Unchallenged currencies and the IMF

IMF Managing Director Kristalina Georgieva attends a news conference ahead of the World Economic Forum (WEF) in Davos, Switzerland January 20, 2020. REUTERS/Denis Balibouse

The full text of this paper is split across the various articles linked below. Readers can browse in any order. To download a PDF version, use the button below.

Whither the IMF?

In July 2017, then International Monetary Fund (IMF) Managing Director Christine Lagarde shocked many when she said in a speech in Washington: “[If] we have this conversation in 10 years’ time…we might not be sitting in Washington, DC. We’ll do it in our Beijing head office.” Her remark was a telling acknowledgement of the Asia-Pacific becoming the new global center of economic gravity; IMF Articles of Agreement require the Fund’s headquarters to be located in the member state with the largest quota. This points to a prospective looming showdown when China surpasses the United States as the largest economy and demands that IMF voting power be redistributed accordingly. 

That is a vision of IMF adaptability that in 2008 many in China would have anticipated was fast approaching amidst the US subprime mortgage-triggered financial crisis. Indeed, there was at the time a mood of triumphalism among many in China who saw the financial crisis as the demise of the reign of the US dollar and the US model of capitalism, the “Washington Consensus.”

The financial crisis spurred doubts about the future of the Bretton Woods institutions—and the role of the US dollar. In an extraordinary statement in 2009, Zhou Xiaochuan, then the governor of China’s central bank, the People’s Bank of China, published an essay in English and Mandarin on the bank’s website arguing, “The desirable goal of reforming the international monetary system…is to create an international reserve currency that is disconnected from individual nations….” Zhou proposed that the IMF’s basket of currencies, the SDR, replace the US dollar as the world’s reserve currency. 

Notable fact

China and other emerging economies increased their voting shares, with China’s nearly doubling from 3.9 percent to 6.4 percent (making it the third-largest IMF shareholder)

Zhou’s proposal reflected long-simmering discontent in China and other emerging economies at the dominance of the United States and other Group of Seven (G7) states over the global economic system in which the center of economic gravity has dramatically shifted toward the Pacific. As a result of the 2010 G20 reforms, China still appears entrenched in the IMF (albeit expecting a larger voice in the next round of reforms) even as it has taken the lead in fostering new parallel institutions like the AIIB, the CMIM, and the CRA. The IMF reforms agreed to at the 2010 G20 meeting and subsequent inclusion of the RMB in the SDR taken together marked an important shift in the global financial architecture. Key features of the 2010 reforms were: China and other emerging economies increased their voting shares, with China’s nearly doubling from 3.9 percent to 6.4 percent (making it the third-largest IMF shareholder); members of the IMF’s Executive Board would all be elected (rather than appointed, mainly by G7 nations); and the IMF quotas would be doubled to roughly $755 billion. Moreover, there has been an increase in the presence of Chinese nationals within the ranks of the IMF’s senior staff, including a deputy managing director. 

On November 30, 2015, the IMF’s Executive Board approved the inclusion of the RMB in a new SDR valuation basket. The RMB would be the fifth currency alongside the US dollar, the euro, the Japanese yen, and the British pound. Explaining the decision, Lagarde said: “The Renminbi’s inclusion reflects the progress made in reforming China’s monetary, foreign exchange, and financial systems, and acknowledges the advances made in liberalizing and improving the infrastructure of its financial markets. The continuation and deepening of these efforts, with appropriate safeguards, will bring about a more robust international monetary and financial system, which in turn will support the growth and stability of China and the global economy.” 

The key point is that the decision assumed “the continuation and deepening” of China’s monetary and financial reforms— it was anticipatory, based on a liberal interpretation of IMF criteria (currency must be “freely usable”). “The inclusion of the RMB in the SDR basket,” an IMF official proclaimed, “consolidates the RMB’s internationalization process.” It is generally true that the RMB is very gradually becoming internationalized (estimated at 2.07 percent of global currency reserves). However, the RMB’s path to internationalization has not been linear, and Beijing has backtracked since the IMF included the RMB in the SDR basket. 

