Will the renmimbi become the next reserve currency?

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Chiara Ravetti's picture

A change in international currency dominance is a rare and fascinating phenomenon. The last of such events was the transition from the pound sterling to the US dollar, around the two World Wars, probably the only well documented transition in the history of international currencies (Chinnand Frankel, 2008)1. The current financial crisis, coupled with the Euro-zone debt crisis, could represent a new decisive point for monetary regimes, with potential for the Chinese Renminbi torise on the international scene. It has been argued that in the future the Renminbi will be widely used in foreign exchange reserves (Lee, 2010) and this could be critical for global financial macroeconomic stability. At the moment, however, Chinese financial markets do not have all characteristics to sustain a global currency. It will depend on the policy choices of the Communist Party whether their “liberalization with Chinese characteristics” (Prasad and Ye, 2011) will convince foreign governments and investors to adopt their currency. An alternative scenario could be a multi-currency reserve system, with greater role for the Renminbi, but differentiated reserve portfolios and no single dominant currency. This essay first analyses the circumstances that could make the Renminbi achieve the status of reserve currency, and then considers the advantages that China could reap from a global Renminbi.

How to build a global reserve currency

History provides interesting hints about the process of change in currency dominance. Similar events in the past, however, were idiosyncratic to the conditions of the time – for instance the US, before achieving economic dominance, never had a central bank until 1913, and the gold standard was present when the sterling was the top reserve currency. Similarly, there are many peculiarities of the present Chinese economy that are unprecedented in history. Still, we can draw some key lessons from the past. For instance, there can be more than one currency sharing reserve status worldwide: this happened in the 1920s for some decades between the sterling and the dollar(Eichengreen and Flandreau, 2009)2. In theory, using a single reserve currency has no major advantage. For international transactions, such as trade invoicing or financial operations, it is efficient to coordinate over a single mean of exchange – like choosing a single language for communication. However, for storage of value it is actually better to diversify across different assets, provided that they guarantee safety and liquidity. Another lesson is that, even if the process to achieve dominant reserve status is slow and path dependent, once an economy has caught-up in size and political importance, the change can happen swiftly (Frankel, 2011). Hence, even if China does not currently have sophisticated financial markets, the process could accelerate rapidly.

Theoretically, there are two major arguments for how a currency can take up global dominance. At the macroeconomic level, if a currency is stable and well managed it can be considered as a potential reserve currency by the international community. At the micro level, it has to be liquid and easy to convert into other national currencies. Practically, financial development is the key to achieve a hegemonic role in international reserves (Prasad and Yi, 2011). Economic sizematters3 and China has excellent prospects to rival the US in the future in this regard. Moreover, foreign exchange flexibility and capital liberalizations are important and China is cautiously moving in that direction. But the crucial element is a developed financial market, where investors can buy high quality instruments, such as government bonds. In this the US still has huge advantages, because of the breadth and depth of its financial markets, liquidity and variety of instruments offered, and volumes of trade in these assets (Prasad and Yi, 2011).

Current trends and lack of data

Nonetheless, from a number of events we can gauge that China is intentionally moving in the direction of building a global currency. It has allowed other central banks to hold Renminbi in their reserves since 20104 (Frankel, 2011) and has set up currency swaps with several countries, for instance Argentina, Belarus and Indonesia (Reisen, 2009). In an effort to deepen its regional bond market, it authorized institutions in Hong Kong to issue Renminbi-denominated bonds, in the so called Dim-Sum-Market (Cookson 2012). It even allowed issuance of corporate bonds by foreigners in the mainland, for instance by Caterpillar and McDonald’s to finance their Chinese operations (Eichengreen, 2011). Furthermore, it authorized selected banks to offer offshore Renminbi deposit accounts (Prasad and Lei Ye, 2011). According to recent studies, the Renminbi is already the most used currency in the region, exerting a large influence on Asian exchange rate and monetary policies, parallel to the weight in ‘factory Asia’5 production chains (Fratzscher and Mehl, 2011).

