Will the renmimbi become the next reserve currency?

comments 0

Comment

share

Share

0

Rate

Michel Pierlot's picture

I will start by outlining why, in my opinion, many people think the Renminbi will become the next global reserve currency. I will then use a cross-disciplinary approach to demonstrate that it is likely that the RMB will become a regionally dominant and internationally strong currency, but not the next reserve currency as such. I will go over how this will happen and will briefly cover what it would mean for China. I will work with an inductive methodology since reliability of official data relating to Chinese economy can be questioned (Chow, 2005).

I think one of the main reasons why many observers think the RMB might become the next reserve currency comes from the fact that people tend to overstate the importance of recent changes while forecasting the future. In other words, if past information is known and forms a trend, a spontaneous cognitive dissonance is to “linearly extrapolate” it by stretching the trend linearly into the future. The only perceived constant being the slope of the line, other things being perceived as equal. By applying this idea to our subject, I think that three different “linear extrapolations” were implicitly assumed in order to conclude that the Renminbi would surpass the dollar and become the next reserve currency:

The first assumption is based on the fact there is one country that imposes its reserve currency at one time, and that this status changes over time: the British Empire held this status, it was succeeded by the US and, hypothetically by China assuming this trend linearly continues. The second part of the essay will demonstrate why this trend is not likely to remain linear. The second assumption relates to “stretched over time” Chinese growth: that it would rise in the coming decades at a similar pace, without overheating or significantly slowing. This will be analysed in the third part of the essay. Finally, considering that historically, nations holding the reserve currency were net foreign creditors and net lenders as the British Empire was, and that the Sterling lost ground when the UK became a net debtor (Roubini, 2009), does not mean that the USD will have the same fate because it does not take into account a change in US economic policies due to a different polarity of the world reserve system.

Therefore, the period since 2002, with dollar’s relative decline as a reserve currency, and booming Chinese economy, made it in my opinion tempting for many people to spontaneously “stretch the lines” in the coming decades, and to conclude that the RMB would become world’s next reserve currency.

Besides underlining the potentially non-linear evolution of the trend, the last reason why I introduced this idea is because I think that the “linear extrapolation” idea has interesting applications to financial markets as will be briefly shown. It is also important to keep in mind that the explanation of facts through this idea has flaws such as its qualitative approach, the fact that it relies on an oversimplified world vision and that it only focuses on a limited number of factors ignoring potentially important variables.

The second part of the essay, which demonstrates why the Renminbi is likely to become a strong international currency in a multipolar world, is based on the two following “intermediate” conclusions:

The first intermediate conclusion derives from the fact that I think there is a trend in the evolution of humanity according to which small social structures tend to group together and form over time greater, more homogeneous societies. Social bodies, like living species, having a Darwinian need to adapt to their environment, the first society to merge with another being more powerful, and imposing others to do the same in order to survive. A simplified illustration of this concept is that historically people lived in tribes, then settled in towns, which latter turned into structured cities, then these cities merged into confederation of cities: countries.

According to this idea, I conclude that the next and current step would be that countries with different identities aggregate in “unions” of countries and/or continental hegemonies made up of heterogeneous societies, shaping a multipolar world, such as the EU, USA, China, India, Russia, Brazil and Japan. Note that “linear extrapolation” had to be used to come to this conclusion, which interestingly shows the difficulty of not relying on this assumption to make any prediction. This trend being furthermore intuitively regressed, it is important to remember there were large deviations from the mean and significant outliers in history.

Second, if tensions between countries are more likely in an instable multipolar world and economic agents are “non homo oeconomicus”, the assertion that they use the most used currency due to network externalities doesn’t hold anymore. First, given the fact economic agents are not always rational, and therefore may transact in a less used currency due to non costs optimizing behaviors, and second, in case of tensions or rivalries between countries, they may switch to another currency if it is physically possible, such as neighbors of Japan did with the Yen due to historical and geopolitical reasons, which implied that it did not obtain regional reserve status (Jong-Wha Lee, 2010).

These two points imply my second conclusion: in a multipolar instable world, network externalities may not be as important to determine a reserve currency status as commonly accepted, thus enabling multiple currencies to coexist (Eichengreen, 2005) and making cases such as the yen one, more likely in the future.

