The Renminbi as a Reserve Currency, Part 1
Earlier this year, NYU professor Nouriel Roubini attracted worldwide attention by speculating in a New York Times op-ed that the Chinese Yuan, or Renminbi (RMB), might someday supplant the U.S. dollar as the world’s main reserve currency. Chinese officials have been quick to embrace the notion, regularly floating either its negative (the U.S. dollar should not be the global reserve currency) or positive (the RMB should be) formulation in their public pronouncements. Just a week ago, a leading Chinese economist told Bloomberg that “Eventually, the yuan should be demanded as a reserve currency,” but noted that China was still far away from this goal.
It’s no surprise, then, that the Renminbi’s prospects as a reserve currency is one of the issues I am most frequently asked to speak or consult on. In particular, people are eager to understand how recent moves by China to swap currencies with other countries and establish offshore clearing markets fit into the equation, and whether they represent significant steps towards a more prominent international role for the RMB. These are some of the topics I’d like to address over the next few days.
First of all, however, it’s worth defining what we mean by “currency reserves” and why countries keep them. It may help to begin by noting the obvious: everyone needs to live and function primarily in their own country’s currency. Americans need dollars, Europeans need Euros, Indians need rupees, and so on. We only need a foreign currency when we want to pay someone who requires it to live and function somewhere else, where that currency is used. Each country’s currency is like a special kind of commodity that allows us to offer something of immediate value to people in that country’s economy. Certain actual commodities like gold and silver can be used as a kind of super-currency whose value is recognized and easily exchanged for local currency in all economies.
In an economic sense, “currency reserves” refer to the sum of all foreign currency (including cash-equivalent liquid assets denominated in foreign currency) and specie (such as gold and silver) available within a country’s financial system. It represents the resources immediately available for any actor, public or private, in that economy to buy goods and services abroad or to pay interest and principal on debt borrowed in foreign currency. If a country’s banking system doesn’t have enough currency reserves to meet such needs, it can buy the foreign currency it requires in exchange for its own domestic currency. It can also, of course, trade one foreign currency it holds for another. Either action, however, affects the overall supply and demand for the currencies traded, and thus their relative prices, the exchange rate. Economists pay attention to a country’s “currency reserves” because they indicate to what extent a country’s economy can meet its trade and debt obligations relying on its own ability to earn foreign currency, without being forced to bid down the value of its own currency in world markets.
Some or all of a country’s “currency reserves” may be held directly by its government or central bank as “official reserves.” These two terms refer to distinct concepts, but are often used interchangeably, especially in countries, like China, where the government restricts private holdings of foreign currencies and/or actively buys and sells foreign currency in order to maintain a fixed exchange rate for its own currency. In principle, a country’s government doesn’t have to hold any “official reserves” at all – it could simply let the banking system meet the economy’s foreign currency needs on its own. In practice, governments often hold their own foreign currency reserves for fiscal, monetary, and structural reasons:
- Fiscal. Some governments accumulate reserves in order to sponsor or facilitate high-priority projects such as roads, dams, or ports. This is particularly true for developing countries that must hire outside technology and expertise, and whose own currency is not widely accepted abroad. Official reserves can also be used to subsidize politically-sensitive imports, such as food and gasoline, and to ration people’s ability to engage in private transactions (such as importing luxuries) that might deviate from state-sanctioned priorities.
- Monetary. The most common reason countries hold official reserves is to maintain a fixed or semi-fixed exchange rate in the face of economic fluctuations. When there’s an influx of foreign currency from a trade surplus or foreign investment, rather than allow the excess supply to lower the price of foreign currency (and raise the price of the domestic currency), the central bank will buy the excess at the official (above-market) rate and hold it in reserve. Then when economic conditions change, and the country runs a trade deficit or foreign investment withdraws, causing a shortage of foreign currency, the central bank will reverse the process, selling back its reserves at the official (below-market) rate. Of course, this can only work as long as conditions correct themselves before the reserves are depleted. If the problem is more serious or persistent, the country will have no choice but to accept a more lasting change in the relative value of its own currency. Nevertheless, the ability to ride out temporary swings can minimize the disruptive effect of unpredictable exchange rates on trade and investment.
