Internationalizing the RMB

Although US dollars are currently the most widely used currency in the world, the Chinese renminbi (RMB) has the potential to become the next global currency, particularly among emerging economies. A May 2012 International Monetary Fund (IMF) report, “RMB Internationalization: Onshore/Offshore Links,” describes the necessary conditions for currency internationalization and provides an economic model to understand the linkages between onshore and offshore currency markets.

There are two financial markets in China: mainland China and Hong Kong. In contrast to mainland China, the offshore market in Hong Kong does not impose strict capital controls. China strictly limits the outflow of RMB to any countries except Hong Kong, so investors can only purchase RMB-settled assets or RMB in Hong Kong. The increasing integration between these onshore and offshore markets implies a rapid progression of RMB internationalization.

The laws of supply and demand are integral to currency internationalization. The article’s authors, Samar Maziad and Joong Shik Kang, state that “the experience of international currencies over the past century points to a few key factors that drive international demand for a currency, supported by policies that aid its supply.”

To explore these relationships, Maziad and Kang question to what extent a government should willingly supply a global currency. They point out relevant points for consideration, particularly the exchange rate risk during times of financial crisis and the abilities of public and private sectors to issue debt in domestic currency. These factors determine the willingness of government to increase or decrease its currency supply in the global market. Maziad and Kang suggest that increases in market liquidity will likely benefit China’s recent adoption of a five-year plan to develop domestic capital-intensive production.

Regarding demand, investors need a stable and credible currency as a store of value. Manufacturers also need a credible currency for use as trading units. While US dollars currently fill these roles in the global market, America’s rising budget deficit and declining ratio of gold reserves to dollar liabilities has generated doubts about the dollar’s long-term credibility as a store of value. As a result, the authors contend that the internationalization of the RMB will be driven by market demand.

While several currencies have played important roles in the global market over the past century, none have developed into a global currency. The authors reference the cases of the German mark and Japanese yen to explain the necessary conditions for currency internationalization. Several factors contributed to these currencies’ failure to gain international use, including slowdowns in economic growth, limited access to domestic financial systems, uneven internationalization of currency in onshore and offshore markets, and limited usage of the currency in trade invoicing. These issues collectively delayed the market-based mechanism and hindered foreign investment in the countries’ currency-denominated assets.

What do these historical experiences mean for China? China has become the second largest economy after the United States, and the second largest exporter after the euro area. It plays a central role within the Asian supply chain and has wide and varied trade links to global markets. China’s GDP growth averaged eight to 10 percent annually with low inflation, particularly in relation to other emerging markets. Nonetheless, China’s financial depth and openness to foreign investors is less developed compared to advanced economies. The authors recommend Chinese regulators loosen certain capital restrictions and provide more policy support to encourage the development of financial products based on the RMB.

The Chinese government has taken several steps to allow the RMB to evolve gradually into a market-driven currency. First, Chinese authorities have encouraged the use of RMB in settling cross-border trade with neighboring countries, including Japan. Second, the government has encouraged the development of RMB financial services in Hong Kong, in hopes of creating an RMB offshore market.

Finally, the authors explain an economic model that demonstrates how onshore and offshore exchange rates have changed simultaneously in recent years. This implies that the offshore RMB exchange rates in Hong Kong may have a predictive impact on future onshore exchange rates in mainland China. Driven by the increasing integration of onshore and offshore markets, the internalization of the RMB is making steady progress.

The ascension of the RMB as a new reserve currency may be a challenge for the US economy. Given increasing investor uncertainty about the dollar’s credibility, avoiding the so-called fiscal cliff may be important not only to resolve the US federal budget deficit, but also to increase the overseas competitiveness of US dollars. Otherwise other currencies, particularly the RMB, may threaten the role of the US dollar as the world’s dominant reserve currency.

Feature Photo: cc/super.heavy