Key Trends in Globalisation

Xi Jinping's perspective of China and Latin America's 'shared destiny'

 

Chinese President Xi Jinping's recent visit to Latin America illustrates that from both the economic and political viewpoint the relation between China and Latin America is increasingly becoming one of the world’s most important. Although Xi Jinping specifically used the phrase "community of shared destiny" to describe China's relations with Brazil, the term clearly applies to China’s conception of the relations between itself and the Latin American continent as a whole.

Economically a specific basis creating the basis for this relation is that China and Latin America are now regions of the developing world at similar stages of development. Adjusting for different price levels, calculating in World Bank parity purchasing powers (PPPs), Latin America's per capita GDP in 2013 was slightly under US$15,000 and China's slightly under US$12,000. Both were substantially higher than South Asia's US$5,000 or sub-Saharan Africa's US$3,400.

That China and Latin America are both at significantly higher levels of economic development than other major regions of the developing world means they have expanding and substantial areas for trade and cooperation. This also helps explain why trade between China and Latin America as a whole is almost exactly in balance – evidently substantially limiting any trade frictions.

Naturally, within that overall framework, individual issues in trade between China and Latin America remain. Manufacturing exports from China to Latin America are much more developed than those in the opposite direction. China's rapid growth in the last decade played a major role in helping most Latin American countries develop, by creating high demand and high prices for their energy and other commodity exports, but over the longer run Latin America will want to develop its own manufacturing exports to China. China's purchase of US$3.2bn of regional range aircraft from Brazil's Embraer, announced during Xi Jinping's visit, is an example of a trend with which Latin America will be concerned. Furthermore, China's relations with Latin America interrelate with a key strategic question for that continent's own development – Latin American economic integration.

China's economy is much larger than any individual Latin American countries – giving China a much larger market than theirs, and therefore creating the potential for huge developments in economies of scale and geographical specialization in different economic sectors. Measured at current exchange rates, China's GDP in 2013 was US$9.2 trillion compared to US$2.2 trillion for Brazil – Latin America's largest single economy.

This means that the question of Latin American integration is linked with its relation to China. For Latin America to develop relations firmly based on equality with China the continent as a whole has to relate to it, while China’s trade would clearly benefit from the much greater size of market and economic dynamism Latin American economic integration would create.

Simple numbers dictate this reality. China has approximately twice Latin America's population, and its economy is approximately twice as large as Latin America's, no matter how measured – in current exchange rates Latin America's GDP is US$5.6 trillion and China's US$9.2 trillion, and in PPPs China's GDP is US$16.2 trillion and Latin America's US$8.5 trillion.

If relations are only between China and one Latin American country, it is therefore objectively difficult to keep them balanced. But greater Latin American integration fits with China's own strengths. A large part of China's extraordinary economic development, an average 9% a year economic growth for over 35 years, is due to huge infrastructure investment. From 1992-2011 China spent an average 8.5% of GDP a year on infrastructure.

China has already promoted infrastructure projects as a key way of ensuring Asia's economic integration. Similarly Latin America's economic integration cannot be achieved without large scale infrastructure links. China's huge financial resources – the world's largest foreign exchange reserves and an economy generating over $4 trillion a year for capital investment compared to only $2 trillion in the United States – makes it the world's strongest economy to aid and participate in such development. China's infrastructure capabilities reach far beyond finance – its sale of ultra-high voltage transmission lines to Brazil, for example, is already important in aiding developing the hydro-electric power potential of the Amazon. Discussions between Brazil, Peru and China, during Xi Jinping's visit, on the development of a transcontinental railway indicate the scope of what is possible. On a smaller scale China is lending US$2.1bn to Argentina for railway development, and US$4.7bn for dam and power construction.