- Structural. A persistent outflow of foreign currency at a fixed exchange rate will ultimately deplete a country’s official reserves. But a persistent inflow can, in principle, go on forever, as long as the government is willing to keep buying excess foreign currency and stockpiling it as reserves. This is the situation in which Japan found itself in the 1980s, and China finds itself in today. In these cases, the accumulation of official reserves has no intentional purpose – or has at least outstripped its original purpose — and is merely the byproduct of pursuing other goals, such as export-driven growth and employment.
Not all foreign currencies fulfill the purposes described above equally well. A pound is not the same as a peso. Even in the last case, where a country accumulates reserves despite itself, the type of currency it accumulates reflects important economic realities. In fact, only a handful of currencies meet the requirements to be desirable and practical as widely-held “reserve currencies,” and of these, only one tends to play a dominant role at a given time. From 1816 to 1914, that role belonged to the British Pound (backed by the gold standard). From 1914 to the present day, it has resided in the U.S. dollar (sometimes backed by gold, but as often not).
There are four main factors that set the Pound and the Dollar apart as viable and attractive reserve currencies. Each was necessary. They were liquid. They were available. And they were perceived as safe. I’m going to run through each of these conditions in turn. I will consider how they applied to the Pound and the Dollar, and to what extent they are satisfied by China’s Renminbi.
(1) Necessity. The fundamental purpose of a reserve currency is to settle external obligations. The greater quantity and variety of obligations a particular currency can settle, the more useful it is as a reserve currency. The currency of a country that produces little of note and lacks funds to lend or invest is not nearly as useful as one whose home economy produces many goods and services desired around the world, serves as an important source of capital, and has many commercial partners who also find its currency relevant to meeting their own obligations. This idea — that the dominant reserve currency derives its status from its connection with the dominant national economy in an interconnected world – is what underlies Roubini’s reasoning that the Renminbi may be next in line to replace the Dollar.
But this conclusion misses something important. A reserve currency must not only be capable of settling obligations in connection with a heavy-weight economy. It must be required to. Because if you can settle those obligations, as sizeable and important as they may be, using your own currency — or the currency of another leading economy — there is no reason to hold that country’s currency as a reserve. That is precisely the case today with China.
During the 19th Century, Britain was virtually the world’s sole source of industrial products and capital for industrialization. Since the world came to London to buy and borrow, Britain could insist on being paid either in its own currency, or in a currency fixed, like the Pound, to gold. After World War I, the U.S. ended up with most of the world’s gold and took over Britain’s role as lead creditor. It, too, was in the position to demand payment in its own currency. And while the U.S. was never the sole supplier of industrial goods, its reliance on exports only rarely exceeded 10% of its GNP, giving it leverage over buyers. (When exports did exceed 10%, it was during the two world wars, when the U.S. enjoyed maximum economic leverage). If the world wanted to do business with America, it needed Dollars.
China, in contrast, relies on exports for 40% of its GDP. Its dependence on exports leaves it in no position to dictate payment terms. It must continue to accept dollars, Euros, and yen or cease to grow (I say this despite China’s recent efforts to stimulate domestic demand as a replacement). And because China accumulates so many dollars it has no use for, it all too happy to lend those dollars back to the U.S. (to be repaid in dollars). Nobody requires RMB to buy Chinese goods or repay Chinese loans. Dollars will easily do.
(2) Liquidity. Holding large amounts of reserves as cash carries a high opportunity cost. It is far preferable to invest those holdings temporarily and earn a return. However, such investments must highly liquid, so they can quickly and easily be redeemed when needed for use, without any significant loss in value. Part of the appeal of the Pound and the Dollar was due to the fact that their home economies hosted the world’s most developed capital markets of their day. Pound and dollar-denominated reserves did not sit idle, they could be invested in a wide variety of liquid instruments that enjoyed a ready market.
According to a 2006 McKinsey study, the United States accounts for 38% of the world’s capital markets (excluding bank deposits), including nearly half of all private debt securities. That does not even include dollar-denominated markets for trading commodities, such as petroleum.
Relative Size of Capital Markets (in trillions of USD)
|Securities||Securities||Debt Securities||Capital Markets|
China’s capital markets are tiny by comparison, accounting for merely 4% of the world total. To offer some perspective, China’s capital markets in 2006 were barely twice as large as its total foreign currency reserves, whereas U.S. capital markets were 23 times as large (and easily able to accommodate such investment, especially when commodity markets are added to the mix). While the precise valuations of all capital markets have fluctuated since 2006, the relative magnitudes have not significantly changed. Markets for investing dollars are at least 10 times deeper than markets for investing RMB. In particular, the Chinese market for fixed income securities — the preferred instrument for storing ready reserves — is severely underdeveloped and illiquid, in sharp contrast to U.S. Treasuries.
