What's Behind Washington's Tussle With China Over China's Asia Bank?

Asia Bank
China's President Xi Jinping (R) meets with the guests at the Asian Infrastructure Investment Bank launch ceremony at the Great Hall of the People in Beijing October 24, 2014. Takaki Yajima/Pool/Reuters

The question is straightforward enough, even if it does sound a bit abstract and academic: What does China want its currency—the yuan—to be?

The answer is much more important, both to the state of global financial markets and to the way the international financial and trade system now functions, than most people realize. A currency is, at root, a medium of exchange, but when someone asks, What does China want its currency to be?, that's not the answer. Currencies are—or can be—so much more than that. The U.S. dollar's post-World War II role as a so-called "reserve currency''—the default medium of exchange for virtually all international trade, and the place where in a crisis nearly everyone runs—had everything to do with the U.S.'s role in the world. Not only was its economy the world's largest and its financial markets the deepest and most liquid, but it enforced (first in the "free" world during the Cold War, then globally ever since) a Washington-driven "pax Americana," a system of institutions and rules that try to guide international commerce. And the fact that the U.S. also has had by far the world's most powerful military has underpinned that system since 1945. The dollar's place in the world has been both the symbol and the result of that geopolitical reality.

That is now slowly changing. China is on the road to superpower status; its economy will sooner or later be the world's largest, and its military (though still dwarfed by the U.S.'s) is growing rapidly, with the annual rate of increase in how much Beijing spends on defense now accelerating. China's leadership, at minimum, sees itself as ascending to equal status with the U.S. in a couple of decades. And some analysts, like former U.S. Department of Defense official Michael Pillsbury, believe Beijing's ambition is to be No. 1—to supplant Washington as the world's dominant superpower.

In either case, China's rise requires that the role of its currency become more internationally prominent than it has been. And even though Beijing still applies capital controls—individuals are not allowed to export more than the equivalent of $50,000 per year (though the country's economic elites ignore that with abandon)—the yuan is becoming more prominent globally. A decade ago, for example, China's currency was very lightly traded abroad. Now it is one of the five most heavily traded in the world—a position that will only increase as Beijing continues to open up its capital account, which central bank chief Zhou Xiaochuan pledged it would in a March 22 speech. It's also likely that this September the currency will be included in the International Monetary Fund's (IMF) basket of currencies that make up its so-called Special Drawing Rights (SDR)—an alternate form of foreign exchange reserves that Beijing has argued should play a more significant role in the reserve holdings of emerging economies in particular.

SDRs, to be sure, represent an obscure corner of the international financial system, but Beijing's ambition to have the yuan represented in them is telling. It's a way for Beijing to make the world less dollar-centric within the institutions set up in the pax Americana world (in this case the IMF), and it coincides with efforts to create new institutions in what Beijing hopes will be a more Sinocentric world.

Most prominent among them is the so-called Asian Infrastructure Investment Bank (AIIB), which Beijing sees as a way to fund the development of ports and railroads and power generation systems across the developing world. And it is the AIIB that Washington and Beijing are having a very public clash about—one that Beijing now appears to be winning.

The Obama administration has leaned heavily on traditional allies in Europe and Asia to not join the AIIB, partly because (it says publicly) it will simply replicate what the (Japan-dominated, Manila-based) Asian Development Bank already does. And, the administration argues privately, the AIIB will be a way in which Beijing funnels big contracts back to state-owned enterprises at home.

This tactic has absolutely befuddled many critics, who believe it would be far better for Western powers and their Asian allies to join the bank and help influence its direction from the inside. And indeed, four big European powers—the U.K., Germany, France and Italy—have in recent weeks snubbed Washington and stated that they will be members of the new multilateral lending institution. Initial reports were that they did so in return for an agreement from Beijing that China would not have veto power over what contracts are awarded and which bidders are allowed to participate. Beijing subsequently denied that it had given up veto power, and sources now say that the issue is still "being negotiated," according to one Western diplomat in Beijing. In any case, the entire episode was a clear boost for Beijing, and for the role it wants the yuan to play internationally in the future.

Yet the path to prominence—to a reserve currency worthy of a superpower—is not unobstructed. "If, as we assume, China's long-term goal is for the [yuan] to become a global unit of account, that can only happen if the currency is perceived as strong and stable," says Louis-Vincent Gave, an economist at Gavekal Dragonomics Global Research.

And that is China's problem. For a decade, Beijing has allowed its currency to slowly appreciate in value against the dollar. (The yuan does not trade freely; the People's Bank of China (PBOC) intervenes to keep it pegged within a trading range against the dollar.) In a world of 10 percent annual economic growth at home and relative currency stability abroad among its trading partners, slow but steady currency appreciation was something Beijing could afford.

Now, however, it's a different world. In a disinflationary if not deflationary global economic environment, some of China's major trading partners (and industrial competitors) are in the process of devaluing their currencies sharply; Europe and Japan most prominently, but South Korea and Taiwan as well. China's growth, meanwhile, is slowing sharply and may dip below the 7 percent mark the government has stated is its goal for 2015.

Big Chinese exporters, therefore, are putting increasing pressure on the government to jump into the devaluation game, lest overall economic growth slow even further. To a degree, the PBOC has agreed. Today, the yuan trades at 6.22 to the dollar, compared with 6.11 six months ago. The foreign financial press and blogosphere are full of speculation that a significant devaluation is coming.

If one isn't forthcoming in 2015, that will tell the world volumes about Beijing's long-run ambitions. If Xi Jinping and his government resist the short-run pressure from politically powerful economic interests and don't join in the world's escalating currency wars, it means China is willing to endure short-term pain in order to gain long-term prominence—and power. A strong yuan may well be a symbol of a strong China—and that, for Xi, may carry the day, even as the pressure to devalue intensifies.