The really wondrous aspect of this topic is that it was only in 2009 that the Chinese government seriously started taking steps to internationalize its currency. Barely two years on and it‘s no longer a game of Chinese Whispers! Maybe it‘s because China is so huge economically, that the thought comes very easily. Or maybe it is because the move comes at a time when other global currencies like the dollar, euro or yen resemble tired, panting boxers resting on the ring side. Or maybe it is because as usual, China has embarked on an unusual path that made economists initially gape in wonder, and then later rationalize with theories! So ingenious is the system that China currently is juggling with three markets for its currency - an onshore market accessible primarily to domestic corporates; an offshore market in Hong Kong; and finally a dollar settled non-deliverable forward1 market. And all this without having to compromise on its policy on management of capital controls, inflation, or currency!
Does China really want to make Renminbi a reserve currency? My suspicion is that it is part of a bigger plan. China realizes that it is a prisoner of its own controls. It would ideally like to transition to a more stable consumption-based economy from an export-driven one. That would significantly reduce its insecurity emanating from appreciation of a floating exchange rate. The ambition of achieving reserve status would be a convenient corollary to this systemic change.
Being a reserve currency is but one specific aspect of internationalization. An internationalized currency generally has three major roles – as a medium of exchange; as a reference currency; and finally as a currency that is worth storing as reserves. These are not necessarily mutually exclusive roles – for instance a successful ‗medium of exchange‘ or ‗reference‘ currency is more likely to be adapted as a reserve currency.
So does the distinction matter? The US dollar proves otherwise. The dollar ‗fits the bill‘ perfectly when it comes to its application as a medium of exchange or as a reference currency. But the dollar seems to be faltering in its role as a reserve currency. US‘ indiscriminate quantitative easing; combined with high current account deficit and high debt has caused a global glut of dollars or dollar denominated debt, depressing its value. It also increases the risk of US‘ inflation, which will effectively erode away the value of the dollar security for its holder.
1In the Non-deliverable forward (NDF) market, no exchange taking place in the two currencies. Instead cash flow equivalent to the difference between the NDF rate and the prevailing spot rate takes place on the settlement date in a convertible currency, which in most cases is the dollar. The NDF market has generally evolved for currencies where there are foreign exchange convertibility restrictions and capital controls prohibit foreign players to have unlimited access to the onshore forward market.
The inevitability of it all...
Global dissent on the erosion of the reserve status of the dollar makes it sound almost inevitable for the Renminbi to take centre stage.
It also has the other charismas of an heir apparent. The US overtook UK as the world‘s largest economy in the 1870‘s, and became the largest exporter following World War I. Soon UK became a net debtor and the US; a net creditor. The US also gradually overtook the UK in its geo political relevance.
A century later, and it seems that the US has met its nemesis in China! Be it size of economy; or growth rate; or trade volume; or foreign exchange reserves; or current and capital account; or macroeconomic stability. The Chinese juggernaut is all set to pulverize the US on most of these fundamentals; if not yet, then definitely in a decade or two.
But what also tilts the favor towards China is the success of its internationalization policies so far.
For instance an increasing proportion of bilateral trade is currently getting invoiced in Renminbi. What started as a pilot project launched in Shanghai and four cities in Guangdong province in 2009, was expanded to the entire country in 2011. According to J.P.Morgan, cross-border trade settlement in Renminbi accumulated to CNY 500 billion between mid-2009 and end-2010. A significant proportion of these were traded in Hong Kong.
Not only did the government encourage off-shore deposits in Hong Kong, it additionally allowed non-Chinese multinational companies to issue Renminbi denominated bonds there. Corporates are interested since the yields are comparatively lower compared to volatile crisis-ridden markets abroad. Investors are happy since they expect the Renminbi to appreciate, hence ensuring capital gains from their investment. Even the Chinese government participated to raise money from the offshore market. The November 2010 auction had saved the government an estimated 144 basis points in yields, while the August 2011 auction saved it 258 basis points; compared to the then onshore yield curve2.
