Nowadays with the soaring demand for stable currencies, Renminbi is arousing increasingly higher expectations from the whole world. However, the author holds that since Renminbi is not convertible yet, and the industrial structure of China could not promise future competitiveness, China still needs a lot of time, preparation and patience to become a reserve currency. China now should take the priority to head for a regional trading currency, and at the same time gradually and cautiously deregulate its exchange rate and strict assets control. In this essay the author sequentially discusses if Renminbi could soon become the reserve currency, whether it should head for it, and what to do to realize it.
Is it inevitable that the Renminbi will become the next reserve currency?
First, we may summarize the basic prerequisites for one to become a reserve currency.
1)Politically and economically stable. Reserve currency is a kind of credit asset, so the stable and sound development of the issuing country is the premise of the maintenance of reserve value.
2)Openness in the foreign currency non-residential bank account and floating exchange rate.Viewing from the demand perspective, non-residents, or more precisely exporters and importers, would not hold deposits of a foreign currency if the country does not permit them to use it to settle their accounts. As to exchange rate, according to Krugman Triangle, with monetary independence and mobile capital achieved in the planned future, China has to allow free floating exchange rate.
3) Large international trade scale. Large scale trade means high demand for its currency.
Then, we need to analyze the extent to which Renminbi fulfills the above requirements, so as to predict whether it will become the next reserve currency or not.
1) China is in a politically and economically stable status. As declared from China Customs, China has become the second largest trading power in 2011. However, the high economic growth in China depends mainly on exporting low value-added products, and its domestic consumption was as low as approximately 39% of total GDP in 2010. 1 Consequently, due to the immature economic structure, China’s long term competitiveness is still unpredictable yet.
2) China now practices managed floating exchange rate, and it would be impossible for China to switch to a free floating regime within a short period. According to past foreign experience, there involves overshooting in the fluctuation of exchange rate. As a result, a sudden transform to free floating regime would definitely lead to tremendous fluctuations in exchange rate, which would be too heavy a strike onto China’s fragile economy.Besides, it seems impossible for current China to completely allow nonresidents to settle trade deals with Renminbi. Since now China has increasing foreign reserves according to the data from SAFE 2, as long as the market is open to nonresidents, tremendous short term hot money would flood into China.
Viewing from the above three aspects, Renminbi is still not well prepared to become a reserve currency in the short term. China needs to at least improve its monetary system and update its economic structure before heading for a global reserve currency. Since all of these adjustments need to be carried out in a gradual and cautious way, it would take a long time. However, the obstacles facing China now are not insuperable, and since China is now actively involved in policy adjustments and the transformation progresses smoothly 3, it is possible that Renminbi would one day become a global reserve currency.
Would this development be in China's interests?
The Chinese authority is actively involved in the internationalization of its currency, but is such development all in China’s interests? To get the answer we might study separately its benefits and risks.
First, we may take the U.S dollar as an example to see the benefits it brings to Renminbi to become a reserve currency.
1) The issuing country could gain tremendous seigniorage revenue. It is like lending one’s earnings to the issuing country with nearly zero interest, and thus the issuing country could take advantage of these low-interest loans and gain more than its tax revenues.
2) The issuing country could shift the risk of debt and currency depreciation to those non reserve-issuing countries. For example, during the financial crisis the reserve-holding countries had to help shoulder the loss since the U.S excessively issue dollars.
3) The issuing countries could be guaranteed with advantageous status in multilateral negotiations. For example, by collectively developing political and economic strategies during the G7 meetings, the developed powers could further strengthen their leading roles and interests. However, China only occupies 3.72% of voting power 4, and thus has no say to protect its own interest. Once becoming the issuing country, China would be more influential in these meets, and thereafter creates a virtuous circle for increasing status and profits.
However, considering the unique situations of China, we cannot overlook the great risks for Renminbi to become a global reserve currency. If Renminbi is internationalized, it has to be convertible and its asset should be allowed to freely flow. This means the current assets would be completely exposed to external risks without previous protections. How to go through the tremendous fluctuations in the global market remains a tough challenge for China especially when its financial system is far from maturity.
To conclude, viewing the generous benefits and potential risks, China should definitely strive for Renminbi internationalization but with caution. Since the monetary system is still fragile and immature in China, the authority must be enough patient and ensure the well control of the progress, or it may cause serious problems like the flooding of hot money, the large-scale bankruptcy of mainland enterprises and so on.
