Chinese currency is shown in this photo illustration. Picture taken October 27, 2022.

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Who wins from US debt default? China.


Photo Credit: CFOTO/Sipa USA via Reuters Connect


As the US stumbles toward a possible debt default, the economic risks are clear. In the worst case, it could set off a global financial conflagration, given the role of US Treasury bonds as the risk-free anchor of a vast network of global financial transactions. Even a last-minute avoidance of default could result in a downgrading of US debt and upward pressure on US interest rates, further stressing an already fragile banking system.

But an additional, and possibly underappreciated, reason to avoid default would be its deleterious impact on the US dollar's key currency role and America's standing in the world broadly and vis-à-vis China.

US dollar dominance would erode

The US dollar is the dominant global currency. It accounts for around 60 percent of official reserves and is used most widely for trade invoicing and financial transactions, though the dominance has been declining. During the late 1980s and into the 1990s, some observers believed that the Japanese yen might have been on a trajectory to supplant the US dollar as the key currency of the international financial system; similar interest surrounded the euro when it was established in 1999.

Now the spotlight is on China. It is the dominant trade partner of the Association of Southeast Asian Nations (ASEAN) and Central Asia, and it is not hard to imagine that as those trade flows grow, there will be rising interest in invoicing them in Chinese renminbi (RMB). Currency invoicing data are fragmentary, but it appears that by 2015, a quarter of Chinese trade was invoiced in RMB, making it the world's second-most frequently used invoicing currency. The currency in which a country's trade is invoiced influences the funding structure in its banking system and in turn the currency composition in its central bank reserves. So, expanded use of the RMB in trade should induce greater use in these other areas as well. Ancillary policies such as the creation of RMB exchanges and the development of a Chinese alternative to the SWIFT bank messaging system could encourage even greater use of the RMB, as could development of the eCNY, a central bank digital currency. These developments could greatly undermine the ability of the US to implement financial sanctions and prevent sanctions evasion by actors such as North Korea.

With the continued development of the euro, the world could be headed toward a system in which several major currencies are used in parallel, akin to what existed before the First World War. Barry Eichengreen, Arnaud Mehl, and Livia Chiţu argue that advances in financial technology will reduce the advantages of incumbency and make it easier for market participants to move between currencies, maintaining diversified portfolios.

In simple macroeconomic terms, such a development would not necessarily be a bad thing for the US economy. As Paul Krugman has pointed out, evidence that dollar dominance allows the US to maintain lower interest rates or more easily run trade or current account deficits is not overwhelming. Indeed, it can be a case of too much of a good thing: Foreign countries' reserve accumulation and sovereign wealth funds are the biggest drivers of persistent trade surpluses, with the US running the biggest associated deficit.

US influence in other areas would wane to China's advantage

 Loss of relative status would be felt in other dimensions as well. US influence within international financial institutions such as the World Bank and the International Monetary Fund (IMF) would be reduced. The US ability to use financial sanctions to achieve foreign policy aims—as against Russia following that country's invasion of Ukraine, or against North Korea in response to that country's nuclear weapons proliferation and sanctions evasion—would be attenuated.

In a period of transition, frictions between the US and rising powers would likely ensue in these arenas. For a variety of reasons, disputes between the US and the EU or eurozone could be relatively manageable.

Not so with China, which represents a non-Western, nondemocratic challenge to the status quo. Across a range of issues, it has revealed preferences that are not aligned with those of the US.

Chinese participation in the G20 Common Framework debt restructuring for low-income countries has been uneven. Coordination with the IMF and the Paris Club on debt restructurings for middle-income countries has been similarly problematic. China has not rejected these initiatives, but it has yet to fully embrace them. The US and China also have very different stances on global issues such as the appropriate response to the war in Ukraine, North Korean belligerence, and the future of Taiwan.

During the 1997–98 Asian financial crisis, China eschewed devaluation of the RMB, sparing Asia from another round of politically destabilizing economic turmoil. Although China had self-interested reasons for pursuing this course, its restraint earned it respect throughout Asia. Ten years later, the global economy was rocked by a financial crisis emanating from the West, further raising China's relative standing.

The assertive China of Xi Jinping is not the modest, calculating China of a generation ago under Jiang Zemin and Zhu Rongji. When the Trump administration pulled the US out of the final negotiations of the Trans-Pacific Partnership without any plan B for maintaining US nondiscriminatory trade access in Asia, China responded by negotiating new or expanded free trade agreements with key Asian markets and emerged as the dominant trade partner of Japan, Korea, and indeed all of the Asia-Pacific region.

If the US again falters and reveals itself to be an unreliable hegemon, China will not stand idly by. Although it faces internal constraints to taking a more proactive role in international finance—most critically the maintenance of capital controls, the relative underdevelopment of its domestic financial markets, and the lack of constraints on executive behavior—when presented the opportunity, China would put itself forward as a benign, reliable leader. For a Congress that is obsessed with America's standing vis-à-vis China, the notion that it would commit an own goal and hand China such an opportunity seems incomprehensible.

Data Disclosure

This publication does not include a replication package.

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