Finally, Renminbi swap lines were established with central banks of its trade partners to promote its reserve status3. The aim is to create a lender of last resort for the Renminbi outside China and provide for financial support through currency swap transactions at the time of liquidity shortages.
Why hasn’t it become a dominant currency already...
Simply because for people to hold renminbi assets and trade in them; there needs to be an efficient and deep market for them. Currently the primary reason for investors holding low yielding Renminbi bonds is the expectation that someday when capital controls will get dismantled; the currency will freely float and the now depressed rate will appreciate rapidly.
Investors hope that they can access bond markets in the mainland, where the interest rates are significantly higher than off-shore owing to market controlled rates4. Infact even the offshore bond market still requires development, since it is only a fraction of the total offshore Renminbi deposits.
Not to be...?
The wish list is a very scary one for the conservative Chinese policymaker. Dismantling capital controls could threaten to swamp the economy with ‗hot‘ inflows and frustrate inflation management. Allowing exchange rates to float would risk sharp appreciation with people demanding the renminbi; and will strongly hit China‘s export sector.
While these fears are not unfounded, they also run the risk of being too stylized. For instance, recent weakening trends in Renminbi and its NDF markets indicate the risk that it is not necessarily a one-way bet. If the word on the street is to be believed, the string of expensive watch shops and casinos in Macao are actually in a business of allowing Chinese nationals to smuggle cash outside the mainland5. Infact the smuggling out of capital has been a long suspected trend in China – maintenance of fixed exchange rate has indeed led to over-monetization of the economy. The M2/GDP ratio for China is close to 200%. So opening up of capital account may not necessarily lead to an exodus of inflows.
Instead bigger concerns exist in my perspective. If internationalization is unleashed upon a ill –developed financial market, then the effects would be disastrous. A fully convertible currency that becomes internationalized has the risk of being subjected to an East-Asian crisis type scenario. Secondly for a country used to working with a predictable exchange rate; internationalization could augur much volatility. China‘s monetary policy would have a direct impact on exchange rates; as will the decisions of other central banks.
Or to be…?
The benefits of internationalization for China will be contingent on ‗how much‘ internationalized the Renminbi will be. Regardless, it will help China preserve the value of its $3.2 trillion foreign exchange reserves.
Assuming that it will go on to enjoys the supremacy that the dollar is facing now; Chinese citizens then could purchase products marginally cheaper than others. China could collect seigniorage6 from the rest of world for the usage of Renminbi. It is likely to open up vast scope of credit – public would be able to get loans at lower rates, while the Chinese government could run larger deficits for longer period, financed at lower interest rates. Much of its worries on local government debt sustainability could become arcane. And as an ultimate coup de grace, the exchange risk will be passed onto the foreign lender.
One leg of the Triffin Dilemma says that a country with an internationalized currency runs the risk of maintaining a current account deficit in an effort to keep up with global demand for its currency. In other words, it is the gift of a credit card7!
The problem is that it is all poised to happen after a very, very long time. Euro and Yen are two instances of currencies that never made it to the dollar limelight. There is no guarantee that China will either. A Euro-style debt crisis or a Japan-style economic crash; and Renminbi will remain yet another unsuccessful candidate for dollar‘s throne. However a key difference from the Euro and Yen is that the Chinese government has unequivocally taken cudgels on behalf of its currency. And it enjoys a strong track record of being resolute.
My generation will see the Dollar vs. Renminbi spar, just as a previous ones saw Sterling vs. Dollar. Incidentally all spellings in this essay are in the United States version of English. Like currency, the US has also overtaken British hegemony over this! One can only hope that nothing similar happens with China – or else some decades later, we could also have characters autocorrecting themselves into Mandarin!
- In the Non-deliverable forward (NDF) market, no exchange taking place in the two currencies. Instead cash flow equivalent to the difference between the NDF rate and the prevailing spot rate takes place on the settlement date in a convertible currency, which in most cases is the dollar. The NDF market has generally evolved for currencies where there are foreign exchange convertibility restrictions and capital controls prohibit foreign players to have unlimited access to the onshore forward market.
