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Professor William Overholt is co-author with Guonan Ma and Cheung Kwok Law of Renminbi Rising: A New Global Monetary System Emerges out now from Wiley. You can read a sample chapter here or buy the book here.
This interview is an edited version of an interiew we conducted before Trump was elected but has been updated to reflect this.
Jacob Bettany: For those readers who don’t know of you, could you give us a little bit of background about you and your co-editors?
William Overholt: I have served in think tanks for sixteen years and was president of the Fung Global Institute in Hong Kong for two years. I ran research teams for banks for over twenty years, ending as chief regional strategy at Nomura. I’ve written seven books and just finished an eighth, on subjects ranging from nuclear proliferation to Asian geopolitics to the rise of China which has been my most widely-read book. And Renminbi Rising is my latest book, about the increasing importance of the Chinese currency in the global monetary system.
My co-authors are both economists who have previously worked for me in investment bank research teams. Guonan Ma worked for a number of investment banks and he was the principal Asian economist of the Bank for International Settlements for fourteen years. C K Law was a distinguished economist, he also became a political figure serving on the Chinese People’s Political Consultative Conference, which is effectively their lower house, for about 2 decades and he runs an aviation consulting group at Chinese University in Hong Kong, in addition to other consulting.
Jacob Bettany: I was interested to read about how the book originated, it seems that it was very much a collaborative effort. Could you tell us a little about how the book came to be?
William Overholt: It started with the CEO of HSBC Stuart Gulliver approaching us and saying that HSBC was having an internal debate about how important to make the Renminbi internationalisation in HSBC’s strategy. Because there were different views he wanted an objective report by outsiders with very detailed calculations about how big various markets would be, in both product and geographical terms. It was an extraordinarily tight deadline. So I reached out to the people I thought were the best in the world to work on this, namely Guonan Ma and C K Law. We agreed to do it and we put forward a report for them between September and December of 2014. It was an extraordinary effort which no other think tank that I know of could have done. Having done that for them we then spent six months converting it into a book suitable for a much broader readership. We scrubbed it of all the regressions and detailed product forecasts and laid out what we thought was important for the world. Then we had a conference that assembled many of the world’s leading experts to gather their ideas and to get criticism for our own ideas. We then packaged that into a version of the book and had it reviewed by distinguished scholars, and put the book to bed in July of 2015. Wiley did a great job in getting it out six months later.
Jacob Bettany: Who is the book’s intended audience and why did you feel the book was necessary?
William Overholt: The target audience are deeply involved in thinking about foreign policy and global financial affairs. That includes government officials, think tank members, scholars from senior students at good universities to professors, and the broad readership of publications like Foreign Affairs. That audience need to know these things because the global monetary system is one of the foundations of how the world economy and politics work. Its influence is pervasive and we’ve had basically one system since the late 1940s. Now it is beginning to change and people need to know how the world is going to change as global monetary system evolves.
Jacob Bettany: Is the analysis in the book useful for the West trying to understand China, and also for the Chinese themselves?
William Overholt: Yes, it’s useful for the west because the system is changing away from the Bretton Woods system that has been underlying global monetary affairs since the 1940s and it’s changing as much because of missteps the United States has made as because of what’s happening in China. It’s useful for the Chinese because it lays out all the hurdles that China needs to overcome in order to make their currency an important global one. For instance, they need to unify their multiple bond markets into a single bond market. They need to do things like fix their legal system; if countries are going to put their reserves in Chinese currency to the tune of tens of billions of dollars, they need to know how disputes are going to be settled and be confident that the legal system is objective. We set out a path for China to overcome the obstacles it is going to face.
Jacob Bettany: You begin the book describing the emergence of the Renminbi as a “transformative event of global significance”. Could you discuss that statement a little?
William Overholt: There are many roles for a currency in a global system. The operational level that is most important to companies and banks is trade finance. With the financial crisis, global trade finance collapsed. Asian countries are much more dependent on trade than western countries and Asian banks are much more dependent on trade finance than western banks are. Asia, and especially the Chinese, had to step into the breach and try to fix the global banking system. The Basel III group decided to put heavy capital requirements on trade finance. One can debate whether those were appropriate or not but what it meant was that western banks wouldn’t be very interested in trade finance and Asian banks would continue to serve their customers. So the Renminbi became the second most important currency in trade finance. “Second most important” means they have 9% of global trade finance. The Euro has less, 7% and the $USD still has 81%.
