China's Progression to Reserve Currency Status

When I first suggested in April 2009 that the RMB might develop into a reserve currency that displaced the $US, I recall that the comments ranged from surprise, through to 'don't be silly' (or words to that effect). Fast forwarding to the present, and the idea is now firmly in the mainstream, albeit without the part about displacing the $US. This is from Reuters:

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:

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.

And later in the article:

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.

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.

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:

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.

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.

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:

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'.

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:

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 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.

The same Reuters article later says:

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.

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.

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.

China and Treasuries - A Puzzle

Perhaps some readers may think that I am obsessed with China as, once again, China is the central subject of this post. A long while back I speculated on what China might do as the current economic crisis unfolds (yes, it is still in full swing). The basis of my speculation was quite simple; I simply thought about what actions I would take if I were in the position of China.

My first thought was that it would be vital to move reserves out of the $US, which would mean offloading treasury positions. I was unsure at the time about how this might be achieved without spooking the entire market, and destroying the value of the remaining holdings. As it was, the exit method is relatively simple and involves shifting holdings from long term debt into short term, and simply not rolling over the existing debt. It turns out that China has been making this shift for some time, but remains a net buyer of treasuries:

For instance, the report showed huge central banks such as Japan and China remained buyers of U.S. assets. China's holdings of U.S. Treasuries rose to $800.5 billion in July from $776.4 billion in June.

The same report showed a net outflow of capital from the US, and this makes the ongoing purchase of treasuries by China ever more curious. Of particular note is a recent article in the Shanghai Daily, which will reflect the official government 'line'.

AS the global economy appears headed toward recovery, concerns are growing that the United States' addiction to massive fiscal stimulus as an economic panacea could eventually lead to an even bigger crisis - a loss of confidence in the US dollar.

Nobel Prize-winning economist Paul A. Samuelson raised the specter of a "truly global financial panic" if countries funding the US deficit, particularly China, decide their investments in US Treasury securities are no longer safe.

Warren Buffett warned in The New York Times that side-effects of the current fiscal intervention could be as dangerous as the financial crisis recently averted - in the form of inflation eroding the dollar's purchasing power.

Preserving the dollar's strength has importance far beyond protecting American tourists from the shock of paying the equivalent of US$25 for a hamburger in London or Tokyo.

Economic experts are concerned about the dollar's health for a number of reasons. Most importantly, the scale of current trade and spending imbalances puts heavy downward pressure on the dollar's value over the long term.

The US imports far more goods and services than it exports, flooding international markets with dollars and undermining their value.

The Chinese 'line' on the $US and the actions of China contradict one another. The standard explanation for this is that China simply can not afford the destruction of the $US, as the two economies are tied inextricably together. Such an assertion would suggest that China sees a future in which it just continues to fund US consumption forever. When the switch into short term debt is considered, this is simply unbelievable. One way or another, China knows that it must move off the treasury treadmill. Why they have not already done so remains a puzzle, but they must begin a retreat soon. In particular, the $US slide seems to be gaining momentum, with Geithner's remarks on the future status of the SDRs as a reserve asset pushing the decline further:

The Dollar Index, which the ICE uses to track the dollar against the currencies of six major U.S. trading partners, dropped to as low as 75.915, the weakest since Sept. 22, 2008, before trading 0.2 percent down at 75.944.

One explanation for the weakness of the $US is that economic recovery is providing an incentive to move into higher yielding assets. This from Bloomberg:

The dollar fell to a one-year low against the euro and weakened versus the yen on speculation the global economic recovery is gathering strength, encouraging investors to buy higher-yielding assets.

A contrast to this explanation was issued a few hours before this post, and comes from China's Xinhua news:

The Fed began its two-day monetary policy meeting on Tuesday and would announce rate decisions on Wednesday. The central bank is widely expected to leave key rates unchanged at historic low level, and its statement after the meeting would be fundamentally same with previous statements.

If the statement is in line with expectations, it means that the Fed would keep its ultra-loose monetary policy for a while, increasing pressures upon the dollar. Any unexpected signal could spark big fluctuations in currency market.

It was reported that U.S. is proposing a broad new economic framework to tackle global economic imbalances on the Group of 20 financial summit due later this week. The framework may lead to weakness in the dollar, analysts said. It prompted investors to take profit from the greenback's gains in previous sessions.

It is very clear that the line in China is that it is US profligacy putting pressure on the $US (a view shared by myself). It is very clear that, if Chinese news sources are following the official government line (the normal practice), the Chinese government has concluded that a $US fall must take place. This makes the ongoing purchase of treasuries ever more puzzling.

I did speculate that perhaps, just perhaps, China is hoping that the US will reverse the current policies (in particular in the face of Chinese complaints). However, the more I thought about this, the less probable it appeared to be as a credible explanation. There has been absolutely no indication from any arm of the US government of any indication of any reversal of current policy. Unless there have been some substantive assurances given behind closed doors, it appears highly improbable that China might hold any hopes for change.

Another line of reasoning I followed was that China simply does not want to be seen as the country that 'pulls the trigger' on a $US collapse. Once the crisis takes hold, they will be able to stand back and suggest that they did all they could to support the world financial system - despite US profligacy. Once again, however, I am not entirely convinced with this argument. Compared with the diplomatic gains, the potential economic losses make this appear to be a very poor trade off. I am also not convinced that China would be that concerned with such niceties, as they will in all cases be able to point to their requests for responsibility from the US and their patience when the US continued to devalue their assets.

