Internationalization of the Yuan - Is It “Foreseeable”?
Last week Liu Guangxi, a professor and director of the science and technology department under the State Administration of Foreign Exchange (SAFE) said that “it would not take long for the yuan to be internationalized though there was no timetable available.”
Delivering a speech at a forum in Tokyo, Mr. Liu said that “there was demand for the internalization of the renminbi and that its convertibility is increasing.”
The Economist wrote on the subject the same day, discussing the relationship between internationalization and liberalization. “So internationalization presents China with a dilemma. Many officials cherish a global role for the yuan both as a status symbol and as a way of checking American dominance of the world’s financial system. But they also fear the upward pressure on the value of the yuan that a looser exchange-rate regime and full convertibility imply.”
It’s a topic that a group of experts discussed last October in Beijing at the ASU/Kearny Alliance forum, “The Currency of Trade: Formulating stronger and more sustainable U.S.-China trade relations.” The white paper that was written from that forum addressed the questions: Will the renminbi become internationalized? Will it replace the dollar as the world’s dominant reserve and trade currency?
In May 2009, Wang Zhaoxing, vice-head of the Shanghai branch of the China Banking Regulatory Commission, suggested to reporters that the renminbi could become a major reserve currency by 2020. Yet the road to an internationalized currency – for the renminbi or any other – is neither easy nor short. There are four prerequisites to becoming an international currency:
1) Complete capital convertibility; and deep and liquid currency and capital markets.
Capital convertibility (the ability to freely convert local financial assets into foreign ones, and vice versa) is necessary for bond issuance to be denominated in that currency. And, capital convertibility and liquidity is necessary in an even more narrow sense in terms of trade – traders must be able to hedge currency risk.
For the renminbi to become convertible, China must liberalize its capital account – which means easing restrictions on capital flows into and out of the country. The biggest challenge in capital account liberalization, according to He Weiwen, deputy director at the China Institute for Open Economy, will be reforming China’s legal regulations of its financial sector.
According to Logan Wright, director of China for Medley Global Advisors, China’s capital accounts will liberalize gradually. “It’s a spectrum of openness, not an absolute state where the capital account is now convertible where previously it wasn’t. We already see many of the market pressures developing toward openness.”
Most analysts expect that the renminbi will be fully convertible in 10 or 15 years. In fact, China planned to begin capital account liberalization in the 1990s, but was dissuaded by the Asian financial crisis, which crippled the region’s more open economies.
2) The country has to decide whether having an international currency is worth the pain of developing capital convertibility, liquidity, and liberalized capital markets.
In other words, when considering the renminbi as a global currency, China must ask: Is prerequisite #1 desirable? Is complete capital liberalization desirable? China is moving measuredly towards capital liberalization, but there are risks of instability associated with that move.
“Markets must be transparent. Banks must be commercialized. Supervision and regulation must be strengthened. Monetary and fiscal policies must be sound and stable. The exchange rate must be flexible enough to accommodate larger flows of capital. . . But to do so, China would have to first abandon a growth model in which bank lending and a pegged currency have been two of the main instruments of development policy. This will not be easy. Witness how the Chinese authorities' first reactions to the economic crisis were to further rely on directed lending (in order to boost investment) and to reinforce the renminbi's peg to the dollar (in order to sustain exports).”
3) Even if a country has prerequisites #1 and #2, the markets will determine whether its currency becomes international – a country can’t do it by official decree.
Today, at least, the market clearly sees the U.S. dollar as the primary global currency. A market switch from the U.S. dollar to the renminbi isn’t likely in the near future because:
- Traders have chosen the dollar as their currency because of its stability and liquidity, because they trust the U.S. government, and because of the dollar’s universal acceptance.
- China simply can’t get away from doing business in U.S. dollars, because the U.S. is the biggest economy in the world.
- Chinese manufacturers can’t say to Wal-Mart, for example, “Now we want you to pay us in renminbi, or in euros, not in dollars.” Wal-Mart would look for other trading partners. Or at the very least, a move to trade in a currency other than U.S. dollars would make trade less efficient – which is worse for everyone.
4) The country has to decide whether its role as an international currency should/will become a policy concern – whether it should intervene in the market.
The two dominant reserve currencies today – the U.S. dollar and the euro – are left fairly free to float with the market. The U.S. Treasury operates under a policy of “benign neglect” and the European Central Bank hasn’t intervened since 2000. China, on the other hand, maintains a policy of market intervention to keep the renminbi pegged to the dollar.
China is clearly more influential than in the past, and the internationalization of the renminbi has sped up. But it will take a long time – several decades at least – for the renminbi to go global.
“For all the talk about change, the dollar’s importance to the world has not diminished. In the foreign exchange market, the dollar actually strengthened following the outbreak of the crisis. When investors fled to safety, they fled to U.S. Treasury bills. In the face of spreading illiquidity, U.S. and foreign investors alike sought refuge in the most liquid market, the market for U.S. government debt securities.”
If China intends to internationalize the renminbi, it will have to diversify its dollar holdings, and it will necessarily do that gradually. In a recent online poll conducted by the Chinese newspaper Global Times, 87 percent of Chinese respondents called China’s holdings in dollars unsafe. Unsafe or not, they are massive – 60 percent of China’s official reserves are held in dollar-denominated assets. Diversification by Beijing, in other words, would be a very big deal.
John Maynard Keynes said, “If you owe your bank manager a thousand pounds, you are at his mercy. If you owe him a million pounds, he is at your mercy.” In that regard, China is at the mercy of its dollar holdings. To significantly alter the composition of its reserve portfolio, the country would need to sell huge amounts of U.S. Treasury securities, which would severely depress the price of those securities. If it exchanged large amounts of dollars for other currencies, the value of the dollar would fall dramatically, causing losses on its residual dollar holdings.
The “sensible” strategy for China, then, is to gradually adjust the composition of its reserve portfolio over time. “This, in fact, is what China’s reserve managers appear to be doing – yet another reason why the decline in the share of the dollar in global reserves is likely to occur gradually.”
The Consistent Dominance of the U.S. Dollar as an International Reserve Currency
While the U.S. dollar’s share of the world’s official foreign exchange reserves has decreased since 2000, it has been because of the rise of the euro (which is still relatively new). Even accounting for the rise of the euro – which is used as a reserve and trade currency primarily in the euro zone – the dollar remains far and away the world’s dominant reserve and trade currency.
 “According to the 2007 triennial survey of the Bank for International Settlements, the dollar was used in 86 percent of all foreign exchange transactions, compared to just 38 percent in which the euro was used (the total for all currencies is 200 percent since two currencies are involved in each transaction).” See Eichengreen.
 In 2008, the U.S. dollar made up 64 percent of all official foreign exchange reserves; the euro made up 26.5 percent. Source: International Monetary Fund. See http://www.imf.org/external/np/sta/cofer/eng/cofer.pdf