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Historians still quibble about what event marked the end of the Roman Empire. Some future historians might choose Jan. 16, 2021 as the fatal moment for the American Empire. That’s when the People’s Bank of China and SWIFT, the global system for international monetary transfers, set up a joint venture to promote the use of China’s digital currency in cross-border payments.
It’s early days, but the joint venture could denote the end of the dollar’s role as the dominant medium of international exchange, and, more importantly, the end of more than $20 trillion of cheap loans to the United States from the rest of the world.
The US is able to run budget deficits now approaching a fifth of its gross domestic product (GDP), a level usually associated with Third World countries on the brink of hyperinflation, because the rest of the world holds foreign exchange reserves and transactions balances equal to a full year of America’s GDP.
China already is the world’s biggest exporter, and will become the world’s largest economy in dollar terms before the end of this decade. When – and the issue is when rather than if – China’s currency assumes a world status commensurate with its economic standing, the dollar’s reserve role will fade like the pound sterling before it, and the United States will have to learn to spend within its means.
That implies a wrenching adjustment for a US economy dependent on vast amounts of foreign credit. Economists call this “seigneuriage,” after the premium that a monarch earned by coining precious metal into currency. The value of seineuriage has exploded during the past decade. Now it may implode.
Blandly titled “the Financial Gateway Information Service,” the new company is the first official alliance of the Society for Worldwide International Financial Telecommunication and China’s central bank. China’s RMB accounts for just 2% of transactions in the SWIFT system today, and China’s financial system is far from ready to take on a reserve role. All of that could change, and swiftly, to coin a phrase.
For the time being the goals of the new Financial Gateway are modest; it has just 10 million euros in capital, 55% contributed by SWIFT and 34% by the China National Clearing Center (CNCC), an entity created by the People’s Bank of China as an alternative to SWIFT after the Trump administration reportedly considered shutting Chinese institutions out of the SWIFT system.
Cross-Border Interbank Payments and Settlement Ltd, the CNCC’s foreign exchange arm, owns 5%, and the People’s Bank of China’s Digital Currency Research Institute owns 3%.
Digital currencies promise to drastically reduce transaction costs for international trade financing while improving transaction security. In the 18th century, financier Nathan Rothschild said a bill of exchange in international trade should taste of salt, after accompanying cargo on a sea voyage. Blockchain allows the tracking of goods from factory to warehouse to port to container to ship, and enables just-in-time deliveries along with just-in-time payments.
World trade financing today requires banks to accept bills of exchange in trade, and importers maintain tens of trillions of dollars in bank balances as collateral for their overseas orders.
The chart shows that the size of cross-border bank deposits (as reported by the Bank for International Settlements) tracked the volume of world exports during the past 40 years, rising rapidly during the early 2000s as trade growth accelerated and leveling off after the 2008 financial crisis as trade stagnated.
The Bank for International Settlements breaks down the volume of cross-border deposits by currency, and the dollar dominates, with more than $16 trillion outstanding.
These deposits, mostly the collateral for international transactions in goods, services and securities, amount to a $16 trillion low-interest or interest-free loan to the United States.
In addition, foreigners own about $8 trillion of US Treasury securities, most of which are hold by foreign central banks as currency reserves. Together with the transactions balances in the banking system, total overseas dollar holdings amount to more than $22 trillion, or more than a full year of America’s GDP.
America’s dependence on the foreign credit made possible by the dollar’s reserve role has risen sharply relative to the size of its economy, from about 20% of GDP in 1978 to 110% of GDP today.
The world continues to use the dollar because the alternatives are limited. The euro recently has overtaken the dollar as a favorite currency in international payments, according to data published by SWIFT. That’s probably a response to the Trump Administration’s talk about excluding China from dollar payments, as well as other US sanctions against European banks who ran afoul of American strictures against Iran.
China’s currency, as noted, comprises just about 2% of SWIFT transactions. The RMB isn’t ready to be a reserve currency, and the Chinese do not yet want it to be.
RMB deposits in China remain subject to exchange controls, and there is only limited convertibility between the mainland and world financial markets. The world holds US dollars because they can be transferred anywhere, used to buy any financial instrument, and exchanged into any other currency.
The Federal Reserve, moreover, has shown that it is ready to step in to support the financial system in times of distress, for example after the Lehman Brothers bankruptcy in September 2008 or the COVID-19 crash in late February of 2020.
China would require years of cautious steps towards freer capital markets and a gradual end to exchange controls to make the RMB a viable reserve instrument. The digital yuan, with all the potential advantages of blockchain technology, remains an experiment limited to a small number of Chinese consumers.
For that matter, China does not require the advantages that a reserve currency brings with it, namely a great deal of cheap credit from the rest of the world. China depended on rapid credit expansion to dodge the Great Recession of 2008-2009 and is now attempting to reduce leverage in its financial system. A reserve currency implies the availability of more leverage.
A reserve currency, moreover, typically is provided by a country that runs a current account deficit. For the rest of the world to have access to a country’s currency, that country must provide it, and that means a negative current account. China’s current account surplus has shrunk markedly relative to GDP, and its emphasis on raising consumption implies even further shrinkage in the current account surplus, but that is a slow process.
A digital yuan, though, well might rewrite the rules of international banking. Because payments can be directly and reliably associated with the movements of goods, the total volume of transactions balances (collateral against bank credit issued to purchase goods) is likely to drop drastically. In other words, digital currencies may be far more efficient than ordinary currencies.
A possible outcome of the research now underway at the new SWIFT joint venture with the People’s Bank of China might be the overthrow of the reserve currency system that has prevailed for more than two centuries, since sterling became the world’s favored reserve instrument and the Bank of England acted as the world’s de facto central bank.
The United States will wake up five or 10 years from now and discover just how dependent it has been on the rest of the world, and how much it will cost to cure itself of this dependency. The sterling crises and austerity budgets that bedeviled Great Britain during the 1970s are a good reference point for what the United States is likely to go through.