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.

With regards to gold, it is now no secret that China has been purchasing gold (600 tons - though are now planning to buy domestic production of gold), and also other commodities (though there are some suggestions that this is easing back). There are also hints that China is going to restrict supply of some of their own key commodities, which will support a growth in high tech industry. Also, with regards to securing access to resources, China appears to be accelerating a process that had already started at the time I made the speculative post. A friend kindly pointed me to a recent article in the FT on this subject:

China’s sovereign wealth fund is deepening its holdings in commodities by investing about $850m in Noble Group, a Singapore-listed commodity shipping and trading company with deep roots in China.

In the past two years, CIC has shifted its emphasis from dollar investments in financial firms, including Blackstone and Morgan Stanley, to investments in commodities groups and hard assets including real estate.

With regards to currency, the $US 50 billion purchase of SDRs is one form of diversification, and perhaps ties in with the ambition for the RMB to displace the $US as the reserve currency. My aim here though, is not to restate my arguments for why the RMB might succeed, though yet further signs can be found of the ambition in action:

[regarding the purchase of $50 billion of IMF SDRs] But the agreement stated that China will pay the IMF up to 341.2 billion yuan ($50 billion), also known as renminbi, for the SDR bonds, based on the Aug. 25 exchange rate [...]

But Zhang also noted several other, more intriguing possibilities about how the IMF could harness the yuan soon to end up in its hands.

It could use yuan to buy assets from other financial institutions or for issuing loans, hence spreading the Chinese currency more widely.

"This would signify that the renminbi, to a certain degree, would replace the dollar as a global reserve currency. It would be an important impetus for renminbi internationalisation and it would have a negative influence on international demand for the dollar," Zhang wrote in a research note.

What all of these points are driving to is that China might be just providing enough support for the $US through bonds to prevent a free fall of the $US. The motive might be that they are using the time of instability to prepare for a post $US world, and are seeking to position themselves to ride out the storm that would follow a major fall in the $US. It is no more than speculation, but they may simply be preparing for the troubles ahead, whilst their $US have some use and value.

So far, so interesting, as they do appear to be following the most logical strategy for a country in their current position. However, I also speculated previously about the next step in the strategy over and above the points I have already mentioned. In particular, if the $US falls dramatically, and there is plenty of speculation on this end emerging in the mainstream media recently, what would China do in this situation?

My argument was that China would, as soon as a $US rout looked realistic, sell hard and fast into the market, and seek to recover as much value from the $US holdings before hitting the bottom. I speculated that they would likely have a contingency plan in place, including a floor at which they would stop selling and hold. In the event that this kind of scenario took place, the US economy would go into severe shock, along with the institutions of government. No doubt, just as China has prepared for this contingency, I am guessing that the US is likewise prepared. My guess is that they will have a plan to stem the tide, but also that they will be playing the role of King Canute.

In the economic aftershock, China will still be left with significant holdings of US assets. In some respects, these will be of little value. However, my speculation is that this would provide a vital element in China's bid for economic ascendancy. In particular, they could use their new found economic strength to go on a shopping trip in which they would seek to purchase leading US companies, and in particular companies with leading edge technologies. The economic position of the US government will be so dire that they will seek any form of an infusion of capital and overseas currency into the country, and will not be in a position to block any Chinese moves on US companies, with the sole exception of industries that are directly related to the defence sector.

In this scenario, China might be able to jump up the technology ladder at a rate that would otherwise be impossible. It would facilitate the step up the value chain that is necessary for China to achieve economic super power status. This from a recent Xinhau news article, in which they report on the Chinese Premier, Wen Jia Bao, as suggesting that the economic crisis presents risks and opportunities:

China has the capabilities of taking over the commanding heights in the fields of economy and science and technology, said the premier.

He highlighted the importance of choosing the correct new and strategic industries that can play a supportive role for the country's current economic and social development. China must master key technologies, otherwise, the country might be controlled by others, he stressed.

Wen said that China needs industries that have broad prospects, consume less energy, have a larger impact on other sectors, offer more jobs and make more money. "We must select and develop new and strategic industries with an international view and strategic thinking," he added.

A total of 47 academicians, professors, experts, entrepreneurs and industry leaders attended the meeting and gave their views on the issues of these new industries.

It is very clear where China's ambitions are directed and they simply reflect the ambitions of most countries. The difference is that China is increasingly moving into a position where those ambitions might be achieved.

As with my original post, the one in which I speculated on China's actions, I can only speculate here, and would emphasise that it is no more than speculation. There are a few problems in the argument, such as why China might undermine the $US with negative statements, if they seek to prepare for a post $US world, and need the $US for preparation. This appears to contradict the argument, and can not be explained. Many elements of my previous speculation have been enacted by China, but they are nevertheless still net purchasers of treasuries, against my expectations. It may be that I am missing something, but I have yet to find any explanation other than the one that I have suggested here.

As ever, and in particular with such a speculative post, comments and thoughts are welcomed. Perhaps there is a more mundane explanation?