Journey may matter more than destination
Updated: 2012-07-20 12:19
By Zhu Ning (China Daily)
There is still a long way to go before the renminbi becomes an international currency
As the Chinese economy continues to assert itself as a growing global power, more and more people believe it is only a matter of time before the renminbi becomes an international currency, and that the country has a major role in world financial markets.
However, for the moment many gaps need to be filled before the renminbi can be seriously considered as a major currency, despite China's still booming economy and its increasing importance in global trade.
Admittedly, the renminbi is being used in a wider range of business transactions accounting for a greater trade volume compared with five years ago, especially through Hong Kong. To some extent this could attest to the renminbi's ascent to an international currency. However, a truly international currency would typically have more roles than as a medium for global trade.
Looking at major international currencies throughout history, they typically play three related yet distinct roles: intermediaries for global trade, vehicles for international investment and clearing, and ballast holdings in central banks' reserve systems.
By such criteria the renminbi seems to have only achieved part of the first criteria, falling well short on the other two. It is clear that China's central bankers and policymakers have been taking gradual steps to guide the currency in the direction of becoming an international currency.
Based on history and on practicalities, it seems natural that internationalizing the renminbi should begin by making it a major medium for trade, especially in the Asia-Pacific region. This explains why the currency's use has increased tremendously over the past five years in Hong Kong, which accounts for a lion's share of Chinese exports and imports. Such a move seems to have served as a good start as some ASEAN countries, important trade partners with China, also start experimenting with invoicing in renminbi. In short, things seem to be on track and developing fast in the desired direction.
Nevertheless, it is the other two roles, vehicles for financial investment and store value for the reserve system, that need greater consideration and effort. If one were to use foreign exchange market turnover as an indicator of a currency's potential as a vehicle currency for transactions involving cross-border trade in goods and financial assets, then there seems to be a long way to go. After all, renminbi transactions accounted for less than 1 percent of all turnover in foreign exchange markets last year.
History teaches us that there can be a long lag between a country's economic dominance and the dominance of its currency. The most recent example is that of the US. About 67 years had passed since the US economy passed that of Britain in size and when the dollar passed sterling as a major international currency, according to research in international economics and economic history.
As a result, the questions that need to be answered are: What are the major challenges facing the renminbi? and what needs to be done to overcome such challenges?
The answers lie in at least three areas.
Free convertibility seems to be an apparent target that many people cite. It is hard to imagine that a currency can be attractive to international investors if they are worried about the amount, its price, and its liquidity. Without free convertibility, many renminbi transactions may have to be held through bilateral swaps between governments, as has been done in recent experiments with Malaysia and Nigeria.
Another closely related topic is constraints on capital flow. Current regulations on capital flow by non-residents in practice separate the international renminbi market from China's huge domestic market. Such separation not only limits foreigners' interest and motivation in getting into the market but also creates unnecessary risks that may deter certain investors. It is clear that foreign exchange reserves and institutions are less interested in holding or investing in a currency if they do not know whether or when segmentation will be removed.
In real terms the Chinese capital account has become increasingly open in the past year, marking a very good start on a long path. The Chinese government appears increasingly ready to remove remaining controls. However, it could take years before the renminbi becomes a freely convertible currency for capital account transactions.
Both above issues pertain to the integration of the Chinese economy into its global counterpart. To be more specific, the reservations about free convertibility and capital flow largely stem from China's worry about its domestic economy. Apart from its concern about the renminbi's exchange rate, which has direct and profound influence on the country's export and domestic employment rate, the investment-driven growth model relies heavily on capital. The loosening of controls on capital flow may risk sudden capital outflow and catastrophic shock to the economy, as evidenced in the Southeast Asian financial crisis of 1998.
So before China can confidently make headway in the above two areas, fundamental changes would have to take place in the country's economic structure, growth model, and labor force skills.
Last but certainly not least, the renminbi as an international currency requires the integration of the global financial market and a well-developed and functioning domestic financial market. Although coming in different shapes and sizes, there is no exception that all reserve currency economies have to have a developed domestic financial market. In particular, each element of the breadth (variety of products), depth (trading volume and investor clientele), and liquidity (trading volume and turnover) of the market seems critical to the ascent of an international currency.
Chinese financial markets have been known primarily as the fastest growing equity markets in the world. The other aspects of the financial markets, for example the debt markets and derivatives markets, lag behind.
The debt market and the derivatives market linked to fixed-income securities have the advantage of facilitating the formation of market-determined interest rates and catering to international institutional investors at the same time, both contributing to the internationalization of the renminbi.
Encouragingly, even though the sizes of the debt and derivatives markets remain small compared with those in developed economies, steady progress has been made in the past few years. The introduction of the high-yield bond markets and stock market index futures can be seen as determining further reform.
In all, some of the key questions on internationalizing the renminbi seem to be inextricably linked to the further reform and opening up of the Chinese domestic market. So internationalizing the renminbi is as much a domestic matter as an international one.
Even with all the proper actions being taken and all the above challenges being overcome, one should be careful not to take it for granted that the renminbi will become a major reserve currency any time soon. To achieve any of the above three objectives, let alone all three, will take time.
Also, it is important to bear in mind that there is no one-size-fits-all rule for international currencies. For example, benefits are not guaranteed for all reserve currency countries. The US runs one of the largest current account deficits whereas Japan and Switzerland have been maintaining consistent current account surpluses even after achieving reserve currency country status.
Hence, in the internationalization of the renminbi it may be the journey rather than the destination that matters most. Moving in the direction of an international currency is definitely the direction that reforms in China should be headed. As long as the reform takes place, the end result may indeed not be that important.
The author is deputy director of the Shanghai Advanced Institute of Finance, Shanghai Jiao Tong University. The views do not necessarily reflect those of China Daily.
(China Daily 07/20/2012 page10)