Will the renmimbi become the next reserve currency?

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Johna Boo's picture

China is now widely accepted as a leading financial power within the global economy. Its economic reforms since the 1980s have established it to become the second largest economy in the world, with the International Monetary Fund (IMF) predicting its economy will surpass that of the U.S within the next decade (Colebatch 2011). Such dynamic growth has led to the consideration of whether the Chinese renminbi will attain international usage and convertibility, ultimately eclipsing the U.S dollar and becoming the next global currency. Contributing to this notion are the ongoing threats to the U.S dollar’s dominance, arising from excessive national debt, current account and fiscal deficits, diminishing investor confidence, and currency weaknesses (Lee 2010). These were all tribulations experienced by the U.K, influencing the pound’s demise as primary reserve currency following World War II (Lee 2010). Furthermore, China has taken steps towards encouraging global use of the renminbi, by establishing offshore trading centres in Hong Kong and easing restrictions on capital flows, as its global acceptance is deterred primarily due to capital control regulation and underdeveloped financial markets (Dobson and Masson 2008). Despite these efforts, further economic reforms are needed, as the ability for the renminbi to reach reserve currency status is typically dependent on developed financial markets, stable macroeconomic policies, free capital flows, substantial economic size and a flexible exchange rate regime – features which China does not all possess (Prasad & Ye 2012). Such economic changes must allow the renminbi to be used globally as a unit of account, a medium of exchange and a store of value and purchasing power, in order for it to properly serve the functions of a reserve currency (Lee 2010). These factors would permit the currency to transact in foreign exchange markets, act as an invoicing currency for trade, be used for denominating cross-border assets and liabilities, represent a peg for local currency, and be held as an international reserve (Lee 2010). As a result of these conventional requirements, this essay aims to critically discuss the circumstances under which the renminbi will be adopted for both official and private use, and the implications that this could create for the global monetary system. Firstly, China’s changing capital controls will be analysed and the effects this could have on other macroeconomic factors and policies will be examined. Next, the underdevelopment of its financial markets will be assessed, and the possible policies that China could take to further strengthen these markets will be considered. Lastly, whether such an advancement of its currency will better serve China’s interests will be reviewed.

China’s capital account is subject to direct government control, restricting the convertibility of China’s assets into foreign currencies, thereby limiting the desirability for its use as a vehicle currency or as a means for denominating international claims and liabilities. For this reason, reserve currencies are characteristically freely tradable, in order to make acceptable payments to a country’s trading partners (Prasad and Ye 2012). The economic adjustments needed to ease restrictions and increase capital account openness gives rise to the “Impossible Trilemma,” identified by the Mundell-Fleming model. This model infers that in an open economy, it is impossible to have a fixed exchange rate, free capital flows and an autonomous monetary policy simultaneously (Shapiro 2009). This point is reiterated by economist, Paul Krugman, as he describes China’s current position, which evidently conflicts with the criteria for a global currency as the model implies that only two goals can be pursued –  “[China has] fix[ed] its exchange rate without emasculating its Central Bank, but only by maintaining controls on capital flows” (Shapiro 2009, p. 19). Responding to the need for great capital account openness, Chinese authorities have taken steps to gradually weaken its capital controls in order to safeguard against any economic instability that may arise. Such examples include encouraging outflows from institutional investors and corporations for direct investment abroad through discontinuing ex ante review and approval requirements for outward remittances of funds (Prasad and Ye 2012). Such a policy relieves some of the pressure for the renminbi to appreciate, which explains the higher regulation of capital inflows, as there are fears that China could lose its exporter competitiveness as a result of currency appreciation. This is evident as the introduction of the Qualified Foreign Institutional Investors (QFII) in 2003 allowed foreign investors to acquire domestic securities in an effort to expand the domestic stock market (Dobson and Masson 2008). Recently the upper limit for portfolio investments for QFII has been raised to, what is considered to be a modest, $1 billion with a reduction in the “lock up” period of such investments (Prasad and Ye 2012). However, a higher level of financial integration by means of capital control openness is risky when there is no flexible exchange rate, as the exchange rate cannot act as a shock absorber in times of capital flow volatility (Chen and Cheung 2011). Furthermore, the fixed exchange rate decreases a central bank’s ability to use monetary policy instruments, such as interest rates, to maintain domestic price stability. According to Prasad and Ye, even though China’s capital account is still relatively closed, these issues remain imminent as “the capital account tends to become porous as interest differentials with the rest of the world increase and the incentives to evade controls become larger” (Prasad and Ye 2012, p. 8). For these reasons, Eichengreen and Rose advocate for abandoning a fixed exchange rate instead of capital account openness, stating that it would permit emerging markets a greater flexibility to modify policies to domestic conditions, rebalance exports to increase China’s domestic spending power, provide relief for inflationary pressures, overheating and asset bubbles (Eichengreen and Rose 2010). Thus, either the easing of capital controls or allowing greater exchange rate flexibility would be steps that China could take to further strengthen the renminbi’s global status. The decision chosen by Chinese authorities will be made “to ensure gradual controlled liberalisation of the previously-planned economy at a rate that delivers sufficient economic growth each year to absorb millions of labour force migrants and laid off workers” (Dobson and Masson 2008). Nevertheless, China’s monetary policy, which is significantly influenced by the restrictions of capital flows and heavily managed exchange rate regime, contributes to the serious obstacle of its underdeveloped financial system and global integration.

