Will the renmimbi become the next reserve currency?

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Takuya Kikuchi's picture

Introduction

Based on the decline in the value of the US dollar and global financial crisis, the Renminbi is expected to be replaced as an alternative reserve currency, given the China’s economic growth and military superiority. In fact, China tries to implement several measures to internationalize the Renminbi, such as the Renminbi bond market and bank deposits in Hong Kong. However, an effort to get the Renminbi reached international status would require China to take drastic actions which poses a challenge to sustainable economic growth. As a result, China would choose an option of abandoning a serious effort to internationalize the Renminbi to the level of the next reserve currency. The following explains the reasons why it would be difficult for the Renmibi to become the next reserve currency instead of the US dollar by demonstrating fundamental characteristics of the reserve currency and current international financial system.

Since the global financial crisis in 2008, the US dollar has experienced deterioration against other currencies and slightly lost its share in the currency composition of official foreign exchange reserves1, bringing about an argument that international financial system based on the US dollar dominance would be replaced as the system with the other dominant currency or multiple international reserve currencies, such as Euro, Japanese yen and the Renminbi, in order to attain global financial stability. As a matter of fact, historical example exists for of an international main reserve currency from the UK pound to the US dollar. Einchengreen2 suggests that the shift of international reserve currency occurred during and after World War l due to the growth of the US trade and the Fed’s effort to the US dollar circulation.

Among major currencies, given economic prosperity and political influence in China, the Renminbi is expected to play a crucial role as one of the main reserve currencies in the near future. For instance, World Bank anticipated that the Renminbi would gain international status as one of the three major reserve currencies including the US dollar and Euro, indicating an end to the US dollar hegemony3.

In fact, the Chinese official also cast doubt on the US dollar preeminence. The governor of the People’s Bank of China delivered a speech on March, 2009, entitled “Reform the International Monetary System”4, which claimed the necessity of adaption of the IMF SDR as a new global reserve currency. The remark was regarded as a future intention of encouraging the Renminbi to reach the main reserve currency instead of the US dollar. As a matter of fact, the Chinese official steadily implemented a wide range of measures to internationalize the Renminbi, such as the Renminbi bond market and bank deposit in Hong Kong. In addition, foreign central banks have been allowed to hold the Renminbi as foreign reserve since 2010.

As a possession of foreign reserves

However, considered basic characteristics of a reserve currency and current international financial system, it seems unlikely that the Renminbi will become the next reserve currency.

First of all, in order to become a reserve currency, a currency must be held as the foreign reserves on a large scale. So, the Renminbi needs to take a significant share in the currency composition of official foreign exchange reserve, in order to reach international status. However, the IMF data shows that the US dollars still accounts for more than 60% of the world foreign reserves even though the share has declined by almost 10% since 2001. Instead, the Renminbi has yet to be possessed substantially in foreign reserve accounts. In addition, more ironically, China has the largest holder of the US dollar in the foreign reserves, in absolute term5 because China has accumulated tremendous trade surplus and capital surplus since late 1990, and contributed to finance the large US trade deficit. This global imbalance has raised mutual-dependency between the US and China, from economic perspectives. Then, if China aims at making the Renminbi a main reserve currency, China needs to make economic and social structural changes significantly in order to mitigate the global imbalance. To do that, the first priority should be to allow for an appreciation of the Renminbi. Tantom6 mentions that the Renminbi appreciation would give negative impacts on trade surplus, money growth, and price stability. It also causes disruption of many domestic firms with regard to production and employment. More notably, the appreciation would serve as a stimulus to speculative capital inflow, making it difficult to maintain sustainable economic growth. Furthermore, if China tries to diversify a substantial amount of its foreign reserves from the dollar- dominated assets, China would face self-contradiction. It means that selling the dollar-dominated assets triggers the decline in the value of the US dollar, financial disruption and economic collapse as well as devastating losses on the China’s foreign reserves. Eichengreen7 claims that the process of curtailing the accumulation of the dollar would be a gradual step with international cooperation. In detail, as well as other trade-surplus countries, China needs to make a shift to mitigating trade surplus by boosting domestic demand, but realistically speaking, China would not feel a strong incentive to resolving global imbalance with a view to internationalizing the Renminbi.