This interlinks with the considerable significance for Latin America of the announcement, at their recent summit, by Brazil, Russia, India, China and South Africa (BRICS) of the establishment of the US$50bn BRICS development bank and the US$100bn BRICS contingency fund. In terms of international finance, previously U.S. dominance of the IMF resulted in a historical record of that organization not being used in a genuinely multilateral way, as a means to allow developing economies to expand their economies, and overcome short term economic problems, but instead to impose policies which served U.S. financial interests and blocked economic growth of countries receiving loans – as writers such as Joseph Stiglitz have shown in detail. Latin American countries, as well as those in Asia, experienced this.

Despite U.S. government proposals to reform the IMF to better reflect the weight of developing economies, made during the international financial crisis, and which would have ameliorated this problem, the U.S. Congress has not passed the necessary legislation to achieve this. The BRICS countries were therefore able to agree to establish a lending mechanism which helps partially circumvent the U.S. veto in the IMF. While only an initial step China’s great financial fire power makes it the core of a trend that is likely to increasingly weaken U.S. dominance of international financial flows.

China's loan and aid policy, which is therefore likely to be influential in the new BRICS institutions, has radically differed in approach from the IMF. China has not required from those receiving loans or aid domestic economic policy conditions – China merely self-evidently required that its loans had to be repaid, receiving in a number of cases guarantees not only in cash but in commodities. But China did not specify what domestic policies should be pursued to ensure loan repayment but left this to the country concerned – a different approach to the IMF.

The BRICS development bank and contingency fund is therefore potentially significant not only for long term growth but for allowing Latin America to avoid experiences of the type seen in the continent's "lost decade" of the 1980s, when severely contractionary economic policies were imposed as part of the "Washington Consensus." In addition to the long term development from the BRICS bank, the sums available from the contingency fund will help countries avoid being forced into adopting unsuitable or damaging economic policies due to short term financial difficulties.

If the advantages of this for Latin America are evident, what are the advantages for China – because to be stable and long term any relationship has to be win-win? The answer is not only in immediate reciprocal trade and investment but the security in supply and markets Latin America can help bring to China.

China is sufficiently strong militarily that not even the most extreme U.S. neo-cons advocate a war with it. But China is conscious it is dependent on extremely internationalized sources of supply and markets – China has already overtaken the United States as the world's largest goods trading nation. Therefore, if any country wished to weaken China, it can attempt this by cutting off sources of supply or access to markets. For example, the sanctions implemented by the United States against Iran can directly put pressure on China's economy. Expanding China’s relations with Latin America allows China to diversify both its sources of supply and its markets – contributing to its economic security.

For these reasons Xi Jinping’s emphasis on the importance of China’s and Latin America’s links, its ‘shared destiny’ is unlikely to have been merely a rhetorical flourish for his hosts. It corresponded to the objective interests of both China and Latin America

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An earlier version of this article was published at China.org.cn .

The most important book on economic growth to have appeared for many years

Vu Minh Khuong's The Dynamics of Economic Growth is the most important book on world economic growth to have appeared for many years. It is for that reason (full disclosure) that I did a small amount of work assisting on editing it.

The crucial importance of the book is rightly summed up by Professor Dale Jorgenson, of Harvard University, in his forward: "The emergence of Asia... is the great economic achievement of our time. This has created a new model for economic growth built on globalization and the patient accumulation of human and non-human capital.' However the book's economic importance goes far beyond Asia - although it is by far the most important comparative study published anywhere of how East Asian countries became prosperous. The aim of this review is therefore to explain why the book is so important from the point of view both of general economic theory and policy making.

There are two different strategies for economic growth, related to two different theoretical analyses of its causes, which have been pursued in the world in the last six decades.

(i) The first analysis is that the primary force in economic growth is accumulation of capital and labour (factor accumulation) and that productivity (Total Factor Productivity - TFP), while significant is less quantitatively important than factor accumulation. This growth strategy was pursued in the developing Asian economies. It has been a spectacular success, creating the fastest increases in living standards ever seen in human history, lifting hundreds of millions out of poverty and now creating `first world' living standards in a series of what were originally `third world' countries (south Korea, Singapore etc.).