Faced with difficult choices pitting economic stability against RMB liberalization, Beijing has retreated from the latter since the November 2015 IMF decision and has placed more controls on capital flows. The portion of Chinese foreign trade in RMB shrank from 26 percent to 16 percent by the end of 2016, and RMB deposits in Hong Kong, its largest offshore center, were down by nearly 50 percent from 2014 by early 2017. China has been deeply dependent on Hong Kong for a full range of its financial services, and it is unclear the extent to which its new National Security Law will disrupt Hong Kong’s role as Asia’s premier financial hub and what the impact will be on China. RMB’s use in global bond markets is down 45 percent since its 2015 peak. Concerned about capital outflows and currency pressures, China has already drawn down more than $1 trillion of its foreign currency reserves. It has yet to control its enormous debt of some $34 trillion (combined public and private debt, including shadow banks). The debt has ballooned from 162 percent of GDP in 2008 to 266 percent in 2018.

Notable fact

Concerned about capital outflows and currency pressures, China has already drawn down more than $1 trillion of its foreign currency reserves. It has yet to control its enormous debt of some $34 trillion.

Despite the market reform decisions taken at the 19th National Congress of the Communist Party of China in 2017 and Chinese President Xi Jinping’s frequent promises of more reform and economic opening, China’s moves to transform its investmentdriven, state-centric economy into one based more on consumption, services, and innovation are erratic at best. The tension between the pledge of “market-based allocation of resources” and the commitment to “support state capital” has become stronger. Chinese loans to the state sector have been increasing, totaling 80 percent in 2016, while only 11 percent went to the private sector. Chinese corporate, shadow bank, and property debt bubbles have yet to be fully addressed. By all evidence, China’s economic dynamic is likely to change slowly. The $840 post-Coronavirus economic rescue and stimulus package promised at the May 2020 National People’s Congress, comprised of business bailouts, fiscal spending and government bond issues appear to reinforce the state-driven economic pattern. Indeed, at the 19th Party Congress in October 2017, Zhou, the outgoing central bank governor, warned of a “Minsky moment” (where overconfidence leads to collapsing economies), and wrote on the central bank’s website that China was accumulating “hidden, complex, sudden, contagious” risks.

Nonetheless, given the financial assertiveness China has demonstrated with the creation of the ambitious trillion-dollar BRI and the AIIB, and aggressive lending by its state banks, if the United States blocked further redistribution of IMF quotas and voting shares Beijing could, over time, be tempted to lead a regional move in a direction more independent of the IMF, perhaps even to an alternative order.

In any case, the United States has recognized that RFAs can, in times of financial crisis, inject liquidity as well as provide policy insights based on local expertise and buy-in from local political stakeholders. The United States also has favored an upfront understanding of the principles and modalities of coordination between the IMF and RFAs so as to reduce the risk of misjudgment through hasty action in a crisis. Speed in a crisis may be important, and thus prior understandings among RFA participants presumably reduce the risk of policy judgment mistakes. The modalities of such coordination remain to be agreed upon. This is increasingly difficult in the current geo- economic environment.

To this end, much like the EU, the United States and Japan have supported a robust linkage of RFAs to the IMF as necessary for bringing coherence to the global safety network. IMF involvement also provides a basis for cross-regional learning with respect to financial crises. If US support for the IMF weakens, the coherence and effectiveness of crisis response may be endangered.

IMF involvement provides a basis for cross-regional learning with respect to financial crises. If US support for the IMF weakens, the coherence and effectiveness of crisis response may be endangered.

Robert A. Manning

As RFAs have proliferated and the risks of fragmentation have grown, the G20 in November 2011 adopted a broad set of nonbinding “Principles for Cooperation Between the IMF and Regional Financing Arrangements.” These principles endorsed enhanced cooperation between the IMF and RFAs, while recognizing that these institutions have comparative advantages and would benefit from the expertise of the other. The principles seek to offer an overarching collaborative framework of common norms while respecting regional differences.

Based on the difficulties and disputes evidenced in IMF- EU management of the Cypriot, Greek, and other European debt crises, agreeing to guidelines for IMF regional safety net cooperation is an issue best addressed before the next crisis unfolds. The IMF and G20 processes offer an avenue for the United States and like-minded countries to work toward more specific norms and operational guidelines related to the relationship between the IMF and RFAs.

Areas where more specific guidance would be advisable include: alignment with respect to lending and policy conditionality; greater transparency and sharing of information and even joint missions; and improved clarity on resolution of differences with respect to debt sustainability.

Ironically, apart from the United States, where support for and contributions to the Bretton Woods institutions have waned, there is sustained support for these institutions among the majority of their member states. There is, however, mounting frustration amongst emerging economies and some leading shareholders that the IMF needs to demonstrate institutional adaptability in terms of reforming voting shares to reflect the realities of the world economy, as well as its ability to respond to crises and rapidly changing realities.

