Friday, December 27, 2013

China's Renminbi Will Not Receive Global Reserve Status for a While

Since its Open Door Policy in 1978, China has seen considerable progress made in its economic growth, development, and integration into the global economy. It has become the world's second largest economy. Even so, is the renminbi (人民币) strong enough where foreign central banks want to hold Chinese currency reserves, or does China need to improve first before acquiring this "soft power?"

For a currency to be internationalized to the point of becoming a global reserve currency, both private and public institutions would need for it to be comparably convenient to use a foreign currency in economic transactions. In the case of the renminbi, that would mean that its macroeconomic and monetary policy needs to be in order, or at least compared to other major economies. China has already attempted to internationalize its currency by creating a separate offshore renminbi market known as the CNH. According to the International Monetary Fund, Hong Kong is having marginal success with integrating the CNH into its economy. If China is to internationalize its currency, it will help bring greater global financial stability. However, if China is going to become an international currency on par with the United States dollar or the euro, China will need to focus on liberalizing its monetary policy.

One of the issues with the renminbi is that it is not completely convertible, which means that the currency can converted into liquid stores of value (e.g., commodities, foreign currencies). Due to the East Asian Financial crisis of 1997, China has yet to make capital accounts (especially securities and assets) convertible because the Chinese government believes that a "repeat of history" would cause hot money to cross the borders rapidly and cause economic decline. Even so, the Chinese government hopes to have a fully convertible currency in the upcoming quarters. Having these capital controls in place are problematic because removing capital controls is a prerequisite of internationalization. However, since China still has a fragile financial system (Bank of International Settlements, p. 8), these controls will not be removed for at least a few years.

If China is going to be an international currency, it needs to deal with its exchange rate issues. For one, it needs to take the renminbi off the managed floating exchange rate. Although it is an improvement from a fixed exchange rate, the renminbi needs to be able to be in a purely floating exchange rate to become more internationalized. There is a matter of China's currency manipulation. While it does exist, we have to remember that China is hardly the only country that manipulates its currency. Even so, it will need to continue its trend to curtailing that manipulation, and allow for the renminbi to appreciate to its market value. With the opening of capital markets, China will have a more difficult time managing the exchange rate.

Much like the Federal Reserve Bank, the People's Bank of China (中国人民银行) likes to keep its interest rates artificially low. Although there is an improvement of relaxing interest rate controls, China could relax them a bit more. China could replace its current interest rate mechanism with a more liberalized one, which will be difficult because China's use of the interest rate is an essential monetary policy tool (Shen, 2013).

Aside from monetary issues, there are other issues China would need to overcome. There is the matter of the prestige effect, which is to say that the United States dollar has seignorage in terms of being the "globally recognized currency." China would also have to run some massive trade deficits to increase its international money supply, which goes against their export-growth model. China does not have deep or wide enough financial markets because capital controls make it nigh impossible for a non-resident to acquire renminbi assets. The same goes for China's fixed income security markets.

It might not be happening as quickly as some would like, but China's markets are becoming more liberalized, which is a prerequisite for acquiring full currency internationalization. Although the renminbi is becoming more prominent in trade and has some currency-swap agreements within the region (BIS, Table 3), China will need to implement various monetary and banking policy reforms at home before the renminbi fully can become a global currency.

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