By applying the two intermediate conclusions to the analysis of the international reserve system, and by doing the reasonable assumption that SDR’s will not carry significant weight in this world, therefore that all countries tend to use their own currency, and assuming economic agents prefer to trade within their geographical area due to shipping costs, I conclude that in the coming decades, as long as no dominant power emerges, the world is likely to be formed by regional hegemonies, mostly continental ones, having their own dominant reserve currency in their respective area of influence. Therefore, the RMB will be embedded in an area proportional to Chinese economic influence. Recent events supporting this idea are the fact that Malaysia, Japan and Hong Kong among other Asian economies are holding more Chinese government bonds as part of their reserve portfolios. The RMB being not (yet) convertible, this development is only a small step further in the forecasted direction.

The last part of the essay analyzes what an internationalized RMB would mean for China: First, in order to become an international currency, the RMB has to be convertible, which will lead to increase its demand due to the importance and size of Chinese economy and therefore, to its appreciation. This revaluation would not be in China’s interest in the short term, because the export-driven and labor-intensive model that propelled Chinese growth has been in my opinion partially due to an undervalued RMB. Therefore, the pace of RMB internationalization will partially depend on how the transition towards a service-based economy with high domestic consumption is achieved. This would be positive for China because it will be less vulnerable to possible external, especially US, shocks.

I think the following factors have to be tackled in order to achieve this transition and therefore, a gradual implementation of reforms towards RMB internationalization:

First, low interest rates and the fact that investors have linearly extrapolated Chinese growth into the future could explain the current asset bubble in real estate, which may burst and carry systemic risk if a catalytic event occurs and/or if authorities do not take necessary steps to gradually reduce the prices without systemic consequences. Other risks that have to be tackled are: high exposure to USD possible devaluation as well as to Euro debt crisis, low domestic consumption, overinvestment, social inequalities, possible bank runs, and a possible sudden stop of foreign capital flows (Prasad, 2007).

Besides economic aspects, other conditions for RMB internationalization are mainly a step-by-step liberalization of financial markets towards full RMB convertibility, deep liquidity of capital markets, removal of various administrative restrictions, and transparency as reliability of data (Hongyi Chen, 2009), (Jong-Wha Lee, 2010). I think the last is a necessary but not sufficient condition, along with low inflation, for traders and investors to perceive an economy as stable, and therefore to use confidently its currency on a widespread basis.

If all these conditions are met and obstacles are tackled, the RMB will become a regionally dominant and one of the major international currencies, but as Nouriel Roubini (2009) stated it, not likely in the near future. To put it in a nutshell, it is not inevitable that the RMB will become the next reserve currency. To illustrate this, I think the Chinese economy is like a powerful fast car approaching a crossroad and having to slow down in order to take a turn: how current policy makers will manage growth and the transition in order to negotiate the turn towards RMB new international monetary status will shape China’s future as tomorrow’s world.

References: 

 

  1. Hongyi, Chen. (August 2009) The Potential of the Renminbi as an International Currency
  2. Gregory Chow. (November 2005) Are Chinese Official Statistics Reliable?
  3. Barry Eichengreen. (May 2005) Sterling’s past, dollar’s future: Historical perspectives on reserve currency competition
  4. Jong-Wha Lee. (June 2010), Will the Renminbi Emerge as an International Reserve Currency?
  5. Eswar S. Prasad. (August 2007) Is the Chinese Growth Miracle Built to Last?
  6. Catherine R. Schenk. (May 2009) The Retirement of Sterling as a Reserve Currency after 1945: Lessons for the US Dollar?
  7. China Daily Europe. Nigeria bank chief sees Yuan becoming reserve currency http://europe.chinadaily.com.cn/world/2011-09/06/content_13641562.htm
  8. Nouriel Roubini. (May 2009) The almighty Renminbi? New York Times http://www.nytimes.com/2009/05/14/opinion/14Roubini.html
  9. Nouriel Roubini. (April 2011) China’s Bad Growth Bet http://www.project-syndicate.org/commentary/roubini37/English