Through trial and error in its efforts to restore financial stability following financial crises over the past two decades, the IMF has taken a leading role in addressing systemic threats to financial stability. The IMF’s learning curve on the policy side and additional resources provided by member states, combined with structural reforms that have given China and emerging economies like India and Brazil a larger voice, have helped reinforce its perceived legitimacy. The G20 process, including the Financial Stability Board (FSB) that was established in response to the 2007-09 global financial crisis, has also proved to be critical to managing global crises.

Yet the trends of fragmentation in the global trade system, US and Chinese economic nationalism, trade and tariff wars, and the disparagement by the United States of multilateral institutions pose new risks. All the above discussed efforts to better coordinate preparation for —and management of— future financial crises could easily unravel. Specifically, there are growing questions about whether the United States and other IMF member states can reach agreement on the current 15th General Review of quotas, which aims to increase and redistribute quotas. The IMF currently has $1.4 trillion in financial resources. This will be reduced in 2020. Restrictions on resources that can be used for lending and a cautious gearing ratio have resulted in less than $900 billion being currently available for new IMF lending.

Notable fact

The IMF currently has $1.4 trillion in financial resources. This will be reduced in 2020. Restrictions on resources that can be used for lending and a cautious gearing ratio have resulted in less than $900 billion being currently available for new IMF lending.

The United States currently has the largest voting share in the IMF based on its quota (16.52 percent). As an 85 percent vote is required to approve decisions, Washington has an effective veto. European quotas and voting rights are apportioned to individual nations, not the EU. Taken together, however, EU member states’ total quotas exceed those of the United States. But based on the factors that decide actual votes, as a practical matter, US voting rights exceed those of the EU. In any case, China has just 6.09 percent of voting rights.

The Trump administration has indicated that it is opposed to a redistribution of quotas, which would also require another increase in overall quotas. There is speculation that the United States might be more amenable to quota redistribution if there is agreement to alter IMF policies in a direction Washington favors. For example, adopting tougher surveillance of trade and exchange rate policies. In any case, the IMF could adjust to a political stalemate by increasing its bilateral borrowing arrangements and multilateral ones, the New Arrangements to Borrow (NAB), in order to obtain more resources to be able to act as a global financial safety net. But this option is problematic because approval from the US Congress will be required for the United States to participate. China and other emerging economies have little choice given the United States’ ability to veto any IMF decision.

What is the cumulative impact of both declining US support for the IMF and obstinance to change on IMF legitimacy?

Global economic dynamics continue apace. The Organisation for Economic Co-operation and Development (OECD) increasingly accounts for less of the world’s GDP, while emerging economies—Brazil, China, India, and Indonesia— account for more. Yet institutional arrangements have, since the G20 and IMF reforms in 2010, remained largely static.

As no major shift in IMF governance is likely in the near term, over the coming decade pressure may build to reapportion IMF quotas and voting shares to reflect global GDP. There are several possible options. One suggested by C. Fred Bergsten, a former PIIE director, would give parity to the United States, the EU, and China, perhaps 15.5 percent each, thus giving all veto power. Another could be to change the IMF charter so that less than 85 percent of the vote would be required for decision-making. Another option would be one of modest, incremental change, as occurred in the 2010 reforms. In such a scenario, Europe, which is somewhat overrepresented (i.e. in terms of total voting shares of individual EU member states) would stand to lose the most.

[If] we have this conversation in 10 years’ time…we might not be sitting in Washington, DC. We’ll do it in our Beijing head office.

Christine Lagarde, IMF Managing Director from 2011-2019

Projecting forward to China becoming the world’s largest economy, as Lagarde imagined, would the United States then accept less than the required 15 percent and give up its veto? Would it agree to 15 percent or more voting rights for China? Would the IMF move its headquarters to Beijing? Under IMF strictures, any change in quota must be agreed to by the nations involved. While this has so far been a hypothetical question, the financial crisis triggered by the COVID-19 pandemic has the potential to force the issue in the near future. Would the IMF be able to sustain its global role, or would China, a pivotal actor in both the CMIM and the CRA, initiate a new monetary fund? The current geo-economic competition between the United States and China could easily expand from trade and tech to include finance. Part of such a troubling scenario is the reality that China is the largest owner of US Treasury bonds—roughly $1.2 trillion. While it would be mutually destructive and a low- probability event, China could sell off substantial amounts of US Treasuries as a last resort for trade and tech punishment.