(ii) The alternative analysis says that factor accumulation, of capital and labor, is not nearly as important for growth as TFP. This is the policy that has been applied in the advanced economies, and has accompanied their economic slowdown. As Jorgenson notes in his forward: `The growth strategy of many advanced economies emphasizes innovation, which has been quite satisfactory for the past decade, but neglects investment in human and non-capital, which continues to fall.'

The two different analyses have different practical policy conclusions:

(i) if the most important driver of economic growth is factor accumulation, then the most important policies are those promoting high rates of factor growth. These include high savings rates (to finance capital investment), policies to widen participation in the labor forces (as this increases labor supply), promotion of education (as this increases labor inputs via increasing labor quality) etc. A reasonable rate of growth of TFP is important, but quantitatively not as important as policies which facilitate factor accumulation. As Vu summarizes the results: `the secret of the Asian growth model lies not in achieving high TFP growth but in sustaining reasonable TFP growth despite the intensive mobilization of factor inputs over extended periods.'
In particular, Vu notes: `The growth model of the successful Asian economies... is not outside the realm of development economics. Rather, this model is the outcome of a strategic policy framework that focuses on fostering and sustaining the high marginal product of capital. In other words, this policy framework pays strategic attention to enhancing the attractive rates of capital investment.'

(ii) Alternatively, if the main locomotive of growth is believed to be TFP growth, then policies promoting factor accumulation (high saving rates, widening participation of the population in the work force etc.) are not so important as factors assumed to increase productivity.

These two different practical growth strategies are directly related to statistical and theoretical analysis of economic growth. The formalisation of `growth accounting' was carried out in the 1950s by Nobel Prize winning economist Robert Solow. There is an immense literature on the key issues in growth accounting - the best single historical survey of which is Jorgenson's introduction to The Economics of Productivity.

But in his justly famous ground-breaking papers Solow's calculations made the error of not taking into account improvements in the quality of investment and labour. This led to the erroneous conclusion that the majority of economic growth came from productivity increases. This latter mistake was subsequently corrected, and accurate methods of calculating growth were formally adopted by the US, UN and OECD.

The person who more than anyone else developed more accurate measuring tools for growth was Jorgenson. Jorgenson initially developed his analyses for the US economy and this was then extended to other advanced economies.

Vu's enormous contribution is to show the same processes operated both in Asia and globally. By doing this Vu shows why earlier predictions that the Asian `economic miracle' could not take its economies to `first world' living standards were shown to be inaccurate by the actual continued development of these economies - Singapore now has a higher per capita GDP than the US.

But the data in the book also gives clear guidelines for the advanced economies. The overwhelming cause of the East Asian countries rise to prosperity was their huge accumulation of capital investment. As Vu notes: `Capital accumulation was... the primary driver of Developing Asia's lead over other parts of the world in terms of economic growth.' There were no exceptions in this pattern of successful Asian development: `The pattern of rapid growth driven by intensive capital investment... is consistent over time and robust to different types of economies in terms of size, location... and level of development.'

In precise numbers, high capital investment accounts for 54% of the growth lead of developing Asian economies over the Western industrialized economies and for 62% of developing Asia's lead over other developing economies. High capital investment was almost twice as important as productivity (TFP) increases in explaining Asia's growth lead over advanced economies.

However, crucially for economic policy in all countries, Vu shows that this fact that investment was the driving force of Asia's rise to prosperity was not unusual. Modern econometrics shows clearly that investment is the main factor in economic growth in all parts of the world economy: `the importance of capital accumulation as the driving force for economic growth is not unique to Asia but pervasive worldwide. For example, Jorgenson and Siroh..., Oliner and Sichel... found that capital input is the most important source of growth in most economies. This source of growth is important not only for the developing countries, in which the capital stock per capita is low, but also for developed nations, in which the capital stock per capita is relatively high... even for the G7 economies, investment in tangible assets was the most important source of economic growth and the contribution of capital input exceeded that of total factor productivity for all countries for all periods examined. This finding is supported by the results... that, on average, capital input accounted for approximately 57 per cent of GDP growth in the industrialized group.'

