Boao Review: The Realities of Renminbi Internationalization

I have an article in the October 2012 issue of Boao Review, the new journal published by the Boao Forum, on what the future may hold for China’s currency, the Renminbi.  I am told the article will be posted on the magazine’s website this week, and I will post a link when one is available.

The Rise of the Renminbi as an International Currency: Challenges and Solutions

By Patrick Chovanec

The rise of the Renminbi as an international currency is looked up with an almost breathless anticipation from London to Tokyo to Sydney. All this excitement has tended to eclipse a more sober assessment of the opportunities and obstacles the Chinese yuan realistically faces, as well as the benefits and burdens a larger international role for the Renminbi would pose for China. Rarely are the questions asked: Does China really want or need to manage a global currency? And if so, what price is it willing to pay?

The growing role of the Renminbi in China

The Renminbi has already come a long way. Not that long ago, the Renminbi wasn’t a fully functional currency even within China’s own borders. All imported goods, as well as services provided to foreign visitors, had to be paid for with Foreign Exchange Certificates (FEC), in exchange for hard currencies. While FEC were ostensibly denominated in the same yuan as the Renminbi used for domestic purposes, their buying power was obviously quite different, giving rise to a vibrant black market on the doorstep of every international hotel across the country.

Gradually, the yuan’s exchange rate was allowed to depreciate nearly sixfold, from 1.5 CNY/USD to 8.2, closing the trading gap and allowing China to phase out the FEC in 1995. This opened the door for China to make the Renminbi convertible for current account (i.e., trade) transactions the following year. The flow of investment funds both into and out of China via the capital account, however, continued to be strictly regulated. When China set up its two domestic stock exchanges in the early 1990s, it went so far as to create an entirely separate market in so-called “B shares,” denominated in US dollars and HK dollars respectively, in which foreigners (and until 2001, only foreigners) were allowed to invest. In effect, the inability to freely buy and sell Renminbi was used as a firewall to insulate China’s financial markets from the outside world.

In practice, convertibility on the current account meant that Chinese companies, or foreign companies operating in China, could exchange Renminbi for foreign currencies to purchase imports, as long as they presented a valid invoice. Trade itself, both imports and exports, was conducted almost entirely in foreign currencies, mainly in US dollars.

The role of the US dollar in international settlement and its effect on international trade

It’s worth pausing for a moment and asking, why US dollars? After the US de-linked the dollar from gold in 1971, demolishing the post-war Bretton Woods system, there has been no institutional framework enshrining the US dollar as the world’s preeminent currency. The dollar retains its role because market participants prefer to use it, for three main reasons:

• The dollar represents a claim on goods and services in the world’s largest economy, presuming it retains its value;
• The dollar can be freely used or exchanged for any (legal) purpose, without restriction;
• The dollar can be held in a wide range of readily traded investment instruments, and in large amounts.

The same is true of other international currencies, such as the Euro, the British pound, and the Japanese Yen, but to a lesser degree. In contrast, someone who accepts a Chinese yuan as payment – or a Nigerian naira, a Honduran lempira, or a Laotian kip – may find it a lot harder to invest or find another trader who will accept it in turn. Many of these countries find it easier – or even essential – to conduct trade in a currency that is far more widely accepted.

Using the dollar as an intermediary, however, does have costs. Take, for instance, an Argentinian exporter selling soybeans to China. Since the seller can’t use yuan, and the buyer doesn’t want pesos, they both must pay a bank commission to change their money into dollars and then back again. They may have no choice but to use a U.S. bank that has sufficient dollars available. Thus both sides run the risk that their currencies will fluctuate in value against the US dollar before the transaction is completed, creating undesired gains and losses.

The drawbacks of relying on the US dollar were driven home by the immediate aftermath of the Lehman Brothers collapse in September 2008. For several terrifying days, credit markets seized up. Exporters and importers all over the world who needed US dollars to conduct business couldn’t secure financing, and trade threatened to grind to a halt. The Federal Reserve stepped in to provide dollars via “swaps” with other central banks, but not every country found itself first in line to obtain relief. It was this crisis that provided the impetus for China to negotiate bilateral currency swap agreements with several of its largest trading partners, including Indonesia, Argentina, Australia, and Brazil.

The RMB’s increasing role in trade between China and other countries

Because few people understand what central bank currency swaps actually are, or how they function, the signing of these agreements has given rise to the misapprehension that the Renminbi has already taken on a more prominent international role that includes being held as a reserve currency. In fact, no currency reserves have been exchanged. The “swaps” are simply an emergency back-up in the event of another crisis. It is unclear how such swaps, if implemented, could be unwound except through careful stage management, since there is no global market for banks to replenish their Renminbi balances, once deployed. For now, that is a bridge nobody is too worried about having to cross.

