Will the Renminbi replace the US Dollar as the world currency?
Will the Renminbi replace the US Dollar as the world currency? 2013 1/1/2013 CRISIL Young Thought Leader Competition (CYTL), 2013 Submitted by: Ishan Abrol Narsee Monjee Institute of Management Studies, Bangalore
2 Table of ContentsExecutive Summary ___ 3
Historical Ascent of Dollar ___ 4
Historical Precedent Analysis ___ 4
Falling Empire of Dollar ___ 5
Internationalization of Renminbi; Roadmap towards replacing Dollar ___ 5
East Asia’s Local Currency ___ 7
Critical Analysis ___ 9
Conclusion . . 10
3 Executive Summary The stellar path of the Chinese economy has led Renminbi to play a prominent role in the global trade and its potential to replace the US Dollar.
With the changes in the liberalization policies, development of financial markets, internationalization of Renminbi and backing the currency with real asset, Renminbi has already become the East Asia’s Local currency. But close capital controls, competition by other currencies and less transparent government policies may make the road bumpier for Renminbi to rise as global currency.
The analysis in this paper is divided into two sections. The first section includes Historical Precedent analysis with the current situation of China. The analysis illustrates the dominant position of China in the future. As compared to America in 1920, china has huge reserves which are not backed by real asset but are denominated in Dollar which will expose China to huge systematic risk. In the second section, China’s policy initiatives towards promoting Renminbi as world currency is analyzed and critical factors affecting the internationalization process are tested. Though China has taken major steps towards internationalization but China is far behind the US in terms of strong financial institutional reforms which are must for promoting Renminbi as the reserve currency.
Currently with the pace of reforms for the internationalization of Renminbi, Renminbi has the prospects to become an active international currency.
4 Ascent of Dollar Post World War II, for the efficient international trade and stable macro economic conditions, US pegged Dollar to gold at $35 per ounce of gold which further gave other countries an enticement to use Dollar as reserve. This was primarily due to the acceptance of gold as the common medium of exchange at that point of time. Furthermore, in the later half of the nineteenth century after the World War II, all the currencies in the world were pegged to gold, which was an advantage for the US Dollar as the gold was denominated in US dollar.
Hence post 1945, rising British borrowing in American Dollars and economic weakness of the UK led to the growing importance of Dollar in the International Trade.
This led the US Dollar to overtake sterling as suddenly every currency became denominated in Dollar. Historical Precedent Analysis Current situation of the Chinese economy overtaking the US can be compared with the SterlingDollar transition phase in the 20th century to know the prospects of Renminbi to replace the US Dollar. GNPIn 1890, US had overtaken the British economy to become the world’s leading economy. But it took more than 40 years for the US Dollar to dethrone the British Sterling to become the supreme currency in 1944. Over the past decade, China has grown at an average rate of 8% and is expected to surpass the US economy by next decade.
Therefore, Renminbi has the potential to become the sovereign currency by the next 15-20 years.
Financial PositionPost World War 1, due to the increasing borrowing by British, US became net creditor and consequently it became the prime exporter in the world. Similarly, in the present scenario, Chinese economy has become the largest net creditor with more than $2 trillion in exports while US is on the opposite position. US’ situation is similar to the situation faced by UK post World War I. Reserve HoldingsMoreover, growing Chinese dominance in the international trade requires the trading countries to hold their reserves in Chinese currency. However, Renminbi is not backed by real assets.
In the 20th century, other countries held Dollar because it was backed by gold; to make Renminbi an international currency; it must be backed by some real asset. Further, it should not erode the value of Dollar reserves held by China.
After World War II, high debt British economy fell to Americans who held the largest British debt at that time. Currently, china is the largest creditor to the world. So, if Historical pattern is an indicator that that the reserve currency would be replaced, then it would be Renminbi. GDP Dominance ( 1872 ) Economic Dependence ( 1914 ) Reserve Currency ( 1945 )
5 Falling Empire of the US Dollar Despite the reserve currency status of US Dollar, the current macroeconomic and financial instability in US is adversely affecting the future prospects of US dollar.
First of all, US accounts for 19% of the world GDP in comparison to more than 40% in 1960. Likewise, the huge decline in exports of goods and services raises the question whether US Dollar should still be used as a reserve currency which accounts for 60% of the world forex reserves. DebtThe current US gross government debt has reached 110% of the GDP. This situation is similar to situation in 1924 when gross debt to GDP reached to 136% due to the budget deficit, war financing and Debt. This is reducing the credibility of the world’s largest economy. Subprime CrisisThe 2008 subprime crisis has led the emerging market economies to accumulate reserves other than US Dollar to diversify due to which the confidence of the global markets is decreasing in US Dollar.
