Will the renmimbi become the next reserve currency?

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A reserve currency is the currency held by central banks and other major financial institutions as part of their foreign exchange reserves in significant quantities. The People's Bank of China (PBOC) announced that the cross-border trade settlement in renmnbi will be expanded to the entire country (Mo, 2011) shortly after Hong Kong has been officially established as an offshore center for renminbi on August 17th (Yun&Law, 2011). Renminbi has made several big steps to become a global currency recently. Will the renminbi become the next reserve currency just as the U.S. dollar eclipsed the Pound Sterling last century? Is the renminbie ready for the reserve currency status? The renminbi’s role in the global monetary system has been triggering a heated debate among worldwide media especially when currently the debt crisis in Europe and the U.S. is weakening Euro and U.S. Dollar, the two main reserve currencies. The following essay would discuss the likelihood for renminbi becoming a reserve currency, examine its impacts, and indicates that Chinese government should focus on rigorous risk management while promoting the international use of renminbi.

What does it require to make the renminbi the next reserve currency? The most important step is to make the renminbi an international currency. Note that the internationalization of a certain currency does not guarantee a reserve currency status. Take Canadian dollar as an example, it is an international currency which can be used and held globally. However, is there any country willing to hold Canadian dollar as part of their foreign exchange reserves? Internationalization is a necessary but not sufficient condition for a reserve currency status. What then determines the reserve currency status would be the country’s economic size. Back to the case of renminbi, China now accounts for 10 percent of world’s GDP and 9 percent of world trade. In 2011, it is estimated to have accounted for nearly one quarter of world GDP growth(Source: National Bureau of Statistics of China). Yifu Lin (World Bank Chief Economist) even predicted that China would replace the U.S. as the largest economy by the year 2030. It seems that the economic size will not become a constraint for renminbi obtaining reserve currency status. In such a circumstance, the internationalization of renminbi seems to become the only determinant we need to consider. What does it mean by internationalization of the renminbi? From the functional perspectives, it refers to making RMB be used and held beyond the borders of China for both private and public purposes including storing value, being a medium of exchange and a unit of account (Gao&Yu, 2009). To see this, look at Table 1, which summarizes the international functions of an international currency.

The recent monetary policies suggested China’s ambition of propelling the international use of renminbi. Moreover, since the European debt crisis and the weakening of U.S. dollar, the internationalization of renminbi seems to have been given new motives. However, is the renminbi prepared enough to be internationalized? We will then discuss the 4 major conditions of internationalizing renminbi.

The economic size and status of China: As stated above, China’s economic size and clout are undoubted. However, while it is important to consider the economic size as a determinant for the reserve currency status, it is also crucial to take the inflation rate into consideration. China, though facing inflationary pressure, has maintained a relative low inflation rate recent years.

The convertibility of renminbi and the financial liberalization: One of the keys to the internationalization of renminbi is to let renminbi be traded easily and freely in global financial markets without control on capital flows. China is gradually and selectively easing restrictions on capital flows (Prasad, 2012). For example, Hong Kong has had the freest capital account for two decades and been established as the renminbi’s offshore center recently (Reisen, 2009). However, that is nowhere near enough, there are still strict capital controls in place.

The development of China’s financial market: A mature (wide, deep, liquid) financial market is the prerequisite to the internationalization of renminbi. Unfortunately, there is still a considerable distance for China’s financial market to be developed to the level required for internationalization of the renminbi.

The flexibility of the renmibi’s exchange rate: Renminbi can be regarded as a global currency when it can be traded freely around the world, thus the renminbi’s external value would be

determined by market. The renminbi has moved to a managed floating exchange rate determined by market supply and demand with reference to a basket of foreign currencies since 2005. However, it is still been tightly managed and only allowed to float in a narrow margin around a fixed base.

Among the factors discussed above, the liberalization and development of China’s financial market are the two major challengers China are facing. Note that both of them are long-term factors which are not achievable in the short-run and in a divided way. This implies that the full internationalization of renminbi will not be a one-off process, it will more likely to be achieved in a gradual way. Though which, China’s ability to meet these challenges will largely determine the renminbi’s role in the future global markets.

Besides the factors analyzed above, there are other external factors, such as pressures from the U.S. and European Union, the global recession, etc. Here, we remark a new factor, the mass migration. In recent years, a large number of Chinese elites have immigrated to foreign countries, which mainly are the U.S., Canada, Australia, and the number is still growing. Those millionaires not only emigrated with their family members and their professional competencies, but also their substantial assets. Since those China’s new riches possess a large part of Nation’s total wealth, an enormous amount of wealth has been transferred overseas. It is very likely that the newly formed mass migration wave of China will have significant negative effects on China’s economy and thereby, go against the internationalization of renminbi.

While we look at the conditions for the renminbi’s reserve currency status, we also need to

analyze its impact. Will the benefits excess costs? What should Chinese government do to prevent unexpected outcomes?

It is generally believed that the renminbi’s internationalization will boost China’s economy. Firstly it will probably promote the international trade of China. Exporters have been suffering a great loss from the appreciation of renminbi since July, 2006 for the U.S. dollar is a common invoicing and settlement currency in China’s exports (Hai&Yao, 2010). The internationalization of renminbi could provide an alternative settlement currency for trade partners and hence reduce the exchange risk so that more enterprises will participate in international trade. Secondly, with renminbi becoming a reserve currency, China’s financial markets will likely to become more efficient. The international use of renminbi will facilitate China’s financial system through developing RMB-denominated products and establish financial center in China (Hai&Yao, 2010).

Some people argue that the large fluctuation in the exchange rate of renminbi caused by its internationalization brings uncertainty to China’s cross-borders trades. Policy prescriptions have generally assumed that exchange rate appreciation would be detrimental to exports and encourage imports (Abeysinghe&Yeok, 1998). In case of China, high capital inflows will raise the supply of foreign currency and are likely to force the appreciation pressure of the renminbi, which will probably erode the competitiveness of export-oriented firms in China. Besides, the large amounts of capital inflows will exerting inflationary pressure on Chinese economy (Tomoyuki, 2004) and make it harder for the PBOC to control money supply. Nevertheless, with careful risk management and tighter regulations on currency market, capital inflows can be controlled and hence the appreciation pressure on renminbi will be eased. China can manage to minimize the side-effects of renminbi’s internationalization as long as the government keep a weather eye on capital market and manage risks properly.

To conclude, the prospects of the renminbi as a reserve currency will be influenced by China’s economic size and status, the liberalization and development of China’s financial market, the flexibility of renminbi’s exchange rate and other external factors such as the mass emigration of china’s millionaires. Among them, the low level of the liberalization and development of China’s financial market will be a major constraint for renminbi obtaining reserve currency status. We believe that the renminbi will become the next reserve currency in long-term instead of being realized soon. In addition, in which way will the renminbi become a reserve currency is a crucial question needing to be considered carefully by Chinese government. In other words, should China follow the way of U.S. dollar or the way of Euro, or adopting a unique approach? The last but not the least, the process of renminbi attaining reserve currency status should be step-by-step and the controllable risks should always be put in the chief place.


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