Comment on “International Finance and Geopolitics”

The international monetary system crossed an important turning point at the end of February 2022, as the USA and its allies imposed financial sanctions on Russia. The greatest controversy was not whether the sanctions were right or wrong in a geopolitical sense, but what does weaponization of the US dollar mean for international monetary system. When China and the USA were in the middle of the trade war, many Chinese investors worried that the US government might freeze or even forfeit China's investments in the US treasury markets. My assessment then was that this was highly unlikely, as it could backfire on the USA by significantly weakening the role of the US dollar. The freezing of Russia's foreign exchange reserves by the USA and its allies in early 2022 suggest that my earlier assessment was incorrect.

But as Eichengreen (2024) argues, there is no credible alternative to the existing system in the perceivable future. Regardless, the US dollar will remain as the most important global reserve currency.

However, important changes have already taken place. For more than half a century, the US dollar has been the global reserve currency. After China started its reform and open-door policy in 1978, it immediately participated in the international division of labor. And for much of the past four decades, exports and foreign direct investment (FDI) have been two important driving forces for China's rapid economic growth. In that globalized world, the US dollar was the global financial public good. Questions about the international roles of the US dollar were raised after the 2008 global financial crisis (Zhou, 2009). The main concern then was that a sovereign currency, that is, the US dollar, serving as the global reserve currency is unsustainable in the long run. This concern was later compounded by the huge spillover effects of the Federal Reserve Bank's monetary policy easing and tightening on other countries.

But now the worries have been escalated to new levels, as the risk premiums on using the US dollar in international financial transactions by other countries are much higher. Although most countries will probably not be directly targeted by such financial sanctions, they could still be caught in the middle when such an unfortunate event happens, especially when the two sides of the conflict are, respectively, the number one and the number two economies of the world. This is probably why many countries, especially developing countries, have been exploring alternative means of payments, units of accounting, and vehicles for investment since early last year.

The real question is not whether the US dollar as the global reserve currency will come to an end. The answer is clear negative. Eichengreen (2024) paints two scenarios for the international monetary system, one the status quo and the other financial rupture, built on different trajectories of the geopolitical tensions between the USA and China. The two scenarios would play out quite differently, particularly in terms of the financial and economic interactions among the USA, China, and the rest of the world. But in both scenarios, the US dollar will remain as the dominant global reserve currency.

The US dollar's status as the global reserve currency is built on a number of unique key features of the US – a powerful economy, an efficient financial system, a vibrant innovation leader, and a strong military force. While gaps between the US and other countries in some of these areas have probably narrowed in recent years, the US is still in an overall advantageous position. More importantly, there is no credible candidate, which could displace the US dollar in the perceivable future.

The renminbi (RMB) is the most talked currency, which could potentially compete with the US dollar. China started to pursue a RMB internationalization policy in 2009. While it has made important progresses in expanding the RMB's international roles in payments and investments, the RMB remains far away from becoming an international currency. It still faces a number of high hurdles. Most importantly, the currency is not yet convertible under the capital account. In recent years, the Chinese government made serious efforts trying to link the domestic financial markets to the outside world, through programs such as the qualified foreign institutional investors (QFII) scheme and the Bond Connect. But it is unlikely that China will completely liberalize its capital account any time soon.

This, however, does not mean that RMB internationalization cannot move ahead with full currency convertibility. Eichengreen et al. (2022) makes the point that RMB's international roles can increase significantly even without an open capital account, if China can actively establish strong offshore markets for the renminbi and sign a large numbers of currency swap agreements with other countries.

However successful the RMB internationalization policy is, it is better for the RMB to remain as a part of the current international monetary system. Therefore, China and the USA should work together to avoid the second scenario painted by Eichengreen (2024).