Will the renmimbi become the next reserve currency?

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Anil Prashar's picture

The renminbi currently accounts for a very small percentage of global reserves and is exceeded by the dollar, the euro, the pound and various other currencies. Yet still there is a belief that it could become the world’s next major reserve currency. One reason for this growing belief is China’s economy. As the global economy’s centre continues to move closer to China it is widely believed that China’s currency will strengthen. Historically the dollar succeeded the pound after the US became the world’s largest economy and exporter. China – with an economy predicted to overtake the US by 2015, in PPP terms, and as the world’s current largest exporter – now finds itself in a very similar position.

The similarities between the developments of the currencies are also quite striking. In 1914 most US business was done through intermediary investment banks located in London which meant American business was carried out in pounds. Also very few international bonds were denominated in US dollars at the time and many countries kept only a small proportion of their foreign exchange reserves in dollars. In the following decade there was a rapid change in the dominant currency structure as the US dollar rose to prominence.1 In a similar way it was only a short while ago that the renminbi was not the chosen currency of business in China and the Chinese bond market was practically non-existent.  The pace of change, as it was with the dollar, has been rapid. In just 18 months the volume of Chinese trade settled in renminbi has increased from 0.7% to 9% and the value of the Chinese bond market has, in four years, gone from nothing to a value of approximately £20 billion.

However despite the similarities there are still clear obstacles that stand in the way of a global currency transition between the renminbi and the dollar today. The renminbi is not yet a fully convertible currency2 and this is not without good reason. The potential market instability that could be brought about by hot money movements following the full internationalisation of the renminbi is evidently undesirable in the eyes of the Chinese government. A government who - wary of Deng Xiaoping’s lessons - have continued on an economic path that values both meritocratic values and state control. The renminbi would have to become fully convertible if it ever truly hoped to become the next major reserve currency and until then is at a severe disadvantage to the hegemony of the dollar and other options such as SDRs and the Euro. Though if the renminbi were to become fully convertible then it is believed that it would quickly be included in the basket of SDR currencies.3 This act would show a faith in the renminbi that central banks should mimic by including or increasing the renminbi in their reserves; accelerating the currency’s internationalisation.

Another obstacle is made clear when one considers that the countries of internationalised currencies tend to have a low and stable rate of inflation.4 In the past some countries have avoided internationalisation of their currency because of the inflationary pressures that the process brings with it. The post-war German government felt that there was more to be lost by giving up control over their money supply than was to be gained by internationalising the Deutschemark.5 Over the past decade China’s inflation had been low and stable although much more recently the Chinese government has found itself struggling with the “vicious tiger”. The internationalising of the renminbi would only add to existing inflationary pressures. This is accentuated by the realisation that this is something that the government cannot first figure out via a Special Administration Region. Inflation is a national phenomenon and will be one of the bigger risks facing China if the renminbi is internationalised.  It has been suggested that the People’s Bank of China has not been as successful at curbing recent inflation due to the inflexibility of the exchange rate, as credit cannot be tightened as effectively.6 The conclusion from this is that the renminbi may have to be allowed to float freely in order to tackle problems efficiently. This decision would depend on how willing the Chinese government is to let the value of their currency be determined by market forces and how much they desire the advantages that come with possessing a powerful currency.

China’s undeveloped financial system also stands in the way of the renminbi internationalising. It has been suggested that internationalised currencies have at their heart open, deep and broad financial markets.7 Much has been written about the weaknesses of China’s financial system and the Chinese government is aware of this. The bond market is not as deep and developed as an internationalised currency requires partly because China’s trade surpluses mean that the government has not needed to issue bonds in order to raise funds. Despite this the Chinese government have signalled their intention to see development in the financial system by reducing restrictions in the bond market. This has led to domestic corporate bonds seeing a gradual increase in volume.8 More promising than this is the great deal of progress that has been made in Chinese equity markets where government reforms have allowed for the floating of non-tradable shares in Chinese businesses. 9 These developments have not only improved the renminbi’s prospects but also helped to increase market capitalisation and turnover in the Chinese economy.

