Could China Be at the Center of the Next Monetary System?

13
Jun

For a reasonably long period of time, currencies were fully backed by gold or silver. In other words, a piece of paper money was simply a bank note (hence the name, an etymology long-forgotten as far as most people are concerned) that granted you the right to receive a certain amount of precious metals, should you choose to redeem it. However, since it was more convenient to simply exchange bank notes (fungibility being the name of this property) than carry around let’s say a bunch of silver, it became the norm in commerce.

After World War 2, the wealth dynamic was asymmetrically in the favor of the United States, with them owning roughly two thirds of the world’s gold. As such, it was decided to switch from currencies fully backed by precious metals to a system where they were indirectly backed by gold. In other words, all currencies were tied to the United States Dollar and the Dollar was backed by gold.

As of 1971, however, Richard Nixon took the United States off the gold standard, after central banks kept demanding gold in exchange for their paper money due to concerns about the United States increasing its monetary base so as to fund projects such as the Vietnam War and Lyndon Johnson’s Great Society.

Do you see a pattern?

It’s not very difficult to figure out that changes of our monetary system tend to be cyclical in nature. Perhaps it’s due to re-balancing brought about by changes in wealth distribution, maybe it’s a result of confidence loss. Whatever the reason(s) may be, we just know this tends to happen every once in a while and an important question arises: can the current status of the US Dollar as the foundation of global trade persist indefinitely?

While it’s impossible to be 100% percent certain, we have valid reasons to believe something will eventually change and a lot of thinkers are wondering whether or not the next monetary system will be centered around China.

While it is true that China has been experiencing tremendous growth and is on a clear upward path, we need to understand that a financial system dominated by China is an unrealistic goal, at least for the next monetary system cycle. While China’s growth has been nothing short of impressive, it’s still not nearly as dominant as the United States was after the Second World War.

Perhaps if China were to reach GDP Per Capita parity with the US and thereby have a five or six times higher nominal GDP as a result of the major population difference between the two, the balance might lean in China’s favor. At this point though, that is not the case, so the question remains: if the next financial system will not be China-centered but the Dollar’s status as the global reserve currency will disappear… then what?

A potential answer lies somewhere in the middle.

While the next financial system cannot, realistically-speaking, become China-dominated, this doesn’t mean China cannot play an important role. The same way, players such as Japan and the European Union (an European Union with a combined GDP greater than that of China and also greater than that of the United States, let us not forget that) might want to or need to play a role as well.

At this point, the best thing we have is something close to the IMF’s SDR system. Or, to put things differently, perhaps our best choice would be embracing a new monetary system based on a basket of currencies rather than one dependent on just the United States or China. As always, however, one can never know for sure.

The two quasi-certainties we have are:

  1. A US-centric monetary system will most likely not be able to persist indefinitely
  2. China is not ready to take over at this point, nor is it a given that just one country has to take over

As such, while not a prediction in and of itself, let’s just say the highest-probability outcome in terms of our new financial system is represented by the “basket of currencies” dimension. Therefore, an adequate answer to the question which constitutes the title of this article would be this: yes, China could be at the center of the next monetary system… but not alone!

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[…] included in the International Monetary Fund’s Special Drawing Rights (SDR) basket of currencies in 2016, China is most definitely getting […]

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