Does the Fiscal Cliff Threaten the Dollar's Dominance?

Recently, Goldman Sachs' (GS -0.23%) CEO Lloyd Blankfein suggested that a failure to resolve the upcoming fiscal cliff could threaten the dollar's status as the leading global reserve currency. His comments add to a growing chorus of business executives, politicians, and economists who argue that the dollar's days as the leading reserve currency are numbered.

But these fears may be overblown. Despite rising government debt, and other fiscal issues, the depth and liquidity of U.S. financial markets remains unmatched. But, perhaps more importantly, there simply aren't any viable alternatives to replace the dollar as of now.

Dollar dominance
Nearly half a century ago, France's finance minister at the time, Valery Giscard d'Estaing, famously criticized the dollar's dominant position in international trade and finance, calling it an "exorbitant privilege." Fast forward some fifty years, and another Frenchman -- this time French president Nicolas Sarkozy -- had some not-so-kind words about the dollar's privileged position.

Mr. Sarkozy cited the very serious global current account imbalances that have built up as a result of the dollar's exalted status as the central reserve currency. He further suggested that the dollar's central role in the global monetary system does not reflect the emergence of a multipolar world, in which countries like China, India, Brazil, and Russia are gaining larger shares of the global economic pie.

What does this show? At first glance, it shows that the French like to complain. But beyond that, both d'Estaing and Sarkozy raised some very valid points about the legitimacy of the international monetary system and the dollar's central role within it.

Perhaps, most crucially, if the dollar were to be dethroned, what would replace it?

Alternatives to the dollar
One currency that has risen to the forefront of this debate is the Chinese yuan. An increasing number of experts are arguing that the yuan will soon replace the dollar as the leading global reserve currency.

Arvind Subramanian, a senior fellow at the Peterson Institute for International Economics, is one of the many economists who consider a dominant yuan to be inevitable. In a Financial Times article last year, he wrote, "...the yuan could displace the dollar as the premier, reserve currency within the next decade or soon thereafter."

But there are a number of reasons why this may be unlikely to happen within the next decade. Let's take a look at one of them.

China's capital account
In order for the yuan to become a plausible alternative to the dollar, not only must it be freely convertible, but China must also adopt an open capital account. In macroeconomics, the capital account is one of two components of a country's balance of payments, the other being the current account. A surplus in the capital account reflects a net capital inflow, while a deficit indicates a net capital outflow.

Currently, China's capital account is strictly controlled, meaning individuals and institutions have a limited number of channels to move yuan between the Chinese mainland and offshore markets. While many of these restrictions are being gradually dismantled, China's capital account remains much more limited than that of the United States, which has a fully open capital account.

There are good reasons for these restrictions. China's ruling Communist Party has an overarching incentive to maintain control. By implementing sweeping capital controls, it enjoys a unique ability to control various economic levers, allowing it to maintain broad control over exchange rates, interest rates, and credit creation via the nation's government-controlled banking system. Liberalizing the capital account would greatly reduce the control that China's authorities exert over the functioning of the economy -- control that has taken decades to acquire.

Reforming China's banks
Even if the authorities succumbed, there would be other major hurdles to cross. A major one is financial sector reform. Currently, China's financial sector consists of a handful of banks that are largely state-controlled. As Peking University professor and China expert Michael Pettis notes, these banks have proven to be incredibly inefficient in allocating capital and appropriately gauging risk, and would have gone belly up were it not for artificially low interest rates and the socialization of credit risk.

Yet, Beijing accepts these inefficiencies as a trade-off for control and "stability." However, to promote a more active role for the yuan through liberalizing the capital account, sweeping reforms of the financial sector would be necessary, including major overhauls to promote greater and more transparent corporate governance. It appears uncertain whether or not the recently anointed Communist Party leaders are willing and able to reform the nation's financial sector.

Final thoughts
While the process of yuan internationalization has accelerated dramatically in recent years, China's currency remains miles behind the dollar and the euro. In addition, China's financial markets are nascent, and need much greater access and transparency for international investors to participate in them, and settle transactions using yuan.

To be fair, China's equity markets have made dramatic progress in recent years. The Shanghai Stock Exchange, the nation's largest, registered a more than tenfold increase in trading volume in the five years since 2005. And Chinese companies like Renren (RENN), Baidu (BIDU 0.98%), Dangdang (DANG), and Yongye (NASDAQ: YONG) are all listed on American stock exchanges and actively traded, with most of them reporting three-month average daily trading volumes near or above 1 million shares. Still, the country's bond markets, which are far more important in terms of promoting the yuan internationally, are relatively immature, with very low trading volumes.

Going forward, the decisions made by the newly-minted Communist Party leaders with respect to capital account and exchange rate liberalization, will be crucial in determining whether or not the yuan supplants the dollar as the leading global reserve currency. Major reforms will be needed to accelerate this process. If history is any guide, the process of becoming a global reserve currency is a long and arduous one. China should be no exception.