The future of the renminbi and its impact on the Hong Kong dollar.

• Author: Yue, Eddie
• Position: Essay

This article outlines our thoughts on the following three issues. First, will the renminbi become an international currency in the foreseeable future? Second, what does the international use of the renminbi mean for Hong Kong? Third, should the Hong Kong dollar exchange rate be repegged to the renminbi?

Will the Renminbi Become an International Currency?

There is no standard or textbook definition of an "international currency," but a simple and intuitive definition would be that an international currency is one that is widely used outside its home country, for trade invoicing and settlement, reserve holdings, and as an exchange rate anchor for other currencies. To become an international currency, a currency must be perceived as sound, and market participants must be willing to hold it as a store of value. It should also be convertible so that nonresidents can acquire it.

It is nevertheless obvious that only a handful of currencies in the world have enjoyed the status of international currencies. One important determinant of such a status seems to be the size of the home economy. A large trading nation will naturally generate a large quantity of foreign exchange transactions with at least one leg in the home currency. Size also matters in terms of the presence of an open and developed financial market, which supplies assets denominated in the local currency that are demanded by international investors. It also seems that the significance of the major currencies in international trade and financial transactions changes only slowly over time. An international currency, like domestic money, derives its value because other economies are using it. As a result, there is inertia in favor of using whatever currency has been the international currency in the past.

In Asia, there are indications of an increasing use of the renminbi outside Mainland China. In the "border trade" between residents of China and some of its neighbouring economies, the renminbi is often the preferred currency for settlement. Most notably, since the launch of renminbi banking business in 2004, Hong Kong is the first place outside the Mainlined to have banks providing renminbi deposit taking, exchange, remittance, and card service. A further major breakthrough was the issuance of the first renminbi bonds in July 2007 by the China Development Bank. (1)

There are good reasons to expect that the international role of the renminbi will gradually increase over time. Already the fourth largest economy and the third largest trading nation in the world, China continues to rise rapidly as an important force in global trade and production. Inflation has been low and stable inside China. Meanwhile, the renminbi exchange rate is gaining flexibility within a framework that has been put in place and continuously refined since July 2005. Significant steps have also been taken to gradually liberalize the country's capital account transactions. Being the currency of a...