Quantitative Easing by US Fed is further decreasing the value of the Dollar foreign exchange holdings and creating a major volatility in the currency markets.
Petrodollar Arrangement-America was the largest oil importer provided an important incentive to other countries to peg against Dollar. Being a monopolized commodity, countries producing oil benefit from Dollar as a reserve currency. Petrol Dollar arrangement is one of the important reasons for Dollar dominance. However, now China is the largest importer of oil. Bilateral agreement between UAE & China for oil purchase in Renminbi and growing trade relations with Saudi Arabia, Russia to establish new oil refineries is challenging the Petro Dollar agreement. The above discussion clearly illustrates that if the value of the dollar depreciates, US debt holders will have to pay more and investments funded with US Dollar will value less.
All these factors are not a positive sign for US Dollar to retain its supremacy. Internationalization of Renminbi; Roadmap towards replacing Dollar Today, China is not only the world’s second largest economy but also the largest Trading economy. However Renminbi trade settlement is meager as compared to the growing Chinese dominance. Hence, it has become necessary for China to internationalize its currency.
6 Besides comparing the Chinese Renminbi with the transition of Sterling to Dollar, another inclination towards Renminbi as a reserve currency is the Chinese internationalization policies. This will further help the Renminbi to become the trade & settlement currency, a financial transaction currency and in subsequently replacing the US Dollar in the near future. Renminbi denominated bilateral swapsMajority of China’s trade with other countries has started getting invoiced in the Chinese currency already. After the sub-prime crisis and in order to internationalize its currency, PBOC (People Bank of China) has entered into Renminbi denominated swaps worth $300 billion with more than 19 countries, further enhancing the trade in Renminbi.
Recently in October 2013, China entered into Forex Swap with Euro zone with the transaction size of 350 billion Yuan and 45 billion Euros.
These initiatives have brought financial stability, enhancing liquidity of Renminbi in the foreign markets, therefore enabling Yuan to become a medium of exchange. Direct Trading and Financing in RenminbiPreviously, USD was required as an intermediary currency to trade Renminbi with other foreign currencies but recently China launched a direct trading platform with Japanese Yen, Australia dollar, New Zealand Dollar and Thai Baht. Another important initiative has been to allow foreign companies to raise money in Renminbi in securities market. Institutions such as ADB & IFC have raised money by issuing Panda Bonds and local Foreign Multinational banks have also issue Bonds in Renminbi.
Foreign Direct InvestmentsCurrently, China represents around more than 9% of the Global FDI in 2013. More than 50% of the outward foreign direct investment from China is in Renminbi which shows the paradigm shift of merely trade currency to investment currency. Renminbi Internationalization and development of offshore Renminbi centers in Singapore, London and Taiwan are creating more opportunities for Chinese Multinationals for outward FDI in Renminbi.
Invoicing in Renminbi and establishing of swap contracts with other countries illustrate the Chinese motivation to become the lender of last resort in times of crisis and liquidity crunch. Furthermore, it will reduce the exchange rate risk faced by the Chinese companies in the global markets.
7 East Asia’s Local Currency Recent research has shown that Renminbi has become a dominant reference currency (invoicing in Renminbi) leading to the De-Facto Renminbi currency block in East Asia. Seven countries out of the ten countries in East Asia are tracking Renminbi more closely than Dollar due to the rising trade prospects with china.
Emerging markets also account for 67% of the China’s imports and 56% of its exports. It is more beneficial for these countries to have a stable exchange rate with China. So, presently Chinese Renminbi is becoming East Asia’s local currency. It is too early to say whether or not in the near future Renminbi will replace the USD worldwide but in East Asia it has already replaced the USD to a certain extent.
Post 2010, 18% of China’s exports has been settled in Renminbi. Renminbi has become world’s 9th most traded currency in the world in just three years but this number can take a giant forward leap if china adopts the floating rate currency regime.
8 Now, more than 10,000 banks worldwide are offering their customers to settle their trade transactions with China in Renminbi in comparison to 900 Banks in 2011. The pool of offshore Renminbi settlement is around $143 billion dollars which has been into existence since 2010. Now more than 16% of the Chinese trade is settled in Renminbi.