As China’s financial system gradually develops it is also necessary to consider the implications if the renminbi were to become the global reserve currency. One of the possibilities considered is allowing the renminbi to float freely, or at least extending the margin within which it is allowed to float. This could, in the long run, result in China running deficits similar to those that the US has experienced. This problem, more commonly known as Triffin’s Dilemma10, would mean that China’s status as a creditor nation could be put at risk. Although there is nothing inherently wrong with a deficit. The Chinese government could enjoy greater seller financing power as they print and pay with money that is only to be stored as reserves abroad. This could herald better standards of living for the Chinese people and help to fund more ambitious Chinese projects, such as the new space program. This additional finance would also be globally beneficial as it could mean greater investment in research and cleaner technologies within a country that is seeking development.

On the other hand there is the effect that changing reserve currencies would have on the US. If the dollar were to stop being the main global reserve currency this would mean that countries would call in the debts that the US has accrued as a result of its seller financing ability. This would put further constraints on the ability of the US to spend, as well as increase its already sizeable deficit. Although this impact may be softened when one realises that in the shorter term an appreciation of the renminbi would help to restore US export competitiveness. In this sense the rise of the renminbi does not require the demise of the dollar.

To conclude, China is in a powerful position. If it were to make the renminbi fully convertible and develop its financial system then it is almost inevitable that the renminbi would accelerate towards being the next global reserve currency. The benefits of internationalising would come in the form of seller financing power, reduced transaction costs and even political power. The disadvantages would come from the lack of control over monetary conditions and the increased possibility of running deficits. In the long run China will most likely see greater benefits to internationalising the renminbi – especially as it continues to pursue economic growth – and recent easing of restrictions shows that the Chinese government is already thinking along similar lines. Yet the effects of this change would be enormous for China and, hence, the world. The possibility of having to allow the renminbi to float freely is one the authorities will most likely encounter and the scale of the potential decisions to be made has led to the Chinese government ensuring caution throughout the process. Though it is worth remembering that China has always maintained that it will not simply follow Western models and dogmas as it develops, thus conventional approaches will not always work when trying to understand it. As the year of the dragon unfolds the world can expect to see the renminbi becoming its own symbol of power and unpredictability.

References: 
  1. Eichengreen, Barry (2010) The renminbi as an International Currency http://www.econ.berkeley.edu/~eichengr/renminbi_international_1-2011.pdf (accessed 2.2.12)
  2. Dobson, Wendy and Masson, Paul (2008) "Will the renminbi Become a World Currency?" Joseph L. Rotman School of Management, University of Toronto, IIB Paper No. 10
  3. Prasad, Eswar and Ye, Lei (2012) The renminbi’s Role in the Global Monetary System  Brookings
  4. Tavlas, George S. (1991) On the International Use of Currencies: The Case of the Deutsche Mark” Princeton Essays in International Finance, No.181
  5. Persaud, Avinash (2004) When currency empires fall http://www.gresham.ac.uk/lectures-and-events/when-currency-empires-fall (accessed 31.1.12
  6.  Dobson, Wendy and Masson, Paul (2008) "Will the renminbi Become a World Currency?" Joseph L. Rotman School of Management, University of Toronto, IIB Paper No. 10
  7. Tavlas, George S. (1991) On the International Use of Currencies: The Case of the Deutsche Mark” Princeton Essays in International Finance, No.181
  8. Dobson, Wendy and Masson, Paul (2008) "Will the renminbi Become a World Currency?" Joseph L. Rotman School of Management, University of Toronto, IIB Paper No. 1
  9. Prasad, Eswar and Ye, Lei (2012) The renminbi’s Role in the Global Monetary System  Brookings
  10. Triffin, R. (1961) Gold and the Dollar Crisis, Yale University Press
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