Will the Renminbi ever be the World's Global Reserve Currency?

Abstract

This paper looks at the factors affecting the internationalization of China’s currency, the Renminbi. The goal is to show what has to change in China’s financial and banking system as well as its current growth model in order for it to become one of the world’s recognized reserve currencies. This is achieved by examining the existing economic and financial structures that China has in place, looking at reforms being undertaken in these areas and evaluating the effectiveness of this reform. From the outset, it is noted that for the Renminbi to become a leading international currency, a change is also required on the behalf of other countries’ financial systems. Although these changes are not within the scope of this paper, it nevertheless provides some useful observations for policymakers in China and elsewhere looking to internationalize their domestic currency.

Introduction

China overtook the United States as the world’s largest goods trader at the beginning of 2014 (Anderlini and Hornby, 2015). Remarkably, until as late as 2011, China conducted less than 5% of its trade in its own currency, the renminbi (denoted by RMB in chart, below). However, as the chart below attests, this usage has seen a dramatic upturn and as of 2015, is currently used to settle over 20% of China’s goods trade. This dramatic growth in the renminbi’s usage provides some early indication of the effectiveness of the Chinese government’s policies to internationlize the currency and take its place among the world’s reserve currencies.

In fact, the future replacement of the dollar by the renminbi (also referred to as the “yuan”) as the world’s reserve currency is treated by many in the financial sphere as less of a possibility and more as just a matter of time. Comments by Chinese ministers about a future “super sovereign reserve currency” (Bergsten, 2009) only serve to enhance the idea. Likewise, in November 2015, the International Monetary Fund will decide whether to add the renminbi to the four currencies it uses to value its Special Drawing Rights (SDR).[1]

However, it is not a foregone conclusion. The United States dollar has held the position of global reserve currency for over 70 years and will not be easy to overtake, not least because of American government resistance to allowing the renminbi to take on global reserve currency status. Until now, this resistance has taken the guise of American objections to manipulation of the currency by the Chinese government. For example, in 2011, President Barack Obama said, “We recognize they may not be able to do it (floating the yuan) overnight but they can do it much more quickly than they’ve done it so far,” and saying that “enough is enough.” (Goldman, Talev and Sobczyk, 2011)

Likewise, geopolitical issues such as ongoing tensions with countries in South East Asia and Japan may not pose a large obstacle to the internationalization of the renminbi, but they won’t smoothen the process either. In April 2015, the Center for Strategic and International Studies, a Washington-based think tank, reported that China was building land reclamation projects in the South China sea, against the expressed wishes of countries like Vietnam and the Phillipines (Berkshire Miller, 2015).

There is some way to go in the internationalization process for the Renminbi. According to the available foreign exchange reserve figures as of the fourth quarter of 2014, the dollar comprised over 60% of official foreign exchange reserves. (Goldman, Talev and Sobczyk, 2011) Of these same reserves, the euro occupies a little over 20% and is followed by other reserve currencies such as the British sterling, the Australian dollar, the Swiss franc and the Japanese yen. The remaining currencies, including the Renminbi, occupied about 3% of global foreign exchange reserves.

Scope of the Paper

It is important to note that the internationalization of the renminbi is also the de-dollarization of the rest of the world. This effectively means that the factors behind the  internationalization process can be broken into exogenous (the actions of external players, including the international capital markets) as well as endogenous (the actions of those within China’s ruling structures). This paper will examine the endogenous factors that influence the internationalization of the renminbi. These interact with exogenous factors such that the process towards internationalization is neither linear nor predictable: ultimately, onlookers can only debate about what drives the internationalization of the renminbi. This paper is an attempt to provide some context to that debate.

Before beginning, a brief note about the literature on the subject of the yuan’s potential to become the world’s reserve currency. Many of the academic studies look at previous reserve currency regimes (such as that of British sterling in the late 19^th century), but this does not seem valid for three reasons: firstly, no country has ever attempted to move from an economy like China’s (nominally communist, heavily regulated and experiencing double digit growth for nearly 20 years); secondly, capital moves a lot faster in the 21^st century than it did in the 19^th; and, finally, the world has far more international trade than it did at any time in the past and the trend appears that this is to continue growing. China’s attempt to internalize the yuan,therefore, deserves particular attention.