Unfortunately it is very hard to observe directly the effect of these actions on currency composition of reserves. IMF data on official reserves shows only values for Dollar, Euro, Pound, Yen, Swiss franc and “other currencies” and the total value of the latter still remains below 3%(IMF, 2011). Reserves are a sensitive issue and much of our knowledge is in the form of estimates(Lane and Shambaugh, 2009). For Fratzscher and Mehl (2011), the international monetary system in terms of currency use is already on the verge of being multi-polar, with US, Euro and Renminbi dominating the reciprocal regions6, but in terms of reserves clearly the Renminbi lags behind.

Ultimately, the choice of government and private investors to adopt the Renminbi as (one of) their main reserve currency (ies) is a matter of expectations and coordination. If most investors decide to move out of the US dollar, this will cause its rapid depreciation, with losses for those still holding reserves in T-bills. China knows this well, holding enormous amounts of US treasury bills, denominated in a currency that over time tends to depreciate.7 The expectations of investors are very much driven by policy choices, such as the ones mentioned above. In addition, China in the last years has steadily relaxed its peg to reduce the distorted position of the Renminbi, a signal that international markets could welcome. However, much still remains to be done.

Cui prodest?8

Although China is eagerly promoting its currency abroad, the benefits of such policy are hardly quantifiable. While the advantages from having an international currency used as a medium of exchange in the world are straightforward, forex reserves are less immediately beneficial. For instance, borrowing on international markets without any exchange rate risk – avoiding the socalled original sin – is defined an “exorbitant privilege” (Eichengreen, 2010). Similarly, trading in your own currency eliminates exchange rate risks. But for reserve holdings advantages are less clear. China would benefit from having its own reserves less skewed towards the USD, highly exposed to losses as the dollar depreciates. However, China would get only a faint political advantage if other central banks held its currency, like to the control currently exerted by the US. Large foreign reserves are not efficient per se, but are the outcome of the 1997 Asian crisis, after which many countries decided to insure themselves with reserves against future balance of payment crises. This is not an efficient allocation of capital, since resources should move from developed to developing countries, where returns to investment are higher. The current situation is just the opposite, with China being the epitome of “reverse aid” (Reisen, 2009).

The real gain for China would be a diversified and stable international reserves system, which does not produce excessive global imbalances. All other benefits would not come from the Renminbi expansion in global reserves, but rather from the policies needed to achieve global currency status. Internally, if China liberalizes the movement of financial capital, the currency will appreciate and the country will need to abandon export-led growth. Many emerging countries fear this phenomenon for their export sectors9. The damage to exporters would be compensated by the gains to financial lobbies given by a strong international currency and an enhanced volume of transactions. At the same time, an appreciation could benefit households, whose purchasing power over imported goods would increase. But again, a lower demand for dollars would cause their brusque depreciation and large losses for holders of dollar-denominated assets (especially the government). The magnitude of these effects will depend on the relative size of the different categories, on how flexibly the Chinese economy adapts to such changes, and on what the government will do to compensate the losers.

Conclusion

The future of the Renminbi in international currency transactions will most likely be strong, but it will be harder for it to become a dominant reserve currency. This latter development will depend on policy choices of the Party and on the expectations of international investors. Possibly the Renminbi will become one of few important reserve currencies. In the current year of the Dragon we will see if the shift of power from President Hu Jintao to Vice President Xi will be accompanied by enough change in economic and political strategies to make China’s currency stronger and benefit everybody in the country.

Bibliography

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  2. To a smaller extent, also Japanese yen and German mark – later the Euro – have been parallel reserve currencies used
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  3. But is not necessary: consider for example how Switzerland, despite being relatively small in the global economy, has its currency used in many countries as forex reserve.
  4. Malaysia was the first country to make use of this instrument (Frankel, 2011)
  5. A term coined by Richard Baldwin in 2006
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  8. Also rendered as « cui bono? », is a Latin expression to inquire about who benefits from something, and for whom is something convenient.
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