Huaying Liu
Renminbi
It is probable, but not inevitable that the Renminbi will become the next reserve currency. Although China has begun implementing changes with the attempt to build the foundation that supports the Renminbi as the next reserve currency, there is still a long way to go in achieving this goal.
A History Lesson1
US dollar overtaken UK Pound Sterling during the WWI by supplying weapon and food in exchange of war bonds, as well as American bonds which have been kept by the UK over the last 100 years, reversing their positions as net debtor/creditor at the end of 1915.
WWI has destroyed European productivity, their demand for American products increased even after the Great War, making America the largest exporter.
However, the US dollar could not penetrate the large British Empire, which accounted for one fifth of the Earth's continental surface, forming the British economic bloc.
It then comes the Second World War. To defend the attack launched by German submarines, Britain was forced to sell eight islands to America. The islands are used by US as military base that guard against any attacks along America's eastern costal line, as well as from the Caribbean Sea. US further encroached British assets as Britain had to sold the shares of its largest companies at a discount, such as the American Viscose Company, in order to maintain war supply.
The Land-Lease Agreement further eroded the UK Pound Sterling, it left Britain with large debts after the WWII. The Bretton Woods system essentially ended the last hope of the UK Pound Sterling, it destroyed the economic barriers into the British Empire. The WWII left Britain with very weak productivity, it had no choice but to accept the new system, which has since rendered the US dollar the most important reserve for other nations.
The Problems to be overcome by the Chinese
Comparing the current situations in China with that of the US at the early 1900s, while there are a few similarities, the disparities nevertheless illustrate China's current problems. Changes must be implemented for the RMB to become freely convertible without dragging China into a long recession.
Although China has become the largest exporter and the largest creditor of US, it does not have the economic dominance and military power that were enjoyed by the US at the early 1900s.
(1) Capital Controls
China restricts the inflow and outflow of funds, keeping the investment and exchange rate under control. The Chinese financial market is also underdeveloped, with small equity and debt markets and undereducated investors .
Renminbi cannot become a reserve currency without being freely convertible by other currencies to be held as reserve. Countries holding the reserve currency also look for ways to invest it in the capital market, and the Chinese financial market would have to be efficient and deep enough to absorb large foreign investments.
China cannot release its control over the capital account in the short term, as it could lead to rapid Renminbi inflation, causing export to collapse, stock market bubbles and real estate bubbles. China must learn from the Plaza Accord which not only destroyed Japan’s export but left it in recession for more than 10 years. Open policy has to take place gradually. Recent changes include the increasing number of currency swap agreements with neighbouring countries such as Australia, Indonesia, Malaysia, Korea, and most recently UAE. China has been promoting the usage of Renminbi in international trades since 2009. The off-shore clearing house in Hong Kong also assists the issuance of Renminbi-denominated bonds. The CME Group has begun to allow holding of Renminbi to be used as collateral for trading in its futures products.2 China is moving towards a convertible RMB.
Economic Policy Reform
The right cure is for China to promote the usage and dominance of RMB, starting from Asia. Revaluation of RMB should happen gradually until it reaches a potential market equilibrium. China’s recent policy shift towards stimulating domestic demand is also a much needed change alongside the revaluation of Renminbi.
Pulling domestic demand further serves to develop the large number of second and third class cities in China. The IMF ranked China 94th in turns of GDP per capital at 2010.3 The Chinese economic policy should aim at bridging the gap between the rich and the poor, pulling up the GDP level per person. It would in turn facilitate personal spending and foreign investment, boosting internal demand for goods and services, reducing China’s exposure to foreign economic fluctuations.
Chinese economic policy is encouraging direct Renminbi investment into foreign countries in purchasing technology and resources. The large Chinese banks would have to expand overseas to facilitate Renminbi conversion, investment and settlements. The Bank of China would have to implement monetary policy, setting cash rate for RMB in a free flow currency market.
(2) Poor Technological Innovation
Like recent China, US during the 1800s was never interested in the concept of "open market", its Tariff Act at 1824 levied extremely high tax on goods that it was able to produce domestically.4 However, the Industrial Revolution since 1820 improved American manufacturing productivity, which placed America's technology and innovation amongst the top nations of the world.
The Global Technology Index in 2011 looked at the level of R&D investment, the number of researchers and engineering, and the level of innovations over the world. China was ranked the 30th, far behind developed nations.
A reserve currency must be widely used in international transactions, which implies that the home country's goods must have a competitive edge, attracting global demand. The US dollar is now supported by oil trades, while Germany and Japan's currencies are supported by the countries' ability to export high-end technologies. These currencies would be forever demanded by other nations to purchase their unique products.
On the other hand, China's export industry is dependent upon the undervalued Renminbi and is focused on light industrial products. If China were to ease capital restrictions immediately, the inflow of international investments would drive up the Renminbi, which could eventually destroy the Chinese export completely. China therefore had to keep tight control of the foreign investments and cross boarder flow of funds, as the Chinese export products is not yet able to compete without price advantage.
To facilitate technological innovation, China has to retain talents. There are many causes which together explain the loss of its talents to developed nations. Firstly, the importance of “connection” in China means unequal work and education opportunity in the country’s system, causing unfairness in competitions. Positions are often filled by the ones with strong connections rather than the ones with the most suitable skills. Secondly, the Chinese style of education undermines personal development and individuality, reflected by the increasing number of student going abroad for secondary and tertiary education. Thirdly, China is still undergone changes in its intellectual property rights regime. Intellectual properties are attracted by developed nations where more protections are offered.
China should offer high wage compensation to attract elites, increase investments in R&D, education and training. It needs to develop unique and competitive industries for its economy to compete in a free market.
(3) Military Power
America had overwhelming military power when its currency replaced UK Pound Sterling, and its military arms deals with Saudi Arabia tighten the bond with the largest oil producer. The US dollar denominated oil transactions guarantee the demand for the currency and its status as the reserve currency.
Advance military force will provide a sense of security guarding China’s future development.5 China has to defend its national interest in potential conflicts with the developed nations. If its military power lags too much behind that of US, it is possible that the US military force might seek to “free the people of PRC from the dominance of one government”.
Being the Reserve Currency
China needs to uphold RMB convertibility when its export industry adapts to the revaluation of RMB. The removal of government protection might not serve the interest of domestic export companies and financial servicing firms, as they are up against large competition from foreign companies.
Nevertheless, reserve currency status would improve the purchasing power of RMB while China shifts its focus from export to import. It will further facilitate foreign investment and acquisition of foreign assets by individuals and the government (most importantly, acquisition of technologies and resources).
A strong and dominant RMB would allow China to achieve Monetary Sovereignty. Its large dollar reserve is currently exposed to devaluation of US dollar, which means China had to continue its purchase of US treasury bonds in order to prevent the US Federal Reserve’s dollar printing machine from running. These extra RMB created for the purchase of US bonds flow back to China, causing inflation pressure.
Moreover, before RMB becomes convertible, the Chinese financial market would forever lag behind those of developed nations. It is a necessary development for Shanghai to be the next financial centre of the world.
Bibliography
- Song Hong Bing, Currency War 4, 2011.
- Robert Cookson, CME to allow Renminbi as Collateral, Financial Times, Dec 2011.
- Troy Partitt, China will never Rule the World, August 2011.
- Song Hong Bing, Currency War, 2011.
- Joseph S. Nye, Has Economic Power Replaced Military Might? June 2011
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