Then in other areas such as general payments, the RMB has been coming up very fast. It went from 9th most important to 5th in a year, 2013-2014. It’s still very small in global foreign exchange trading but as they open up their capital controls it will become much more important very rapidly.
There is no area in which it’s challenging the $USD and there’s no area in which it’s likely to challenge the pre-eminence of the $USD in the next 5-10 years but it is becoming one of the important currencies and changing the system which has been dominated by the dollar, Euro and £sterling.
Perhaps the most important change is in the institutional arrangements. We relied on the so-called so-call Bretton Woods system where the IMF, the World Bank and associate institutions like the Asian Development Bank and the dollar are the foundations of everything in the global monetary system. That worked pretty well up to 2009 when the US Congress started refusing to modernise the system. They refused to increase the capital of emerging institutions and they refused to modernise the governance to reflect the fact that the world economy is very different today than it was in 1947. In particular China, Brazil and India have a big global role and that needs to be reflected. Given the refusal of US Congress to modernise those institutions there is a vacuum. and the Chinese moved to fill that with a group of institutions like the Asia Infrastructure Investment Bank, the so-called BRICS bank, also known as the New Development Bank and a reorganised part of the China Development Bank, which together would have a lot more capital than they would in the Bretton Woods institutions. So we now have a dual structure emerging in the international management of global monetary affairs and that creates a major question as to whether those institutions will converge on common standards and consistent behaviour or if they will diverge into competing centres of monetary power.
What I haven’t talked about yet is the role of the Renminbi as a reserve currency. The IMF accepted the Renminbi last October as one of the components of the Special Drawing Rights which are the most prestigious reserve currencies. That gives an official stamp of approval but has very little practical significance because the number of SDRs in circulation is very small. Still, we must ask whether the Renminbi can challenge the $USD as a reserve currency? It seems to be the question at the forefront of everyone’s mind even though it’s a much less important question than trade finance and foreign exchange trading and those kinds of things. For the foreseeable future it’s very unlikely that there will be any kind of challenge. Many countries are using the Renminbi as a reserve currency. They reserve a little bit out of a desire to please the Chinese authorities and to cover their trade obligations to China. But they still overwhelmingly use $USD and secondarily the other major currencies rather than the Renminbi. They will rely on the RMB heavily only when China has a bond market like the American bond market, which everyone trusts to remain open in a crisis, and when the Chinese legal system can be objective and trusted. Only then will there be even any question of the Renminbi becoming as important as the $USD reserve currency. Barring some kind of global catastrophe, that’s unlikely to happen much before the middle of this century.
Jacob Bettany: So some way to go. But you do foresee the possibility that the Renminbi will challenge the Euro in little more than a decade. Could you explain that a little bit?
William Overholt: Yes, around 2005 I worked on a study on the future role of the Euro and reported back that whereas the $USD is a deep pool of liquidity, the Euro is a group of puddles of liquidity. You have a German puddle and some Italian puddles and some Spanish puddles, and it is puddles rather than one big pool. If you do a relatively small trade you move the currency against you. For instance back in 1997 when Thailand ran through thirty billion dollars in a couple of weeks. Such trades which would create huge moves if they were done in Euros but not much if they are done in dollars. So the Euro is not a significant competitor for the dollar as a principal crisis reserve.
The Chinese currency today is like the Euro. The size of their bond market is only 10% of the US size but could grow very quickly, and we present a scenario on how they could accomplish extremely rapid growth. But, it is also fragmented like the Euro. In China it’s fragmented under four different regulators. Different parts of the market have different regulators and different yield curves. When you look at the Chinese bond market as a whole, its yield curve is all over the place. If China unifies those bond markets, and that will be the only rational way for China to go, then in a few years it will have a very deep bond market. It won’t be fragmented like the Euro, and the question then will be will it be open like the $USD and stay open in a crisis like the $USD?
Jacob Bettany: The book describes a perfect storm of four trends which underlie the rapid rise of the Renminbi over the last five years. Could you outline those trends and perhaps indicate if there are any additional factors which may play a role in driving things forward in the near future?
