By Paul Bowles and Wang Baotai
For the past three years, the US administration has been publicly pressuring China's policymakers to allow the renminbi to appreciate. In response, China's policymakers have taken small steps in this direction but have sought to resist US pressure.
As we look to the future, however, China's reemergence on the global economic scene raises the possibility of role reversal. Will China's rising economic power and burgeoning monetary muscle lead to pressures on the dollar which might threaten its value and its role as the international reserve currency? If this were to occur, then it would likely lead to the US administration's urging the Chinese to support the value of the dollar and not to move out of holding dollar reserves.
The future role of the US dollar as the world's key currency depends in no small part on China. But it is not China's reemergence as an economic power that points to the end of the dominance of the dollar. Nor do we see much possibility of any Asian currency unit being a challenger.
More problematic for the future of the dollar as the undisputed international currency is that current tensions in the bilateral US-China economic relationship are likely to be enduring ones.
China's foreign exchange regime is unlikely to change significantly over the medium term, defined as the next five to 10 years, and China's bilateral trade surplus with the US is also a medium term phenomenon.
China's foreign exchange reserves are likely to continue at high levels. The US-China bilateral relationship is therefore critical in managing the tensions which arise as a result of the trade imbalances and reserve buildup.
It is true that both the US and China have strong interests in preserving a stable international economic and monetary order. But managing this order is the challenge. It is not malevolence but rather policy miscalculations and market reactions which pose the greatest threat to the future value and role of the dollar.
The emergence of China as an economic power does not, in itself, imply a reduced role in the medium to long term for the US dollar.
Looking to historical experience as a reliable guide, the pound sterling continued to play a significant role in the international monetary system long after Britain's economic preeminence was lost.
Even if simple extrapolation exercises are accurate and China overtakes the US as the world's largest economy by mid-century, the dollar is likely to continue for a significant time thereafter as the world's leading currency.
There will be a threat to the dollar's dominance if current economic policies and imbalances are not properly managed. The current situation is one marked by China's having a large bilateral trade surplus with the US, a rapid buildup of official reserves already exceeding US$1 trillion, and a slowly appreciating renminbi against the US dollar.
Not surprisingly, this situation has caused considerable tension between the United States and China, with the US pressuring China to let the renminbi appreciate in an effort to reduce the bilateral trade deficit.
The Schumer-Graham proposal for a 27.5 percent tariff on Chinese imports to offset the extent of China's alleged "currency manipulation" remains an option before the US Senate.
Some change in the direction of greater exchange rate flexibility is likely, and indeed is already happening with the faster appreciation of the renminbi. But it is highly likely that the change will be gradual and will fall far short of the 20 to 40 percent appreciation that US legislators are seeking.
This stems partly from the imperative of providing jobs in China's export sector and from an analysis of what happened when other countries undertook large scale currency realignments.
The exchange rate realignments of the past, such as those with Japan in 1985 and South Korea in 1989, have been seen as an attempt by the US to force other countries to adjust their policies in the name of burden sharing but with the US not accepting its share of the burden.
While China may be willing to go some way down this road, top leaders do not see it as being in China's economic interests to move more than gradually on this issue.
If we look at the trade picture apart from the past few years, China's export growth has not been exceptional by East Asian standards.
If we look at comparable historical experiences, China's export growth might be expected to continue to increase substantially while slowing somewhat from the exceptionally rapid pace of the early 2000s.
China is following the East Asian growth experience in its ability to avoid the trade deficits (and associated balance of payments constraints) which have plagued development efforts in other regions, most notably Latin America.
There is no historical comfort here for those looking for a quick solution to current global imbalances.
Given that we expect the exchange rate regime to change only slowly and the trade imbalance to continue, China's massive foreign exchange reserves will also continue to climb. The trade surplus is a major source of the rising official reserves, and foreign direct investments are expected to continue to be positive and significant.
Our guess as to the most likely path of events over the medium term, therefore, is that, firstly, we will not see a dramatic change in China's exchange rate regime or a rapid change in the value of the renminbi relative to the US dollar.
Certainly, some appreciation can be expected along with a gradual widening of the currency trading band. But the key word here is gradual. China's reforms have been premised on gradualism and this is not about to change with respect to the exchange rate.
Furthermore, Chinese analysis of the impact on Japan of the 1985 Plaza Accord means that its leaders will not be pressured into entering a similar type of agreement with the US.
China's export growth is likely to continue over the medium term although probably at a reduced rate. The comparative historical experience of other East Asian countries suggests that, in general, China's experience has not been exceptional and there is, therefore, no reason to expect a sudden slowdown or reversal.
At the same time, the export growth of the past four or five years has been exceptional and is likely to either slow down or be reigned in. From a policy perspective, the export-led industrialization strategy is seen within China as responsible to a considerable degree for the widening regional income inequalities, which the leadership views as threatening social stability.
Over the medium term a greater reliance on the domestic economy can be expected, a shift again gradual which may lower the trade surplus.
The level of China's foreign reserves is recognized as excessive, causing problems for policymakers both domestically and internationally.
While the scale of reserves and the switch to a foreign exchange basket float mean that diversification out of the US dollar is likely, again this can be expected to occur gradually. It will not be in the interests of the Chinese leadership to spark a fall in the value of the dollar.
The gradual changes that we see happening all mean that the current economic tensions between China and the US are likely to be enduring ones.
Managing the interests of both China and the US over the medium term in the face of these enduring economic tensions will be no easy matter.
On the Chinese side, policymakers wish to maintain the current exchange rate regime. At the same time, they want to gradually reduce the trade surplus although they recognize that this will not necessarily happen with the US bilateral surplus and prevent foreign exchange reserves from increasing much further.
But this is a difficult task with potentially inconsistent objectives (such as maintaining the exchange rate regime while avoiding a further reserve buildup).
On the US side, policymakers have expressed the desire to see the renminbi appreciate substantially against the US dollar and for the bilateral trade deficit with China to shrink significantly so that more painful domestic structural changes can be avoided.
The problem for the US policymakers is that, even if they were successful in achieving a significant renminbi appreciation, this may do little to solve either the bilateral or overall trade deficit.
Both sets of policymakers have their own interests and objectives. Both the US and China have an overarching common interest in the preservation of a stable international economic and monetary order.
However, they have different interests within it and the main threat to the dollar arises from the scope for mismanagement and the length of time during which cooperation will be needed.
US unilateralism, hectoring and demands coupled with Chinese nationalism and exclusion from a major role in international financial institutions leave plenty of room for overreaction, political miscalculations and policy errors.
The only credible alternative to the dollar is the euro. Although China's central bank, along with others in Asia, would undoubtedly like to diversify its reserve holdings to a greater extent and shift into euros, it is not in China's interests to do so in a way which sparks a panic in the markets.
But while malevolence is unlikely, the scope for policy miscalculations and misunderstandings between China and the US is large. The future of the dollar rests in no small measure on the ability of the two powers to successfully navigate the rocky road ahead.
Professors Paul Bowles and Wang Baotai teach economics at the University of Northern British Columbia, Canada.
(China Daily February 27, 2007)