Stephen Jen makes four important points:
1. Size of GDP is not all in determining a reserve currency.
2. It also requires "soft infrastructure", including liquid capital markets, a relatively stable economic regime, a sustainable political regime and a mighty military force.
3. There are strong incumbency advantages reflected in the "half-century lag" between the rise of the American economy and the ascendancy of the dollar to reserve-currency status.
4. The dollar's decline and the yuan's rise depend on America doing everything wrong and China doing everything right.
He is right that the size of GDP is not all. In fact, an economy needs to be more broadly dominant in terms of trade and external financial strength. On these counts, China, with its rapidly growing trade and the fact that it is the world's premier and unsurpassed creditor, looks very dominant; America looks weak for the foreseeable future, given its fiscal, external and growth problems.
Note too that the error that most analysts make is to focus on size and then claim that there was a half-century lag between the rise of the US economy and that of the dollar. This is historically inaccurate. In a broader sense, Britain retained its dominance through the first world war and beyond because its trade remained larger and external finances stronger than those of America into the 1920s. And indeed the dollar overtook sterling, as Barry Eichengreen and Mark Flandereau's 2008 discussion paper has shown, in the mid-1920s. Sterling's international role persisted thereafter in large part for political reasons because Britain promoted trade and exchange agreements with its colonies that induced the latter to hold sterling rather than switch to dollars. Correcting for these factors, the real lag in the rise of the dollar was only ten years.
Mr Jen has a point about the soft infrastructure. But the case of Japan is illuminating here. When Japan was a rising power and dominant in Asia, the yen began to be used as a reserve currency, even though Japan had less-developed capital markets and no army to speak of. Then, when the country's dominance faded, so did its reserve-currency status. Now China is the dominant power in Asia; it is the main trading partner of most of the key Asian countries. This example suggests that China's currency will gain in stature, notwithstanding that it lacks some of the factors that Mr Jen alleges are preconditions.
Moreover, the Chinese situation is changing rapidly. Just as they have done with the hard infrastructure of roads and railways, the Chinese authorities are currently building an advanced soft infrastructure. Not a day seems to pass without China announcing some new initiative to internationalise the yuan, and the political incentives are in place to continue the process.
Yes, the dollar has an incumbency advantage. But as trade within Asia becomes increasingly centred on China, it will start to make sense to denominate that trade in yuan (ie, use the yuan as a unit of account). And since the yuan is already a good store of value, it will soon also become a medium of exchange. Once these conditions are in place, it will make sense to use the yuan as a reserve currency, starting in Asia and then spreading to the rest of the world. And the flip side of incumbency must also be remembered: once a tipping point is reached, the transition to the next equilibrium is very swift.
Because the economic fundamentals are moving strongly in China's favour, I would argue that as long as there is no major political or social upheaval (which cannot be ruled out, of course), and as long as China posts a reasonable rate of growth and continues its policy reforms, the default is in favour of the yuan's rise.
And on the other side, Mr Jen seriously underestimates America's predicament: because of its over-indebtedness and because persistent short-term problems (unemployment, idle capital) can morph into long-run ones, its medium-term growth prospects look bleak. Meanwhile, the entitlement explosion and political polarisation suggest that the long-term fiscal position is fragile. And above all, America has now a long-entrenched "middle class problem", comprising a number of related pathologies: stagnating median income, rising inequality, declining social and economic mobility, problems in education, and competition from China and India even at the upper end of the skill spectrum. It is not at all obvious that we should be more bearish about China's economic fundamentals than those of America.
To use Mr Jen's metaphor, China has an overbuilt upper body with the legs of a 12 year-old. Doesn't it make sense to think that eventually the legs will develop, rather than the upper body wither? In that case, its reserve-currency status will eventually fall into line with its underlying economic "fundamentals".
And, if you really want to look back, as Mr Jen does, one conclusion leaps out from history, as Ian Morris points out in his recent book, "Why the West Rules for Now?": China was the dominant power for nearly 1,000 years until the 1500s. So, never underestimate the Chinese.
