China recently passed a national security law that may be used to crack down on foreign companies operating in China. According to the law, even tacit support for Hong Kong’s autonomy from China can subject a person or entity anywhere in the world to sanctions. Of course, right now China can only target businesses that have operations in China or Hong Kong. These include a significant number of American multinational corporations.
That’s not a great option for China, either. China still needs outside investment, so a crackdown won’t happen. But Beijing has big plans. They seek to emulate America. Sort of.
The United States currently sanctions and fines all sorts of international businesses for running afoul of American law, even in regions friendly to the United States. Washington can do this because of the dollar’s global dominance. And it’s not just foreign companies—Washington has crippling sanctions on whole countries, including Iran, Syria, and Russia.
Because of this, China and Russia have long sought to escape the dollar’s grasp. They’ve done this by setting up a way to do transactions with each other without using dollars. But both countries still have banks and international trade that rely on dollars. This is thanks to the dollar’s reserve-currency status, which means countries the world over are more than happy to sit on dollars to back their own currencies and to use the dollar as a means of exchange.
China now wants to supplant this setup instead of just trying to mitigate it. China is seeking to make its yuan (renminbi, or RMB) a reserve currency, at least on a regional level among China’s big trading partners in Asia.
Already the RMB has been making inroads in Indonesia. China is pushing the RMB in Southeast Asia generally. It is trying to get its trading partners there to use RMBs to trade goods, instead of dollars as is currently the norm. In fact, China’s complete takeover of Hong Kong may end up serving this goal. While it may not be good for Hong Kong itself, it might allow China to make better use of Hong Kong as a tool to advance Beijing’s financial interests.
China’s attempt at monetary ascendance is boosted by America’s fiscal situation. Even before the pandemic hit, America was running trillion-dollar deficits, and the cost of interest on our debt was projected to overtake the cost of our national defense in just a few years.
Despite all this, the RMB is a long way off from seriously competing with the dollar. For such a challenge to mean anything, holders of the RMB will need to trust that they can use it to buy real assets, especially in China, and have liquidity when they wish to sell those assets and move money out of China. Right now, investors can’t be sure that they will be able to buy assets in China that they truly own, and they are equally unsure that they will be able to pull their money at will.
Regionalization, not dominance
What is more likely is that a currency regionalization emerges in the near term. Under such a regime, dollars will still be held as reserves but will increasingly share the role with RMB, euros, yen, and pound sterling.
Such an outcome isn’t completely bad—with the dollar as the only reserve, foreign countries have been happy to sell goods to America in return for dollars, without ever expecting America to produce goods in return. By doing this, foreign countries have kept their currencies low relative to the dollar, which has helped keep it relatively cheaper to produce goods (and hire workers) in those foreign countries instead of in America. Such a setup may have disproportionately harmed blue-collar American workers, even as the country benefited on balance from globalization.
Yet Washington loves the current setup: Politicians can overspend without rates rising, and without inflation spiking (thus far), which is a situation only made possible by the dollar’s status as the sole global reserve currency. The dollar losing this status would probably end the party in D.C.
None of this means that Washington spending us into oblivion in the meantime is good, or that the potential rise of the RMB doesn’t carry risks. One risk is that the RMB gaining some regional power further enables China’s bullying of its neighbors. The biggest risk is that Washington can’t politically right the fiscal ship. This would open the risk that the RMB could eventually supplant the dollar altogether, not just become a more assertive backup to it. In such a scenario, Americans and American firms could find themselves hounded by Chinese sanctions that stretch across the globe (among many other unthinkable implications).
What to do
Instead of a managed decline, or an orgy of spending that leads to ruin, policymakers should opt for a strategy that focuses on America’s strengths and moves us back to our core geopolitical interests.
First, America needs to pursue bipartisan entitlement reform to mend the long-term fiscal situation. Second, America should pursue a policy of greater R&D investment as a percentage of GDP. Many of today’s leading industries are based on technologies that were developed by government efforts to win the Cold War. Third, the United States should begin to work at the presidential and congressional level to examine ideas for international monetary reform.
Finally, America needs to tighten its geopolitical interests to focus on core issues. U.S. troops shouldn’t be guarding Germany, Saudi Arabia, or Iraq, nor should they be spending nearly 20 years fighting a stalemated war in Afghanistan. Instead, America needs to focus on beefing up its deterrence capabilities, and it needs to further invest in a strong air-defense system and Navy. Keeping trade routes open in accordance with international law will be key to American economic dominance in the 21st century.
Willis L Krumholz is a fellow at Defense Priorities. He holds a JD and MBA degree from the University of St. Thomas, and works in the financial services industry. The views expressed are the author's own.