This paper will begin with an analysis of the key issues surrounding the internationalization of the renminbi. Although there is a degree of overlap between the two, these have been divided between (i) the banking and financial system, and (ii) China’s economic growth model. Both sections will be followed by a discussion of what has to change in each case for the renminbi to become a fully fledged international currency. These will be followed by a discussion of the US dollar given that the internationalization of the global economy amounts to de-dollarization.The paper will finish with some conclusions as well as some predictions as to how the situation surrounding the internationalization of the renminbi is likely to play out in the coming years.

Analysis

i. China’s Banking and Financial System

The breakneck speed of reform in China’s banking and financial system quickly makes an irrelevance of many studies trying to analyze what’s happening. The past 25 years have brought a broad range of changes introduced to the system which  have typically occurred over several decades in other countries. These include the opening of the Shanghai and Shenzhen Stock Exchanges (1990), the commercialization of the four state-owned banks (1995), a nationwide personal credit rating system (2000) and the creation of a bond market (2007). If anything, the reform seems to be speeding up. In 2014, measures introduced included new financial procedures inside Shaghai’s Free Trade Zone, the Shanghai-Hong Kong Stock Connect program and expansion of “qualified” investment schemes (Bloomberg, 2015).

However, perhaps the unifying theme of China’s banking and financial system is its debt pile. The total debt in China’s financial system has now become so large as to be a driving factor behind many of the reforms being seen in the industry. An example of this is in action – and further evidence of the breakneck speed of change in the system – is  provided by the introduction of local government bonds in 2015 (McMahon, 2015). The government stated in early March 2015 that local governments would be allowed issue 1 trillion yuan ($160 billion) in 2015 in order to pay off maturing loans.

The size of the debt run up by local governments has created what one Credit Suisse analyst referred to as a “ticking time bomb” in 2011 after the government carried out its first audit of local government debt. The audit revealed liabilities of 10.7 trillion yuan (US$1.7 trillion) and warned of repayment risks and an over-reliance on land sales (Sanderson, 2011). The Chinese government report showed that, by the end of 2010, 6,576 financing vehicles had been established by local governments, accounting for 4.97 trillion yuan.  At the time of writing in 2015, according to the Financial Times, this figure has grown to 15 trillion yuan and accounts for 40% of China’s GDP – up around 25% over an 18 month period. In those terms, the 2015 decision by the central government to permit local government bonds seems prudent.

Local governments in China were able to accumulate such a massive debt pile through trust companies and other shadow banking institutions. This unregulated sector of the economy has the potential to create a financial crisis on the scale of that witnessed by the United States in 2008 if not dealt with properly, believes former US Secretary of the Treasury, Hank Paulson. He is on record as saying, “frankly, it’s not a question of if, but when, China’s financial system will face a reckoning and have to contend with a wave of credit losses and debt restructuring.” (Goldstein, 2015) Mr. Paulson’s prediction for China’s financial industry is dramatic but not without reason.

Aside from bringing money out of the shadows, the introduction of municipal bonds (´muni’s´) will serve to further internationalize the Chinese capital markets – which in turn, should lead to further internationalization of the yuan. These bonds will be issued with yields of around 7% (Tahara-Stubbs, 2015) and will probably lead to more transparency on the part of each city, which will be competing for both domestic and international holders of their debt.

While growth in local government debt has become a major concern, it is still dwarved by that of the corporate sector. Its debt now accounts for 200% of Chinese GDP (Sender, 2015). This is the highest such figure in the world and is some indication of the lending that has been partly responsible for fuelling growth in China until recently. Paying down this debt may involve a simliar process to that outlined for municipal bonds. Unlike the municipal bonds, however, the firms’ debt could be issued in dollars, in which case their debt issues would not be a contributing factor to the internationalization of the renminbi.