McCauley (2011) ―Renminbi internationalisation and China‘s financial development.‖ BIS Quarterly Review, December 2011
For instance, The Chiang Mai Initiative Multilaterization Agreement worth $120 billion was signed between China and Japan, Korea and ASEAN members; effective from 2010.
An overwhelming proportion of domestic credit allocation is intermediated via the banking system, where rates are policy driven; as opposed to bond markets where yields are market driven.
The legal limit is CNY 20,000/$ 3100. Sender, H., 2012. ―China‘s capital flight looks ready for take-off‖ Financial Times [online] Last Updated on 1:56 p.m. 2nd February 2012. (http://www.ft.com/intl/cms/s/0/7f9d917a-4d92-11e1-bb6c-00144feabdc0.html...)
Seigniorage is the margin between the denomination of the notes and the cost of issuing the notes obtained by the note issuer.
As dangerous as tempting! Quintessential example is the US.
Cassola, N (2000): ―Monetary policy Implications of the international role of the euro‖, in ―International financial markets and the implications for monetary and financial stability‖, BIS Conference Papers, no 8, Basel, pp 75–91 (www.bis.org/publ/confer08d.pdf).
China Banking Regulatory Commission (2007): 2007 Annual Report.
- Chinn, M and J Frankel (2005): ―Will the euro eventually surpass the dollar as leading international reserve currency?‖, NBER Working Papers, no 11510.
- Duisenberg, W (2000): ―The international role of the euro‖, keynote address at the European Banking Congress, Frankfurt, 17 November 2000.
- Executives‘ Meeting of East Asia Pacific Central Banks (2006): ―Working group on financial markets: review of the Asian Bond Fund 2 initiative‖, June 2006 (www.emeap.org/ABF/ABF2ReviewReport.pdf).
- Frankel, J (1999): ―No single currency regime is right for all countries or at all times‖, NBER Working Papers, no 7338, September.
- Gao, H., and Yu, Y., (2009): ―Internationalisation of the renminbi‖, Bank for International Settlements, Research Papers – Monetary Policy and Exchange Rates (August 2009)
- Greene, J (1991): ―Currency convertibility and the transformation of centrally planned economies‖, IMF Occasional Papers, no 81, 1991.
- Iwami, T and K Sato (1996): ―The internationalization of the yen: with an emphasis on East Asia‖, International Journal of Social Economics, vol 23, issue 10/11, pp 192–208.
- Kenen, P (1983): ―The role of the dollar as an international currency‖, Group of Thirty Occasional Papers, no 13, New York.
- ——— (2009): ―Currency internationalization – an overview‖, paper presented at the BoK/BIS seminar on Currency internationalisation: lessons from the global financial crisis and prospects for the future in Asia and the Pacific, Seoul, 19–20 March.
- McCauley, R., (2011): ―The internationalisation of the renminbi‖ 2nd Annual International Conference on the Chinese Economy ―Macroeconomic management in China: Monetary and financial stability issues‖ 14th January 2011.
- McCauley, R., (2011): ―Renminbi internationalisation and China‘s financial development.‖ BIS Quarterly Review, December 2011
- McKinnon, R and G Schnabl (2004): ―The return to soft dollar pegging in East Asia. Mitigating conflicted virtue‖, International Finance, no 0406007.
- Michalopoulos, G (2006): ―The internationalization of the euro: trend, challenges and risks‖, in V Alexander and H-H Kotz (eds), Global divergence in trade, money and policy, Edward Elgar Publishing.
- Sender, H., (2012): ―China‘s capital flight looks ready for take-off‖ Financial Times [online] Last Updated on 1:56 p.m. 2nd February 2012. (http://www.ft.com/intl/cms/s/0/7f9d917a-4d92-11e1-bb6c-00144feabdc0.html...)
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