This study of Asia also confirms findings that as a country moves towards being an advanced economy the role played by investment in its growth increases. Taking countries in ascending order of economic development, the percentage of growth due to investment is 50% in non-Asian developing economies, 55% in Asian developing economies and 57% in advanced economies. Growth in advanced economies is therefore more `investment led' than in developing economies, and development to advanced economy status leads to growth becoming more capital investment intensive.

This explains why the downplaying of factor accumulation (capital investment and labor development) in the advanced economies has been unsuccessful as a growth strategy. TFP by itself is just too small a part of the economy to create rapid economic growth.

In short Vu's book has decisive implications for economic policy in developing economies outside Asia, for the developing Asian economies, and for the advanced economies. Its demonstration that: `the secret of the Asian growth model not in achieving high TFP growth but in sustaining reasonable TFP growth despite the intensive mobilization of factor inputs over extended periods' is applicable in every economy.

This also directly applies to developed economies, and, as Jorgenson notes, the successful growth strategy of Asia is counter posed, and has proved itself superior, to those strategies based on TFP growth (innovation, entrepreneurship) in Europe and the US. As Jorgenson notes: `Economic commentators, especially those outside Asia, have been reluctant to recognize the new paradigm for economic growth that originated in Asia, since this would acknowledge the failure of Western ideas that still greatly predominate in the literature on economic growth and development.'

It is not accidental that two of the most important writers on economic growth and policy today are Asian - Justin Yifu Lin from China, although for period Vice President of the World Bank, and Vu Minh Khuong from Vietnam, currently based in Singapore.

The most widely discussed book on economics at present is Piketty's Capital in the 21st Century. This is justified. It is what economics should be about - a masterpiece of factual research from which its theoretical conclusions flow. Piketty's subject is distribution of the results of growth.

Vu's book is a factual masterpiece on the process of economic growth itself. The book is, unfortunately is very expensive, £80, but find a way to read it somehow. To be well informed on the causes of economic growth it is necessary to have read this book.

If that sounds like the highest possible praise it is because it is intended as such. This book really is that important for economic policy in every country.

 

Why China won't suffer a Western type financial crisis

Inaccurate articles sometimes appear claiming China faces a "severe debt crisis." Factually these are easily refuted. Changyong Rhee, the IMF's Asia and Pacific Department director, pointed out that China's national and local government debt is only 53% of its GDP, compared to U.S. government debt which is roughly as big as GDP, or in Japan where government debt is 240% GDP. Foreign debt is 9% of China's GDP – insignificant set against the world's largest foreign exchange reserves.

Factually, it is therefore unsurprising that China's predicted "Lehman" or "Minsky" moment, a financial collapse, invariably fails to occur. But there is another, even more fundamental, reason why China's economy does not suffer severe financial crises of the type that struck the Western economies in 2008 or wracked the Eurozone. As this illustrates a way that China's economic structure is superior to the West's, it is worth analyzing.

Starting with fundamentals, the way the argument is constructed that China faces a "serious debt crisis" violates the most elementary accounting rule – more precisely that of double entry book keeping, which was invented in Italy "merely" eight centuries ago! This is that for every debit entry there has to be a credit one, and vice versa. Discussion of only of one side of a balance sheet without the other is financial nonsense. Claims, such as in the Financial Times, that the big story of 2014 is "the black cloud of debt hanging over China" are financially meaningless given they do not discuss assets to be set against debt.

To illustrate this elementary accounting principle, take a simple example. A company borrows $100 million at 5% interest, uses it to build houses, and sells them at 15% profit. To declare "there is a crisis – the company has a $100 million debt" is evidently nonsense. The company has debts of $100 million but assets of $115 million. It can repay $105 million and make $10 million profit – there is no "debt crisis" whatever. That its assets are greater than its debt illustrates why it is financially illiterate to discuss only debt without assets. A "balance sheet" is called that because it has two sides, not one.