William Overholt: One trend has been the rapidly rising use of the Renminbi. It’s a very large, increasingly wide-open economy and so the use has become very widespread. The second is that the Chinese have created a group of institutions that foster and facilitate the widespread use. They’ve created a bunch of trading centres which make it possible to use the currency freely. A third factor has been the U.S. refusal until late 2015 to modernise the Bretton Woods institutions; that created a vacuum and the Chinese have been able to move into that vacuum. Another factor is disillusionment in Asian countries, Russia and other places internationally with dependence on the $USD and established institutions after the financial crisis. There’s a feeling that the West’s crisis spread to Asian countries even though they hadn’t made major mistakes; then for a long time their dollar reserves were depreciating rapidly in value, which they viewed as unfair and there wasn’t much they could do about it.
The final thing was that, with its Belt and Road Initiative, China started promoting development in the way that the US started to in the 1940s with the Marshall Plan and various aid programs. This has given China a major positive role, still mostly a declaratory role but the money is starting to appear. This could promote a comparable level of progress and development in many countries between China and Europe to what the US achieved in the wake of World War II.
Jacob Bettany: You mentioned that perhaps the policy response has been late from the point of view of the US, are you optimistic that there will be an appropriate policy response?
William Overholt: Well first of all to frame what happened. The US Congress tried to keep things the same as they’d always been by refusing to modernise the Bretton Woods institutions. That created a vacuum in which new, potentially much more potent institutions emerged, and then the US refused to join the new key institution, the AIIB, so the US locked itself out. The Presidents, both Republicans and Democrats, understood that that was a dumb thing to do but the US Congress, pushed by right-wing institutions, was determined to go back to the good old days. But in late 2015 the US agreed to modernise the old institutions and has muted its previous opposition to the AAIB. That’s at least an adjustment to reality but depending on who is president and who the key players are in Congress starting next year, we really have no assurance as to whether a policy response will be appropriate or not.
If he were to follow through on campaign commitments to tear up major trade agreements and start a trade war with China, and follow the instincts of his right wing supporters to refuse to support and modernize major international institutions, President Trump might well be catastrophic in his policy response. Optimists are hopeful that his advisors will moderate his positions, but his support for Brexit and his encouragement of Nigel Farage show that he might follow through on some of his destructive positions.
Jacob Bettany: What do you feel are the key challenges facing China and the Renminbi?
William Overholt: China has a dual challenge in its real economy. It has been trying to do all the right things in terms of internationalising the Renminbi but it has to make the underlying economy work and that means overcoming two problems. One is that they have to make a transition to a new growth model and this is widely understood. The old drivers of net exports and investment have become ineffective and they have to transform their growth model to one driven by domestic demand and retail consumption, by services rather than manufacturing and by innovation rather than by technological emulation. Those things are easy to say but they are very difficult to do. A services economy behaves very differently from a manufacturing economy. In a manufacturing firm an extreme hierarchy with one boss and workers doing exactly what they’re supposed to do is the norm. China does that very well and its whole social structure and politics are organised that way. In a services economy, for instance if you are running a restaurant you have to train your workers very well but then you have to give them a lot of leeway for independent decisions. The whole social structure and thought process are very different. We talk about consumption rising to replace investment and a lot of leading authorities talked as if consumption might rise much more rapidly. My colleague Guonan Ma has done studies which show that Chinese consumption has risen faster than any other country in the world in the last decade. And now the economy is growing half as fast as it used to grow. The problem has never been suppression of consumption. The problem is that they’ve been investing wildly too much so the investment is going to come down a lot without consumption being able to rise any faster than it has been. So, they’ve got difficult problems there.
The second problem they have is a major financial squeeze. The housing market is bubbly and there are cities with ghost areas of buildings with no occupants; they’re hurting the banks. Local government debt is way too high, state enterprise debt is way too high and the state enterprises are not earning back their cost of capital. There’s a shadow banking sector that’s got a bit out of control. They need to deleverage to get out of this financial squeeze but it’s very difficult to solve the first problem, transferring resources to new growth drivers, in an economy growing much slower and deleveraging. The time when you want to be transferring funds into new sectors is when you’ve got a rapidly expanding economy.