In any event, the much-touted currency swaps that China has entered into are a tailored response to a specific set of concerns, and in no way herald the Renminbi’s arrival as a fully functional global currency.

Of course, China is not Honduras, Laos, or even Argentina. China now has the second largest economy in the world, and is the world’s largest exporter. There are plenty of people around the world who want to buy Chinese goods, or make investments in China, and would be willing to acquire Renminbi to do so. Thus, the Renminbi fulfills at least the first criteria that made the US dollar a globally accepted currency: it represents a claim that many people wish to possess.

In response, China has begun to allow companies to invoice and pay for import and export transactions in Renminbi, rather than a foreign currency. Starting with a pilot program in 2009, settlement in Renminbi grew four-fold in 2011 to 2 trillion yuan ($330 billion), or 9% of China’s foreign trade, and in March 2012 was made available to all firms nationwide.

The growth in yuan-denominated settlement, and in offshore holdings of Renminbi in Hong Kong, have been hailed as a sign of the currency’s inexorable rise to global dominance. But critics, including Chinese economist Yu Yongding, have pointed out that Renminbi settlement has been heavily lopsided towards imports, resulting in a net outflow of the yuan. They argue that this currency outflow has been driven more by speculative anticipation of Renminbi appreciation, and by opportunities for exchange rate arbitrage, than by any desire to hold Renminbi as a genuinely useful currency. Beyond these immediate concerns, however, the imbalance in yuan settlement raises a more fundamental challenge to China’s long-term vision for the Renminbi.

Two undesirable scenarios in RMB’s internationalization and the solutions

In the 1960s, the economist Robert Triffin observed an interesting dilemma involving the dollar’s role as the dominant global currency. In order for the dollar to be a desirable currency to possess, it has to buy things that everyone all over the world wants. But in order to meet that need, the dollar has to be readily obtainable, which means the U.S. must run a balance of payments deficit – in other words, it has to export currency either by running a trade deficit or by channeling a very large amount of investment abroad. For the dollar to be a global currency, there has to be some way for people around the world to get their hands on dollars.

Up until very recently, China has been running surpluses on both the current and capital accounts. The result is that, far from Renminbi accumulating abroad, China has accumulated a massive stockpile of $3 trillion in foreign currency reserves. Foreign buyers can’t pay for Chinese exports in Renminbi because, in net terms at least, they’ve had little chance to earn Renminbi. And unless China starts running a trade deficit, or opens its capital account and allows a lot more investment to flow overseas, any yuan the Chinese use to pay for imports only adds to the sum of foreign currency left in China’s official reserves – heightening, rather than reducing, China’s dependence on dollars. For the Renminbi to take on a more prominent international role, much less emerge as the world’s chief reserve currency, would require a dramatic change in China’s relationship to the global economy – a change it is far from clear China either anticipates or desires.

Opening China’s capital account is the key to another obstacle facing the Renminbi: where, if investors do hold yuan, they are supposed to put them? According to McKinsey, 40% of global capital markets are denominated in US dollars, giving investors, including central banks, deep and liquid markets in which to maintain large dollar balances. China, including Hong Kong, accounts for just 4% — mostly in equities, and a large part of it barred to foreign investors. China has tried to fill the void by issuing so-called “dim sum” bonds, yuan-denominated securities sold in Hong Kong: 35.7 billion yuan’s worth in 2010, and 131 billion in 2011. But as long as the offshore market in “dim sum” bonds remains set apart in quarantined isolation from Mainland capital markets, it risks sharing the same fate as the stunted and illiquid B share market. The only viable solution is for China to finish the process it began in the 1980s and make the Renminbi fully convertible on the capital account.

Allowing free flows of capital is really the only way China can – in time – develop into the kind of global financing hub that could support a truly international currency. The problem, for China’s leaders, is that achieving that goal requires giving up a substantial amount of control over the economy. Economists call it the “trilemma,” or the “impossible trinity”: no country can allow free flows of capital, support a fixed exchange rate, and manage an independent monetary policy at the same time. One of them has to go. And as the Japanese discovered with their “big bang” in the mid-1990s, opening China’s financial system to outside market forces would make it a lot harder to hide and quietly manage any bad debt problems lurking in Chinese banks.

So the question is not just whether the Renminbi has the potential to become a truly international currency, but whether China wants to go down the path that could make it one. That path involves risks and rewards, obstacles and opportunities, but wherever it leads, it will not leave the Chinese economy unchanged.