Will the renmimbi become the next reserve currency?

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Romy Menec-Le Bris's picture

Until recently, the legitimacy of the US dollar as the world’s dominant reserve currency was unquestioned. However, new worldwide economic conditions put the US dollar as the main reserve currency in question. This paper will first examine the reasons to the potential collapse of the US Dollar. The necessary steps that China needs to take to internationalize the Renmibi will then be discussed. This paper will also address the fundamental changes in China’s economy if the Renminbi becomes a reserve currency and the implications of this change in currency supremacy for the world.

The last financial crisis that started in the US raised concerns about the US dollar’s strength in a world with unstable economic conditions. The US dollar as the dominant reserve currency in the long-term is now put in question. The decline in value of the US dollar as well as United States’ credit problems can be seen as an opportunity for the Renminbi to become the next reserve currency.

The Renminbi has the potential to become the next reserve currency but China needs to promote its currency as a global currency. China should open its financial markets to foreign investors by easing capital controls. China needs to set a flexible exchange rate and must allow the Renminbi to appreciate. The promotion of the Renminbi can be done by having the Renminbi used more frequently in international trades. For example, China should enter currency swaps with foreign countries and foreign central banks to allow them to settle trade bills in the Renminbi currency. This technique can also be used in the issuance of international bonds. This would generalize the use of the Renminbi in global trades and make the currency fully convertible and widely accepted in the long-run. China would also have to change its economic model by switching from an economy led by investments to an economy led by consumption.

The Chinese economic policy would profoundly change if the Renminbi becomes a reserve currency. In fact, China’s economy is currently led by investments which make the country the largest sovereign creditor with large US dollar reserves. However, if China wants the Renminbi to emerge as a reserve currency, it will have to change its economic model by switching to an economy led by consumption. The Renminbi currency would be used for international trades and the world’s demand for this currency would significantly increase. By being the reserve-issuing country, China would inevitably face the Triffin dilemma because this fundamental change in China’s economic model implies that China would have to run balance of payments deficits to meet the growing demand for the Renminbi. In the long-run, China’s debt would rise without limit causing investors to lose confidence in the value of the Renminbi. This Triffin dilemma is not a zero sum game because the reserve-issuing country always runs balance of payments deficits while surplus countries always accumulate reserves.

Switching from the position of a surplus country that accumulates US dollar reserves to a reserve-issuing country implies for China the loss of control over its economic decisions. China would have to achieve a balance between its domestic monetary policy goals and the international monetary policy goals by ensuring it meets other countries’ demand for Renminbi currency. With the internationalization of the Renminbi, China takes the risk of failing to adequately meet the global demand for Renminbi resulting in instable global financial markets.

The emergence of the Renminbi as a reserve currency involves the loss of the reserve currency status for the Unites States because there is usually only one room for one dominant reserve currency. This fact will probably bring an economic, financial, commercial and political crisis in the United States and worldwide because the United States is the world’s largest debtor and will have to reimburse its huge debt.

China’s main problem is that it accumulated large US dollar reserves because of its status as a surplus country. China is stuck into a US dollar trap because it bought massive amounts of US debt. Therefore, if China wants the Renminbi to become the next reserve currency, it will have to diversify away from the US dollar by underexposing itself to US dollar-denominated securities. This will cause an immediate threat to the United States and the world financial stability because the US dollar will immediately depreciate in value causing other currencies to appreciate including the Renminbi. The Renminbi’s appreciation in value would be an opportunity for China to have its currency to become a reserve currency but China would also suffer a huge capital loss and its US dollar reserves will decline in value.

The worst case scenario for China would be the depreciation of the US dollar combined with the Federal Reserve’s decision to print more money to deal with the national debt problem. This would result in an increase in the inflation rate and consequently deeply hurt China’s financial situation because it holds the US debt, and by the same mechanism severely hurt China’s huge foreign US dollar reserves.

As a result, it is not in China’s interests to displace the US dollar as the leading reserve currency because China’s economy and the United States economy are interdependent. The United States needs China to finance its economy based on excess spending and China needs the United States to maintain a favorable balance of payments. 

The Renminbi has the potential to become the next reserve currency if China takes the steps necessary to internationalize its currency. Nevertheless, it is not in China’s interests to become the next reserve currency. The main issue is that financial markets need a new stable reserve currency to strengthen the global reserve system and the Renminbi is a legitimate candidate for this role. Since it is not in China’s interests to displace the US dollar as the dominant currency, the solution would be to have a system of multiple reserve currencies such as the Special Drawing Rights (SDR), including all majors currencies such the US dollar, the Renminbi, the Euro, the Yen, the British Pound, and the Swiss Franc. The Special Drawing Rights system is a good solution to avoid all the disadvantages linked to the change in currency supremacy between the US and China because it is an international reserve asset. The SDR system would avoid a major financial crisis and strengthen the global reserve currency. However, the use of a Special Drawing Rights system in international trade and finance will be probably slow to emerge.

 

References: 

1. Barry Eichengreen, Marc Flandreau (2008), “The Rise and Fall of the Dollar, or When did the Dollar Replace Sterling as the Leading Reserve Currency?” Graduate Institute of International Studies, University of California, Berkeley.

2. Zhou Xiaochuan (2009), “Reform the international monetary system”, Governor of the People’s Bank of China.

3. Professor John Ryan (2009), “China, the Eurozone and Global Reserve Currencies”, Center for Economic Policy Analysis, University of Venice, Italy

4. Jong-Wha Lee (2010), “Will the Renminbi Emerge as an International Reserve Currency?” Asian Development Bank

5. Sebastian Mallaby and Olin Wethington (2012), “The Future of the Yuan, China’s Struggle to Internationalize Its Currency”, Foreign Affairs

6. Derek Scissors and Arvind Subramanian (2012) “The Great China Debate, Will Beijing Rule the World?” Foreign Affairs

7. International Monetary Fund (2011), “Factsheet; Special Drawing Rights (SDRs)”

8. Harold James (2011), “The Poetry of the Euro” Princeton University, USA Project-syndicate.org

9. Prakash Kannan (2007), "On the Welfare Benefits of an International Currency", International Monetary Fund

10. Avinash Persuad- Whiskey & Gunpowder (2012), “One Dominant Currency: When Currency Empires Fall”. A Daily Reckoning White Paper Report