Abheek Barua explains why China's renminbi is a long way from becoming a global reserve currency
There is a common assumption these days that any discussion on currencies would be dominated by the future of the euro and the euro zone. Attending the conference themed “Currencies of Power and the Power of Currencies”, organised by a heavyweight think tank, the International Institute for Strategic Studies, at its Bahrain office earlier this month, I was somewhat surprised that China got as much talk time at the conference as the European currency. There seemed to be two issues related to China that appeared to bother the conference participants — a motley mix of politicians, international bureaucrats, economists, defence analysts and bankers. First, the kind of strategic power that China’s large holding of dollar reserves endows it with. Second, the consequences of China’s bid for rapid “internationalisation” of its currency, the renminbi.
Let’s get to the first issue, which has been debated widely over the last few years. Is China’s dollar reserve holding indeed a serious threat for the US? Is there a risk of US interest rates skyrocketing if China were to suddenly sell off a hefty portion of reserves? The problem with the alarmists’ arguments that raise this China bogey is that they fail to recognise the fact that it is against its interest to shift away from dollars. Any effort by China to sell a significant proportion would lead to a sharp depreciation of the dollar and that would entail a large loss for all dollar holders including China. Thus, it would be irrational for China to shoot itself in the foot by shifting its reserves away from the greenback.
Indeed the converse might actually be true — the fact that the US is a large debtor gives China reason to handle it with caution. As economist John Williamson argued at the conference, “far more credible is the fact that the balances [China’s dollar reserves] act as a restraining influence on any Chinese inclination to engage in acts that would be regarded as hostile to the US. ...As Keynes once observed, when I owe my bank a thousand dollars, I have reason to fear my banker; if I owe it a million, he fears me”.
There is much less clarity on where the effort to “internationalise” the renminbi is headed. China is the biggest trader in the world, with about an 11 per cent share in global trade. This dominance in trade could give its effort some traction. But first things first: what exactly does internationalisation mean?
It could simply mean more trade and investment transactions are billed directly in the yuan (RMB). Thus, say, an Indian company importing a machine from China could ask for a price quote in RMB instead of dollars and be able to execute the transaction by directly exchanging RMB for rupees. (Currently the company would have to do a three-leg transaction, buying dollars for rupees and then RMB for dollars.) This would be the most basic internationalisation, and it has progressed considerably with a number of East Asian economies using the yuan extensively. The most extreme form of internalisation would be to make RMB a major reserve currency that sovereign governments would hold their surpluses in.
It is not entirely clear that it would be in China’s interest for RMB to emerge as a reserve currency. Reserve currency status effectively entails a loss of control over the exchange rate, and for a country that has long been accustomed to managing the exchange rate, this could be somewhat difficult to accept. However, for China, many of their economic aspirations stem from the need to make power statements rather than the balance of costs and benefits. Significant international holdings of RMB as reserves would be one such assertion of power.
That said, there could be impediments to internationalisation beyond a point. To start with, the capital account is controlled and the exchange rate is managed. Neither of these things is easy to abandon in a hurry. While it is true that China has made the RMB more flexible over the last couple of years (it is at a 19-year high currently), it is far from being a free float. Besides, Chinese policy makers have in the past shown a penchant to fall back on time-tested policies at the first sign of any serious trouble on the economic front. Thus, the possibility of China suddenly reverting to a de facto currency peg is not negligible, and potential holders of the renminbi have to bear in mind this risk.
Besides, a robust currency market cannot exist in isolation; it needs the support of free and flexible financial markets, particularly the money and bond markets. China might have undertaken financial sector reform over the past few years, but much more needs to be done. The question is: does it really have the incentive to do so?
It is possible to argue that financial sector reforms would help the process of internal rebalancing that it has embarked on. This entails a shift away from exports and investments. Deeper financial markets could encourage households to leverage their future incomes to finance consumption. It would also help improve the return on savings, create products that insure against contingencies and reduce the volume of “precautionary savings” that households hold to insure against contingencies. This could raise the share of consumption in the economy.
But China has another problem. Its first shot at rebalancing the economy that effectively commenced in the mid-2000s has been somewhat tardy. The share of investment in national income continued to rise at least until 2011. A significant portion of this would involve banks and other lending agencies lending extensively to unviable “zombie” investment projects. This would have added to the amount of impaired loans that are known to be sitting on the books of Chinese lenders. To prevent an implosion in the financial sector, China needs to ensure that the savings rate remains high and real interest low. This creates an incentive to retain the status quo in the financial sector.
These are some of the contradictions that China needs to resolve on the path to internationalisation. Unless it does this successfully, the renminbi is unlikely to emerge as a store of global value.
The author is with HDFC Bank. These views are personal