The internationalization of China's currency, the Renminbi (RMB) or yuan, has accelerated since the global financial crisis. On the one hand, die rate at which China is overtaking the United States as the largest economy in die world sped up because of the lingering effects of the crisis on U.S. growth and the fact that China weathered the crisis very well. On the other hand, global and Chinese confidence in die dollar and U.S. financial institutions was seriously undermined by die crisis. China's central bank governor, Zhou Xiaochuan, wrote an article in 2009 criticizing the dependence of the world on the dollar and launching a period in which China actively promoted the internationalization of its currency (Zhou 2009).
Initially there was steady and rapid increase in measures of internationalization, such as the RMB's share in global payments (Figure 1). However, the growth came to an end in the middle of 2015, and since then China's share has declined modestly. There was also an expectation that China's growing role as a source of development finance would enhance the importance of the RMB. China in the period 2012-14 lent about $40 billion per year to developing countries for infrastructure projects, including along the Belt and Road, according to updated AidData (Dreher et al. 2017). Curiously, most of this lending is in dollars and only 2.6 percent was denominated in RMB.
How do we understand the stalled progress in the emergence of the yuan as a major currency? China's prospects to be the largest economy in the world in about 10 years have not changed. But other factors that are relevant for reserve currency status are coming increasingly into play. Prasad (2015) identifies several factors that are relevant to reserve currency status, in addition to market size: open capital account, flexible exchange rate, macroeconomic policies, and financial market development.
In addition, there is a significant literature relating financial market development and macroeconomic policies to underlying institutions such as property rights and rule of law and open political institutions. At the moment, China has institutional weaknesses that hamper its emergence as a major reserve currency country. It also has limitations on capital account openness and exchange rate flexibility that are more in the nature of short-term impediments.
The next two sections focus on (1) the institutional weaknesses that are long-term impediments and (2) the current situation with macroeconomic policies, the capital account, and the exchange rate. It is not surprising that the initial enthusiasm over RMB internationalization has waned to some extent: China is a long way from meeting the conditions to be a major reserve currency country.
Evolution of Institutional Quality in China
The issue of institutional quality in China presents something of a puzzle. In genera], we think that economic institutions such as property rights and the rule of law are fundamental to long-run growth (Acemoglu, Johnson, and James 2001). However, China appears to have rather poor institutions, and yet has grown at about 10 percent per year for four decades. One resolution of this paradox is to think of institutions relative to development level. China emerged from the Mao era and the Cultural Revolution as one of the poorest countries in the world, poorer than Sub-Saharan Africa. It began its economic reform under Deng Xiaoping with a series of institutional reforms that dramatically increased incentives to invest and produce: the household responsibility system that restored family farming, opening of a growing number of cities to foreign investment and trade, and legalization of private firms (Eckaus 1997). Unfortunately, there are no consistent measures of institutional quality from this early era, but the basic picture emerges from an examination of data from the mid-1990s.
Empirically, there are a number of options for measuring economic institutions. I prefer the Rule of Law Index from the World Governance Database, which "captures perceptions of the extent to which agents have confidence in and abide by the rules of society, and in particular die quality of contract enforcement, property rights, the police, and the courts, as well as the likelihood of crime and violence." The index, which has a mean of zero and standard deviation of 1.0, is available for a large number of countries.
In general, measures such as the Rule of Law Index rise with per capita GDP, though in fact the fit is not that tight and there is a lot of dispersion (Figure 2). Most developing countries have below-average institutional quality, but, as noted, there is large dispersion. Figure 2 illustrates Rule of Law 1996 (first year available) and log per capita GDP in 1990.
China was measured to be about half a standard deviation below the mean on the index: it did not have especially good economic institutions. However, it was above the...