Renminbi: the Next International Reserve Currency?

Currency is an iconic expression of a country’s economic dominance. Even if the economic benefits of currency dominance are ques- tionable， countries and their governments do seem to prize that status. Even if currency status is not prized for one’s own currency， at the very least， countries seem to resent the currency dominance of others.The recent economic crisis has led some， including most famously the governor of the People’s Bank of China， to question the legitimacy and effectiveness of having the dollar as the international reserve currency. There are calls to strengthen the role of the real currencies such as the euro， artificial ones such as SDRs， or both as an alternative to the dominant status of the dollar.The question that I will be addressing is not the normative one of the desirable composition and configuration of reserve currencies but a positive one: whether changes in the world economy will lead to or be accompanied by any changes in the status of different currencies as international reserve currencies. In particular， I will attempt to answer whether the dollar will be eclipsed by the renminbi， what will be the timing of this transition， and the prerequisites that will have to be met for the transition to occur.DefinitionAn international currency is simply one that is used outside one’s own country. The greater the use， the more it merits the description of a reserve currency. Foreign governments and/or foreign private agents seek to use the currency of another country because of the three functions that a foreign currency can perform.Although much of the research on international reserve currencies has focused on reserve holdings by foreign governments， it must be emphasized that reserve currency status reflects use not just by governments but also by the private sector for trade and financial transactions. Hence， a meaningful distinction is between a “reserve currency，”which relates to official transactions， and an “international currency，” which includes transactions involving foreign private agents.The quantitative dimensions of the official holdings of reserve currencies are dis- cussed below but it is worth recalling some of the basic numbers relating to international or private-sector dimensions of reserve currencies. More recently， when the dollar has ruled， 45 percent of international debt securities were denominated in dollars (end-2008); the dollar was used in 86 percent of all foreign exchange transactions (2007); 66 countries used the dollar as their exchange rate anchor (2008); for many countries， 70 to 80 percent of their trade is denominated in dollars; oil and most commodities are priced in dollars; and in the shadowy world of crime and illicit transactions， “the dollar still rules”. In some ways， one could argue that private-sector actions are indeed the deep determinants of reserve currency status.Short historyOne way of answering the question of changes in reserve currency status， especially in relation to the dollar and renminbi going forward， is to turn to history. Which countries have enjoyed reserve currency status historically and when and why have there been significant transitions?The dollar made its first appearance as a reserve currency in the interwar years. In this period， the pound and the dollar accounted for roughly equal share of reserve holdings. Although the dollar surpassed sterling around the mid-1920s， they traded places for the top spot afterwards: In 1931， when sterling went off the gold standard in the wake of serious economic problems， sterling reserves fell. But when the dollar went off the gold standard some switching occurred back into sterling.After the establishment of the Bretton Woods system in 1945， the dollar was the de facto reserve asset and enjoyed a near monopoly status. The European currencies， including sterling， were not convertible into gold until 1958. But this dominance of the dollar is not quite reflected in the data because of the persistence of sterling as a reserve currency. According to estimates， the share of sterling in world foreign exchange reserves was higher than that of the dollar until 1954; thereafter the dollar’s share rose steadily， reaching 65 percent in 1973. On other measures of reserves， the dollar had overtaken the pound by 1945.Holding European currencies as reserves started becoming attractive in the 1960s as the European countries began to gradually relax exchange controls for capital account transactions， while the United States generated inflation， and imposed ad hoc restrictions on capital outflows as a way of protecting the balance of payments. This led to the development of the euro-dollar market. The German mark and Japanese yen featured more prominently in official reserve holdings from the mid-1970s onwards， with a corresponding decline in the dollar， according to IMF data.Since the early 1990s， the dollar has made a comeback， and the euro， since its introduction in 1999， has increased its share of global reserve holdings. For much of the post-1973 period， though， the dollar has accounted for a vast bulk of the share of official foreign exchange reserves held by the world.In 1970， a new reserve currency was issued by the IMF called the special drawing right. The shortage would result because there were limits on the amount of dollars that the United States， or any reserve currency center， could supply to the rest of the world in response to the demand for them. If there was too great a supply foreigners would lose confidence in the currency and in its ability to stabilize and hold value. And if the United States responded by reducing its deficits， there would not be enough dollars in the rest of the world to grease the wheels of trade and finance. The solution therefore was to create a synthetic reserve asset to supplement the supply of the reserve currency (and gold).What Determines Reserve Currency Status? A Simple Econometric AnalysisTo be an attractive store of value， the issuing country should have low and stable inflation as well as a stable and relatively strong currency. To be a good medium of exchange and to serve as a unit of account， a reserve currency must be widely transacted and accepted. A country that is large in output， trade， and finance will naturally find its currency widely transacted and hence more likely to be widely accepted.There is a certain circularity or self-reinforcing quality here: The more transacted a currency is， the more there will be an incentive to use this cur- rency as a medium of exchange and as a unit of account， and hence the more it will be transacted and so on. Also， the more deep and liquid the financial markets of a country， the easier it will be to raise money in that currency and hence easier to make payments and easier to store value.Putting all these together suggests that any quantitative analysis of the determinants of a reserve currency must include the size of a country’s economy， trade and external financing， the development of its financial markets， the confidence that investors have in the currency as a store of value， and how extensive its use already is.The future of the Dollar and RenminbiThe preceding analysis suggested that economic