If media coverage were a gauge of importance, China’s fixed exchange rate regime would be almost entirely responsible for America’s ills.

But someone needs to point out to the Americans that a weaker Yuan would not necessarily be a good thing.

The current Argument:

  • China keeps the Yuan artificially weak by building up foreign currency reserves when the demand for yuan threatens to strengthen the currency.
  • This keeps Chinese exports cheap.
  • Chinese products are therefore cheaper in the US, and the world, than American products.
  • This puts American manufacturers out of business.

The Obvious Flaw:

  • American manufacturers account for less than 13% of America’s GDP;
  • If you protect them, then the living costs of 100% of Americans will go up.

The Less Obvious Flaw:

  • America has the “exorbitant privilege” of being the global currency of reserve; but
  • A more convertible Yuan will have the power to threaten the status of the Dollar. 

The Exorbitant Privileges 

There is actually some debate around whether being the global currency of reserve is advantageous or not. There is a McKinsey discussion paper (http://www.mckinsey.com/insights/mgi/research/financial_markets/an_exorbitant_privilege) that argues that the exorbitant privileges consist the following:

  1. Seigniorage revenue – being “the interest free loan generated by issuing additional currency”; and
  2. Cheap capital – the foreign demand for US dollars drops the cost of borrowing.

This comes with costs:

  1. A stronger currency as the dollar is seen as a safe haven for value; and
  2. As a result, less competitiveness for US exporters and local US companies that compete with importers.


  1. the cheaper capital story is not so relevant when the borrowing costs of the US are already sitting close to zero; and
  2. McKinsey estimates the net benefit to the US in a normal year to be between $40 billion and $70 billion per year (or between 0.3% and 0.5% of GDP). That is: close to negligible. And possibly negative in a crisis year.

And therefore, according to McKinsey, it’s not so clear that being the global currency of reserve is a good thing.

The Counter-Argument: the Exorbitant Status Quo

Whether or not it is advantageous to be the global currency of reserve is academic: the fact is that the US dollar is the global currency of reserve. It has used that position* to build up high debt levels (in absolute and relative terms) through loose monetary policy; and large deficits through loose fiscal policy.

Now: the question becomes “what will happen if the US loses that status?”

Because global currency reserve status is an act of markets. And if the capitalistic pressure of the growing class of Chinese millionaires pushes the yuan into full convertibility, then the markets can take that status away and give it to the yuan.

If that happens, there will be an adjustment process. To put this in perspective, 85% of all foreign exchange transactions are currently conducted in dollars**. Some figures:

  1. In 2008, total world merchandise exports for the year amounted to ± $16 trillion.
  2. According to the Bank of International Settlements, daily foreign exchange transactions amount to around $4 trillion as of April 2010. PER DAY. So around $1.5 quadrillion annually.

What those figures are suggesting is that the bulk of the demand for foreign exchange has nothing to do with trade (represented by the merchandise exports figure). And if 85% of that annual $1.5 quadrillion demand begins to slip…

One hell of an adjustment.


Because the annual GDP of the US is only around $15 trillion. Which is tiny compared with that of the world, and the world demand for reserve-currency-denominated transactions.

*Or, if you like, that position has forced it to build up the debt and the deficit. There’s this article (http://business.time.com/2011/04/15/is-the-dominance-of-the-dollar-bad-for-america/) that discusses it. But the basic summary is the flipside of the China-keeping-the-Yuan-weak debate; which you can equally read as China-keeping-the-Dollar-strong by stockpiling its foreign reserves. As Chinese exports steal global demand from US products by being cheaper, the US is forced to increase domestic demand through higher consumption (financed by debt), or risk higher unemployment by allowing demand to shift abroad. The US has chosen debt-financed consumption.

**There will be some shift to that figure depending on who you’re quoting – but it’s the principle that’s important.