As a mean of payment

Moreover, the Renminbi needs to prevail in international trade markets as a mean of payments. To meet requirement for that, China would push up opening up the capital account. Based on an inescapable trilemma that freedom of financial flows, monetary policy autonomy, and exchange rate stability can not be all coexisted, and a historical experience of Asian crisis caused by fixed exchange rate regime and free capital account, the capital account openness would require discontinuance of fixed exchange rate regime and adoption of free exchange rate regime.

Generally speaking, capital account openness serves as a stimulus to attain optimal resource allocation. In case of China, it will promote capital outflows to other countries and mitigate domestic inflationary pressure. On the contrary, it goes without saying that the capital account openness and following the adoption of foreign exchange regime would raises a substantial risk of exposed to the capital flow speculation. In this context, Tatom8 put emphasis on the necessity of upgrading its financial system to obtain the ability of resistance to massive speculative capital flows. However, considered the weak banking sector and lack of reliable legal and financial system, the reform would be required to take multiple steps, far from soon. In conclusion, given the condition that, without elimination of capital control, the Renminbi would not be distributed and used as a mean of payments, the steps will call for a substantial amount time.

As a measure of value of financial assets

Finally, it is worth focusing on the fact that most of financial products all over the world are priced in the US dollar, as well as oil and other commodities. Then, even if the investors move assets from the US dollar to oil, it means that investors still have financial assets priced in the US dollar. Indeed, after the financial turmoil, there have been little effects on the US dollar’s role as a measure of value in terms of financial assets. Furthermore, Goldberg9 suggests that “inertia” in currency use and relatively stable economic condition in the US makes the US dollar remain predominant. Therefore, given the US dollar prominence, it seems likely that there is no incentive for users to make a significant shift from the US dollar to the Renminbi.

Conclusion

Financial turmoil from 2008 and the decline in the US dollar provoke the argument that the US dollar would lose its role as a dominant reserve currency and the Renminbi will become the next reserve currency in the near future. However, given the international finance and Chinese economic system, the possibility would be substantially low. As a main reserve currency, the US dollar has still played a crucial role in terms of payment, foreign reserves, and a measure of value of many financial assets. In addition, from the China’s own perspectives, the internationalization of the Renminbi would have little incentives because it will give massive losses on its foreign reserves composed of the US dollar, and be exposed to international speculative capital flows. More importantly, in order to become the next reserve currency, there are many obstacles that need to be overcome in terms of capital account openness and financial reform. However, the cost would exceed the benefit.

References: 
  1. IMF data, “Currency Composition of Official Foreign Exchange Reserve” (http://www.imf.org/external/np/sta/cofer/eng/cofer.pdf)
  2. Barry Eichengreen(2010)
  3. The People’s Bank of China “Zhou Xiaochuan: Reform the International Monetary System”
  4. The U.S. Department of the Treasury, http://www.treasury.gov/Pages/default.aspx
  5. John A. Tantom(2009)
  6. Barry Eichengreen(2008)
  7. John A. Tantom(2009)
  8. Linda S Goldberg(2010)
  9. Jeffrey Frankel, 2011.”Historical Precedents for the Internationalization of the RMB”, Council on Foreign Relations
  10. Arvind Subramanian, 2010. “New PPP-Based Estimates of Renminbi Undervaluation and Policy Implication”, Policy Brief in Peterson Institute for International economics.
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  15. Paul R. Krugman, Maurice Obstfeld, Marc J. Melitz, in 2012.”International economics, theory&policy, ninth edition”
  16. Goldstein, Morris and Lardy N.R, 2009. ”The Future of China’s Exchange Rate Policy”, Peterson Institute for International economics,
  17. Linda S. Goldberg, 2010. ”Is the International Role of the Dollar Changing?”, Federal Reserve Bank Of New York Current Issue.
  18. John Ryan, 2009. “China and the Global Roles of Currencies”, International Network for Economic Research, working paper.
  19. Helmut Reisen, 2009. “Is the US dollar empire falling?”,VOX
  20. Jong-wha Lee, 2010. ”Will the Renminbi Emerge as an International Reserve currency?”, Asian Development Bank
  21. Barry Eichengreen and Marc Flandreau, 2010. “The Federal Reserve, the Bank of England and the Rise of the Dollar as an International Currency, 1914-1939”, BIS working paper no328