is that the home country must be able and willing to run trade deficits since this is the only way the rest of the world can permanently accumulate reserves.'

The US has been willing to run huge trade deficits, most noticeably with China, enabling the rest of the world to use the dollar as the reserve currency. This will continue in the foreseeable future.

Making the yuan fully convertible can be done, though not without difficulty. Having it accepted as an international reserve country is something entirely different. China has pointed out the advantage the US enjoys by having the dollar as the international reserve currency. But it must also realise that there is a huge price tag attached. Is China willing to pay it?

Frank Ching is a Hong Kong-based writer and commentator.