However, perhaps conscience of the “credit crunch” which contributed to the US financial crisis, the Chinese government has instead opted to increase debt further – and importantly for the internationalization of the renminbi – to bring the debt out of the aforementioned trust funds and the extended shadow banking industry. In April 2015, it was announced that the Chinese central bank had reduced the amount of reserves commercial banks are required to hold, in theory freeing up around $200 billion for further lending (Wei, 2015).  This was the second cut in 2015 and is seen as a measure to stimulate economic activity as well as encourage more lending in the official sector. The reserve-requirement ratio now stands at 18.5%

Interest rates are also expected to be cut again in the second quarter, having already been cut significantly since November of 2014 (see chart below). Although on the surface, this may appear a counter-intuitive measure given China’s already enormous debt, there is some logic behind the move. Firstly, it is in standing with the government’s commitment to maintain GDP growth above the 7% threshold. Secondly, it allows local governments to borrow against the central government, which still has an extremely healthy looking balance sheet by the standards of most modern governments. In spite of the large munipal government and corporate debt present in China, its government still a net lender to the rest of the world (Sheng, 2014).

As a final note on the debt which is present in China’s banking and financial systems, the government announced in the second half of April 2015 that it plans to open its market for clearning domestic bank card transactions, effectively paving the way for players such as Visa and Mastercard to enter China. This market was estimated at around $7 trillion in 2014 (Miller, 2015).

This move not only ends the near monopoly held by the state-run, China UnionPay but also opens another corner of the financial sector to international competition. The move should serve to lower risk in the Chinese banking and financial sector through spreading potential losses. The fact that international credit card companies now trade in renminbi also represents an important milestone in the currency’s internationalization.

The tendency to spread credit is also being witnessed in banking: one of the motives behind the development of capital markets in China, as in any country, is to reduce the dependence on bank-led financing. The advent of more transparency in capital markets should also conspire to decrease the size of the shadow banking industry as well as channel funds to more investment worthy projects, in turn increasing the desire of foreign investors to hold renminbi.

Discussion on China’s Banking and Financial System

It is thought that one of the  principal motives behind internationlizing the Renminbi is to convert Shanghai and Hong Kong into global financial centres (Palmer, 2010). The overview of the banking and financial system above suggests that the Chinese system, more than anything, requires an injection of capital. On this basis alone, the development of existing capital markets in China should be embraced by the authorities. There is even some speculation that QE may be turned to. (Zero Hedge, 2015)

Soaring debt levels are never a good thing. In the words of Hank Paulson on the same issue in China: “slowing economic growth and rising debt levels are rarely a happy combination.” (Sorkin, 2015) However, the advent of these figures at least points to a growing level of transparency in the Chinese banking and financial industry. Likewise, the local government bond markets and Dim Sum bonds have the potential to ensure that capital flows to more deserving projects – rather than, say, the pet projects of party insiders.

The need for capital in turn, will drive the internationalization of the renminbi. In the near term, this will provide China with stability; in the long term, it has the potential to provide it with more sway in international financial markets. That is to say that in the short term, China needs to internationalize the renminbi for the sake of stability in its banking and financial systems. This internationalization is a natural part of more foreign investors partaking in China’s capital markets. It doesn’t mean though, that the yuan will become a fully-fledge international currency.

The currency swaps that China has undertaken with other governments (2008, over $500bn in such swaps have been put in place since 2008) (Economist, 2015) ranging from New Zealand to Uzbekistan.(Zin and Qing, 2015), can be viewed as a sort of feeble attempt to internationalize the renminbi while still maintaining China’s non-market exchange rate for the currency. As welcome a move as currency swaps are, they will have more credibility when carried out on secondary markets rather than between government entities.

When the Chinese government began loosening restrictions on trade in Renminbi between Chinese nationals and foreigners in 2003 (Gagnon and Troutman, 2014), trade in the renminbi already existed through non-official channels. However, the move opened the doors to even greater flows of currency and paved the way for a series of clearing banks for the renminbi, which currently exist in countries such as Germany (Zha and Doff, 2014), France (Xinhua News, 2014) and Australia and will soon open in Thailand and Malaysia. More of these clearing banks need to open if the renminbi is to internationalize fully.

ii. China’s Economic Growth Model

China’s GDP for 2014 reached US$9.24 trillion, confirming its status as the world’s second largest economy. However, with annual growth of 7.4% (Yao, 2015), the economy failed to meet the government’s set target of 7.5% and pointed to what many analysts have been saying for some time: Firstly, that the Chinese economy is slowing down; and secondly, that the growth model which has brought such consistent high growth over the past 30 years needs to be revised. The internationalization of the renminbi seems to form an integral part of that revision.

