SUMMARY AND CONCLUSIONS IN A FEW BULLET POINTS
- In the future, the Chinese currency will be an international currency, playing a major role in Asia, as the US dollar and euro do in their respective zones.
- Competing with the US dollar on the international level will take much longer, and it is a complex goal.
- An international currency has four main characteristics: liquidity, “acceptability”, stability and “predictability”.
- An international currency has four functions: a reserve currency, an intervention currency, a settlement currency and a reference currency.
- History recalls that moving to a multipolar system (as regards all functions of an international currency) would require an significant (and negative) shock on the international currency, i.e. the US dollar.
- Nevertheless, the Chinese currency is gradually emerging as an international currency, thanks to the efforts made by Chinese officials to make the yuan the major currency in Asia as a reserve currency, an intervention currency and a settlement currency.
- RMB as an international currency also means increasing its use in settling cross border trade and financial transactions, an area in which the US dollar has been predominant so far.
- Japan never succeeded in promoting the yen as an international currency. The lessons for China from the Japanese experience are crystal-clear: 1) the liberalisation of capital markets represents a prerequisite for the internationalization of the currency; 2) confidence in the economy is crucial; 3) domestic markets have to be attractive to foreign investors and foreign financial institutions in order to increase the need to use the currency; 4) bargaining power in trade invoicing currency helps to install the currency as an international one; 5) domestic financial centres must be developed as regional centres; 6) the relative stability of the RMB in Asia is a prerequisite for this currency to be used and accepted as an international currency, and as a substitute for the US Dollar .
- Amongst the most important achievements: more than 10,000 financial institutions are doing business in RMB; the RMB is now used to settle around 20% of China’s total trade; the RMB is the third most important currency of global issuance of letters of credit for trade-related purposes; there are more and more official offshore RMB clearing centres (15 at present); China has closed currency swap agreements with more than 30 central banks, totaling Y3.2 trillion…
- Some projections suggest that by 2020-2025, 30% of China’s trade should be invoiced in RMB, making the RMB the fourth largest global payment currency. Daily RMB FX turnover would exceed $500 billion (three times higher than its current level). The offshore RMB (dim sum) debt market would also amount $500 billion (up from around $90 billion in 2013). China would represent 30% of global equity market capitalisation (bigger than the US) and 20% of the global fixed-income markets (as large as the euro market). Two prerequisites have to be met though: the RMB needs to be largely a freely floating currency, and the capital account needs to be more open.
- The debate about capital account openness remains intense as regards China, because this type of liberalisation implies major constraints on Chinese policy: a less independent monetary policy, a more flexible FX rate, a more important role for international players in determining asset prices, greater transparency on economic indicators, on independence of statistical offices, on state-owned enterprises, on monetary, fiscal and FX policies… these are the consequences usually mentioned.
- History recalls that a gradual opening of the capital account is better than a big bang.
- History also recalls that financial liberalisation does not necessarily pave the way towards financial crises, except when policy makers and central banks misunderstand the effective operation of newly unregulated financial markets. Moreover, to avoid boom-bust cycles, reforms need to be properly sequenced to minimise pro-cyclical effects. Past experiences also recall that the financial supervisory system has to be reformed prior to or (at the latest) simultaneously with financial liberalisation.
- At present, around 62% of China’s FX reserves are USD denominated assets; 20% are EUR denominated assets, which is in line with other emerging market countries. The PBoC has started diversifying FX reserves into other currencies, especially in Asia.
- The yuan is undoubtedly gaining ground as part of FX reserves in the rest of the world. A growing number of central banks and sovereign wealth funds have diversified their holdings to include renminbi reserves and investments or have plans to do so. This is one of the major prerequisites for the yuan to become an international currency.
- Our results clearly suggest that the RMB is already an anchor for emerging currencies and its influence seems to go well beyond its neighbourhood area. Note that the RMB as a reserve currency held by foreign central banks will necessarily increase after SDR inclusion in October 2016.
- The question of the undervaluation of the yuan has been debated for the past two decades, particularly because it plays a more dominant role in determining the valuation of emerging countries’ currencies and hence the rest of the world.
While the question of the renminbi being undervalued was relevant before the Great Recession, the valuation of the renminbi is far less clear at present. We tend to conclude that the RMB is globally in line with fundamentals.
- The emergence of the RMB as an international currency will have major consequences. The USD never had a real contender in the past, and a tri-polar system (USD, EUR and RMB), more precisely a system of competing international currencies, may be unstable at certain points in time.
- History recalls that the instability is essentially due to the capacity and incentives for investors, including central banks, to shift the composition of their international portfolios and FX reserves in response to events and shocks. These shifts create more volatility in the foreign exchange markets. In sum, the stability of the future tri-polar system will depend on the (political, social, financial and economic) stability of the countries issuing an international currency.
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