Apply this to China and the West's financial systems. Evidently no financial problem exists in either if a borrower makes a profit on a loan – they repay it. A problem only exists if the borrower does not make sufficient money to repay the debt.

If the borrower is a small or medium one, again there is no difference between Western and Chinese financial systems. In both cases the borrower partially or fully defaults and, if necessary, goes bankrupt.

Specific criticisms can be made, which this author would tend to agree with, that in the West's system companies are sometimes too easily allowed to use bankruptcy to escape debts, and China has propped up some companies that would have been better allowed to go bankrupt. But these are detailed points, not affecting the essence of the matter. China is also now taking a more robust line in forcing into default small and medium borrowers that cannot repay loans – recently Shanghai Chaori Solar Energy Science and Technology defaulted without a bail out.

But, by definition, individual bankruptcies by small and medium companies do not affect the financial system's viability – they are a normal part of market functioning. The key difference between China's and the Western financial system comes with debts by large institutions – "system making" ones to use technical economic terms. Here Western and China's systems differ – and China's is superior.

First take Western government debt. As Western governments ideologically oppose state investment, Western state borrowing is overwhelmingly used not to finance investment but consumption – via social security payments, unemployment pay etc. For example, in the United States at the depth of the post 2008 Great Recession, annual government borrowing was 13.6 percent of GDP but state investment was only 4.5 percent – borrowing overwhelmingly financed consumption. As Western government debt primarily finances consumption it therefore creates no lasting asset. That is why in the West it is not wholly misleading to look at state borrowing purely from the debt point of view – even if it is wrong conceptually.

China is different. The bulk of borrowing, particularly by local government, is for investment, primarily in infrastructure. Borrowing therefore creates lasting assets – roads, subways, housing etc. Assets in turn create revenue streams directly, indirectly, or both. Direct revenues are fares, rents, tolls, etc. Indirect revenues are generated as infrastructure investment aids economic growth, yielding taxes, and has well-known effects in raising land values – land sales being one of Chinese local government's biggest sources of income.

As China's government debt is used for investment, not consumption, analysis not financially offsetting debt by assets created by them is not merely wrong formally but is therefore a serious factual mistake. Similarly, company borrowing is primarily used for investment, i.e. asset creation.

This leads to a final difference between China's and the West's financial system. In both Western and China's financial systems, if the value of an asset created by borrowing equals at least the value of the debt, there is evidently no problem. The difference between the two comes with bad investments – where the value of the asset created does not equal the borrowing.

A major financial crisis occurs when there are large scale bad investments by "system making" institutions, those that are "too big to fail" – this need not be a single bad investment but can be very large numbers of small bad investments, as with the U.S. sub-prime mortgage crisis. In these cases, in both the West and China, only the state has the resources to solve the problem. But the way the state intervenes is entirely different in China and in the West.

In the West, the financial system is fragmented – individual institutions are financially separate. As there is no unified financial system, the necessary transfer of resources from the state, to prevent collapse of "system making" institutions, is therefore external and chaotic. For example, following Lehman's collapse, essentially every private Western bank had to be salvaged by government subsidies, direct nationalization etc. The same occurred with GM and Chrysler. In Greece, the EU and IMF ordered partial bond defaults, bailout packages etc. The transfer of resources from the state, and in some cases private bond holders, was via chaotic "crisis" means – the "Lehman moment."

Basic laws of economics cannot be avoided, so if in China a substantial number of bad loans occur, as with banks in the 1990s, the state also has to transfer resources. But in China the core of the financial system is not fragmented, but is a single integrated whole constituting central government, local governments, state banks, and large state owned companies. Resources are therefore not transferred by chaotic crisis, as in the West, but within this integrated financial system. China's financial system could be conceptualized by the analogy of a single person transferring money from one bank account to another – for example from the central government to bail out local governments. Or, if you want to put it more popularly, it is as though money is transferred from one pocket to another.

A transfer of resources from the state therefore takes place in China, as in the West, but in an orderly and not a chaotic fashion. That is why China never has a "Lehman moment" or a "Minsky moment," a large scale financial crisis – the superiority of China's financial system to the West precludes it happening.