Strikingly, Chinese bond market has grown exponentially from 69 billion Renminbi to 405 billion Renminbi. This paradigm shift shows the potential of Renminbi to replace the dollar in the long term. Since 2012, the Chinese Currency market (CNY Market) has become one of the fastest growing markets worldwide.
Despite being the world’s largest trading nation and the second largest economy, Renminbi’s share in the global trade compared to major currencies is insignificant. Growing CNY market and importance of Renminbi in trade settlement are long term initiatives of China to create an alternative to US Dollar as the world currency.
9 Critical AnalysisThe most important question that Chinese policymakers have to answer is: Would the Chinese Government have more benefits in bringing flexibility in controls in exchange for internationalization of Renminbi? China is aggressively trying to internationalize its currency but the policies adopted to do full internationalization are daunting for a conventional Chinese policymaker.
Cost of being a reserve currency will be higher for China as compared to US or UK because once China liberalizes the capital controls; it will lead Renminbi to appreciate significantly. It was different in case of US because being a consumption driven economy and leader in technology exports faced less currency appreciation pressure. Unlike US, China has a long way before it can become a leader in technology exports.
China’s export comprises of 48% of the GDP and Chinese Renminbi appreciation will adversely affect the competitiveness of its export sector and economic growth. China’s TrilemmaIn 1960, Noble prize winner Robert Mundell inferred that a country at one time can’t have an open capital account, along with control over interest rates and currency. For a country like China which is having a fixed currency rate and restricted capital conversion, it will be a very tough task to decide on the tradeoff between giving up of the controls and Internationalization of Currency.
China needs to have higher financial stability and economic integration than those of US to replace Dollar.
Apart from the above impediments, there are other roadblocks for Renminbi to become the reserve currency which can be imputed to the following factors- 1. Dollar as Safe AssetPost subprime crisis, USD is regarded as the safe haven as it global turnover increase from 2007 to 2013. But in 1940, post crisis Pound weakened and its global share also reduces. This further explains the strong belief of the global investors in the USD.
2. CompetitionEarlier US Dollar had no competition other than Pound but Renminbi is facing competition from the Euro and the SDR (Special Drawing Rights). Euro is the second largest reserve currency with 23.8% share in the global reserves. Growing importance of SDR will also challenge the dominance of Renminbi 3. Dollar Dilemma-. To replace the dollar as a reserve currency it is very important for the Chinese Central Bank to exonerate the Dollar reserves with less volatility in the forex market. 4. Low Inflation and Macroeconomic stabilityTo have the macroeconomic stability and low inflation for the support of reserve currency, a country should have full currency convertibility and free floating exchange rate.
10 It will be a long term goal for Chinese officials to regulate the capital controls because in a short span, the pegged exchange rate and stringent capital control will lead to the unsustainable monetary imbalances in the Chinese economy. 5. Depth of Financial MarketsChinese Securities and Bond market are in its nascent stage. In spite of the broad steps taken by the Chinese policymakers such as creation of high yield junk bond markets, introduction of collateral debt swap transaction for private sector, Chinese bond and securities market is far behind than the developed countries capital markets.
Further, Chinese policy makers also have to take a step to strengthen its derivative market. Moreover, Global investors are not allowed to take part in the derivatives or the money markets.
The above factors such as strong political, economic, social stability factors can only make US economy and Dollar stronger as compared to the Chinese economy. China has to make major restructuring changes in its whole system to challenge the USD. Furthermore, USD can be called as the English language of the Forex Markets because most commodities such as oil are priced in US Dollar just like most people interact in English with each other. ConclusionA conventional wisdom proposes that any successful internationalization process should also complement with the open policies of the government, relax capital controls, flexibility of exchange rate and depth of financial reforms.
Presently, China is not ready to replace USD in the near term and if history is any guide, then possibly by the Year 2040, Oil prices reaching 600 CNY/Barrel causing inflationary pressure in countries like India. The MSCI World Index, all the commodities and Trade will be denominated in the world’s most traded currency. Internationalization of currency is a multi-stage process which begins with promoting local currency as a trade currency than the investment currency before becoming the reserve currency. China is at stage one where it is establishing itself as a trade currency. Thereafter, in the medium term it will be an addition to the other reserve currency or basket of currencies before dethroning the US Dollar.
Renminbi will become an important reserve currency within the next decade but prospects of surpassing the Dollar as the reserve currency in the near term doesn’t look so much probable.
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