China's yuan could become a reserve currency in future if the country undertakes further economic reform, International Monetary Fund managing director, Christine Lagarde, said in a speech on Sunday.
The IMF chief, speaking to a gathering of leading Chinese policymakers and global business leaders, added that China needed a roadmap for a stronger, more flexible exchange rate system.
China operates a closed capital account system and its yuan currency is tightly controlled, although Beijing has said it wants to increase the international use of the yuan to settle cross border trade and has undertaken a series of reforms in recent years to that end.
Following a pattern that China long ago established, this is another piece of news from Reuters:
And later in the article:
Japan will buy 65 billion yuan ($10.3 billion) of Chinese government debt, the country's finance minister said on Tuesday, giving China a mark of approval in the credibility of the yuan as an international currency.
Other countries are investing in China through state agencies, but Japan's investment is by far the biggest in the yuan. As a currency with limited convertibility, such bets are symbolic of the shift in global power towards China as the world's fastest-growing major economy.
Japanese purchases of Chinese bonds would also be a sign of credibility in Beijing's long-term efforts to elevate the yuan's status as an international currency. That effort so far has involved China's promotion of the yuan to settle trade.In order to understand why the RMB is gaining ground, I would point to an article that I wrote for TFR magazine. The argument is simple:
Beijing has struck agreements with several nations from Malaysia to Belarus and Argentina on the use of the yuan in trade and other transactions. It has expanded a pilot programme started in 2009 into a nationwide one allowing firms to settle their trade in yuan.
Imagine a world in which there was no international reserve currency, but that an organisation was proposing that the US dollar ought to be the future reserve currency. Would you take such a proposal seriously?We have all simply become so used to the $US as a reserve currency, that it is difficult to imagine the world any other way. This is why I used the idea of imagining a world in which the $US was not already the reserve currency. In a world where the $US was not a habit of mind, it looks like an absurd prospect. Nevertheless, the currency still retains a reserve status, and the diversification out of the dollar is a symptom of the shift in the habit of mind that is all that retains the dollar's status.
Your response might be that the US dollar sits atop mountains of debt, a shrinking economy and you would point out that the US monetary authorities are printing money to fund record government borrowing. You might actually laugh at such a prospect.
On the other hand, how would you view the Chinese renminbi? You might point out that China holds large reserves of other currencies, the renminbi rests on top of a massive current-account surplus, China’s economy is growing and that the prospects for future growth are all positive. Furthermore, China is a country of savers, with a small fiscal deficit and is an export machine selling goods around the world, ensuring an ongoing utility for the currency in trade.
Another way to look at the rise of the RMB versus the $US is in terms of the utility of the currencies. At present, the dollar retains utility in trade, as the US still remains a very, very large economy. However, it must be remembered that the US runs an ongoing current account deficit, such that the utility also includes funding the US current account deficit.The US is a major exporter of goods and services, but still consumes more than it produces. And China is one of the countries that is responsible for the deficit in goods and services, and therefore an element of that utility is financing a current account deficit to fund the purchase of Chinese goods and services.
Although still a very important player in trade, the US gained reserve status for its currency due its former dominant position in world trade. As I hope the previous paragraph suggests, the dominance in trade is diminishing, albeit it is still important. Despite the reducing importance of the US in trade, large amounts of trade are settled in $US, and this is an economic structure that reflected the former position of the US in global trade. It is obvious that China has understood that the road to reserve status is rooted in the utility of a currency in settling trade, and they are using their growing trade strength in order to piecemeal displace the $US. The problem for the US is that it is apparent that, with regards to trade, the RMB has the potential to have greater utility in trade settlement.
The simple point is this. A currency only has underlying utility in its potential to buy goods and services. To use an economist's expression, all other things being equal, the country that produces the goods and services subject to the greatest overall demand should be the natural reserve currency.The currency's value is rooted in demand for its use to purchase goods and services. However, we do not live in the economist's world of all other things being equal; we live in a world in which the way that currencies are managed and the economic policy of the issuer impacts upon the underlying value of the currency. It is here that I return to the point made in the TFR article. Honestly, which currency would win in a world with no history of a reserve currency?
As I long ago argued, the key turning point for the RMB will be the use of the currency as the benchmark for trading in oil. This is what I wrote about the RMB in April 2009:
In short, I argued that pricing and trading in oil in the RMB will be the signal that the RMB has really become a de facto reserve currency. This from Reuters:
However, the real key to reserve status is when trade is more broadly conducted in the RMB, such as move to trading oil in RMB. Perhaps Venezuela will offer such an opportunity? An article here suggests that Venezuela may need to turn to China for financial support, and this may well present an opportunity for China to start this process:
In Latin America, the external funding situation remains relatively stable but in the case of further deterioration of capital flows, the solid economies would be able to tap the IMF or the Inter-American Development Bank (IADB) for non-conditional lines of credit, while the economies with less sound macroeconomic frameworks such as Ecuador, Argentina and Venezuela would most likely only be able to obtain funds through more formal conditionality or by turning to lenders like China.Returning to the question of whether it is possible, I see no reason to prevent the RMB from taking on this role. There has been talk about the RMB not being 'liquid' enough, the lack of depth of their financial markets. However, I take a fairly simplistic view, which is to ask whether a currency has the underlying strength of being able to be used to purchase goods and services. The answer to this question is, of course, 'yes'.
HONG KONG, March 1 (Reuters) - After the impressive success of the offshore yuan trading in Hong Kong, China has now zeroed in on a new hub for its overseas renminbi trading - the Middle East.The same Reuters article later says:
The three-year dream run of the offshore yuan trade settlement plan has given Beijing confidence to look beyond the region and boost the renminbi's muscle power in a big area: oil.
Industry sources told Reuters last Thursday that the Dubai International Financial Centre (DIFC), the United Arab Emirates' financial hub, may permit transactions in Chinese yuan from this year.
"The internationalization strategy should move westward to find a supplementary region to the existing Asian region," said Cao Tong, senior vice president at CITIC Bank, adding that the oil-rich Middle East, Central Asia and Russia would be a good breakthrough.
The amount of trade settled in yuan jumped sharply to 2.08 trillion yuan ($330 billion), grabbing a 10 percent share of the total trade volume in the currency, compared with only 2 percent a year ago.
What is more important is that if yuan is accepted and used by these oil producing countries, it will significantly enhance the currency's status in the global currency system.On this final quote I close my case on why the RMB will likely displace the $US, albeit nothing is certain or cannot be derailed (e.g. a major crisis in the Chinese economy). The surprising part is that it was so evident that this would be the path so long ago, but habit of mind prevented so many from seeing what was right in front of them.
In fact, the dollar's status as a global reserve currency is to some extent also because oil contracts are priced and settled in that currency.
China has already started accelerating its opening up of capital account by allowing yuan FDI and ODI recently, together with an ambitious outline of making Shanghai a global renminbi products innovation, trading and clearing center by 2015.
The timing could not have been better as the yuan is steadily appreciating which makes it more attractive, while the main currency-issuing countries are printing notes to solve their debt woes.