While the floors of the Shanghai and Shenzhen stock exchanges were awash in red ink, much of the black stuff was being splashed on financial pages to divine the fate of China’s currency, the Renminbi (RMB). Outsiders might care about the currency because of international competitiveness. China cares about it as a matter of international status, aspiring for the RMB to join the U.S. dollar as a so-called reserve currency, a globally accepted store of value and purchasing power (see e.g. Eichengreen: 2011 for more).
These two issues might be systemically related by capital flight and other financial risks, but they are both rooted in something deeper — a fundamental contention between state authority and the animal spirits that drive markets. China has come a long way from its planned-economy days, but the urge to control runs very deep. Can the Party have its cake and eat it too?
The answer for the RMB is simple: The scale of the Chinese economy is consistent with reserve-currency status, but its current financial policy framework is not. Reserve currencies are technologies for managing international financial liquidity and risk, and their adoption is a voluntary global process responding to the quality of these two services.
Over the next five years, the best approach to promoting internationalization of the RMB is to improve the currency’s international liquidity and risk characteristics through more determined financial-sector reforms, including capital account opening, interest-rate deregulation, central-bank independence, and greater participation of private actors in the financial sector.
Fig. 1: RMB trade settlement
It is a consistently stated goal of the Chinese government that the RMB achieve global reserve currency status. To support this process, the government has sponsored a variety of initiatives that, together with complementary action by bilateral and multilateral partners, has rapidly expanded offshore access to RMB liquidity. In two primary services, trade and bond finance, growth rates have been truly explosive, but from a very low initial base.
Fig. 1 and 2 give an indication of how these markets have expanded more than tenfold in the last five years.
Fig. 2: RMB bond issuance by country of issuer
These trends clearly demonstrate fast growing, non-negligible demand for offshore RMB services, yet the drivers of may be complicated. For example, there is a widely held suspicion that a significant component of these holdings may be motivated by currency speculation, recognizing the RMBs long-term path of appreciation against the USD. This behavioral driver has recently been tested by intermittent downturns in the RMB/USD rate, but it remains unclear if those episodes fundamentally changed expectations.
Whatever the speculative share of these holdings, a more important issue is the relative scope and importance of RMB reserve services across the global trade and financial community. As the following figures indicate, RMB-denominated international finance is still very limited in terms of market share and geography. Certainly the services reflected here are important to existing participants, but their relative magnitude, sector specialization, and geographic concentration suggest only a very limited influence on global finance at the moment. If RMB reserve services continued to grow at recent rates, this could change, but in the discussion that follows it becomes apparent that this growth will probably moderate soon.
Fig. 3: RMB share of world currency payments (percent)
Fig. 4: RMB bond issuance by sector
Fig. 5: RMB adoption by country of intermediation
Thus we see that international RMB adoption has grown rapidly in recent years, reaching seventh place among national currencies used in this manner. Having said this, offshore RMB settlement, lending, and other instrumental use remains a small fraction of that for the leading reserve currency. Combining all types of RMB deployment that could be interpreted as reserve services, a stock of less than US$400 Billion is probably represented. In contrast, as the following figure shows, about US$5.6 Trillion of US T-bills alone are in the hands of overseas institutions. Ironically, the largest individual holder is the central bank of the PRC (Fig. 6). When all reserve services are taken into account (Fig. 7), the US dollar and the Euro comprise over 90% of the currency portfolio.
Fig. 6: Holdings of U.S. government securities
Fig. 7: Emerging market foreign exchange reserves
Fig. 8: Reserve currency distribution
Despite the absolute size of the Chinese economy and its prominence in international trade then, the country’s currency still comprises a small fraction of international settlements and financial flows. Eventual reserve status for the RMB could confer many benefits on the Asian region and beyond. Three of these are of particular importance:
- Offshore RMB liquidity for trade settlement, reducing exchange rate exposure in supply chain and other counterparty transactions for goods and services.
- Financial and intermediation services denominated in a major currency of global corporate balance sheets, private investment portfolios, and international commercial and sovereign bank holdings.
- Foreign exchange diversification and attendant risk management tools (e.g. derivatives).
