Response to “No Reservations”

Scholars continue to grapple with China’s impact on the international monetary and financial system.  According to surveys conducted by the Teaching, Research, and International Policy (TRIP) program, the rising power of China and the decline of the U.S. dollar as a reserve currency are considered two of the most pressing problems facing the United States today. Liao and McDowell’s innovative article (2016) greatly furthers our knowledge about how China’s rise has influenced the dollar’s role as an international reserve currency.  Liao and McDowell convincingly show that political considerations influence countries’ willingness to hold renminbi (RMB) reserves.  Their main finding is that states that are opposed to the U.S.-led liberal international order were more likely to acquire RMB reserves between 2009 and 2014. 

More broadly, Liao and McDowell make a compelling case that structural or geopolitical factors have an important influence on the international monetary system. In this post, however, I want to stress some important limitations to structural theories of international monetary relations.  A focus on geopolitics alone will not enable one to answer the crucial question of whether the RMB is likely to emerge as an international reserve currency that rivals the dollar.  In order to answer this question, it is essential to also pay attention to domestic politics – both within states that are considering holding RMB reserves and within China itself. 

First, domestic politics influences a state’s willingness to hold RMB reserves.   Even if a state’s preference for international order directly influences its willingness to purchase RMB, as Liao and McDowell find, it is important to ask the prior question: where do preferences for international order come from?  Though this question is quite understandably beyond the scope of Liao and McDowell’s article, the authors address this question in passing, where they acknowledge that domestic politics drives preferences for international order (2016:26).  

In short, states are investing in RMB reserves because they share basic domestic institutions and norms with China. Domestic political factors are very strongly correlated with the measure of state preferences that Liao and McDowell use, which comes by Bailey, Strezhnev, and Voeten.  The figure below illustrates the relationship between state preferences for liberal international order and one important attribute of a country’s domestic political system: the degree of democracy, as measured using the 21-point Polity index.  The figure uses data from the year 2012, the most recent year in Liao and McDowell’s dataset with coverage on both variables.  To illuminate this relationship, I present a scatterplot of the data along with a LOESS line of best fit.  The left panel of the figure focuses on countries’ ideal point distance from China.  It shows that highly democratic countries tend to have preferences that are much farther from China’s than non-democracies.  In the right panel of the figure, we see that there is a strong negative association between democracy and a country’s ideal point distance from the United States.  The data reveal that dictatorships are typically more sympathetic to China than to the United States, whereas full-fledged democracies tend to be much more in favor of the liberal international order.

To further probe the importance of domestic politics, I ran some simple linear regression models using this cross-sectional data for the year 2012.  (All variables were obtained from Liao and McDowell’s dataset).  I modeled these two measures of state preferences as a function of three domestic political variables: the degree of democracy, which was entered as a quadratic function since the above figures indicate that this functional form is correct; the partisanship of the executive; and a measure of economic development (the logarithm of per capita GDP).  These domestic political factors alone explain over half of the variation in countries’ ideal point distance with the US (R-squared = 0.51) and they explain 54% of the variation in countries’ ideal point distance with China.  Preferences for international order are largely determined by domestic politics.  This implies that domestic politics also matters greatly for states’ willingness to hold RMB.

Second, China’s domestic politics also influences the RMB’s prospects as a reserve currency.  Liao and McDowell recognize that “the RMB’s rise is without question dependent on Beijing’s continued implementation of monetary and financial reforms” (p. 37).  Although China’s financial system is more market-oriented today than it was in the past, monetary and financial reforms in China have been quite limited: China’s exchange rate remains heavily managed and cross-border capital flows heavily restricted.  China has been unwilling to adopt a more market-based financial system for domestic political reasons.  As Hongying Wang has pointed out, if “the political foundations of the current model remain in place…it is reasonable to expect minor tinkering to continue without fundamental changes” in Chinese financial policy.  China’s international financial policies are likely to continue to evolve in the direction of greater liberalism and internationalization, but domestic political considerations are likely to hinder major policy changes.  Thus, to understand the future of the RMB, we need to pay attention to domestic politics within China. And once domestic politics are taken into account, contrary to many structural theories, the case for the RMB as a reserve currency gets murky.

The idea that domestic politics is important for international monetary relations is not new, nor is it novel to argue that domestic politics shapes state preferences.  These arguments are also perfectly consistent with Liao and McDowell’s article.  However, by neglecting the domestic political sources of state preferences for liberal order, Liao and McDowell’s article may give readers the impression that domestic politics can be ignored when studying international monetary relations.  This would be a mistake. Determining whether the RMB is likely to rival the dollar in the future is a pressing question, and answering it successfully requires attention to the domestic political underpinnings of state preferences and, by turn, the international monetary system.

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