Professor Gunther Schnabl is head of the Institute of Economic Policy at the University of Leipzig.
As the U.S. wavers under the weight of dire economic, social and health crises, historic measures introduced to stabilize the country have increased general government debt to 130% of gross domestic product. Most of the newly issued government bonds were purchased by the Federal Reserve, which has significantly inflated its balance sheet.
Meanwhile, China's economy is working again, and general government debt has increased to only about 60% of GDP. The balance sheet of the People's Bank of China has not grown much either, while Beijing has demonstrated its economic leadership in East Asia by joining the 15-nation Regional Comprehensive Economic Partnership, the biggest trade deal in history.
Has a window of opportunity opened to allow China to finally break dollar hegemony in East Asia?
There are -- among other things -- historical reasons why the dollar is the international financial system's leading currency. The dollar was the foundation for the Bretton Woods system established after World War II, serving as an anchor and reserve currency for all central banks participating in the system.
When the U.S. financed the Vietnam War by printing money, the dollar came under severe deprecation pressure, forcing other central banks to buy large amounts of dollars to stabilize their exchange rates. With other countries in effect cofinancing U.S. government spending, this led then French Finance Minister Valery Giscard d'Estaing to lament the "exorbitant privilege" benefiting the U.S. economy.
When -- concerned about imported inflation -- the German Bundesbank allowed the Deutsche Mark to appreciate in the 1970s, other countries followed suit and the system collapsed. Europe became decoupled from the dollar, whereas Asian countries -- with the exception of Japan -- kept stabilizing their exchange rates against the U.S. currency.
When China opened up to international transactions in 1994, it introduced a tight dollar peg. An informal dollar standard in East Asia emerged, with many countries stabilizing their exchange rates against the dollar. This created a high degree of exchange rate stability within the region, intensifying the division of labor and trade.
China plays a pivotal economic role in East Asia because, unlike Japan, China has been growing strongly since the 1990s. Within the East Asian production network, Southeast Asian companies are often suppliers for the Chinese companies that export to the U.S. and Europe.
The yuan's close dollar peg helped to stabilize the region when many of the region's currencies plummeted during the 1998 Asian and 2008 global financial crises. In the current crisis, the yuan is standing like a rock in the surf. China's currency has, however, not yet become the regional anchor and reserve currency, because China's capital markets are strictly regulated and sealed off by capital controls.
However, the cards may now be set for a reshuffle. With President Joe Biden aiming to finance the reanimation of the U.S. economy and ambitious climate goals with the help of the Fed, this is likely to bring the dollar under further depreciation pressure.
The financial effects of running persistently loose monetary policy can be expected to gradually weaken U.S. financial markets. Herein lies the opportunity for China to promote the international role of the yuan, as the German Bundesbank it could with its own currency demonstrated in the 1970s.
Back then, in a period of global monetary easing, the German central bank held its monetary policy tighter than the Fed, so that the mark persistently appreciated. This transformed the mark into an attractive international store of value. By the late 1970s, the U.S. government had to issue Carter bonds in marks and Swiss francs, symbolizing the endangered global currency status of the dollar.
When the United States returned to a tighter monetary policy under Fed Chairman Paul Volcker in the early 1980s, Europe was already decoupled from the dollar, with the mark becoming Europe's anchor and reserve currency.
For China's leaders, dependence on the dollar has long been a thorn in its side. Beijing was reluctant to cofinance U.S. rescue packages for Wall Street as the People's Bank of China strongly increased its foreign reserve holdings between 2000 and 2014.
But China has since taken two important steps. Since late May 2020, the yuan has been allowed to appreciate against the dollar by close to 10%. In addition, China's holdings of U.S. Treasuries have gradually declined from $1.3 trillion at the end of 2011 to about $1 trillion by the end of 2020. This comes along with a significant decline in the share of foreign and international investor holdings in U.S. Treasuries, from 43% in 2013 to less than 30% today.
Instead, the Fed is holding a growing share of its own outstanding Treasuries. This could herald an erosion of trust in the international role of the dollar. If the yuan continues to appreciate, the temptation for other East Asian countries will be to keep their currencies pegged to the yuan in order to maintain intraregional exchange rate stability.
Furthermore, Southeast Asia's economies may be tempted to exchange their dollars for yuan to capture revaluation gains against the dollar. An informal yuan block would emerge, with the yuan becoming an anchor and reserve currency for the smaller Southeast Asian currencies. Japan may be tempted to join as well.