They’ve got a difficult problem putting these two things together. With that background, they’ve committed to themselves and to the world that they’re going to move toward a more market-orientated currency and they’re going to have a stable currency. Well if a company or country is in a slowdown, in a financial squeeze, its bonds are going to be worth less than they were before. The pressures on the currency are going to be very strongly downward for a while, and a while doesn’t mean months it means years. So moving to a market-orientated currency and moving to a stable currency are incompatible. That is the dilemma they are facing right now.
Jacob Bettany: The book talks about a virtuous circle of reforms and the preconditions required for true internationalisation. Could you briefly talk us through that virtuous circle, does it provide some optimism towards this difficult situation?
William Overholt: Yes, the lesson the western world derived from the Asian financial crisis was that there is a set of prerequisites that a country has to put in place before it can liberalise its currency. It needs to fix its banks. It needs to liberalise interest rates. It needs to open its capital accounts. If it doesn’t have these prerequisites in place then there’s a risk that liberalising the currency and opening the capital markets will permit an outflow of funds and jeopardise the banks. The Chinese decided to turn that on its head and use currency liberalisation the way they use the WTO as a lever for domestic reform. And, if we liberalise a currency that will create pressure to open capital markets and opening capital markets will create pressure to liberalise domestic interest rates because otherwise capital will just flow in and out and there wouldn’t be any valve opening and tightening to manage those flows. That in turn will create pressure for bank reform and as part of that they’ll have to implement a deposit insurance fairly quickly. As long as things are stable and normal that kind of process makes a lot of sense but when they are already facing massive capital outflows and more currency volatility than they expected, getting that virtuous circle working without having a series of major problems is proving much more difficult.
Jacob Bettany: The book is optimistic in general, where does that optimism come from given this is a complex and long-winded process?
William Overholt: Well what we did was to do alternative scenarios. Our middle scenario, which assumed that economic growth would remain relatively strong and that other economic conditions would remain relatively stable, was one in which things like that virtuous circle work. Then we had a more optimistic scenario and we had a more pessimistic scenario. In the whole book there’s one italicised sentence, to emphasise the importance of that sentence. That one italicised sentence is, “The risks are primarily on the downside.” At the moment I’d say we’re a little more toward the slower scenario. Growth is probably significantly less than the official figures indicate, capital flows are more than the authorities anticipated, and the contradiction between the policy of having a more market-oriented currency on the one hand and having a stable currency on the other is more severe than the authorities anticipated.
Jacob Bettany: You indicate that this scenario will play out at some point although the timescale is uncertain. I was curious about what failure, if it is possible, would look like in this instance.
William Overholt: If I were to write the ultimate failure scenario it would go like this. The economy would go the way of Japan’s economy. Through about 1975 Japan was very dynamic and it was reforming and globalising quickly. Then starting in the mid-1970s the major interest groups and the governing party turned inward. They became less interested in globalising and they became more protectionist internationally and more protectionist domestically. As a key indicator, they stopped sending a lot of students abroad; now they send fewer students abroad than even Taiwan. As a result they’ve stagnated for 20-25 years. It wasn’t the financial crisis of 1990 that led to the lost decades; it was the cessation of reform and the turning inward after the mid-1970s.
In China you have a rigorous effort at reform and continued globalisation, from the very top. Their economic reform plan is probably the most impressive plan of any that we know of in history, but it steps on the toes of every powerful interest group. It damages the interests of the party, the government, the state enterprises, the banks, the local government and the military. So there is enormous pushback. On previous performance one would hope that the leadership will be able to push through its reforms using the anti-corruption campaign as a hammer. But if the interest groups succeed in blocking much of the reform program, as they have so far done, then you get stagnation in the manner of Japan. Such stagnation would be at a much lower level of income than Japan-- stagnation in the $10000-$15000 per capita area rather than the $40,000 per capita area. That would lead in turn to social disruption and perhaps even political instability. That’s an extreme scenario but it’s not an impossible one. People lost interest in the yen when Japan stagnated and they would lose interest in the Renminbi if China were to stagnate and have a time of troubles. So that’s not a prediction, it’s a scenario but it’s not at all impossible.
Jacob Bettany: Thank you very much Professor.
Renminbi Rising: A New Global Monetary System Emerges is out now and you can order your copy direct from Wiley here.