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

Richard J. HerringDuring August 2011, this privilege was extended to 67,359 companies.Not surprisingly, foreigners prefer to sell goods and services foryuan rather than to purchase Chinese exports with yuan. (Their presumptionis that the yuan will inevitably appreciate relative to mostother currencies.) The result is that there is an increasing offshorepool of yuan (‘redbacks’) held mainly in Hong Kong. A nascent offshoremarket in yuan-denominated bonds has emerged (the dimsum market) based mainly in Hong Kong, but with recent issues inLondon.33Nonetheless, all of this activity is far short of what would be requiredto launch the yuan as a major reserve currency. To do so, Chinawould need to end its policies of financial repression and capital accountcontrols – which have been important tools to sterilize reserveinflows and manage the economy. China would also need to giveup setting its exchange rate, which has been a key policy tool, andpermit itself to run sizeable current account deficits to accommodatethe reserve currency demand for the yuan. This agenda is not impossible.Indeed, it would probably be in the best interests of China’scitizens. But the difficulty in moving from China’s current financialsystem to the open financial system necessary to sustain a reservecurrency should not be underestimated. The measures necessary toopen domestic capital markets might, indeed, undermine the currentpolitical structure.What can be concluded from the preceding observations? First, if theU.S. should default on its obligations it is likely to be a soft default,not a hard default. The main risk that should concern foreign holdersof dollars is the risk of diminished purchasing power that is not compensatedfor by higher nominal interest rates. Second, although thereserve currency role of the dollar is not overwhelmingly valuable, itcannot be renounced without global systemic impact. Third, in viewof the substantial network advantages that the dollar has achieved,the loss of its role as the principal reserve currency would occur onlyif a viable substitute emerges slowly over time, or in the aftermathof a truly major shock such as a hard default on dollar obligations.