Pragmatism vs. Ideology: China’s SDR Proposal

Since Deng Xiaoping embarked on the policy of economic reform and openness in 1978, China has steadily been gaining prominence as a rising world power. Newspapers start allocating more spaces to articles on China. Television channels begin airing more shows on China, with topics as diverse as history and politics to foods and travels. The media blitz covering Beijing Olympics, billed as coming-of-age party last year further gave China the opportunity to showcase its remarkable transformation to the world. Gone are the days when it is an embarrassment to associate one with China.

The latest financial crisis also appears to be a blessing in disguise for the Chinese leaders. One by one, they denounced the deregulations of the financial industry by the Western capitalists which have been blamed as the root cause of the current downturn. They extolled their highly regulated system of government. Zhou Xiaochuan, Governor of China’s Central Bank, even went as far as proposing that US dollars be replaced by SDR as the new reserve currency. (SDR is accounting unit defined in terms of a basket of major currencies and is used primarily by IMF.)

As many countries, US included, begin to propose more measures to better control the financial industry, it seems that China is finally winning the war of ideology. But is the proposal to replace US dollars with SDR purely ideological? Is China sending a message that the role of US as sole superpower has ended? Well, not really according to Paul Krugman and I couldn’t agree more. Here’s his take in my own words plus additional comments.

To ensure that exchange rate remains fixed and hence its competitiveness as the world’s factory, China has been buying US dollars to counteract the increasing demand for Chinese yuan. The end result: lots and lots of US dollars in its reserves. If the US dollars weaken, there will be huge unrealized capital loss on the Chinese side.

Anticipating that such a scenario may happen in the future, in particular when the currently sidelined talks on yuan revaluation regain its momentum, China is looking at ways to minimize its impact. Replacing those US dollars with other currencies by itself is not an option because it is not possible to sell immense amount of dollars in the free market without triggering the value of dollars to drop and hence the much dreaded capital loss as well as the loss of its leading position as a premier manufacturing location.

Replacing those dollars by worldwide consensus, on the other hand, is a different story altogether. Because the transition from US dollars to SDR will be heavily regulated and closely monitored, it is unlikely to cause a sharp drop in the value of dollars, allowing the Chinese to more or less preserve their capital.

At first sight, the proposal gave the impression that China is flexing its muscle in the long-drawn ideological warfare. In reality, it is nothing more than the thinking of pragmatic leaders.