Will China’s Renminbi Replace the Dollar as the World’s Top Currency?

A ChinaFile Conversation

Patrick Chovanec:

This week’s news that Brazil and China have signed a $30 billion currency swap agreement gave a renewed boost to excited chatter over the rising influence of China’s currency, the renminbi (RMB). The belief, in many quarters, is that the renminbi is well on its way to becoming an “international” currency—and many, both inside and outside China, are convinced it will inevitably eclipse the U.S. dollar as the world’s leading reserve currency.  China is destined to surpass the U.S. as the world’s largest economy, the thinking goes, so just like everyone uses dollars now, they will soon be using RMB.

I would argue that this excitement is vastly over-hyped. China’s much-heralded swap agreements with Brazil and other countries give the impression that those nations are now holding RMB as a reserve currency. They are not. After the Lehmann Brothers collapse in 2008, international markets for trade financing in dollars seized up for several days, until the Fed stepped in to provide more dollars to get the markets working again.  China’s swap agreements are an emergency backstop in case that ever happens again.  In the meantime, no actual money is being swapped.  If it ever came to that, Brazil’s temporary stocks of RMB would be used for the limited (but important) purpose of keeping trade alive until a more readily traded currency, like dollars or euros, became available again. There are three basic criteria for a nation’s money to serve as an attractive global currency:

1) There must be a great deal of demand to buy what your country has to offer;

2) There must be a ready place for them to put your currency, while waiting to spend it;

3) There has to be a ready way people in other countries can get their hands on your currency in the first place.

China’s renminbi only fulfills one of these criteria, the first: there is a great deal of global demand for what makes. Plenty of people around the world would be happy to pay in RMB to buy Chinese goods. But where would they save and invest that RMB in the meantime? About 40% of the world’s capital markets are in dollars; China accounts for just 4%. Much of that is in Hong Kong dollars, not RMB, and most of it is in riskier stocks, not the safer bonds that are good for stockpiling money. Because China’s domestic markets are mostly closed to foreigners, and the RMB isn’t freely convertible, moving money into and out of Chinese investments isn’t easy. That may be gradually changing, but it won’t happen overnight, and right now there’s no good place to put large quantities of RMB.

Of course, that assumes you, as a foreigner, can get your hands on large quantities of RMB in the first place. China runs large trade surpluses and, until very recently, has been receiving more investment funding than it sends abroad.  Through both channels—the current and the capital account—China has been a net importer of currency.  For the RMB to be widely accessible beyond China’s borders, China must export currency. That means running a trade deficit, or opening the doors to a lot more investment money flowing out of China than China's control-minded leaders have been comfortable with so far (allowing money to flow abroad like that could pose serious challenges to the way China's closed financial system currently functions).

The main point that a lot of people miss: for the RMB to become a truly global currency, China’s entire relationship with the rest of the world economy would have to change, in ways the Chinese have strongly resisted so far.  (This is the main reason, by the way, that Japan, even when it was riding high in the 1980s, deliberately chose not to embrace a much larger international role for its currency, the Yen).



Patrick is of course right that these swaps and likely future currency swap lines do not mean that the RMB is anywhere near a reserve currency. He is also right that one of the fundamental criterion for achieving reserve currency status is to get your own domestic financial and economic house in order, something that the U.S. also knows well.

However, much of the discussion surrounding RMB as a reserve currency revolves around the here and now—that is, every step that China takes, or every swap line deal is smacked down, and rightly so, as more or less a nothing burger. But China, as we all know, plays the long, long game. Did anyone think that China would have a reserve currency by 2015 or even 2020? Yet what about by 2030, 2035? Those who argue that China will never have a reserve currency that could potentially supplant the U.S. dollar is essentially making an indirect argument about the state of China’s domestic financial and economic conditions now—and assuming that it will not change much. I have no crystal ball, and I do not know the answers, but I also do not want to simply rest on straight-line assumptions that China will not make any of the necessary changes, say by 2030, that would actually achieve what it set out to do. The world also needs to prepare for a possible upside scenario for the RMB, whether it seems likely at this point or not.

Again, I do not know the answers at all. But I do think that any discussion of "will the RMB or will it not" needs to be centered around what people ultimately think about China's domestic economic prospects and what it will do to its financial markets. Focusing on these near-term baby steps potentially risks missing the forest for the trees, in my view. 

I think Patrick puts the skeptical case very well and it’s a convincing one to me. Damien raises some good questions, but I think those questions have answers – or at least answers that are the best we can do, given the inevitable uncertainties of the future.