But the relative size of the market is just the tip of the iceberg. A more immediate problem is that most of China’s capital markets are off-limits to foreign investors. Even when owning domestic debt or equity securities is permitted — through a QFII fund or a strategic joint venture investment, or by getting special permission from SAFE and MOFCOM — the process of getting money into China and back out is usually lengthy and cumbersome. Nor can these securities be freely traded to other foreign investors, which severely limits their utility as foreign exchange. For foreigners, faced with so many capital controls, the Chinese market is simply not liquid. If you own a RMB asset, what can you do with it outside of China? In most cases, the answer is “nothing.”
(3) Availability. It may seem obvious, but to hold a reserve currency you first have to be able to get your hands on it. That means its economy must export currency. 19th Century Britain was a net exporter of goods, paid with gold, but it re-exported both pounds and gold by investing its capital around the world. From World War I to the early 1970s, the United States performed essentially the same role. At that point, it switched to become a major importer of capital, but continued supplying the world with dollars by running trade deficits. In both cases, the balance of payments made it possible for other countries to obtain access to Pounds (or gold) and Dollars to use as currency reserves.
China does not export currency. It runs a large and growing trade surplus and — if you exclude the management of its reserves — is a net importer of capital, in part because it effectively prohibits Chinese companies and individuals from investing abroad without government permission. Currency flows into China through both the current and the capital account, leaving it no way to flow out again. As long as this continues — as long as China’s government continues to bolster export-oriented growth and employment by buying up all that influx of currency, and by barring private outflows of capital – there is virtually no way for foreigners to build up net balances of RMB. Even if they wanted to hold RMB reserves, the one-way flow of funds would make it impractical.
(4) Safety. Holding sizeable amounts of any foreign currency puts the owner at the mercy of another country’s fiscal and monetary policy. If that country were to undermine the value of its currency, either by defaulting on its debts or printing too much money, whoever held that currency would suffer a real economic loss. So when deciding which currency to hold as a reserve, the credibility and responsibility of the issuer is a constant concern. The British resolved these concerns by linking their currency firmly to gold. So did the Americans until 1971. The gold standard ensured that neither Britain nor the U.S. could arbitrarily inflate their currencies and damage their value.
After 1971, the United States was no longer constrained by a fixed exchange rate with gold. Some thought that meant the end of the Dollar as a reliable reserve currency. But in the end, people decided to trust the U.S., at least for the time being. Since the days of Alexander Hamilton, even through a Civil War, it had never defaulted on its sovereign debt. And the Fed’s decision to crack down on inflation in 1981, even at the expense of a recession, inspired confidence. But such trust was never irrevocable. Today, in the face of burgeoning budget deficits, many are wondering whether the Dollar is still a “safe” currency — the Chinese foremost among them. This is precisely the reason why people are starting to talk about the Renminbi as a potential alternative.
China is an unknown quantity. It experienced hyperinflation and defaults in the early 20th Century, but under a different government. The U.S. has a long track record as a leader in global economic affairs; China has only just stepped onto the stage. Its authoritarian style of leadership and opaque decision-making processes can sometimes inspire distrust. Just as China is reconsidering whether it feels confident entrusting its assets to the U.S., the world will have to decide, over time, whether it feels confident entrusting theirs to China.
On all four counts — necessity, liquidity, availability, and safety — the evidence suggests that China’s Renminbi is a long way off from being an attractive and viable reserve currency. Of course, this situation could change. China could reduce its dependence on exports to the point where it can start insisting on its own payment terms. It could expand its capital markets and open them to foreign investment. It could buy more imports and allows its citizens to invest abroad, letting currency flow out as well as in. And it can develop a positive track record of economic leadership that involves considering other nations’ interests as well as its own. But all of these steps will involve a dramatic and sometimes painful restructuring of its economy, from an export-led growth model to a more balanced and open system. For now, China’s policies and priorities are more reflective of a country that holds currency reserves than one that supplies reserve currency to the world economy.
That’s where I’m going to stop today. In the next installment, I’ll talk about China’s recent moves to expand the use of the Renminbi, and what they really mean. These initiatives are significant, but not in the way they are often portrayed. If the Renminbi is not on track to becoming a global reserve currency, as I have argued, then what is it ready to become?