Is it possible or even necessary for the Renminbi to become a dominant international currency ?

Since 2009, we have seen a rapid rise of Renminbi in the international trade settlements. China’s exports and imports settled in Renminbi have increased 48 times from January 2010 to December 2011. The Renminbi has also become the third-largest currency for LCs, with 4% market share after the US dollar and the Euro, according to the SWIFT. Many analysts believe these are perfect evidences that the Renminbi internationalization has been successful and it will continue to be very successful in the future. Some even argue that Renminbi will replace the US dollar as the dominant international currency in two decades, because China will become the world’s largest economy very soon as what they believe. However, can the Renminbi become a currency of more importance than the Japanese yen in two decades?

Let’s go through the fundamentals first. What makes an international currency? An international currency means that it is widely used in international trade settlements, in international investments and in central banks’ reserves. The US dollar is regarded as the world’s dominant international currency because it accounts of more than half of international trade settlements, more than 80% of foreign exchange transactions, more than 50% of cross-border borrowings and more than 60% of central banking reserves. Euro is the second most important currency in the world by most standards. It has 37% share in foreign exchange transactions, 31% in international bond issuance and 28% share in central banking reserves, but there is still a big gap between it and the greenback. Other currencies such as the Japanese yen and the British pound are only of very little importance now. The Renminbi still cannot be viewed as an international currency by any standard, but many believe it has the potential since it’s been growing rapidly in the past 3 years. Cross-border trade settlements in Renminbi quadrupled in 2011 after increasing 12-folds in 2010 and the total turnover has reached USD 40 billion.

Figure 1 Cross-border settlement amount in RMB (Billion RMB)

Source: State Administration of Foreign Exchange

What triggered the rise of Renminbi in trade settlements? It is natural that Chinese traders would prefer to use Renminbi in their transactions because their businesses are settled in Renminbi and they can avoid exchange rate risk. But why would non-Chinese traders settle trades in Renminbi? A lot of evidences suggest that currency speculation is the major driver of the Renminbi internationalization in the last round. In 2010, the amount of China’s imports settled in Renminbi was five times of exports, which means that non-Chinese traders were net Renminbi receivers instead of payers. As a consequence, deposits denominated in Renminbi rose rapidly in Hong Kong. In the first 8 months of 2011, the amount of China’s imports settled in Renminbi was still twice of exports and Renminbi deposits kept growing in Hong Kong.  However, the growth decelerated in the last four months of 2011, when the Renminbi stopped its appreciation against the US dollar. Non-Chinese traders became net Renminbi payers as China’s imports settled in Renminbi fell short of exports settled in Renminbi. Also, Renminbi deposits dropped in Hong Kong while deposits denominated in foreign currencies increased fast in China.

Figure 2 Cross-border RMB receipt and payment

Source: State Administration of Foreign Exchange

Figure 3  HK Renminbi deposits (Million RMB) and US dollar/Renminbi exchange rate

Source: Hong Kong Monetary Authority, People’s Bank of China

An appreciating currency is surely more welcomed by the investors and it will accelerate its internationalization process, but currency internationalization based on appreciation speculation is very costly and even harmful to the economy. It is a bad kind of currency internationalization and many nations are against it. Among them stands Switzerland, who has made it clear that it does not want investors to purchase the Swiss franc.

Last month the Wall Street Journal reported that Switzerland is considering capital controls to fight a sharp rise in the Swiss franc in the event of a euro-zone collapse…Switzerland—surrounded by, but not a member of, the European Union—is seen as a haven of fiscal and political stability, but turbulence in the currency bloc is a major risk for its economy. The country depends heavily on exports for growth, and the strong franc is hindering exports at a time when demand is slumping in the euro zone, Switzerland’s biggest trade partner.

Some people might say that it is a good opportunity for the Swiss franc to become a more important international currency if the euro-zone collapses, but obviously the Swiss central bank does not think that way. It fears that the rise in the Swiss franc would hurt its exports. Between currency internationalization and economic growth, the Swiss central bank chose the latter one without hesitation.

Switzerland’s choice seems to undermine the prevalent theories on international currency. Conventional wisdom believes that every country is competing to have an important, if not dominant, international currency because it brings “exorbitant privileges” to the currency issuing country.  In the past, the United States, Japan, Britain, Germany and France were the major competitors in the game and now China is joining in. But what are the privileges that the United States is enjoying? Professor Barry Eichengreen summarized three in his book exorbitant privilege. It has lowered the transaction cost for US households and enterprises, it has brought seigniorage revenue to the US government, and it has also reduced the funding cost of US government and enterprises. But it is not always appealing to own an international currency and some countries may not be even interested in having an international currency. Countries relying on exports growth would set restrictions on foreign exchange transactions to avoid currency appreciation. What Switzerland is doing now is not novel.  Decades ago Germany did exactly the same thing to its D-mark. Seigniorage or funding cost is not their primary concern.

The same problem is facing China. If China continues to push Renminbi internationalization, by definition it means allowing foreign investor to purchase more Renminbi, which will cause Renminbi appreciation and harm its export growth. It is very doubtful that the Renminbi can become an important global trade currency. Let’s say all of China’s exports and imports can be settled in Renminbi now (which is too optimistic to be true). The only way that Renminbi can be accumulated outside China is that China runs current account deficit, which is very difficult for China to do.  

Renminbi cannot become an important global investment currency either. Some analysts suggest that China should allow more Renminbi ODIs (overseas direct investments), but why would those non-Chinese counterparties want to receive Renminbi investments? How could they deal with the Renminbi? Let’s say a Chinese company purchases an office building in Australia with 10 million Renminbi. The Australian company would want to convert the Renminbi into Aussie dollar, save the Renminbi at a bank, purchase some Renminbi-denominated financial securities or import from China. However, Renminbi is still not fully convertible so it will be difficult for the Aussie firm to convert the money and there are not enough financial instruments denominated in Renminbi either. There is no reason for a foreign company to receive Renminbi unless it has businesses with China. Even if it does trade with China, it does not have to want to receive in Renminbi. As a consequence, there is little hope that Renminbi can matter in global investments before it becomes convertible and a large and open Renminbi-denominated financial market is developed.

Can Renminbi become an important global reserve currency? Last year Nigeria decided to convert 10% of its reserve into Renminbi and it became the favorite example for some optimistic analysts. But Nigeria is too small. If some central bank wants to convert USD 100B into Renminbi, the PBOC would definitely turn it down. Firstly it will cause the Renminbi to appreciate significantly against the US dollar which is harmful for exports. Secondly it will further increase the size of China’s foreign reserve, making it much more difficult to manage.

The Renminbi has made remarkable achievement, but it is still unprepared for becoming an international currency. Moreover, the drawbacks of becoming an international currency may even outweigh the benefits. If the Germans and Swiss are not mad for the so-called “exorbitant privileges”, why should the Chinese?

Chen Long

Central Banking Seminar

Read more at Institute for New Economic Thinking