Quick Study: China’s Plan to Challenge the Dollar
What Beijing must do to achieve its ambitious monetary goals
China hopes that its currency will someday challenge the U.S. dollar’s place as the world’s reserve currency. Getting there won’t be easy. But, as Stanford Graduate School of Business finance professor Matteo Maggiori explains, if Beijing sticks to its plan, it will have profound effects on the global economy.
Here, in the latest episode of our video series Quick Study, Maggiori discusses what China must do to achieve its ambitious financial and monetary goals.
Matteo Maggiori: Hearing the latest news about China’s ebb and flow in global economic power feels like riding a rollercoaster. When things are going well for China, the headlines scream about how it’s going to overtake the US in the next five years. When things are going badly for China, you’ll read about how it’s done for. It will never catch up.
Our research at The Global Capital Allocation Project takes a step back to examine the larger pattern in China’s ups and downs. One thing we’ve been watching is how China is trying to become a global reserve currency. A reserve currency is a currency that other countries hold as a rainy day account because it’s going to hold up its value when investors need it the most in a crisis.
For the last hundred years or so, the US dollar has been the world dominant reserve currency. When a crisis hits you and you need money, if you have bonds in dollars, you can sell them without losing much value. And because it’s their own country’s currency, the federal government and American corporations have the privilege of borrowing in dollars at very low interest rates. The United States has the home court advantage, so to speak.
China now wants to be a player in this reserve currency space, both to build its own financial power and to isolate itself from the financial reach of the US. One way to do that is to internationalize its currency, and a basic requirement of that is getting foreign investors to participate in its bond market. That’s a big deal. China’s bond market is the third largest in the world, but until recently, it was essentially restricted to Chinese residents. Foreigners couldn’t really invest there. Over the last 10 years, that has started to change, and foreigners have progressively entered this new vast market.
As China gradually opened up its bond market to foreigners, our research found that it was strategic, targeting different types of investors at different times. At first, China was only looking for large official creditors like foreign central banks or foreign sovereign wealth funds, investors looking for long-term stable returns. That helped get the world familiar with this new market and started to build up China’s reputation as potentially a safe place to invest.
A few years ago, China opened up to typical short-term investors like mutual funds and hedge funds. Surprisingly, we found that the investors holding Chinese debt are an unusual mix. Some normally specialize in emerging markets, and others usually invest in developed countries. So investors see China as somewhere in the middle.
Now, China is still at the beginning of this internationalization process, and it has a very tight rope to walk. Our research provides a framework to think about China’s strategy. China needs to build a reputation for being a place where you can park your money, where it’s liquid and safe, meaning if you want to take it out, you can.
Unfortunately, part of that means that if the rest of the world gets scared about China and wants to get their money out, that sudden withdrawal of capital will be expensive for the country. Now that it has allowed more and more short-term investors, this type of capital flight is bound to happen. In fact, through most 2022, we saw some foreign investors pull their money out of China. And historically, it has been hard for countries to resist the temptation to prevent investors from fleeing. That’s why it’s really difficult to become a reserve currency. During China’s next political or financial crisis, the government might decide to shut down the markets, lock the gates on foreign investors, and get stuck with a terrible reputation. Or they might find the strength to go through the short-term pain and build for the long run.
Ultimately, why do we care about this? Well, this is a pattern that is going to change the way money is invested around the world if it continues. For example, it’s going to change how Americans and Europeans invest abroad. A big chunk of what your pension funds or mutual funds hold could be in China, and this could push up interest rates in other countries like the US.
On the geopolitical side, if China’s currency becomes a viable alternative to the dollar, it will limit the United States’ ability to freeze bad actors out of the world financial system. For example, recent efforts to economically punish Russia for its invasion of Ukraine wouldn’t be as much of a threat to Russia if he had another available option beside the dollar.
Of course, the United States doesn’t want to be eclipsed as the epicenter of the world financial system. So while China tries to build up its investor base, the US can try to keep its good repetition by issuing a lot of safe assets and making it clear it’s a safe and open market, it honors its promises and it pays debts. The US wants to signal to investors that there is no need to go to China or anywhere else.
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