First, I’m not sure that we really do all know that China plays the long, long game. Take the question of economic rebalancing. Prominent officials have been talking for years about the urgent need to shift away from an investment-led growth model, yet China has not managed to do so. Why? Short-term pain is the best explanation. I think it’s hard to demonstrate that Chinese officials are markedly better than their counterparts in other countries at making and implementing policies that will pay off over the long term. Thus, it’s not clear to me that we should interpret each of these steps as part of a larger plan, designed to reach fruition decades from now, to achieve reserve currency status for the RMB.

Second, if we do interpret these steps as part of a coherent policy aimed at internationalization, then that’s a policy that exists now, and it’s perfectly reasonable to compare it with other policies existing now to see if it’s compatible. As Patrick points out, it’s not: “China’s entire relationship with the rest of the world economy would have to change, in ways the Chinese have strongly resisted so far.” Of course, as Damien points out, China’s policies could change and we can’t simply assume that what was true in the past will be true in the future. Ironically, however, the argument that people make when they predict internationalization of the RMB seems to be based precisely on such a straight-line extrapolation from the past into the future: it’s more internationalized than it used to be, and so we can expect it to continue on in the same direction.

I agree with Damien that what happens in China’s domestic economy is important, but I don’t think it’s determinative on the question of whether the RMB will achieve international reserve currency status. After all, as Michael Pettis points out, “[t]he Spanish (later Mexican) silver dollar, to take the opposite example, was one of the world’s dominant currencies (or tracking currencies) for hundreds of years up to the late 19th century, and yet it would be hard to argue that either Spain after the 16th Century or Mexico at any time was one of the world’s dominant economies.” And as Patrick points out, the Japanese yen had a very limited international role even when the Japanese economy was going gangbusters.

Finally, of course, there’s the question of whether and to whom this should matter. It’s by no means clear that having your currency become an international reserve currency is a good thing. Michael Pettis makes the skeptical case here, arguing that China’s policymakers understand these costs, too, and have shown no sign of being willing to pay them. 

Brazil and China have signed a currency swap agreement that permits them to exchange up to $30 billion of their own currencies with the other.  It gives them more flexibility to deal with emergency situations. $30 billion is a lot of money, except when it isn’t. For comparison, $30 billion is the amount transacted on world foreign exchange markets in ten and a half minutes. That’s the average, over 365 days a year, 24 hours a day, but of course at peak moments, these markets easily turn over hundreds of billions of dollars each minute.

In current foreign exchange transactions, US dollars are involved in over 80% of transactions. The renminbi?  Less than 1%. So is the renminbi replacing the US dollar? Nope. Patrick Chovanec has no trouble whatsoever knocking over the straw man, and takes us deeper, explaining some of the pre-requisites of the renminbi becoming a global currency. Why, then, does such a question matter? It matters because it injects something of great importance to the Chinese domestic discussion. Will China become a global power, perhaps even the pre-eminent global economic power? Yes, that can happen. But it will happen only when China really builds further on its strengths: when China becomes more open; when China is perceived as a place where global actors can get a fair shake; when China is a place where rule of law and fair regulatory systems mean that people all over the world are willing to hold their money in renminbi-denominated assets.  If and only if that happens, Chinese money will become global money, and China will become a true global economic power.

Barry Naughton raises a very important point: the “holy grail” of building the Renminbi into a global reserve currency may have greater relevance to China's domestic political debate than to the global economy. I think it's fair to say that China’s central bank (the People's Bank of China, or PBOC) is largely staffed by Western-educated economists who would like China to move in the direction of market reform: deregulating interest rates, opening the capital account, letting the exchange rate float, etc. If they took these to the State Council, and tried to sell them as market reforms per se, they would likely face stiff opposition. It is a far more clever strategy, in my view, to go to the State Council and tell them China’s goal must be to make the Reminbi into the top global reserve currency. It appeals to national pride and sounds like it will put China in position to call the shots in the global economy.

There is a great deal of obsession, bordering on conspiracy theory, in China regarding the so-called “exorbitant privilege” that the dollar's reserve currency status gives the United States to manipulate the global economy to its advantage. I think a lot of that is nonsense, and I doubt the PBOC buys into it either. But selling the vision of an all-powerful Renminbi gives them; the mandate to pursue steps to that goal, which so happen to include market reforms such a deregulating interest rates, opening the capital account, and letting the exchange rate float. How far the PBOC can push these reforms before they get push-back from more control-minded politicians, who never realized this is what they were signing on to, time will tell, but the reformers are going to take the ball and run with it as far as they can. Cynical and machiavellian as it may seem, this is my impression how and why Renminbi “internationalization” became part of the national agenda.

Sometimes countries do the wrong thing for the right reason. Sometimes they do the right thing for the wrong reason. Opening up China's economy in order to make the Renminbi “top dog” among currencies is a good example of the latter.

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