Does internationalizing the RMB make sense for China?

• Author: Huang, Yukon

The last time a Chinese currency was used as an international medium of exchange was four centuries ago, when China's share of global GDP in PPP terms was nearly 30 percent (about twice its current level), the country was a major global trading power, and Chinese copper coins circulated throughout East Asia to India and even beyond (Horesh 2011). In the following centuries, silver dollars and paper bills replaced copper coins and China's share of external trade declined. Now, with China's return to the position of largest global trader and second-largest economy in the world, it is not surprising that discussion of internationalizing China's currency has resumed.

Since the onset of the 2008 global financial crisis, China has taken a series of steps to promote internationalization of the renminbi (RMB). Some observers have taken the financial crisis and weak recovery of Western economies as an argument that the RMB should in the foreseeable future equal, or eclipse, the dollar as the dominant international reserve currency. But despite a number of significant initiatives to increase use of the RMB externally, RMB internationalization is still in its early stages.

The starting gun for serious discussion of RMB internationalization can be dated to March 2009, when People's Bank of China Governor Zhou Xiaochuan called for reform of the international reserve system. Zhou (2009) drew attention to weaknesses of the current international monetary system, which he argued is too reliant on holding sovereign currency reserves (i.e., the U.S. dollar). He urged expanding use of the IMF's Special Drawing Rights and proposed a stronger international role for the RMB in the valuation of SDR.

Zhou's call to reform the international monetary system has since expanded into a broader discussion of internationalizing the RMB. There is now a huge body of literature on RMB internationalization. The focus is on China's progress in RMB internationalization and includes relatively abstract discussions of the merits of liberalization in general and noncontroversial recommendations for strengthening financial markets and institutions.

What the discussion often lacks is a more discriminating examination of why China is pursuing currency internationalization and an evaluation of how internationalization might actually affect policymaking and the Chinese economy. More attention needs to be given to China's longstanding development objectives in relation to the reasons put forth for internationalization--both valid and misplaced in some cases. While internationalization carries long-term benefits such as heightened prestige and influence, greater say in the international system, and improved trade efficiency, there are also increased risks--namely, more volatility, increased exposure to external shocks, and potential loss of control over domestic monetary policy.

A critical examination of these objectives along with the necessary preconditions shows that internationalization is neither feasible nor necessarily beneficial in the short term, as was recognized by Japan and Germany when they were considering this possibility decades ago. Ironically, if China were able to miraculously complete internationalization within the next few years, this could actually run counter to the aims of Chinese policymakers, who tend to be fixated on maintaining stability and control over macro aggregates.

But conditions are currently ripe for China to accelerate key financial reforms that would in principle move the country closer to embracing the concept of internationalizing the RMB in the future. Moving more aggressively in promoting exchange rate and capital account flexibility should now be high on the reform agenda. However, given weak capital markets and the dominant role of state-owned banks, near-term prospects for meaningful interest rate flexibility are less clear, despite symbolic reforms. These reforms would have a greater chance of succeeding if a major fiscal reform were also part of this process. Overall, as China moves forward on financial liberalization, leaders should set aside the question of internationalization and consider whether these key reforms are beneficial for China's economy in their own right.

Motivations for RMB Internationalization

A useful question to consider in divining the motivations behind internationalization is Why did 2008 mark the start of the process? The 2008 crisis did reveal weaknesses and vulnerabilities in the existing global financial system, and may have signaled the failure of the Western liberalized financial order for some observers, but China in Fact was less affected than other major economies. If anything, the financial turmoil in recent years could be expected to have made Chinese policymakers more inclined to retain controls over key financial variables and capital movements than to pursue liberalization.

In principle, China's policymakers often emphasize the importance of self-control or autonomy in economic management. Yet despite its newly secured economic prowess, China is still beholden to a global financial system that underweights its importance. Some have argued that internationalizing the RMB will increase China's geostrategic clout and international prestige, mad allow it to expand its global "soft power." How valuable is this prestige effect is unclear.

A more tangible concern is the priority given to maintaining stability of economic growth. Zhou's paper was released shortly after the U.S. central bank's quantitative easing program, which was perceived lay many developing countries as contributing to more instability in global financial markets and accentuating pressures for them to appreciate their currencies. External shocks to the value of the RMB are of concern to Chinese policymakers for their spillover effects on trade. However, internationalizing the RMB does not necessarily solve the problem of volatility in exchange rates for China. In fact, successful internationalization could actually increase fluctuations and risks as the country relaxes capital controls and moves away from a managed exchange rate regime.

Trade efficiency is a more generally acknowledged benefit of internationalization. Almost half of China's large trade share of GDP is processing trade, comprising parts and components originating from other East Asian countries that are assembled in China for export to the West. These transactions are often denominated in U.S. dollars, even when the trade largely involves movement of products within the region. It is argued that internationalizing the RMB, or expanding its use as a regional Asian currency, could reduce transactions costs and help insulate China and its regional production partners from the exchange rate risks of multiple cross-border movements of processing related components that are currently denominated in a variety of...