What circumstances need to be in place for this to happen?
With the golden timing that global monetary system after financial crisis is claiming for reconstruction, China now should definitely make further adjustments to facilitate itself towards currency internationalization:
1) Further strengthening the status of Renminbi as a regional trading currency within Asia. It is natural for a currency to be marketized within regions before becoming a global one. Renminbi should continue to promote currency exchange operations, sign cross-border local currency settlement agreement with more countries, and thus become more widely accepted within Asia for products pricing and closing.
2) Renminbi should continue its gradual transformation into a convertible currency. Recently, the executive of IMF Kahn said that Renminbi is warmly welcomed into the basket of SDR as long as China is partly convertible 5. More specifically, being convertible means mainly the openness of the asset control, the Renminbi backflow mechanism, the exchange rate system, and the deep development of the asset market. First, as to the exchange rate, China should continue to appreciate Renminbi gradually until it approaches the purchasing power parity, and gradually enlarge the floating interval. Then, after the central bank gets more experienced in the more free monetary systems, China could further open its capital market to non-residents. The reason for choosing such gradual steps is to progressively release the pressure of currency appreciation, minimize the shock from floating exchange rate, and leave more time for corporates to make preparations and adjustments. Furthermore, the currency appreciation could eliminate those firms with low efficiency and encourage imports of foreign advanced technologies, which would be beneficial for structure upgrading and industry competitiveness in the long run. Meanwhile, China should take advantage of the Hong Kong offshore market, tentatively deregulating its exchange rate, interest and capital market and analyze the effect. Based on such information the authority could make better policies for the more complex China markets.
4) To maintain sustainable economic growth, China had better upgrade its industrial structure to a more technology-intensive one, instead of an export-oriented economy depending mainly on low-end products. Furthermore, it should no longer excessively encourage the inflow of FDI.As declared in 2007 the ratio of dependence on foreign trade for China already rose to 59.70% , 6 which means China’s economic growth and stability would be largely determined by its trading partners and the large-scale export of low-end and high energy-consuming products seem to earn China profits at the sacrifice of its future sustainability.
Then as to FDI, only when total demand is higher than supply in full employment conditions does the country need foreign investments to fill the gap in between. However, the main problem for China is actually a lack of demand, and in this situation the introduction of FDI occupies the already scarce investment opportunities. In reality, since 1995 the domestic capital has been outflowing, causing considerable current account surplus 7. The mainstream voice supporting FDI is that it brings foreign advanced technologies. However, according to a multi-country general equilibrium model, the inflow of FDI accounts for lower home technology capital growth and inertia to catch up. 8
To conclude, if Renminbi keeps the gradual and cautious transformation as suggested above, it should naturally build up its global acceptance and become one reserve currency in future days.
- National Bureau of Statistics (2011), The national economy and social development statistical bulletin of 2010, available: http://www.gov.cn/gzdt/2011-02/28/content_1812697.htm
- State Administration of Foreign Exchange (SAFE) (2011), Monthly Foreign Exchange Reserves. Available:http://www.safe.gov.cn/model_safe_en/tjsj_en/tjsj_list_en.jsp?ID=30303000000000000&id=4.
- Yanhong Bu, ‘The Effect Analysis and Policy Advice to the formation mechanism reform of China’s Exchange Rate ’, The Central Party School Journal, Vol.15 (6).
- International Monetary Fund (February 9, 2012). IMF Members' Quotas and Voting Power, and IMF Board of Governors. Available:http://www.imf.org/external/np/sec/memdir/members.aspx#C.
- International Monetary Fund (February 10, 2011). IMF Managing Director Dominique Strauss-Kahn Calls for Strengthening the International Monetary System. Press Release No. 11/36. Available: http://www.imf.org/external/np/sec/pr/2011/pr1136.htm.
- PEI Fangfang (2010), ‘Research on Influence Factors of China's Degree of Trade Dependence: Based on Principle Components Analysis’, Value Engineering, vol.2 (2010).
- McKinnon, Ronald and Schnabl, Gunther (2003). ‘China: A Stabilizing or Deflationary Influence in East Asia? The Problem of Conflicted Virtue’ Working Paper No. 23/2003.. HKIMR
- Thomas J. Holmes, Ellen R. McGrattan, Edward C. Prescott (2011). ‘Technology CapitalTransfer’. Federal Reserve Bank of Minneapolis Research Department.
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