International Reserve Currency: will the RMB edge out the US Dollars?

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Ayodele Ibrahim Shittu's picture

International Reserve Currency: will the RMB edge out the US Dollars?

Introduction

The role of the US Dollar, as a store of value, is increasingly being doubted day by day, following the lingering global financial crisis 1, while several arguments have ensued with a view to justifying the need for a system of multiple reserve currencies. Ironically, China’s economic performance has been consistent and contributing meaningfully to the global economy. Besides gradually becoming the manufacturing plant of the world, China is also expanding in outward foreign direct investments. Thus, the Chinese enduring performance is attracting more attention from both the developed and the developing economies, which is visible in the settlement of trade accounts in RMB, as well as the growing financial investments in the RMB denominated assets.

However, one issue, which beckons for an answer and which is also generating quite a number of arguments is the internationalization of the Chinese Renminbi (RMB). Gregory Chin reportedly said in 2011, “…it would be natural for the Renminbi to become one of three or four major international currencies in the world economy.” This raises the question, “in a quest to be a reserve currency, will the Chinese Renminbi (RMB) edge out the US dollar?”

The Demand for International Reserve: Theoretical Underpinnings

There are three fundamental theories, which explain why countries would demand for international reserves; the global monetarism or international quantity theory, the Triffin-Dilema, and the Micro-foundation approach 2. According Williamson 3, Robert Triffin remains one of the most original analysts of the postwar international monetary system. He challenged the inner working mechanism of the system agreed upon at the Bretton Woods and argues that such mechanism would fail. The inner system encourages the US to run balance of payment deficits in order to supply more dollars to the world. Triffin argues that consistent deficit would undermine confidence in the US dollars, which is the basis for its reserve asset status 4. This would, in turn, lead to crisis. However, Triffin opines that the demand for international reserves would be motivated by expansion in the world trade 2.

Is the Demand for More International Reserve Currency Justified?

The international reserve currency is a creation of the international monetary system. The quest for more reserve currency, besides the US dollar has been a subject of debate for more than a decade 2. Fundamentally, a reserve currency must have the following three factors, which include; as a store of value, medium of exchange, and unit of account 5. These are similar to the qualities of the domestic money of each sovereign nation. Thus, the reserve currency is also addressed as international money.

The reserve currency, as a store of value, guarantees trading across borders. It can be used for invoicing of imports and exports, while the government can also adopt such as a component of its official foreign exchange reserve. As a unit of account, domestic currencies can be pegged, while trading in assets and liabilities can be denominated in this currency. Finally, as a medium of exchange, it guarantees intervention in the domestic official foreign exchange market. Thus, it encourages liquidity. 

According to Chen, et al 6, low and stable inflation, open, deep and broad financial markets, and large share of the world’s trade are the fundamental determinants of demand for an international currency. While Dobson and Masson 7 support these, they added network externalities. So far, the US dollar has enjoyed the monopoly of reserve currency. The international monetary system (IMS), at present, is being pressurized to increase the special drawing rights (SDRs) in order to reflect the increasing multi-polar structure of the global economy 8.

The Renminbi in view:

Several arguments have ensued with a view to justify the inclusion of the Chinese Renminbi as a reserve currency. Using the determinants of demand for an international currency as a point of reference, the Renminbi deserves to be an international currency. Recently, two factors (i.e. the rising impact of the RMB on regional currencies, and market forces) adjudge the RMB worthy of being a reserve currency. Beyond its outward foreign direct investment, China is now influential in global trade. It has maintained a positive growth rate of export to and imports from eight different economies; Brazil, Mexico, Saudi Arabia, France, Germany, Japan, and USA [9].

However, this analysis will be incomplete without referring to Chinn and Frankel’s analysis of the Chinese performance. They observe that in PPP terms, China’s GDP exceeds that of all countries, except the United States and the Euro Area. Another short fall, which China needs to correct, is the depth and flexibility of her financial market. This, in particular, features in literatures frequently.

Steps taken so far:

The Chinese government exemplifies leadership quality both locally and internationally. It has long realized that it would be in the interest of the Chinese economy should the world accept its RMB as a reserve currency. The Chinese government is, however, not in haste for it has plans in place to achieve the set goal steadily. It realizes its weakness and thus, seeks to have in place a solid foundation complemented with steady policies, steady growth in macro-economic management capacity and prevention of radical changes that may affect its economy.

The lessons from Japan’s experience linger in the memory of the Chinese government. The history from a powerful trade force in the 1980s, to the Plaza Accord of 1985, and the tight policies of 1989 are realistic experiences. To avoid falling into the same pit in future, the Chinese government mapped out three steps to achieving the goal of a reserve currency.

The first step seeks to make the RMB an international trade settlement currency based on the convertibility of the RMB on the current accounts. The next step seeks to change the RMB into an investment currency that will guarantee two-way flows, and finally, achieve internationalization and turn the RMB into a reserve currency.

