Will the renmimbi become the next reserve currency?

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John Paul De Guzman's picture

China’s rise in the economic spectrum had been an inevitable topic of the last decade. It may probably continue to be the hottest topic in this decade. The present order of international trade is dominated by the dollar but this might change sooner or later. Along with China’s rise, renminbi as global currency gains worldwide attention. Against this backdrop, Chinese policies would be more relevant in the international arena, albeit present Chinese policies are as important. The world should closely monitor as history unfolds. This century may belong to renminbi (perhaps it is now the case).

If we analyze the events leading to dollar domination (ninety-eight years earlier), we would find out that the dollar played a negligible role in international trade and payments, albeit US already dominate world trade at the time. Negotiable trade credits denominated in dollars were minimal to nonexistent. In fact, manufacturers and wholesalers from all over the world seeking to export and import from the US and, more strikingly, even US exporters and importers themselves, when seeking to obtain credit for a transaction, did so with the intermediation of investment banks based in London 1. Sterling dominated international trade, and to a smaller extent, markets in trade credits existed in French francs and German marks. US dollar was nowhere to be found in the scene albeit by 1914, US already hold the title of being the largest trading nation.

A major turning point was when the US turned from capital importer to capital exporter after 1890. Even so, the dollar played a negligible role as a currency in which to denominate international bonds. The dollar accounted for just a tiny sliver of the foreign reserves of central banks and governments; only de facto US dependencies like the Philippines held any of their reserves in dollars. The subsequent change was dramatic. In a span of just ten years, between 1914 and 1924, the dollar surpassed sterling as the leading international and reserve currency 2. Fast forward to 2012, renminbi is now in the same position as the dollar hundred years ago. Will history allow renminbi to repeat the former?

Historic experience and economic theory suggest that in order to become global reserve currency, four preconditions need to be met simultaneously: the home economy of the subject currency needs to demonstrate stability and low inflation; the volume of the home economy should be the largest in the world; the home country must possess mature and solvent financial system 3. In addition, the currency must achieve full convertibility 4. It may come as a surprise but economists declared that China already met most of these preconditions. In fact, the idea of transforming the renminbi into a global currency has been under consideration by China’s economic policy advisors for at least a decade 5.

China already accounts for large share of the world economy and has until recently been able to overcome inflationary pressures for the most part. Whilst capital-account movements across the border are still restricted, greater current-account convertibility is now permitted. In the face of financial market shortfalls, policy makers have of late gingerly moved to bestow on the renminbi more international exposure. In June 2007, the first batch of the so-called dimsum bonds (renminbi-denominated PRC) was floated in Hong Kong and total issuance has subsequently grown to around Rmb230bn ($36.2bn) 6. In the following month, the People’s Bank of China (PBC) set up a specialized Exchange Rates Department with a mandate to promote renminbi’s internationalization as well as to enhance its prestige overseas. In December 2008, China’sruling State Council approved two pilot programs to experiment with cross-border trade settlement in renminbi 7. One program would allow trade settlement in renminbi for transactions between Guangdong Province and the Changjiang (Yangtze) River Delta in China and the cities of Hong Kong SAR and Macau SAR. A second program would allow trade settlement in renminbi between the Chinese provinces of Guangxi and Yunnan and ten members of the Association of Southeast Asian Nations (ASEAN). Later on, a third trial program was approved that allowed selected Shanghai companies to settle trade transactions in renminbi for larger projects in ASEAN nations, Hong Kong, Macau, and Russia 7.

Following the announcement of the pilot programs for trade settlement in renminbi, China rolled out several other trial programs designed to foster the greater use of the renminbi overseas. China negotiated and signed currency swap agreements with several other nations that allowed the settlement of bilateral transactions in the two nation’s respective domestic currencies. The PBC created new domestic foreign exchange markets, adding such currencies as the Malaysian ringgit and the Russian ruble to the list of foreign currencies offered in Beijing 5.

