Slow internationalization of the Chinese renminbi

Anwar Nasution, Jakarta | Mon, 08/22/2011 7:00 AM A | A | A |-Klipping the Jakarta Post.

The renminbi (RMB) is a potential candidate for a leading international currency. Some pundits have predicted that in the long run the RMB will become one of the anchors of the international monetary system in addition to the US dollar and the euro.

The RMB deserves the international currency status, as China is now the second-largest exporter after Germany and has surpassed Japan as the second-largest economy after the US.

China’s economic growth has been at its highest during the past three decades, ranging between 8 and 10 percent per year, and has become the growth engine for both emerging economies and the global economy.

The export-led development strategy adopted by the People’s Republic of China (PRC) since the 1980s has produced surpluses both in its current account and capital account that has allowed the country to accumulate huge foreign exchange reserve amounting to more than US$3 trillion at present. Nearly two-thirds of the external reserves are held in US Treasury bills and sovereign bonds.

There are three objectives of the RMB internationalization. First, trade invoicing in the RMB eliminates risks for China in conducting international trade and finance both as a unit of account, a medium of exchange and a store of value.

Second, elevation of the RMB status to a reserve currency reduces the need for China to accumulate large external reserves in other major currencies, including the US dollar.

Third, it would fix the structural weakness of the present unipolar international financial system dominated by the US dollar as a reserve currency.

Unlike a domestic currency that is declared by the government as a legal tender, international money is not mandated by the central bodies of the international monetary system, such as the IMF.

The composition of international reserve holdings are decided by individual economic agents and countries.

Making the RMB a global money requires a wide range reforms in China. The present fixed exchange rate system that pegs the RMB to the US dollar at an undervalued rate should be replaced by a free-floating exchange rate system.

To make the RMB fully convertible, capital account should be liberalized and capital controls should stop.

China also needs to nurture a deep, wide and liquid world-class financial center, ending the financial repression, and corporatize state-owned financial institutions that are presently being used as instruments to pursue the government’s industrial and development policies.

In terms of assets and liabilities, the Chinese banks may be the largest in the world, but none of them measure up to the clout of major Western banks in international financial intermediation.

It takes decades and a lot of effort to meet these prerequisites. Only with these modern and market-based systems can the RMB be used as an unit of account, a medium of exchange and a store value for transactions between non-residents of China.

In spite of several calls of the governor of its central bank to shift away from the US dollar, China cannot escape from the present of the US dollar’s preeminence as a reserve currency.

China’s dependency on the US dollar is partly a factor of the structure of its economy, which is only part of intra-regional trade in East Asia.

China serves as an export platform that assembles spare parts, components and other intermediate inputs produced in Japan, Korea and other Asian economies and exports the final products to the rest of the world, mainly the US and EU markets.

China’s exports and imports are expected to be denominated in the US dollar and euro. Energy, raw materials and foods imported by China are also denominated in those currencies.

China will likely use a gradual approach and the ASEAN+3+3 platform (including Hong Kong, Taiwan and Macao) to pursue its objective in making the RMB a global currency.

Unlike in the European Union, this region has no regional economic common market with a single currency.

However, the regional approach makes sense because trade, investment and financial relations between the ASEAN+3+3 countries and China has became closer and deeper, giving its trading partners an incentive to use more RMB for transactions purposes and reserve holdings.

Currencies of several of these neighboring countries are either pegged to the RMB or to baskets of major currencies in which the RMB has a large weight. In some of its immediate neighbors the RMB is accepted as a substitute for local currencies.

For those countries that fix its exchange rate t o the RMB, it is making commitment to monetary, fiscal and other economic policies aiming at maintaining the fixed rate.

Fostering monetary and financial cooperation in the ASEAN+3+3 region also depends on the progress of the CMI (Chiang Mai Initiatives) and ABMI (Asian Bond Market Initiative). Like the European Financial Stability Facility (EFSF), the CMI provides liquidity supports in addition to the IMF facility to member countries of ASEAN+3 against financial turbulence.

As they are denominated in local currencies, ABMI reduces currency mismatches and builds deep and resilient regional capital markets. The meeting of ASEAN+3 Finance Ministers in Madrid in 2008 multilateralized the CMI, and enlarged the size of the facility. This was a giant leap toward greater political cohesion in the ASEAN+3 countries as, for the first time they transferred some national powers to a regional institution.

China has taken three steps toward the internationalization of the RMB. First, in April 2004 China introduced a pilot Trade Settlement Scheme (PRTSS) that allows eligible enterprises in China to settle trade payments in RMB with their corresponding enterprises in Hong Kong and other countries. This allows for the invoice of exports and imports from and to selected countries in RMB.

Eligible enterprises in Hong Kong are allowed to open corporate RMB accounts at selected banks in Hong Kong. By the end of 2010, more than 67,000 exporters in 20 provinces in China were licensed to invoice in RMB.

The PRTSS Scheme started with trade between five main cities in China with ASEAN+3 countries and now has been expanded to other cities in China and other regions in Central Asia, Europe, Latin America and Africa. The value of the scheme has also been expanded rapidly from a modest beginning at RMB 5 billion in the first quarter of 2010 to more than RMB 100 billion at present.

Second, it has allowed for the issuance of RMB denominated bonds in offshore markets. Five state-owned Chinese banks issued RMB bonds in Hong Kong in 2007 and were followed by foreign institutions including HSBC, IFC and ADB.

To set benchmark risk-free interest rates for RMB debt instruments for Chinese companies, the authorities issued sovereign bonds denominated in RMB in Hong Kong on September 28, 2009. With huge external reserve holdings, China does not need to borrow to finance its budget deficit.

The third step to expand the use of the RMB for trade settlement was the provision of a currency swap facility with nine countries, including Indonesia, during the Global Financial Crisis in 2007-9. The currency swaps allowed China to receive payments in RMB for its exports to the participating countries.

China collects seigniorage from foreign holdings of the RMB. On the other hand, China has to maintain the RMB outside its boundaries, controlling counterfeiting and providing depository vaults for new currency available to be exchange for old RMB. For these purposes, China has opened RMB trading centers in Hong Kong, Singapore and Taipei.

The writer is professor of monetary economics at the University of Indonesia. He is also a former senior deputy governor of Bank Indonesia.