May 3, 2022 - 1:31pm

Last month a debate was raging in financial markets about whether the seizing of Russia’s foreign exchange reserves signalled the end of the US dollar as the world’s reserve currency. There were multiple theories as to how this might happen. I pointed out that China might start to dump their enormous US dollar reserves to prevent them being seized in the case of military action in the South China Sea.

On Saturday The Financial Times reported that the Chinese central bank and finance ministry held an internal conference discussing how to protect against potential US seizures of foreign currency reserves. Around the same time, leading Communist Party intellectuals were discussing the possibility of dumping US dollar reserves to protect them from seizure.

China has by far the world’s largest reserve holdings. At $3.2trn it dwarfs Japan, which comes in second place with $1.3trn. Since China is by far the largest holder of US dollar reserves, this looks like the beginning of the end of the US dollar as the world’s reserve currency.

If it happens, this will be the single largest economic development since the Second World War — when the US dollar was made the reserve currency at the Bretton Woods conference. By consequence, it would almost certainly mean that Western countries are going to see a sharp drop in living standards over the coming decade, as consumers see inflation eat away at their wages.

The sad fact is that many wealthy Western economies have allowed their manufacturing base to be completely hollowed out over the past 50 years. These countries import much of their manufactured goods from countries like China. In exchange for these goods, we send paper money which is then recycled into paper debt — mostly government bonds. China currently holds just over $1trn in US government debt. Until now, the developing world accepted this arrangement because it helped them develop their economies. No longer.

So, how will this rebalancing work? Presumably, countries like China will be far more reticent to hold Western currencies and debt due to fears that these can be seized. As they move away from accepting our paper, Western currencies will decline relative to currencies like the yuan. Chinese products will thereby become more affordable for Chinese people and less affordable for us. In the West, prices will rise, and wages will not keep up.

Does this hurt China in any way? It will mean that they will have to rely less on exports to the US to grow their economy. But the Chinese economy is far less reliant on trade than it was in the past. Back in the mid-2000s, China ran current account surpluses of anywhere between 7-10% of GDP. During this period, China was completely reliant on the US buying imports to develop and grow, but since the financial crisis of 2008-09, it has moved away from relying so heavily on trade for their economic growth. As of last year, the Middle Kingdom’s current account surplus was just under 2%.

Meanwhile, the US appears to be losing the biggest point of leverage it has over world affairs. If the US dollar becomes just one currency among others, its status as a global superpower will be under threat. This is an extremely serious development — arguably the most serious since the invasion — and it is incumbent on our leaders to develop a response to it. The sands are shifting beneath are feet and yet very little is being done to stop it.

Philip Pilkington is a macroeconomist and investment professional, and the author of The Reformation in Economics