This growth model which is currently in place amounts to a heavy-regulated economy where government-owned businesses can finance at uncompetitively low rates, the currency is manipulated to prop up exports and consumer spending is encouraged by providing low savings deposit rates. The growth provided by this model now seems to be tailing off because of a range of factors which include an ageing workforce, slowing exports (Grigg, 2015), an exodus of foreign capital (Ruan, 2015) and a sluggish investment environment (Miller, 2015). The sluggish investment environment is exhibited by a lack of CAPEX expenditure in a survey of over 200 firms by the Wall Street Journal at the outset of 2015. (Miller, 2015)

Where investment slows down, the Chinese government seems to be looking to consumer expenditure to bridge the gap. Hence, the addition of international credit card firms to the domestic arena, lower interest rates and lower capital controls on banks. While Chinese consumption has been growing steadily ove the past few years – reaching nearly 40% of GDP in 2014 – it has some way to go before catching up with investment, as its share of GDP already stands at 54% (M&G Investments, 2014), which has led more than one commentator to suggest that China is over-investing (Lee, Syed and Xueyan, 2012).

In addition to the above factors, China’s real estate market appears to be overheating. As Hank Paulson noted in a recent interview with the New York Times (Sorkin, 2015), “the trigger [for an economic downturn in China] would be a collapse in the real estate market.” In April 2015, one of the biggest developers in the country, Kaisa, reported that it was going bankrupt and that its investors – many of whom were foreign – will receive as little as 2.4% of their money back (Bloomberg, 2015). This news was followed by another large developer, China Vanke, announcing that its first quarter net profit for 2015 was 57.5% down on the same period for 2014 (Fung, 2015).

Finally, and worryingly for existing investors in China, the country’s economic data remain highly unreliable. A 2015 Citibank report notes that first quarter growth, which was reported at over 7% by the China government, could in fact be below 6% (Fung, 2015). Other research firms put growth as low as 3.8%. One thing is certain – China’s government is unlikely to ever understate its eocnomy’s growth figures so onlookers can assume that the 7.4% growth reported for 2015 is a ceiling figure, rather than a true estimate.

The Chinese economic model would appear to have reached its limits if growth is to remain the priority. Growth is falling despite high investment and consumption and other outlets need to be considered. One such outlet might be the liberalization and by proxy, the internationalization, of the renminbi.

Discussion on China’s Economic Growth Model

The four pillars of financial liberalization (and thus, the move towards internationalization of the renminbi), are in order: liberalization of interest rates, reduction of entry barriers, enhancement of financial innovation and lifting restrictions on cross-border capital flows. China’s economic growth model until now has restricted all four pillars to varying degrees. If the renminbi is to become a fully fledged international curency, diligent efforts will need to improve these areas by the Chinese government.

However, major progress can still be made in all four areas as was recently noted by U.S. Treasury secretary Jacob Lew. (Katz, 2014) The economy will continue to grow (with occasional blips) with or without the internationalization of the renminbi, so it can be difficult to suggest what needs to change in the economy for the internationalization process to be accelerated. A good place to start though, would the macroeconomic stability of China and aligned with that, transparency in economic data.

The primary reason the US dollar became the global reserve currency was not trade; trade was purely the main catalyst. The primary reason was that the US dollar offered a unit of account to individuals and businesses in high-inflation environments. The greenback comes with a guarantee that the US federal reserve will honour its commitment on that dollar. “In God we Trust,” is not just a calling card for America’s founding fathers: it is a financial commitment. 

Furthermore, although the 2013 ‘fiscal cliff’ experienced by the United States brought criticism in China from the editorial of its best-selling newspaper (Wang and Qing, 2015), it at least exhibited a level of transparency (we can assume) that the Chinese government would not so openly portray. When the fiscal cliff issue arrived, holders of dollars – faced with the deterioration in spending power – could decide whether they wished to continue holding them or otherwise.