The result so far shows that the RMB is moving towards being a reserve currency. For instance, the RMB swap among fourteen countries/ regions sums up to 1.29 trillion RMB 10. The Foreign Direct Investment (FDI) in RMB between October and December, 2011 spans through 74 projects, and sums up to 16.53 billion RMB 11. In addition, progress is also being recorded in the use of the RMB as settlement currency following the issuing of the RMB-denominated bonds. The RMB deposits in the Hong Kong Special Administrative Region are also growing.

More importantly, is the increasing trade transactions between the China Mainland and the Island. In 2009, only five provinces (i.e. Shanghai, Guangzhou, Dongguan, and Shenzhen) participated in trading with Hong Kong, Macau, and ASEAN. In 2010, twenty provinces traded directly with the rest of the world recording a trade value greater than 500 billion RMB, while as at October, 2011, all the Provinces traded directly with the rest of the world recording a trade value greater than 2 trillion RMB 12.

Benefits and Costs Associated with the Reserve Currency:

The benefits associated with the RMB being accepted as a reserve currency is enormous. First, the country will enjoy seignorage. This implies that loan can be issued in RMB with low interest rates. So, both China and the foreign-holder of the RMB benefit. These will stimulate increasing business opportunities. Thus, encouraging the promotion of entrepreneurship across all the Provinces, as well as creating more financial transactions. So, the financial institutions also benefit. The Chinese citizens can also trade internationally, without fear of foreign exchange risk.

This will also entrench regional integration and economic cooperation. The World Trade Organization (WTO), the Association of South East Asian Nations (ASEAN), the ASEAN Regional Forum (ARF), the East-Asian Latin America Forum (EALAF), etc. are a few among the regional organizations that China associates with. The independent nations of the organizations will all benefit from the RMB, if it achieves the reserve currency status.

The cost, however, are structural in nature. Basically, the costs are related to the depth and flexibility of the Chinese financial market. It also includes the liberalization of the sector and convertibility of the RMB. There could be fluctuations in the demand for the RMB, the currency will be prone to appreciation, and this also places more responsibility on the Chinese government. These are in terms of commitment and obligation to maintain financial stability.

Conclusion:

The RMB has the potential to be and will be a reserve currency. This may take some years more, but that day will eventually come. I do not subscribe to the complete overtake of the UD dollar radically. If the RMB would achieve this, let it be market forces-propelled. In other words, the Chinese government should stay focus, and concentrate on building a solid foundation for the responsibility behind hosting a reserve currency is enormous.

 

References: 

1. Todokoro. M (2010), After dollar? International Relations of Asia-Pacific, Vol. 10 (3), pp. 415-440, doi:10.1093/irap/icq012

2. Mendoza. R (2004), International Reserve-Holding in the Developing World: Self Insurance in a Crisis-Prone Era, Emerging Market Review, Vol. 5, pp. 61-82.

3. Williamson. J (2009), Understanding Special Drawing Rights (SDRs), Policy Brief No.9, extracted from: http://nowandfutures.com/d2/understanding_sdrs_pb09-11.pdf

4. Lago. I, Duttagupta. R, and Goyal. R (2009), The Debate on the International Monetary System, IMF Staff Position Note No. 26 (Washington D.C: International Monetary Fund)

5. Chinn. M and Frankel. J (2007), Will the Euro eventually Surpass the Dollars Leading International Reserve Currency? In G7 Current Account Imbalances: Sustainability and Adjustment (ed), Clarida. R, http://www. nber.org/chapters/c0126.pdf

6. Chen. H, Peng. W, and Shu. C (2009), The Potential of the Renminbi as an International Currency, extracted from http://www.bis.org/repofficepub/arpresearch200903.06.pdf

7. Dobson. W and Masson. P (2009), Will the Renminbi become a World Currency? China Economic Review, Vol. 20, pp. 124-135.

8. Mazaid. S, Faralmand. P, Wang. S, Segal. S, and Ahmad. F (2011), Internationalization of Emerging Market Currencies: A Balance between Risks and Rewards, IMF Staff Discussion Note No. 17. (Washington D.C: International Monetary Fund)

9. Asian Development Outlook, 2011.

10. China Daily (2012), China’s Cross-Border RMB Settlement hits USD 408 bn, extracted from http://www.chinadaily.com.cn/usa/business/2012-01/11/content_4424243.htm

11. Chen. O (2011), More Active Renminbi Role urged for HK, extracted from http://europe.chinadaily.com.cn/business/2011-12/15/content_14272259.htm

12. China Daily (2011), Promoting basically Balanced Growth of Foreign Trade, extracted from; http://europe.chinadaily.com.cn/business/2011-12/08/content_14233667.htm

Comments

A well written paper, l couldn`t agree more with the recommendation that in it quest to achieve the status of a reserve currency,sight must not be lost of the need to build a solid economy the foundation of which should be a true market based mechanism.

In terms of the costs associated with the RMB as a reserve currency, l believe the Chinese government stands to benefit from the late-mover advantage since it will have the benefit of learning from the experience of the reserve currencies in force now (US Dollar, the Pound Sterling,the Euro and the Japanese Yen).