Written by Niv Horesh.
In October, the UK government became the first in the Western world to issue a sovereign bond in China’s currency, the renminbi. The 3 billion yuan bond ($477 million; 416 million euros), which will be used to finance Britain’s reserves, marked a hugely significant moment in China’s efforts to internationalize the renminbi and cement its position as a future reserve currency, alongside the US dollar, euro, pound sterling, Japanese yen, Swiss franc and Canadian dollar.
It reignited the debate over whether the renminbi can eventually supplant the US dollar as the leading global reserve currency. Some analysts are forecasting a gradual transformation of the renminbi into the world’s next principal reserve currency. Others contend that China’s financial markets will need to undergo dramatic changes for any such power shift in the foreseeable future.
To reach a reasoned conclusion it is vital to avoid falling into the trap, as many do, of solely weighing the arguments through the twin prism of economics and politics, while ignoring the valuable lessons that history teaches us. History reminds us that the prospect of Chinese currency used as international currency may not be entirely new. For even though traditionally cast Chinese copper coinage was swept aside by Western steam-powered minting technology in the late 19th century, it had for a millennium or so before that set the benchmark for East and Southeast Asian monetization.
In fact Chinese currency – in the form of pre-modern copper coinage – reached the apex of its global presence around the 14th century. By this time it had been circulating widely in Japan, Korea, Vietnam and along the coastal trading hubs of Cambodia, Thailand and Myanmar. It was also present in Indonesia, the Philippines, Borneo and parts of India and Sri Lanka. China’s copper coinage served as a model for the first indigenous currencies of Japan and Korea.
So it can be argued that China’s currency has a track record as a reserve currency. It also meets many of the key requisites that an aspirant international reserve currency must satisfy: China has a large economy; it has significant geopolitical clout; it has low inflation and low exchange rate volatility.
Where it has a long way to travel is in opening up its domestic capital markets to overseas investors. Progress has been deliberately gradual. Foreign investors can access China’s capital markets through schemes such as the Qualified Foreign Institutional Investor program. It has increased the flexibility of the exchange rate by widening the renminbi trading band.
As the decision by the UK government to issue the renminbi sovereign bond demonstrates, the renminbi has become an integral part of the international monetary system. Around a year ago, the renminbi temporarily overtook the euro to become, for about a month, the second most used currency in letter-of-credit trade finance after the US dollar, according to the Society for Worldwide Interbank Financial Telecommunication.
China, then, has set out on the long road to internationalizing the renminbi. But what are the pros and cons of taking the leap? The primary quantifiable advantage is the ability to enhance seigniorage revenue – the profit made from the difference between the face value of money and its production costs. In addition, renminbi tradability is likely to increase the volume of international financial transactions that are cleared in China, creating more skilled employment at home and higher financial services tax revenues.
Other key advantages of renminbi internationalization are less tangible but equally important. Chinese firms would benefit from lower exchange commissions when carrying out business overseas. And the Chinese government seems certain to benefit from greater soft power. Economists have estimated that the United States derived a compounding windfall of $953 trillion between 1946 and 2002 purely as a result of the fact that the dollar was the main global reserve currency during that period. The overall benefit to the US economy could have been even bigger had intangible measures been factored in.
Economists further suggest that should the renminbi become a regional reserve currency in East and Southeast Asia over the next decade, the Chinese economy could rake in a windfall of 744 trillion yuan, not to mention the boost to China’s geostrategic clout in multilateral organizations such as the World Trade Organization and G20.
On the other side of the coin, so to speak, the most obvious downside to renminbi internationalization is 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 – speculative capital that can move between markets rapidly – to more easily penetrate the domestic economy and inflate another property bubble.
China’s financial markets are not sufficiently open at present to allow comprehensive renminbi internationalization. Notably, Chinese nationals and firms still cannot independently purchase financial assets denominated in foreign currency. They are only able to invest in the renminbi in a select number of government-accredited foreign financial institutions or buy foreign securities only via a select number of state-controlled financial institutions. There is also insufficient competition in the domestic financial market, with state-owned banks still accounting for the lion’s share of retail loans and credit.
But many of the other preconditions for internationalization have largely been met: by some measures, China has overtaken the US as the world’s largest economy; inflationary pressures are low; greater current-account convertibility is now permitted; and, as we have seen, governments overseas have issued renminbi-denominated sovereign bonds.
The global financial crisis of 2008 and the subsequent eurozone crisis, which has never gone away, have made speculation of imminent renminbi internationalization all the louder. And the viability of the Japanese yen – once mooted to supplant the greenback – has been tarnished since Japan’s “lost decade” of the 1990s.
The renminbi came to the fore as a future alternative to the US dollar mainly because China’s banks performed so much better than Western ones through the global financial crisis. Until recently, some Western economists labeled China’s banking system as the weakest link in its development model. Yet the fact that following the financial crisis – contrary to Europe and the US – no major bank bailouts were reported in China, that a growth rate of over 9 percent was still achieved between 2008 and 2009, and that China is now challenging the US for the title of the world’s largest economy points to the continuing shift in power from West to East.
In light of this, some may be tempted to conclude that the question we should be asking is not if the renminbi will supplant the US dollar as the global reserve currency but when. However, there is distinct reticence among senior Chinese policymakers to set the renminbi in direct competition with the dollar.
The governor of the People’s Bank of China, Zhou Xiaochuan, has long said that the renminbi need not supplant the US dollar as the global reserve currency. Instead he advocates an international reserve currency that cannot be controlled by a single sovereign state.
For now China is focused on trying to enhance the role that the renminbi plays in trade with neighboring Asian countries as part of a regional trade bloc. After all, China is entitled to ask why much of intra-Asian trade should be carried out in dollars even though US firms are scarcely involved. Such a regional experiment could help coordinate renminbi overseas exposure and help gain experience in averting currency instability in the future.
According to accepted, Western-dominated economic norms, China seems a long way away from a full flotation of the renminbi in the world’s financial markets, particularly given the country’s strict capital controls, which make its financial system quite insular from global money markets.
But perhaps one of the greatest challenges in assessing this debate is the tendency of commentators to judge the prospects for renminbi internationalization based on what happened to the pound sterling and the US dollar in the 20th century and to the euro in the early 21st century. On this basis we find that the Chinese economy of the present is compared to the British, American and EU economies of the past.
If we head blinkered down this path we risk ruling out the possibility of China carving out its own unique route to global economic eminence – one where, for example, the depth of domestic capital markets might not turn out to be a critical determinant of renminbi internationalization as was the case in the Anglo-American development trajectory.
Therefore we may find that the extent to which the renminbi can go global in the near future may not be determined solely by domestic financial and equity-market reform moves but, more importantly, by the overall geostrategic posture that China opts to embrace in its dealings with the International Monetary Fund, the World Bank and the G20 – and the next stage of the development model that China chooses to follow.
The author is director of the China Policy Institute, the University of Nottingham, and professor of the modern history of China. The views do not necessarily reflect those of China Daily.