To avoid misunderstandings, this does not mean that if large scale bad investments are made in China this does not create problems. If, for example, a bad railway investment is made which fails to generate adequate users, the resources transferred within the system to bail it out means these resources are not available to build a railway which is required. But the problem therefore not does appear in the form of systemic financial crisis, which does not occur for reasons outlined, but in the form of the economy's overall investment efficiency declining as resources are sucked into inefficient ventures at the expense of efficient ones.

The data on this latter process is clear. Every major economy suffered a decline in investment efficiency as a result of the international financial crisis. Taking the five years after the financial crisis began, the percentage of GDP that had to be invested in China for its economy to grow by 1% rose from 3.4% to 4.9% – China's investment efficiency worsened under the impact of the global financial crisis. But in the United States the percentage of GDP that had to be invested for the economy to grow by 1% rose from 8.1% to 33.1%! In other words, China came through the negative consequences of the international financial crisis much more successfully than the United States.

Because they ignore elementary accounting rules, those writing that China will suffer a severe "debt crisis" are writing financial fairy stories – which is why, as with all such tales, they never actually occur.

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A slightly longer version of this article originally appeared in Chinese at Sina Finance and this English version, under a different title, was originally published at China.org.cn .

The dangers of exaggerating RMB internationalisation

RMB ‘internationalization’ is one of the most discussed issues in China’s economic policy. But many claims regarding the extent of RMB internationalization are greatly exaggerated and the practical proposal to attempt to achieve it, capital account convertibility of the RMB, is extremely dangerous for China’s economic and social stability. To eliminate false estimates and policies, it is, therefore, necessary first to accurately establish the facts regarding the real international role of the RMB and then analyze what consequences flow from these.

Those wishing to present a highly exaggerated picture of the degree of RMB internationalization frequently do this by presenting percentage growth figures. This gives a misleading impression because it fails to mention that such growth rates look impressive merely because they are calculated starting from extraordinarily low levels. To take a typical example, the proportion of RMB payments carried out in the US in April 2014 had risen by 100% compared to a year earlier. This sounds spectacular - until it is noted that the rise was only to 0.04% of all worldwide currency transactions!

A sense of reality is immediately injected it if its noted that in April 2014 the RMB accounted for only 1.4% of international payments – globally, RMB payments are entirely marginal. Furthermore even this very low figure exaggerates the RMB’s internationalization because a large percentage of the payments are merely between mainland China and Hong Kong.

To illustrate the real situation, start with China’s strongest area internationally – trade. By the end of 2013, 8.7% of world trade was denominated in RMB – but the dollar’s share was almost 10 times as high at 81%. Furthermore, the RMB figure was artificially flattering as around 80% of RMB payments were for Hong Kong. Excluding Hong Kong RMB payments were marginal. For example, by April 2014 only 2.4% of China and Hong Kong’s trade with the US, China’s largest single country export market, was in RMB.

The same situation exists with international bond markets. The European Central Bank states that by mid-2013 a miniscule 0.3% of international bonds were in RMB, of which 75% were by China and Hong Kong companies – meaning issuance of RMB bonds by other countries was under 0.1% of the global total.

Regarding world foreign exchange reserves, at the beginning of 2014, 60% were held in dollars and 25% in Euros. The percentage in RMB was 0.01% - which is too small even to be considered marginal.

These numbers are so low that there is certainly room for huge percentage increases, yielding profitable business for individual financial institutions, without altering the reality that the RMB remains entirely peripheral in the global financial system.

But beyond the extremely low numbers, there are even more fundamental structural reasons why the RMB will not play a central role in global finance in any near time frame, and why the dollar will retain its dominance for a prolonged period.

