Saturday, December 15, 2012

The RMB as a Reserve Currency: Breaking Habits of Thought

The economic power and influence of China continues to grow. In September, 2009, I wrote the following:

The last line of reasoning I considered appears to be the most probable. It is simply that China's wealth is indeed denominated in the $US, and they are just doing enough to hold the $US from free fall. The reason is that this allows them time to use the $US, which they are still accumulating in large quantities, to prepare themselves for the post-$US world. Returning to the speculative post in which I imagined what I might do if I were China, I suggested that they would also diversify their holdings into commodities (in particular gold), other currencies, and would continue and accelerate their purchase and control of commodity/resource companies.
Some quotes from a recent article from AFP:

Chinese firms have become more active in mergers and acquisitions since the global financial crisis that began in 2008, as economic distress has thrown up bargains around the world.


Between 2005 and 2011, the number of China's overseas acquisitions tripled to 177 and jumped five-fold by value to $63 billion, according to law firm Squire Sanders and intelligence service Mergermarket.


But academics said more was at work than commerce, as China seeks growing stature and competes with other countries for resources.
If you can cast your mind back to 2007, how did you think of China? The AFP reports on the unease being felt by China's growing influence. If jumping back in time to 2007, if somebody had suggested that China would be this influential, would you have taken them seriously? Whilst China was seen as important, the idea that China would be causing this kind of unease would have been dismissed as fanciful. Another point that I long ago made, at about the same time as discussing China's potential shopping spree, was that China would seek to displace the $US as a reserve currency, and develop the RMB as a potential replacement. This from April 2009:
I have a very curious sense at the moment of the world moving in slow motion. I had thought that the economic crisis would create dramatic moments, but in some respects it appears to be moving through a gradual shift.

One of the predictions that I have made, on two occasions, is the collapse of the $US and the end of the reserve status of the $US. However, it appears that the end of reserve status is being achieved with little drama, as it is apparent that the RMB is slowly but surely being positioned as a replacement of the $US as the reserve currency. We have this latest news from the China Daily:
Five major trading cities have got the nod from the central government to use the yuan in overseas trade settlement - seen as one more step in China's recent moves to expand the use of its currency globally.
From these modest beginnings, the process of moving the RMB to reserve status has continued, and I have occasionally given examples in my posts. This is recent development:

Cracks are beginning to appear; the latest sign is that China and South Korea have come to an agreement in which banks from either country are able to borrow funds from a swap line that makes loans available to companies for deals in local currencies. (Source: “China, South Korea to Boost use of Local Currencies in Trade,” Bloomberg, December 4, 2012.)

This is analysis from Reuters:

Fed up with what it sees as Washington's malign neglect of the dollar, China is busily promoting the cross-border use of its own currency, the yuan, also known as the renminbi, in trade and investment.
The aim is both narrowly commercial - to reduce transaction costs for Chinese exporters and importers - and sweepingly strategic.

Displacing the dollar, Beijing says, will reduce volatility in oil and commodity prices and belatedly erode the ‘exorbitant privilege' the United States enjoys as the issuer of the reserve currency at the heart of a post-war international financial architecture it now sees as hopelessly outmoded.

Zha Xiaogang, a researcher at the Shanghai Institutes for International Studies, said Beijing wants to see a better-balanced international monetary system consisting of at least the dollar, euro and yuan and perhaps other currencies such as the yen and the Indian rupee.
However, I would not want to give a false impression that everyone thinks that the RMB as a reserve currency is likely. For example, this rather curious article from Forbes gives a consideration of the many ways in which the RMB's status is accelerating before then oddly concluding:
Does all this mean China is about to overtake the dollar as the world’s reserve currency? Not anytime soon. A reserve currency, in our view, requires deep and credible government bond markets, an open capital account and critical mass in global financial systems. China’s central bank has laid out a 10-year plan for “internationalization” of its currency. China’s FX bands are widening, but in an incredibly cautious way. Dollar holders need not panic.
Indeed, most articles, including the Reuters one quoted earlier, give caveats, express doubts etc. It is all rather odd, as the expansion of the international role of the RMB is an actuality. Indeed, as long as I have been tracking this steady expansion, the same things are said with each new step, and always that reserve status is something for the distant future. There is a growing conflict between what is taking place, and the analysis of what is taking place. This is a habit of thought and I made the point in an article for Trade and Forfaiting Review in November 2009:

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?

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.
I do not have a copy of the full article to hand, but recall that I argued something along the lines of the $US as a reserve currency was a habit of thought, rather than a rational assessment. Time has moved along since I wrote the TFR article, and time has supported my case, and still there is a sense that it just isn't possible, even though the step-by-step expansion of the RMB into a reserve currency progresses forwards.

However, at this stage, I am not so certain that the RMB will be the major reserve currency, but not for the reasons that are generally given (e.g. deep bond markets). As regular readers will be aware, I am increasingly cautious about the overall position of the Chinese economy. I am not entirely convinced that China can sustain its economic miracle and, as ever, see political risk in any major slowdown in the growth of the Chinese economy.

Nevertheless, if China does manage to continue its growth, then the indications are that it will continue to chip away at the reserve status of the $US. Returning to the start of the post, the influence of China continues to expand, as the Chinese state encourages firms to seek out and purchase access to resources, and also expand internationally. It is but one example of the astonishing growth in China's economic heft. That influence is being felt throughout the world, and the influence just further enhances China's credibility as a 'major player', and that, in turn, enhances the credibility of the RMB as a reserve currency. Set against this, the economic policy of the US can only continue to erode the influence of the $US. The following is a commentary on the $US and the challenge of the RMB:

Rome in its day held the reserve currency of the world, and how the mighty have fallen. Unless real changes are made, we might be witnessing the beginning of such a shift here. The rising U.S. debt levels are raising questions by many countries around the world as to the legitimacy and viability of the U.S. dollar as the reserve currency.
Politicians in Washington must wake up to the realization that the U.S. dollar’s status as a reserve currency is not written in stone. The financial markets are currently more dynamic and fluid than ever before. It takes only the click of a mouse to move money around the world.
Unless America gets its fiscal house in order, I believe we will see more agreements, such as this one with China and South Korea, which will avoid the U.S. dollar and increase the continuing questions about the viability of its reserve currency status.
The author has a point. After all, if the $US was not already the reserve currency, would you pick it out as a new reserve currency? I think that this unlikely, but perhaps you would disagree?


  1. Michael Pettis strongly disagrees :

    "anyone who follows the Chinese financial system closely knows that China is decades away from having the kind of financial system that is consistent with important – let alone dominant – reserve status."

    1. Thanks for the link. I had a (very) quick look through. The first problem I noted is that he seems to think that the disadvantages (as he sees them) mean China will not seek reserve status. However, their actions speak louder than theory.

      It is also interesting in that the question of the de facto progression to reserve status is questioned. However, he notes the argument about currencies tracking the RMB but ignores the large numbers of bi-lateral deals being made by China for trade purposes.

      As I said, a very quick read.


  2. If the US$ were not a reserve currency, presumably fewer dollars would be bought and the price would fall. This would reduce US living standards but improve their long-term competitiveness. COnversely, a role for the RMB as a reserve currency would boost its value, and the living standards of people in China, but reduce their competitiveness and long-term rate of growth.
    Tempting to conclude that the Chinese will err on the side of caution, at least until they are reasonably sure they can out-compete the US on skills and technology, not just price.


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