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In America we trust – for now, sort of.

(ATF) From Huawei to the power of their currencies, the battle for global supremacy between the US and China boils down to a battle for global trust. America is winning the contest for now but cannot be assured of keeping its lead.

With positions hardening in both Washington and Beijing, it is hard to see mutual trust being restored any time soon. That raises the risk for markets of a steady splintering of the world economy into two antagonistic spheres, reducing efficiency, increasing costs and slowing technological progress.

Huawei is the unwanted poster child of mistrust. The UK government had agreed to let the telecoms kit provider play a limited part in rolling out the country’s new 5G mobile networks, but sweeping new US sanctions against the company now appear to have doomed its chances.

The sanctions are aimed at cutting off Huawei’s access to semiconductors made with US equipment, fanning fears among Western security services that the company would have to buy “untrusted” Chinese-made chips. Prime Minister Boris Johnson said he was concerned about “hostile state vendors“.

China’s imposition of tough national security legislation in Hong Kong has raised the temperature further. In response to what they see as a breach of Beijing’s commitment to “one country, two systems”, members of Britain’s ruling Conservative party are demanding that Johnson act firmly with Huawei.

“We want a positive relationship with China… but the real issue here is one of trust, and whether China can be trusted to live up to its international obligations and its international responsibilities,” said Foreign Secretary Dominic RaabA ban on Huawei would damage Chinese trust in the UK, China’s ambassador in London shot back. 

Dollar stewardship

The new national security legislation also feeds into a rumbling debate about Washington’s stewardship of the dollar. Both chambers of the US Congress unanimously passed legislation earlier this month that requires the administration to punish foreign banks if they continue to do business with sanctioned Chinese officials, including possibly denying them access to the global dollar payments system.

To critics in China, the extra-territorial reach of US law – actively used in the past to punish Iran, Russia and North Korea among others – shows Washington cannot be trusted to manage the world’s reserve currency in the global interest.

“By taking advantage of the dollar’s global monopoly position in the financial sector, the US will pose an increasingly severe threat to China’s further development,” according to Zhou Li, a former deputy director of the Communist Party’s International Liaison Department. “The US dollar could become a major risk issue that ‘has us by the throat’.”

What’s more, unlimited quantitative easing by the Federal Reserve creates a real risk of devaluing the purchasing power of China’s dollar assets, Zhou said. China must respond by accelerating efforts to spread the use of the renminbi in cross-border payments, trade and global supply chains.

Such rhetorical flourishes from Communist Party officials is not new. But non-partisan voices in the US are also starting to wonder whether President Donald Trump’s America First leadership is eroding global trust in the dollar.

Stephen Roach, a former chairman of Morgan Stanley Asia now at Yale University, says America’s “abysmal failure” to manage the coronavirus outbreak could bring forward the verdict on whether the US deserves to retain the exorbitant privilege that comes from issuing the world’s reserve currency.

“America is leading the charge into protectionism, deglobalisation and decoupling,” according to Roach. As the pandemic causes the US budget and current account deficits to balloon, Roach expects the dollar to fall 35 percent in the next two to three years.

US an embarrassment

Harold James, a professor of history and international affairs at Princeton University, says the dollar’s long reign over the international financial system has depended on the US remaining economically stable, financially credible and culturally open. Under Trump, however, America has become an “international embarrassment”.

“Now that the US system’s dysfunctions are being laid bare, the rest of the world may start to question its basic competence and state effectiveness,” James writes.

The dollar sits on a pedestal with strong foundations and will not be toppled easily. There is no ready alternative. However, James argues that the Trump administration’s repeated resort to long-reach sanctions is inviting an eventual backlash against its weaponisation of the dollar for political ends.

Hong Kong could conceivably be the trigger of the backlash. The US government has denied a report that it is contemplating measures to undermine the territory’s currency peg with the US dollar by curbing local banks’ ability to buy dollars.

But, were Washington to do so, the Hong Kong Monetary Authority could presumably ask the People’s Bank of China to supply dollars from its vast stockpile. As well as sidelining the Fed, such a move would instantly enhance the Chinese central bank’s credibility as an anchor of monetary stability. 

America’s currency belligerence also risks backfiring by hastening the development of the PBoC’s digital currency, the DCEP, which is already being used in pilot projects in a clutch of big cities.

It has not gone unnoticed in Washington that China is way ahead of the US in developing a digital currency. 

In remarks to a recent Senate Banking Committee hearing on the digitisation of money and payments, Republican Senator Tom Cotton said the US needed a digital version of the dollar to underpin its reserve currency status: “The dollar has unmatched advantages, but without digitisation, I worry that the dollar may end up being like the very best flip phone in 2006.” 

The DCEP faces a hard slog to establish itself as an alternative to the dollar. After all, the “analogue” renminbi has yet to win widespread acceptance. It accounted for just 2.02 percent of global reserve assets at the end of March, according to the International Monetary Fund.

Still, Cotton’s warning is a reminder to the US not to rest on its currency laurels. Trust, like a reputation, is hard to earn but easy to squander. If the US wants to retain the priceless advantages that come with issuing the world’s dominant reserve currency, it needs to measure its words and its actions.

AF China Bond