There have been only two international currency systems in the last 300 years. In 1717 Isaac Newton linked the pound to gold, thereby establishing the gold standard. This gold standard system lasted for 200 years – its collapse can be dated either to 1914, when it was temporarily suspended, or to 1931, when the pound formally broke its previous parity with gold. The second system, a de facto dollar standard, has lasted for almost seven decades since 1945. The interregnum between the two systems, 1931-45, accompanied the most catastrophic crisis in international economic history.

It is immediately striking from this how long is the lag between the economic rise and fall of domestic economies and changes in monetary dominance. The UK fell behind US as the world’s largest market economy in the early 1870s, but Britain maintained international monetary dominance for almost half a century. There was a seventy year lag between the US becoming the world’s largest economy and the dollar becoming the dominant international currency.

This great ‘rigidity’ in international payments structures flows from the fundamental nature of a market system itself. A functioning efficient market can only operate if there is a single measure of prices – if there were different price standards in different parts of the market uncontrollable arbitrage and/or fragmentation would destroy that market. Gold therefore provided a single measure for international markets, then the dollar did. The only period in which there was no single measure, 1931-45, could only exist because the world economy was disastrously fragmented – and the accompanying effects of that, the Great Depression and World War II, were catastrophic.

It is this fact that a market, including the global market, can only function properly if there is a single price unit that explains the key features of the history of the international monetary system - and will therefore dictate its necessary future development. It is why there were only two global price standards, gold and the dollar, over a three hundred year period; that there was no period, except in the chaos of the 1930 and World War II, when there was a mix of dominant currencies; and that the transition between the gold standard and the dollar standard did not take place gradually but abruptly and in a short period. These were all features which expressed the necessary dominance of a single price standard within a market.

A further necessary consequence of a single price standard is that, in order to allow its practical functioning, substantial international holdings of whatever is the price unit must be held – large gold holding under the gold standard, and large dollar holdings under the dollar standard. The scale of these reserves then itself becomes a powerful factor in maintaining the dominance of that monetary unit.

To guard against risk flowing from such large holdings, this international reserve unit must itself have great intrinsic power. In the case of gold this was ensured by the very high costs of gold production, which ensured it remained scarce and had a very high value in exchanges with other commodities. In the case of the dollar, it was the fact that that the entire world wished to purchase the products of the US economy, which could be bought with dollars – the historical guarantee of the dollar was the production of Exxon, Ford, Chevron, General Motors, Caterpillar etc. The strength of the dollar was not based on “paper” but on the US production that could be purchased with it.

For this reason a monetary unit which is not backed by great intrinsic economic value cannot function as the core of an international payments system. The Special Drawing Rights (SDRs) of the IMF, or the ‘paper gold’ proposed by Justin Yifu Lin, have no intrinsic economic value but rely on agreements between countries – Justin Yifu Lin for example proposes “countries would agree that p-gold could be used to settle all international transactions for goods and services, commodities and securities.” But unfortunately history shows clearly that agreements between countries can be, and frequently are, broken.

No reserve currency unit could therefore be based on something so insubstantial as an agreement. The RMB, certainly, is backed in the final analysis by China’s economic productive power and international desire to purchase China’s products – something very real. But China’s GDP at market prices, the only measure that counts for monetary purposes, is only just over half of that of the US. Furthermore the enormous accumulated reserves of dollars held by other countries during the dollar’s period of dominance, as well as other factors, ensure there is no possibility of the RMB replacing the dollar, at the earliest, for several decades – as already noted, such factors ensured the dollar did not achieve global dominance for a prolonged period after the US was already the world’s largest economy. Nor can the dollar ‘share’ a dominant position with other currencies – as already seen, for a market to function there can only be one price unit within it.

These fundamental economic realities are the reason why periodic predictions, which ignore these economic fundamentals, that the dollar is about to be replaced by some other unit invariably turn out to be false. For example, the prediction was made that the Euro could replace or challenge the dollar. The reality, as the statistics given show, is that the dollar continues to dominate international payments.

