CHINESE RMB – THE NEXT RESERVE CURRENCY?

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CHINESE RMB – THE NEXT RESERVE CURRENCY?

In the wake of the global financial crisis, the Chinese government has speeded up a policy of promoting the internationalization of its currency, the Renmini (RMB). The crisis demonstrated that the Chinese economy had been overly dependent on using the dollar as the currency of settlement in international transactions. The deleveraging of the American financial system caused a sudden plunge in the demand for goods made in China. Meanwhile, the Chinese policymakers are under increasing pressure to appreciate the RMB, which essentially would devalue China’s massive foreign exchange reserves, valued at $3.18 trillion as of December 2011. These experiences encouraged Beijing to promote its own currency in bilateral trade. This essay analyzes whether the RMB will become the next reserve currency and whether such a potential switchover would be in China’s best interest.

Understanding Reserve Currency

One factor is the amount of public debt denominated in the currency. A large amount of debt is necessary to ensure a functional monetary system and a reserve currency position. However, the tradeoff is that the public debt to gross domestic product ratio must be maintained at a healthy and sustainable level. A delicate balance aimed at achieving both ends is difficult to strike. Not only the new potential reserve currency needs to be widely acceptable in international transactions, but also the old reserve currency must lose credibility in a substantial manner that most countries are urged to switch.

Historically such a switchover did happen. Between 1860 and 1914, almost 60 percent of world trade was invoiced and settled in British pounds. However, the World War I triggered the decline in the dominance of the British pounds, and the UK finally abandoned the gold standard. At the same time, the US dollars quickly rose as a store of value, largely because of the manufacturing driven expansion of the US economy during the two World Wars.

The second factor is whether the currency is tied to any commodities or natural resources traded on the global market. Take the US dollar as an example: one major incentive for most countries to peg their currencies to the US dollar has been the United States being the largest oil importer. Oil, as a scare resource, is correlated with a number of high profit-margin and monopolized industries. By pegging currencies to the US dollar, any countries producing oil-related products benefit from the US’s role as a global price setter.

The Renminbi Dilemma

Despite China’s rising economic power, the Renminbi is unlikely to replace the US dollar as the dominant currency in the coming decades. However, internationalizing the RMB is in the interest of China, and Beijing will most certainly continue its multi-stage and multi-track approach to make the RMB a reserve currency.

First and foremost, the US dollar dominance shows no sign of significant decline in the near to medium term even with the global financial crisis. According to a survey published by the Bank for International Settlement in September 2010, the financial crisis did not challenge the US dollar’s position as the dominant currency in the foreign exchange market. Before the crisis, in 2007, US dollar accounted for 85.6% of the turnover, whereas in 2010 it accounted for 84.9%. Chinese RMB, on the other hand, accounted for 0.5% of the turnover in 2007 and 0.3% in 2010. This startling difference is unlikely to be narrowed in a mere few years.

Even if investors’ confidence in the US dollar fade precipitously to a level that an alternative reserve currency becomes absolute necessary, the Chinese RMB still does not seem to be the most attractive candidate. The root cause is China’s arcane political system and rudimentary financial markets. Currently the Chinese RMB is pegged to the US dollar at a highly regulated floating exchange rate, and conversion to other currencies is controlled. In addition, China does not have a reliable bond market, with few credible rating agencies and an immature trading center, let alone sophisticated derivatives trading. There obstacles are internal, and China’s political and financial reforms are very unpredictable from the perspective of outside investors. Without strong political and financial systems, Chinese RMB would not have sufficient credibility to attract investors from around the world.

Moreover, it is important to remember that the US is a price setter in oil. Admittedly, China nowadays imports a massive amount of commodities, from iron ore to copper to soybeans. However, China is far from being a price setter. Commodities producing countries set the price according to demand, and China’s increasing demand has pushed up commodity prices. This high level of commodity prices is not sustainable. As China transitions into a more technology-focused economy, its decreasing demand will likely drive down commodity prices. Therefore, in order for the Chinese RMB to become a truly global currency, China needs to bundle its currency with a major commodity as a price setter, thus effectively giving more credibility to the RMB.

Internationalizing the RMB is beneficial to China in several ways. It matches China’s rising economic power and will allow China to exert a greater influence on other nations. The internationalization would also allow China to make more direct investments in foreign countries, therefore unleashing the huge pile of wealth it has accumulated over the years. The takeaway is that even though RMB internationalization still has a long way to go, it is in China’s best interest to pursue this goal.

A Better Way?

The emergence of a new multipolar world poses new challenges for asset allocation on the national level. Pegging to a single currency is showing greater downside risks for many countries. As the Federal Reserve uses more rounds of quantitative easing, there is a trend that countries move towards pegging to a basket of currencies. Singapore is one such country. Starting in 1985, Singapore has allowed its Singapore dollar to float against a basket of Singapore’s major trade partners’ currencies. All issued Singapore dollar currency in circulation is fully backed by international assets to maintain public confidence.

In an era of public debt crisis, Singapore’s measured approach deserves greater popularity. Should this become prevalent, a more realistic goal for China is to be one of the currencies in most countries’ peg basket. This would avoid a direct confrontation with the more dominant US dollar but would also give the RMB enough spotlights in the international community.

 

References: 

1. Bank for International Settlements. “Triennial Central Bank Survey: Foreign exchange and derivatives market activity in April 2010.” September 2010.

2. Eichengreen, Barry. George C. Pardee and Helen N. Pardee Professor of Economics and Political Science. University of California, Berkeley. “Managing a Multiple Reserve Currency World.” Prepared for the Asian Development Bank Institute project. April 2010.

3. HSBC Global Research. “The rise of the redback: a guide to renminbi internationalization.” November 9, 2010.

4. Kaminska, Izabella. “What makes a reserve currency?” Financial Times. October 5, 2011.

5. Wong, Ka Fu. “Historical Exchange Rate Regime of Asian Countries.” Web, Department of Economics, The

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