US Government Debt Different - Finance Department - University of ...

32 Default and the International Role of the Dollarsuddenly decide to diversify their foreign exchange holdings for economicreasons, with the result that the U.S. might face much highercosts to finance its debt and deficits that it appears politically unableto manage fiscally – at least in the short run.In my view, both the Chinese and U.S. views are misplaced. Interdependenceon this scale tends to align incentives rather than exacerbatedifferences. Even with the depth, breadth, and resilience ofU.S. financial markets, the Chinese would drive rates sharply againstthemselves if they tried to reallocate a large portion of their portfolio.And the question remains: reallocate to what? At the momentthere is no credible alternative foreign currency market to place theirfunds. Countries with attractive currencies such as Switzerland orSingapore could not possibly absorb the magnitude of inflows, norwould they tolerate the consequent appreciation of their exchangerates. The euro area surely looks less promising as a refuge than theU.S. at present and the Chinese are likely to rule out the Japaneseyen on a number of grounds.The history of the pound sterling suggests that reserve currency statusneed not last forever. Nonetheless, it would take a dramatic shockto the system – much larger than the recent financial crisis – to eliminatethe enormous network advantages the U.S. currently enjoys.Of course, a hard dollar default that is not cured immediately couldbe precisely that sort of shock. Although the benefits of issuing thepredominant international reserve currency may not be overwhelminglylarge, the costs of suddenly abandoning that role would havesystemic consequences not only for the U.S., but equally for the restof the world.What other currency might ultimately challenge the dollar in its reservecurrency role? The Chinese government is taking the first stepstoward enhancing the international role of yuan. China has the naturaladvantage of an enormous, well-diversified economy, but, to date,the development of their financial markets has substantially laggedbehind the development of their economy. In June 2011, however,the Chinese allowed most corporations to pay for imports in yuan.Then 365 Chinese companies were allowed to sell exports for yuan.