What are the consequences of these economic realities for RMB ‘internationalization’? The RMB can certainly become a minor international currency, but it cannot challenge the dollar’s dominance. That could only occur if the ‘dollar system,’ as a global price unit, were replaced by an ‘RMB system’ – which would require a revolution in the global economy, and is entirely unrealistic in the coming period. It is for this fundamental reason that ensure that despite the fall in the dollar’s exchange rate against most major currencies since the 1970s the dominance of the dollar within the international monetary system continues.

These realities of the international monetary system in turn have major consequences regarding the issue of liberalization of China’s capital account – making it extremely dangerous. As it will be impossible to replace the dollar as the dominant international currency for a prolonged period, and therefore the dollar will remain the dominant unit which people wish to hold, the inevitable overall result of global capital account liberalization since the 1970s was not a really multilateral flow between currencies but merely a net inflow into dollars. This strengthened the international position of the dollar and allowed the US to finance its huge balance of payments deficits. The net effect of capital account liberalization was therefore necessarily to allow the US to strengthen in its own economy through the use of other countries savings.

Countries which mistakenly believed that international capital account liberalization was a multilateral system, rather than one to allow funds to flow into dollars, were taught harsh lessons in fundamental economics by the economic crisis which therefore hit them. For example, South East Asian countries, which had mistakenly imagined that they could benefit from capital account liberalization, were taught a devastating lesson in the crisis of 1997, with huge exits of capital from their economies demonstrating that the only large scale net flows which the dollar based financial system permits are into dollars.

It is argued that this current international monetary system is “unjust”. Gold was produced internationally, therefore could not be controlled by a single country, and therefore was a truly multilateral unit against which all currencies were measured. In contrast the ‘dollar standard’ means that one country’s currency is the unit in which all others are measured - giving the US a type of ‘monetary monopoly’, with many consequent advantages in the international financial system.

The answer to that is ‘yes’. It shows our world is very injust – for those who were unaware of this already. But there is nothing that can be done about it until another unit can entirely replace the dollar as setting international prices – an event which is decades in the future. It is for this reason that international crises, even those originating in the US as in 2008, do not weaken the dollar’s position. As Eswar Prasad factually documented in his book The Dollar Trap: ‘global financial crisis has strengthened the dollar’s prominence in global finance.’

It is because the real content of capital account liberalization is to allow flows into the dollar, that it has become an extremely destabilizing international economic force. As Joseph Stilitz, Nobel Prize winner in economics, concluded reviewing the history of financial crises:

“capital account liberalization was the single most important factor leading to the crisis. I have come to this conclusion not just by carefully looking at what happened in the [Asian] region, but by looking at what happened in the almost one hundred other economic crises of the last quarter century… capital account liberalization represents risk without a reward.”

The reason capital account liberalization is necessarily ‘risk without reward’ is because its sole real content, for the reasons already given, is that in net terms money flows into dollars. The real result of RMB ‘internationalisation’, which would require liberalization of China’s capital account, would therefore be a large outflow of its capital into the US, and into dollar assets, to the detriment of investment in China. For this reason leading Chinese economists are correct to oppose liberalization of China’s capital account. As Yu Yongding correctly put it:

“China has to maintain its capital controls in the foreseeable future. If China were to lose control over its cross-border capital flows it could lead to panic and so capital outflows would turn into an avalanche and eventually bring down the whole financial system.”

But the consequences of capital account liberalization would not only destabilize China economically but socially and politically. As Martin Wolf, chief economics commentator of the Financial Times, noted:

“such a reform would not be merely financial and economic. It would also be political. If China’s capital account were to be fully liberalised, the government would lose its grip on the most effective of all its economic levers.”

China can therefore, undoubtedly, develop RMB internatalization within a global monetary system which will continue to be dominated by the dollar. But large scale internationalization of the RMB would require liberalization of China’s capital account and that in turn would economically, socially and political destabilize China. Any idea that the RMB can in any significant way challenge the position of the dollar, or escape the dangers of liberalization of the capital account in a dollar dominated system, are therefore at best an illusion and at worst could very seriously damage China’s economy.

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This article appears in Chinese on Sina Finance.