A country’s financial market must be, “open, unrestricted, deep and developed” (Lee 2011, p. 11), however China’s government and corporate bond market appears to be shallow and illiquid, relative to other developed economies, with limited access to foreigners. A larger securities market is needed to support the credible use of the renminbi in international transactions, and there is demand for derivatives markets from importers and exporters to circumvent foreign exchange rate risk resulting from an open capital account (Prasad and Ye 2012). Moreover, higher liquidity is important for the demand of renminbi-denominated assets, thereby attracting foreign investors and other central banks to hold these secured bonds as part of their portfolios (Jaeger 2010). Yet, it appears that not only capital controls, but institutional deficiencies are causing the underdevelopment of China’s markets. These include: default procedures not based on market principles, lack of transparency employed by issuers, insufficient investor education and lack of market discipline, and the absence of transparency for investors given by a credit rating system (Zhou 2005). The official institutions that regulate China’s financial markets are also underdeveloped. The People’s Bank of China (PBOC) uses direct control over banks’ lending and deposit rates, instead of regulating the money supply and credit though indirect instruments such as open market operations (Zhou 2005). Moreover, the renminbi’s ability to be held globally depends on the confidence that the international community has on its regulation system. Thus, a central issue is whether lending can be based on credit worthiness instead of misdirected lending to state-owned enterprises. This leads to the point that continued government ownership also constrains the development of China’s banking system, as central bank independence is imperative to the liberalisation and credible reliance on financial markets. Therefore, it is apparent that China needs to address and improve upon the lack of transparency and credibility of its financial policies.

The implications of China’s domestic political issues and international relationships with other economies must be considered, as the effects on China’s interests could determine the extent of market liberalization and international use of the renminbi. In early 2009, the intention to make Shanghai an international financial centre by 2020 was announced by China’s National Reform and Development Commission (Swire 2012). Consequently, the attraction of financial reform in order to achieve this goal is significant, and as Shanghai strives to draw interest from global banking services and international companies, this desire may place added pressure for quicker economic changes to capital controls and the exchange rate regime. This could create tension and debate between authorities who want to act cautiously through gradual implementation, and those that encourage quicker financial growth. A key benefit of reaching reserve currency status is the notion of “exorbitant privilege”, which explains that a country can not only finance its deficit by issuing its own currency or debt denominated in its own currency, but also borrow at low rates and lend at higher yields (Jaeger 2010). The increased number of investors would also lead to the deepening of financial markets causing them to operate with greater efficiency. However, a study by McKinsey Global Institute identifies that a drawback of being a reserve currency include the loss of exporter competitiveness as the renminbi would likely be overvalued, which could impede on economic growth (Dobbs et. al. 2009). Thus, Chinese authorities need to carefully outweigh the costs and benefits of making its renminbi a reserve.

In conclusion, it is clear that numerous economic reforms need to occur before the renminbi can become a reserve currency. With changing capital controls already in place, and the consideration of increasing the flexibility of its exchange rate regime, China appears to be promoting global use of the renminbi. However, as few market based instruments are readily available to policy makers, this constrains the ability to maintain economic stability, questioning the extent of involvement of geopolitical influences in financial markets. It is evident that the liberalization measures already in place will increase the number of reserve holding in renminbi, as well as increase it as an invoicing currency. It is likely that the renminbi will become a reserve currency in the future, alongside the U.S dollar and euro, but whether it will replace the U.S dollar as primary reserve currency cannot be said to be inevitable yet.

References: 
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