Will the renmimbi become the next reserve currency?

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Amro Sarafy's picture

It is not inevitable, in the least, that the Renminbi replace the Dollar as a reserve currency. China’s current policy does not promote this idea, and most importantly, its national interests are not best served by pursuing a reserve currency status for its Renminbi. China’s foremost interest is its exports, and it is the world’s largest exporter, which has helped it fuel its booming economy. However, China has been able to achieve this boom through meticulous policy that includes capital controls, limitations on investing, and currency manipulation.

The US dollar as a reserve currency was born about from the Bretton Woods System, aimed at reforming the global economic system at the end of the second World War. By that time, a war-battered UK saw its status as a global power overshadowed by the US, and with that, the Pound Sterling took a back seat to the US Dollar.

A reserve currency is in essence the premier currency in the world, being the most held currency in bank reserves around the world. Free access to US markets, stable US government securities and the world’s largest and most advanced economy all give credence to the dollar as a reserve currency. The US is a large, diverse, open market economy complemented by a democratic political system. China’s economy is large and increasingly diverse but is not very open or at all democratic and these go a long way in promoting a currency as a reserve currency. With democracy comes transparency and accountability, factors that are important to investors seeking to place their money in a country or hold its currency in their portfolios. As China lacks transparency, it is hard for investors to read into the Chinese political situation, and with that, future economic policy. Uncertainty of what may come about is a major reason, for investors, against holding a country’s currency. Similarly, the lack of transparency means that China’s Central Bank is not under the spotlight like in the US, and its short and long-term goals (such as the target value of the Renminbi against the dollar) may not be fully understood, creating a problem of asymmetric information. Accountability is another factor as investors need to be assured that there is a path to fair legal recourse should it be necessary. In short, the very nature of China’s political and economic policies make the Renminbi too shrouded in uncertainty to be a reserve currency. However, it is also current and obvious Chinese national interests that make the Renminbi unattractive as a reserve currency.

Beijing’s national interest is maintaining its export dominance, and to do so it must keep in place controls on capital movement, and a strict tie of its Renminbi to the US dollar. It is not in the interest of China to see its currency strengthen against the dollar as Chinese exports to the US would become more expensive for American consumers, who would then consume less of it. China’s current practice is to set the Renminbi at a consistent non-market determined value against the dollar. In essence, when US dollars are converted to Renminbi, the Renminbi strengthens, but the Chinese Central Bank goes into the market and buys up dollars until it strengthens to the desired level against the Renminbi. The Chinese government then does two things: buy up mainly long term US government securities, and hold dollars as reserves.

The large trade imbalance between China and the US coupled with China’s national interest in an artificially undervalued Renminbi, serves to counter the idea that the Renminbi would become a reserve currency even if China desired this. Consistent with their vital interest in strong exports, the Chinese government buys up dollars and keeps them out of global markets, and one way they do this is by holding the dollars as reserves. China holds nearly $2 Trillion in its reserves1.

There is talk of China dumping these dollars into the market as it seeks its own currency domination, or because of the bleak outlook of US recovery. However, any such talk, from analysts or Chinese officials themselves, is either pure sensationalism or saber-rattling. If China were to flood the market with $2 Trillion, the USD would plummet against all currencies, not the least of which is the Renminbi. Consequently, Americans would not be able to buy nearly as many Chinese goods, and the trade imbalance (nearly $300 billion in 20112 ) that China benfits from would dwindle. The Chinese economy would lose much of its income. However there is another serious repercussion and that is oil prices. China’s per capita oil demand has increased by 50% over the past decade, and its oil demand is expected to increase by 35% through 20153. The problem is that oil prices are denominated in USD, and if the USD were to severely devalue against world currencies, then oil would be cheaper and hence purchased at much higher demand. This would cause a massive surge in world oil prices, slowing down the Chinese economy, which is hungry for natural resources. 

There are thus two factors impeding the Renminbi from becoming a reserve currency: 1) China’s policy (capital controls, lack of democracy and transparency etc), and 2) China’s national interests (dominant exports). If the Renminbi is to become a reserve currency, investors must be assured that they have access to the Chinese market, allowing them to buy and sell freely as they see fit. Similarly they must be communicated to openly from a policy of transparency, reliability and unambiguity by the Chinese government. However there still stands the hurdle of Chinese national interests, dominant exports; this is a goliath of a hurdle.

China itself is not ready to see its Renminbi, and hence future national interests, subject to the whims of international investors and institutions, not when it has so cleverly and successfully controlled its own destiny for more than a decade now. The USD came to be the reserve currency of the world after the US, ready to take on such a role, promised a fixed exchange of gold for USD4. If China is not ready to assume this role, then the Renminbi’s time as the overarching currency is not upon us, and it appears that the Chinese are content with this for now. For them, the main reason seems to be “why mess with what has worked so well for us in the past?”.