dominance in a broad sense (comprising GDP， trade， and net creditor status) is the key determinant of reserve currency status but that there is persistence so that reserve currency shifts occur after those in broader economic dominance. But how long are these lags? History provides some clues. In what follows， we willuse the estimates of economic dominance from Subramanian (2011)， apply the lags between economic and currency dominance from history， and thereby project the timing of future currency dominance. But what does history suggest about these lags?The history of reserve currencies shows that there are in fact two transitions: the rise of a currency from anonymity to dominant reserve currency status， and the demise of a once dominant reserve currency. Persistence tends to delay both transitions: A new currency becomes the reserve currency well after the rise to ascendancy of the economy of that currency and a currency remains a reserve currency even if not the dominant one， well after the economy of that country declines. The impressive fact here is surely the inertia; sterling remained the first-ranked currency for half a century after Britain had ceased to be the first-ranked economic power.But persistence in relation to the first transition seems to have been overstated. The conventional view on persistence is based on comparing the period when the United States became the largest economy (in the early 1870s) and the period when it became the premier reserve currency (around World War II). The rise of the dollar is supposed to have lagged the rise of the US economy by more than 60 years.But both the dating points， for economic dominance and currency dominance， respectively， need to be altered. The econometric analysis suggests that reserve currencies are determined not just by income but crucially by trade and by the strength of the external financial position. While the United States may have overtaken the United Kingdom in terms of GDP in 1870， the United States became economically dominant in the broader sense， surpassing the United Kingdom， only around the end of World War I.The key finding that trade is a significant determinant of reserve currency status combined with China’s growing trade dominance portend strongly for the yuan. And it is likely that the route to renminbi internationalization will be via its increasing use as a currency within Asia because trade links between China and Asia are increasing especially rapidly. Rising trade will then increase the advantage of using the renminbi in Asia， which might engender policy changes such as Asian countries linking their exchange rates to the renminbi， which would further increase the use of the renminbi and so on. Thus， it looks likely that the road to renminbi internationalization is likely to occur via renminbi regionalization within Asia.The historical experience of the other transition， from dominance to demise of sterling is also instructive. On the one hand， the handover was difficult for the United States for reasons of history， namely the inheritance of the sterling area from the era of empire. This inheritance became difficult to eliminate because of the weakness of the UK economy. Any move on the part of holders to diversify out of sterling balances raised the prospect of devaluation， which caused problems for the British government.Today， the environment is quite different. There is likely to be less cooperation between the governments of the United States and China if there were a similar need to manage the transition. On the other hand， today the scale of private flows so overwhelm official flows that transitions are likely to be endogenous and market driven with governments， individually or collectively， less able to control or influence the transition.Before the eyebrows go up at the magnitudes and timing implied by either of these scenarios， one must be careful about their interpretation. These numbers are suggestive about the long run and about the eventual impact of fundamentals， and they are conditional. Many policy changes will need to occur before these fundamentals can prevail.A prominent role for the renminbi as a reserve currency may still be some ways off. The key point is that the renminbi still remains inconvertible for many international transactions， which means that foreigners can use it to purchase goods only within China， with a few exceptions.There are restrictions on the use of renminbi for capital account transactions. Foreigners cannot easily buy Chinese assets and Chinese citizens’access to foreign assets is also limited. Foreign central banks cannot use the renminbi to intervene in foreign exchange markets.China is seeking a dominant role for its currency and working gradually but consistently toward it (Governor Zhou Xiaochuan’s demarche in late 2009 in favor of the SDR is now widely interpreted as an aberration and not as a signal of China’s true intentions.) The strategy toward renminbi internationalization might be described as typically Chinese in two respects. Highly interventionist means are being used. The opening is controlled， discretionary， and micromanaged， even if the ends are liberalizing. One might describe this aspect of Chinese strat- egy of currency internationalization as interventionist opening， targeting transactions， countries， and companies rather than liberalizing across the board as some European countries did in the 1960s.Consider the various actions taken in this direction. The actions to internationalize China’s renminbi are coming so fast and so furious that it is becoming difficult to keep up with them. In 2009， in what was hailed as a significant departure from the status quo and a signal of future intentions， China issued renminbi-denominated sovereign bonds amounting to RMB6 billion to offshore retail investors in Hong Kong in a move to provide foreign investors with an attractive means by which to hold renminbi and to create an offshore market to set the benchmark “risk-free” interest rate for renminbi debt instruments， thereby paving the way for further issuance by mainland borrowers in the offshore bond market. And in April 2011， Singapore announced that transactions could be settled in renminbi， paving the way for further internationalization of the Chinese currency. As of this writing， gross bond issuance in renminbi is expected to reach between US$180 billion and US$230 billion in 2011， from virtually nothing just a few years ago.Above all， it seems increasingly clear that China seeks reserve currency status for the renminbi not least because it offers China the political exit from its current mercantilist strategy. The funny thing about currency dominance， of course， is that it is not an unalloyed blessing. It might even be a poisoned chalice. Both the economic fundamentals and the policy changes are more China’s to realize than they are America’s to prevent. Indeed， faltering US performance could hasten the transition away from the dollar. But strong US performance may be able to do little to arrest the move in favor of the renminbi. The fate of the dollar is thus more likely to be in the hands of the Chinese rather than those of the United States.(Author: from the Peterson Institute for International Economics)