The anomalous, unchallenged US dollar?

One reason that such scenarios may be far-fetched is an anomalous reality: while the center of gravity of the global economy continues to shift from the West toward something more resembling pre-modern times when China and India accounted for a preponderance of the world economy, the US dollar remains the world’s unchallenged global reserve currency. This, despite European and Chinese chagrin at US economic and political privileges, and increasing weaponization (e.g., sanctions) that accrue to the United States. Echoing earlier sentiments often heard in China, in September 2018, Jean-Claude Juncker, the then president of the European Commission, frustrated by US extraterritorial sanctions, vowed to have the euro challenge the US dollar as a global reserve currency. The euro, he said, “must become the active instrument of a new sovereign Europe.” 

Trump’s imposition of extraterritorial sanctions after rejecting the Iran nuclear accord has catalyzed efforts to find alternative payment systems to the dollar. France, Germany, and the United Kingdom, for example, created Instex (Instrument in Support of Trade Exchanges) based on the euro, but this is problematic. It is, in effect, a complex multicountry bartering exchange system so far limited to consumer goods and medicines not covered by US sanctions. China has tried to increase use of the RMB in trade. It launched an oil futures market as 80 percent of its oil imports are in US dollars. This is a problem as most nations exporting oil have currencies pegged to the US dollar. Sino- Russian trade is increasingly done in RMB and rubles. However, this accounts for about only 18 percent of their bilateral trade despite Sino-Russian efforts to move away from the US dollar. Even China’s BRI loans are all in US dollars, though China is increasingly likely to use the leverage of its BRI infrastructure connectivity to conduct more trade in RMB.

For the foreseeable future, either the euro or the RMB overtaking the US dollar as the world’s anchor currency remains largely in the realm of aspiration. While in theory both the euro and the RMB could be global reserve currencies on par with or displacing the US dollar, in both cases there are sizable structural impediments that will require transformational policy shifts in both the EU and China to enable them to displace the US dollar. With trade and trade financing largely conducted in US dollars, and amidst economic uncertainty, the demand for US dollar assets, a safe haven, remains high.

With regard to the euro, it would require a lot “more Europe,” as French President Emmanuel Macron and German Chancellor Angela Merkel have often said in response to the eurozone crisis. The EU is a monetary union absent a fiscal union. There is no EU-wide sovereign debt, but an individual nation state debt. A deep, EU-wide bond market, with the backing of the ECB, is one prerequisite for the euro becoming a lead global reserve currency. But EU division on economic policies, banking regulations, as well as foreign policy, now further challenged by rising populism, suggests little movement in that direction. The eurozone’s conservative fiscal policy, marked by an emphasis on debt reduction, points to a dearth of euro assets to invest. This is in contrast to the US Federal Reserve, which in response to the 2008 run on liquidity acted as a global lender of last resort providing US dollars via currency swap lines. The ECB was slow to move in this direction—even in coming to the aid of some weaker eurozone economies. It would require a major revision of EU macroeconomic policies for the euro to become the lender to the world and a magnet for safe-haven investment rivalling the United States.

Similarly, notwithstanding Beijing’s ambitions, for the RMB to assume a global reserve currency role would require a major revamping of China’s financial system. Beijing is gradually increasing the use of the RMB in trade and engaging in more currency swaps. But these are small steps. More fundamentally, China is slow to address its debt bubble—a massive $7-plus trillion combined public-private debt, some 266 percent of its GDP. Moving away from capital controls to allow free movement of capital and allowing the RMB to float freely, creating a deep, transparent bond market are basic steps that run counter to Beijing’s current financial policies. This would also require much improved regulatory transparency and corporate governance at a time when China’s economic policies are becoming more state-centric. Who will view holding RMBs as safe? The RMB is a long way from having the capacity to absorb large-scale global financial flows.On top of these obstacles for the euro and the RMB, the US dollar’s role is further reinforced by what is known as a “network effect,” its dominance in foreign exchange markets in the pricing and trading of oil and other core commodities. History suggests transitions of primacy of reserve currencies is a protracted, gradual process. It also suggests that it may not be a question of either/or in terms of global reserve currencies, and that several currencies can play that role to varying degrees. It is worth noting that although the US economy surpassed the UK’s in 1870, it was not until the 1920s that the US dollar replaced the pound sterling as the world’s leading reserve currency. One wild card, however, given the unraveling of global institutions and US disregard for multilateral institutions, is the fear that the United States will either drive the international economic system toward fragmentation or be unable to play an adequate leadership role in holding it together in the face of the challenges and trends discussed above. The challenge of reviving the post-COVID-19 global economy may be the supreme test.

