China plans to have its currency rival the dollar. A new study assesses its prospects.
In the past 70 years or so that the U.S. dollar has been the world's dominant currency, plenty of challengers for the title have come and gone.
Now, China is trying to establish the renminbi as a formidable competitor to the greenback — and its strategy is worth paying particularly close attention to, says Matteo Maggiori, the Moghadam Family Professor of Finance at Stanford Graduate School of Business and a senior fellow at the Stanford Institute for Economic Policy Research (SIEPR). “China is a viable contender,” he says.
Maggiori would know: As one of the world’s top international macroeconomics and finance experts, his research has garnered acclaim, including a Carnegie Fellowship to study China’s internationalization of its currency, the 2021 Fischer Black Prize and, more recently, the Germán Bernácer Prize. He is also a cofounder and director of the Global Capitol Allocation Project, which aims to improve international economic policy by studying how capital moves around the world.
Here, Maggiori discusses why China's currency bid matters and how his latest research — newly released as a working paper by the National Bureau of Economic Research — sheds light on both China's moves and the broader dynamics at play when countries look to dominate global currency markets.
Why is China's bid to position the renminbi as a major player in international finance so important from a global macroeconomic perspective?
When a country succeeds in making its currency an international one, two things happen: The currency becomes a primary source of payments around the world and it builds a reputation as a reserve currency — just as the U.S. dollar stands today. This means that foreign investors see its government bonds as a very safe, very liquid place to park money so that, when an economic crisis hits, they can get their money out if they want to. In return, the government can usually sell its bonds at very low interest rates and, as my earlier work suggests, companies may have a much easier time raising money from foreigners in their own currency.
A number of countries have had the potential to become a reserve currency but haven’t been able to dislodge the U.S. dollar for one reason or another. We saw this with Japan in the 1980s and the eurozone in the 2000s. China, however, is an interesting case because it has a lot working in its favor. It has the world’s third-largest bond market, which makes it potentially attractive to large investors like central banks and sovereign wealth funds that don’t have a lot of places aside from the U.S. market to store hundreds of billions of dollars of wealth. China’s large trading partners likely see value in holding assets in renminbi.
The country is also important from a geopolitical standpoint. For example, since its 2014 invasion of Crimea, Russia has been moving away from U.S. dollar-denominated bonds and increasing its renminbi reserves. The recent sanctions following Russia’s invasion of Ukraine will push countries that have political tensions with the U.S. further in the direction of the renminbi.
Your latest paper analyzes China’s process of opening its bond market to foreign investors.
A safe and reliable bond market is almost the definition of a successful reserve currency, but China historically has put very heavy restrictions on foreign buyers of its bonds.
That started to change about 10 years ago. My co-authors and I take a detailed empirical look at how China has gradually lifted these restrictions, although its bond market is still not yet fully open to foreign investors. We show that policymakers first made a conscious decision to allow in relatively stable, long-term investors like central banks. Then, starting in 2017, they let in what are usually called “flightier” investors — for example, mutual funds, exchange-traded funds and some hedge funds — through a program called Bond Connect. It had a very light approval process and investors could get their money in and out very quickly. It was also integrated with international trading platforms.
These are all characteristics that make entering a bond market feasible for the typical private investor. And from 2018 until 2021, we saw a big influx of private investors into Chinese government bonds.
We also show that bond investors hold Chinese bonds neither uniquely as an emerging market investment, like bonds of Brazil or South Africa, nor as those of a very developed, large country like the U.S. or the eurozone. Chinese bonds rank somewhere in the middle in global portfolios.
What’s your take on China’s renminbi strategy to date?
I think it makes a lot of sense, although promising the world that the renminbi is a very safe asset that you don’t tamper with in a crisis is a very expensive promise to maintain. The country is facing a test of that commitment right now as its economic pain from pandemic lockdowns and some political tensions have scared foreign investors. They have been taking their money out of the country.
In the short run, it is going to be very tempting for China to favor domestic economic rationales over long-term goals of becoming a reserve currency.
The last time China experienced large capital outflows was in 2015. Then, the government didn’t tamper with foreigners; they instead prevented domestic households and firms from getting their money out of the country. Foreign investors might have perceived that as a test that China passed, and returned with more investments in subsequent years. Today, China is thus far signaling that it will continue to open its bond market. It recently announced a new program, called Swap Connect, that lets foreigners trade interest-rate derivatives. This is attractive to hedge funds and other investors who are even flightier than mutual funds.
Clearly, China has positioned the renminbi as a potential reserve currency. But everything could change dramatically tomorrow and there is no reason to believe that the renminbi’s path is going to be a straight line. It might also never happen. But we do need to understand and track what is going on without making unfounded predictions about exactly how it’s going to play out.
Your paper also has a lot to say broadly about how reputation affects the global competition to be a dominant currency.
Our model shows that, as competition among currencies increases, many countries ultimately decide that the trade-offs necessary to become a reserve currency are not worth it. Just as competition among companies providing the same good lowers profits, competition in bond markets leads to higher interest rates on government bonds. In our model, as competition increases, more and more countries choose to stick to their currency’s lower reputation. A dominant player like the U.S. could also flood the market with Treasuries to make it very unattractive for anybody else to try to compete. That strategy comes with its own risks for the U.S. if things go wrong, something I explored in my earlier work.
The U.S. dollar has ruled for so long that its position seems immovable. Is it?
If you take that view, that is certainly going to be a recipe for disaster. Many currencies have been at the core of international finance and eventually failed. A typical example is England in the 1920s. The British pound had a stellar reputation — arguably even better than the U.S. has now — until a very severe economic crisis led the British government to aggressively depreciate the currency and to renege on promises of convertibility. Similarly, the U.S. broke its promise of convertibility to gold at a fix parity in the 1970s. But the role of the dollar didn’t suffer much from that broken promise, maybe because there weren’t viable reserve-currency alternatives at the time. The presence of China might — in the not-so-distant future — increase the number of alternatives.
As I’ve said, it’s not very easy to sustain the level of commitment that is needed to be a reserve currency. You could imagine a world where a future U.S. administration decides to go wild for short-term benefits. It’s very unlikely that there is going to be a massive move away from the U.S. dollar in the near term. At the same time, we tend to think these things never happen until they do.
Along with Maggiori, Christopher Clayton of Yale University and Amanda Dos Santos and Jesse Schreger — both of Columbia University — authored the new working paper, “Internationalizing Like China.”