Economics

QE, the renminbi and Scotland

March 17, 2014
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Eswar S Prasad is a professor at Cornell University and a Senior Fellow at the Brookings Institution. His latest book, The Dollar Trap, published by Princeton University Press, explores the global monetary system, and the dominant role played in it by the dollar.

Prasad explains that the dollar cannot for now escape its role as the global reserve currency, “due to weaknesses in the rest of the world and deep problems in the structure of the global monetary system.” There are substantial consequences of this, for the US, other western nations and the developing world.

He spoke to the Prospector about this and other subjects, the full results of which will be published here over the coming days.

Jay Elwes: Do you think that quantitative easing in the US and the UK, has been pro-cyclical—that it has amplified movements in markets and prices that would have taken place nonetheless?

Eswar Prasad: Not quite, because these economies are still well below potential output, especially in the US given where the labour market is right now. There is clearly a lot of room for the economy to expand and do better so in that sense the policy has certainly been counter-cyclical in the sense of trying to mitigate the weaknesses in the economy.

If the economy does recover very strongly and the Fed does not pull back quickly enough it could turn pro-cyclical but I don’t think there is any risk of that at least as yet in the US. The UK does seem to be a little further along in terms of the repair, but my sense is that in the UK too there is a significant output gap that it is likely to mean that we are not able to talk about pro-cyclical monetary policy.

JE: On the question of the renminbi. There was excitement last year when George Osborne secured certain arrangements with the Chinese government for allowing renminbi-denominated deals to go on in the City. Might the renminbi challenge the dollar as the desirable global currency?

EP: So China is an economic powerhouse and a trading powerhouse, everyone wants to be friends with China. So I think the sense that this is a big economic power that has a currency which is becoming more prominent internationally will certainly lead to more central banks signing local currency swap lines with China, perhaps even holding some renminbi as part of their foreign exchange reserve portfolios. If China goes forward with its economic reforms, which allows the country to continue on its growth trajectory—although perhaps at a slightly lower growth rate than in the previous decade—if China moves on with financial market reforms that allow its financial markets to become deeper, broader, give foreign investors more renminbi assets to hold, if China continues towards its move to opening of the capital account, then the renminbi becomes a reliable reserve currency.

So there are many “ifs” here. My sense is that over the next decade or so, the renminbi will become a viable reserve currency. It will erode—but will it challenge the dollar’s dominance? For that, one would have to think about the renminbi becoming a safe-haven currency. And for that you need a lot more than economic size and financial markets, you kneed people to trust you and that sense of trust will require very significant political, institutional and legal reforms. I don’t think that any of these are on the cards.

But there is an important point raised by your question, because the dollar right now is the dominant currency as a unit of account, as a medium of exchange and as a store of value. Let’s take the unit of account function, so if you think about commodities like oil, they’re all priced and denominated and settled exclusively in dollars, that’s because the dollar is the cheapest currency to trade, it’s a very liquid currency. As other financial markets become more developed, as the cost of transacting in other countries falls there is no good reason why the dollar should remain dominant in that role.

As a medium of exchange, it’s likely to become less important. China is now signing bilateral currency pacts with many of its trading partners, with Indonesia, with Korea, with Japan, with Russia. So they can settle trade transactions in each other’s currencies, they don’t need the dollar to intermediate those transactions. So in those two functions, it isn’t happening yet, but over time I can see the dollar playing a less important role.

But as a store of value, I see few competitors to the dollar and certainly not the renminbi, unless again they undertake very significant reforms.

JE: You were talking about China developing new relationships with its regional neighbours. We in Britain have our own question about currency unions with regional neighbours. The big monetary and political story is the question of Scotland and the pound. Do you think Scotland would be able to have anything like the global economic standing that it enjoys if it were to lose Sterling?

EP: Having an independent currency would certainly give [Scotland] another shock absorption mechanism. But my sense is that they have benefited enormously from the very close integration with the rest of the United Kingdom. So it’s not obvious to me that this is going to be a big net plus for Scotland to break away from the currency union. It will create some degree of instability.

Now if Scotland can move forward very quickly with setting up its own institution mechanisms and make them distinct from those of the UK it could work, but setting up institutions that work well, that are credible takes a long time and I’m not sure that Scotland is quite there yet in terms of being able to run its own ship effectively from the United Kingdom.