Blockchain: The rise of cryptocurrencies

Another factor that could accelerate the demise of the US dollar’s dominance is technology and the prospect of digitization of national currencies. Perhaps the most heralded new tech tool, if not cure-all, to not only improve cybersecurity but alter the financial world is called blockchain. A blockchain is an open-source, time-stamped transaction or block of data shared across a network of computers. Each block is protected by cryptographic algorithms and must be verified and accepted by all others. The blocks are bound together. Once a record has been added to the chain it cannot be changed internally. This limits the possibility of hacking. Blockchain eliminates the need for intermediaries and establishes trust as the integrity of data in every transaction must be verified by all in the chain. Blockchain began in 2009 as the mechanism to buy and sell the cryptocurrency, Bitcoin, but has evolved into what many see as the Next Big Thing in digitization. It is also seen as a means to enhance data privacy.

While debate continues about the viability of cryptocurrencies (with no nation’s treasury backing them, why are they credible?), blockchain is becoming a mainstream cybersecurity tool with major US financial institutions investing hundreds of millions of dollars in an effort to have a more secure financial database. Blockchain, which has provided the ballast for a global financial tech (Fintech) industry now competing with major multinational banks, may be an important tool in such national digitization efforts. IBM has created an entire division on blockchain; venture capital firms in Silicon Valley have invested more than $500 billion since 2017; and some projections forecast a $2.3 billion market for blockchain technology by 2023. There has also been a proliferation of cryptocurrencies for which there are no regulations or accountability.The impact of blockchain cryptocurrencies on the global financial system is an issue of growing importance on which the IMF, the US Commerce Department’s Bureau of Industry and Security (BIS), and other international financial institutions need to assess and fashion appropriate regulation. Unlike the Internet that has governing institutions (e.g., the Internet Corporation for Assigned Names and Numbers, ICANN), blockchain has no approved standards or norms. As the use of blockchain spreads, the need for shared norms, standards, and accountability becomes more imperative. A number of central banks, including in the United States, are actively studying the idea of digitizing their currencies. China has filed eighty-two patents on the various aspects of digitizing currencies, suggesting advance planning. Some fear that along with the BRI seeking to integrate Eurasia’s infrastructure, including digital infrastructure, an attempt by China to digitize its currency might be a path for the RMB to rival the US dollar as a global reserve currency.

In Summary…

The global financial system has yet to display the fraying and fragmentation seen in the global trade system. But the trends of regionalization and exclusive nationalism, now supercharged by great power competition, combined with digitization and emerging technologies suggest that the status quo is unlikely to persist. The current economic downturn, the most severe since the 1930s, and attendant financial stresses that may exceed those experienced in 2008, promises to be a colossal challenge. Failure to adequately mobilize a coordinated and cooperative economic response could leave major economies, particularly China and the EU, feeling an urgency to go their separate ways. Such a development could catalyze efforts to create rival reserve currencies to challenge the US dollar and trigger either the fragmentation or reordering of the global financial hierarchy.

Tue, Jul 7, 2020

Trade and financial fragmentation: New challenges to global stability

There is greater uncertainty today about the future of global trade than at any time since the post-World War II trading system was created seven decades ago. This was true before the COVID-19 pandemic froze much of the world economy; the health crisis has added a new layer of uncertainty. We are at a historic inflection point: the global trade regime urgently needs renovation and updating to meet new challenges, yet it is fraying and fragmenting.

In-Depth Research & Reports by Robert A. Manning

China Digital Policy

Tue, Jul 7, 2020

The United States, China, and economic fragmentation

If current trends persist, the future of an inclusive regional and/or global trade architecture is uncertain. The complexity of the US-China economic relationship, China’s mercantile industrial policies, and trade differences will require sustained negotiations to reach new understandings.

In-Depth Research & Reports by Robert A. Manning

Tue, Jul 7, 2020

The international financial system

The economic fallout of COVID-19 is only the most recent in a series of challenges that have raised serious questions about the durability of the Bretton Woods system. In particular, tensions between global and regional financial mechanisms have remained unresolved.

In-Depth Research & Reports by Robert A. Manning