The guarantee provided by the dollar is  – almost always – one that occurs in a low-inflation environment. Hence, in Latin America, Africa and everywhere else with macroeconomic instabiility, the dollar is preferred as the unit of account. Other SDR (special drawing rights) currencies are also accepted, but the dollar, being the global reserve currency, is the standard. For the renminbi to achieve this kind of status, the Chinese economy needs to mimic many of the features of the United States economy. This includes its near guarantee of low inflation (for the currency to keep its value over time), a stable macroeconomic environment in China and the ability to trade with others using the currency.

Some progress has been made on all three of these. Take inflation – until the first half of the 1990s, China has an exemplary record on inflation (coming in under 5%), which hasn’t been in double figures in China since 1995. There was a period of deflation at the turn of the millennium, but for the most part, China’s inflation can be seen to be under control. But whether this remains the case for inflation after the country undergoes the program of quantitative easing predicted in some quarters is dubious.

Macroeconomic stability is about to be tested in China. Although it recovered well from the global financial crisis (as one might expect it to given its restricted capital flows), the more international the renminbi becomes, the more sophisticated China’s government will need to be in all areas. The local government bonds initiative, to take one example, would have been a fine way to raise project financing in the first place. As it is, it currently looks more like a desperate measure to plug a hole.

Likewise, the party model of keeping near full employment has thus far relied on cheap imports and broadly speaking, a huge number of manufacturing jobs. But this too, has its limitations. For China to maintain growth, it needs to upskill many workers, taking them from manufacturing positions to higher value-added roles. China’s services sector still only encompasses less than 50% of GDP (World Bank, 2015). For the macroeconomic stability that is required for the renminbi to internationalize, it needs to move away from the boom-bust cycles that accompany manufacturing.

The ability to trade with others may be the slowest part of the equation, but it is the most powerful. When people in foreign countries are storing yuan under their mattress as a method of retaining wealth, China will know that the renminbi has arrived as a fully-fledged international currency. The process of this happening is imperfect and unpredicable. However, the advent of the AIIB – which should flood many developing countries with the renminbi under the guise of infrastructure development – will be a good start.

Finally, binding all of these factors is transparency. As previously mentioned, the lack of transparency is hindering China’s economy. Rarely is China government data mentioned without a disclaimer on the reliability of data. Without this transparency, how can holders of the renminbi be sure that they’ll be able to redeem their yuan in the same way as with the dollar ? How does anyone know, in the midst of economic certainty like now, that the Chinese government is not busy printing trillions of yuan to inject into the country only to later doctor inflation figures? If and when transparency increases in China, the internationalization of the renminbi will be just one of the benefactors.

The Role of the Dollar in the Internationalization of the Renminbi

It would be remiss of a paper discussing the internationalization of the renminbi to not provide some analysis of the US dollar’s role. The dollar has been the global reserve currency since 1921. However, its position as the global reserve currency was preceded by a range of other currencies, some of which, like the Spanish peseta or the Portuguese escudo, don’t exist anymore, as shown in the timeline below. (Gundlach, 2014)

Depending on how you wish to read the timeline, it could suggest that the dollar is now on limited time as the global reserve currency. But such extrapolations should be made with caution. The US economy is far more sophisticated than anything that preceded it. Likewise, the US geopolitical machine is arguably more influential than even the British one that went before it. Therefore, to just assume that the dollar is on its way out because of a pre-determined timeframe could be to draw the wrong conclusion.

In spite of considerable skepticism, the dollar continues to prove extremely resilient. The US has a large and growing public debt and the government has flooded its financial system with dollars through two programs of quantitative easing, thus opening the possibility for a major devaluation of the currency which never occurred. The so-called “fiscal cliff” of 2014 came after a prolonged financial crisis, both of which had the potential, if not to shift the dollar from its reserve currency position, then at least to make it look unsteady. But it still looks very steady in the position. Its dominance has declined only very modestly over the past 15 years (Prasad, 2014).