Furthermore, in March 2010, the State Council approved an experimental global RMB clearing center in Hong Kong which is to be extended onto twenty Mainland regional centers in the near future. Indeed, in October 2010, the 12th PRC Five-Year Plan reaffirmed that Hong Kong is to become a test ground for clearing global renminbi-denominated transactions. Most recent, on June 1, 2011, the PRC government announced a new experimental scheme whereby accredited institutions and individuals without domestic representation would be allowed to directly purchase renminbi overseas 4. Against these seeming progressive steps taken by China, PBC Governor Zhou has recently stated that there is no timetable for full convertibility of the renminbi which implies that it is a long-term goal 8.

China has been eyeing the benefits of a globalized renminbi. The primary quantifiable advantage would be, of course, the ability to enhance “seignorage” revenue in its abstract modern form (as opposed to the metallic seignorage of pre-modern times). In addition, renminbi tradability is likely to increase the volume of international financial transactions to be cleared in China and thus hold out the prospect of more premium jobs created locally and greater financial services tax revenue.

China’s dependence on US economic policies would lower substantially. China’s leaders have serious doubts that the US will act as a responsible global citizen when the needs of the international financial system run counter to the preferences of US domestic policy. To Chinese analysts, the Federal Reserve’s decision to push $600 billion into the world economy in November 2010 or the so-called “quantitative easing,” or QE2 was further proof that China could not rely in the US. A globalized renminbi would reduce China’s exposure to US policy decisions 5.

A globalized renminbi would transfer the exchange rate risk inherent in international trade and financial transactions away from Chinese companies and over to foreign companies. Most of international trade and finance is currently denominated in dollars, forcing Chinese companies to accept the risk of a strengthening or weakening of the renminbi with respect to the dollar. However, if trade and financial transactions are denominated in renminbi, the Chinese companies no longer must account for exchange rate uncertainty in their international transactions. Similarly, Chinese entities possessing a portfolio of assets denominated in renminbi would no longer risk the erosion of their wealth due to exchange rate changes.

China anticipates an elevation in its international prestige if the renminbi becomes a global currency. As a provider of a global currency, other nations would view China as a source of stability and strength in the world economy, and China’s views of economic policies would have greater influence and importance. When this happens, China may undermine US and the greater international pressures against the former’s policies.

Internationalizing renminbi has downsides too. The most obvious downside to renminbi internationalization is associated in PBC thinking with the potential weakening of macroeconomic levers that have so far stimulated Chinese exports, for example, the managed-band exchange rate regime. Internationalization would also pose the risk of Chinese nationals transferring assets overseas on short notice and allow for “hot money” to more easily penetrate the domestic economy and aggravate the already acute property bubble across much of the county’s eastern seaboard 9. Another downside is the problem of renminbi counterfeiting, and with it the cost of policing international financial markets 5.

The downfall of the dollar may only be a matter of time; likewise, when renminbi becomes the next global currency. It must be emphasized though that renminbi’s taking the front seat does not require dollar’s demise similar when sterling took the back seat. Nevertheless, whichever global currency dominates this century, world economy will continue to be intricate, if not getting more intricate. The onus is for the present and emerging leaders alike to control the situation for humanity’s best interest.

 

References: 

1. Eichengreen, B., The renminbi as an international currency. Journal of Policy Modeling, 2011. 33: p. 723-730

2. Eichengreen, B. and M. Flandreau, The rise and fall of the dollar (or when did the dollar replace sterling as the leading reserve currency?). European Review of Economic History, 2009. 13: p. 377–411

3. Tavlas, G., On the international use of currencies: the case of the Deutsche Mark, I.M.F.w. paper, Editor. 1990

4. Horesh, N., The people’s or the world’s: RMB Internationalisation in longer historic perspective. Economics Research International, 2011. 2011: p. 1-13

5. Martin, M., Hong Kong and the globalization of the renminbi. Washington Journal of Modern China, 2009: p. 53-69

6. Flood, C. Van Eck offers 'dim sum' bond ETF. 2011 19 February 2012]; Available from: http://www.ft.com/intl/cms/s/0/39a4574a-f5a8-11e0-be8c-00144feab49a.html...

7. Daily, C., Shanghai may start yuan settlement trials, in China Daily. 2009.

8. Yung, J., PBOC adviser: Yuan to be 'basically convertible' within 5 years, in Wall Street Journal. 2011

9. Group, R.I.S., The timing, path and strategy of RMB internationalization. Zhongguo jinrong, 2006. 5: p. 12–13.