Despite the appeal of these reserve currency services, as well as their appropriateness to China’s economic scale (Chinn and Frankel: 2007), most expert observers agree that the RMB’s progress toward reserve status will be gradual, and there are good reasons in the PRC’s own domestic economy to justify cautious expectations about RMB internationalization (e.g. Loungemar: 2014, and Eichengreen and Kawai: 2013). Fundamentally, the capacity of a currency to provide reserve services depends on the real scope and risk characteristics of those services. These, in turn, depend critically on the home economy’s policy environment and the depth, integration, and market dynamics of its financial sector. In the following discussion, we highlight some salient issues relevant to the RMBs progress toward international adoption. It is apparent from closer examination that both the scope of RMB services and their risk characteristics will slow international adoption relative to the initial surge seen in recent years.
The first issue to consider is China’s overall progress toward market reform. While this economy has dramatically advanced both private agency and market institutional development, the financial system remains heavily influenced by state decision making, directly in terms of regulation and indirectly in terms of state ownership. China’s unique approach to this kind of economic management makes historical comparison with other reserve currencies (Sterling and USD) quite difficult.
Expert observers also agree that a currency cannot be effective in reserve service unless the home economy has an open capital account. The reasoning is simple – a closed capital account rations offshore RMB, leading to systemic distortions in relative (domestic and international) asset values. Some agree that capital account regulation remains important to the stability of the Chinese economy, but it must be recognized that it is not fully compatible with reserve status.
Another prominent issue, closely related to the last, is the degree of openness and market responsiveness of the Chinese financial sector. Interest rates remain strictly regulated across the banking system, which many authors have noted have noted is inconsistent with an open external capital account. This kind of regulation also conflicts with efficient, market based risk valuation, and creates systemic distortions like spontaneous informal competition with the commercial banking system (see Fig. 9 below). Opening China’s capital account under these circumstances would merely leverage these instability risks in the formal banking sector. The most decisive way to remove structural risk like this would be to privatize the banking sector.
Fig. 9: China domestic credit by source
A third obstacle to the RMBs performance as a reserve currency is lack of policy independence on the part China’s monetary authorities. Advanced economies like China need independent and transparent monetary management. This can support efficient and equitable capital allocation domestically and effective financial coordination with the rest of the world. In the present circumstances, with opaque policies of foreign reserve accumulation, preferential credit allocation to state entities, and a variety of ad hoc interventions in real and financial asset markets, PRC monetary policy cannot meet these international standards.
All these factors have an important characteristic in common – they represent structural market barriers that transfer risk to financial actors holding RMB, especially offshore. As such, risk characteristics are the primary limitation to wider RMB adoption. It is essential to recognize that reserve currency status is the result of a global process of voluntary adoption in millions of individual bilateral transactions and financial decisions. While this international diffusion can be facilitated by home country policies, this is most effectively done indirectly, by creating conditions for effective liquidity and risk management.
In this sense, reserve status must be recognized as a consequence of economic reforms that open Chinese financial markets and make them operate more efficiently. With more determined and extensive reforms, substantial progress can be made in this area over the medium term. Without it, international RMB adoption will be driven more by political than economic forces, with commensurate distortions in risk bearing and higher costs for public and private financial market participants.
How high these costs can be was demonstrated dramatically over the last two weeks, as about $400 billion was committed unsuccessfully to avert Chinese equity losses approaching $5 trillion. Economic reform has accomplished so much in China, lifting hundreds of millions out of poverty and building the world’s largest economy in a single generation. To remain credible, however, this grand experiment must respect market fundamentals.
Note: This post is an extended version of a letter published in the Financial Times.
Chinn, Menzie, and Jeffrey Frankel. 2007. “Will the Euro Eventually Surpass the Dollar as Leading International Reserve Currency?” In Richard Clarida (ed.), G7 Current Account Imbalances: Sustainability and Adjustment. Chicago: University of Chicago Press.
Eichengreen, Barry, and Masahiro Kawai. 2014. “Issues for Renminbi Internationalization: An Overview,” ADBI Working Paper 454, Asian Development Bank Institute, Tokyo, January.
Eichengreen, Barry. 2011. Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System. New York: Oxford University Press.
Loungemar, Thierry de. 2014. Keynote Speech of Vice President Thierry de Longuemar, RMB Internationalization National Asset-Liability Management Conference, Singapore, June.