Of the 25 largest holders of US government debt (i.e. holders of dollars) in February 2015, only 4 had lowered their holdings on a year previously (Treasury, 2015). These were China, Taiwan, Russia and Norway. The same figures showed that Japan replaced China as the largest holder of US debt in February 2015, presumably in an ongoing effort to de-dollarize. The problem where the internationalization of the renminbi is concerned is that evidence shows that while China may be de-dollarizing, others aren’t.

Outside of public debt, there is the issue of government-issued debt, there is private-issued debt. US corporations have been taking advantage of the historically low interest rates on offer since the financial crisis. This in turn will serve to further strengthen the dollar’s position as a reserve currency. Chinese firms, on the other hand, are often seen as going cheek-in-jowel with the government. Generally, when they’ve sought a loan in the past, it has been from the Chinese government rather than the capital markets. The dollar’s share of world corporate debt had risen to 56% by 2014, prompting some to suggest that ‘the dollar’s role as the dominant reserve currency has strengthened since the crisis.’ (Prasad, 2014)

The differing structure of the United States economy relative to that of China will play a continuing role in the number of dollar-holding entities in the world economy. According to the World Bank’s 2014 Doing Business Report, the United States is the 7^th easiest country in the world to carry out business in. China, by contrast, is 90^th on the list – which doesn’t even include capital markets in its parameters. It it’s difficult to carry out business in a country, logic would suggest that there’s also less of an incentive to hold the currency of that country.

The Doing Business Report is merely a reflection of what anecdotal evidence already points to: the United States’ culture is engrained in doing business and making money. This isn’t a soft measure where the decision to hold a currency is concerned. It may be the greatest reason of all why China’s government will find it extremely difficult to make the renminbi the world’s global reserve currency, even if it enterse the international basket of reserve currencies.

Conclusions

The internationalization of the renminbi transcends finance and economics for China. Having the renminbi as a fully-fledged international currency would provide China would with increased influence and prestige on the world stage. It would also provide some vindication for the communist party for their economic model (which looks increasingly like a western economic model anyway). The process is therefore partly economic, partly political and perhaps even partly ego-driven. It is also only partly inevitable.

Fundamaental changes have occurred in China’s banking and financial system and its broader economy over the past twenty years. The opening of stock exchanges, a bond market and international clearing houses can all be seen as steps towards the internationalization, not just of the renminbi, but of China as a country. In the economy, China’s GDP is now the second largest in the world and it is the world’s largest trader. Inflation is steady and the country has amassed huge foreign exchange reserves.

These developments have all taken place against a backdrop of advances in the four pillars of financial liberalization (liberalization of interest rates, reduction of entry barriers, enhancement of financial innovation and lifting restrictions on cross-border capital flows). All four  have all been improved to varying degrees in the past two decades, even if there is a considerable way to go. Further advancements in the pillars will do no harm to China’s efforts to internationalize.

The Asia Infrastructure Investment Bank (the AIIB) can be seen as the latest in a long line of such developments. It is a significant landmark in China’s aspirations to internationalize the renminbi. It is a multilateral development bank first proposed by the Chinese government in late 2013. Although the bank has 57 nation members, it is viewed by most as a future rival to the IMF – traditionally an American source of influence in developing nations (the United States has not joined the AIIB as of April 2015) and will surely fund many projects using the Renminbi, just as the IMF funds projects using US dollars.

These developments are all impressive on their own standing. But they do not constitute a guarantee for the internationalization of the renminbi. As mentioned in this paper, the process is tied to endogenous and exogenous factors. The recent surge in trade in the renminbi could just as easily turn to a trade in another currency were the right conditions to arise. Furthermore, given the economic predicament outlined for China, it is likely that its progress to the summit of currencies will at least be slowed in the coming years.

The renminbi can become a fully-fledged international currency but it is unlikely to usurp the dollar as the global reservce currency. After all that has been written on the subject, perhaps the main reason is that the renminbi won’t replace the dollar as the global reserve currency is that there is no reason for this to happen. The US dollar seems to have reached a critical mass that no other currency has achieved. In the future, there’s every chance that not even the renminbi will achieve the same critical mass.

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[1] For full definition of Special Drawing Rights (SDR), see: http://www.imf.org/external/np/exr/facts/sdr.HTM