Cost Benefit Analysis: Renminbi as the World Currency

Posted in Finance Articles, Total Reads: 3337 , Published on 02 May 2014
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The global crisis faced in 2008-2009 revealed the weakness of international monetary system. The international monetary system has not only contributed to global financial instability but also to a weak global economy. For developing countries, which depend heavily on international trade and capital flows, the failure of the current global reserve system in ensuring sufficient international liquidity caused them to suffer from impact of global shocks. With the U.S. economy fading under burden of debt, the argument that the U.S. dollar should continue to function as the primary reserve currency of the world stands weak. The US dollar’s run as the world’s stable currency has stumbled with the recent financial crisis. The alternatives are multi-currency, Euro and renminbi. China is ranked second in the world’s largest economies and has overtaken USA as the largest trading nation marginally. In the context of the IMF, China plays a key role, since it holds the largest amount of foreign exchange reserves in the world; there is actually a surplus in China’s foreign reserve account that is equivalent to 10.5% of its annual economic output.

image:freedigitalphotos.net

Rise of the middle kingdom’s RMB

  

The above graph very clearly depicts the rise of RMB and in turn economy of China. The GDP of China has risen steeply in the last decade. The major reason for it has been the rise in exports and consumption.

GDP = C + I + G + (X - M)

The foreign direct investment and outward direct investment has risen steeply in the last  decade. The rise of ODI primarily indicates that the nation's economy is booming to the extent that sufficient risk capital is available for further ventures.

Also the exports and imports have risen considerably as compared to other countries and the daily average turnover is more than other single currency after USD.

 A quick look at the data substantiating the rapid expansion of RMB usage outside China suggests that it has now worldwide presence. According to a report by HSBC, in a typical month approximately one sixty countries use RMB currency for business purpose.  More than 50 territories have established RMB capabilities of which 21 have swap/settlement agreements. Also, four RMB centres are developing including Hong Kong.

Road Map for Internationalization of renminbi

  • JUNE 2009

Launch of RMB cross-border trade settlement scheme

  •  JUNE 2010

Expansion of the RMB cross-border trade settlement scheme

  •  AUGUST 2011

Announcement on further expansion of the

scheme  nationwide

  • JUNE 2012

Expansion of RMB export trade settlement from businesses on the Mainland Designated

Enterprise (MDE) list to all companies qualified for external trade.


  • JULY 2010

Establishment of the offshore RMB market in Hong Kong

  • AUGUST 2010

China interbank bond market (CIBM) opened to foreign central banks or monetary authorities,

RMB clearing banks designated by PBoC, overseas RMB participant banks; expanded to

overseas insurers, QFII and RQFII in 2012

  •  JANUARY 2011

Mainland enterprises can make overseas investment in RMB in the form of ODI

  • AUGUST 2011

Mainland corporate can issue RMB bonds in HK

  • OCTOBER 2011

Formalization of RMB FDI

  • DECEMBER 2011

RMB QFII (RQFII) launched with initial quota of RMB20bn (later expanded upto RMB 200bn)allowing HK subsidiaries of Chinese AM and securities firms to invest onshore;

  • OCTOBER 2012

RMB Qualified Foreign Limited Partner (RQFLP)launched in Shanghai

Minimum criteria: full RMB convertibility

(expected by 2017)

Initial progress: some foreign central banks have already announced that they have

invested or will start investing in RMB as part of their reserves


The launch of RQFII(RMB Qualified Foreign Institutional Investor) has led to very steep rise in foreign investment in Chinese assets as shown in the graph above.

Cost- Benefit Analysis from China’s perspective

As discussed above, the process of Internationalization of the renminbi is ad hoc to say the least. An important question is whether China really wishes to internationalize its currency: the answer is both yes and no.

Benefits of Internationalization of the renminbi

Considering that there is a very high probability that renminbi becomes the next international currency, the benefits of it can be explored as below:

(a)Reduction in the exchange rate risk of Chinese firms: Internationalization of renminbi will bring in more foreign trade to China. Most of the financial transactions will be preferably settled in RMB reducing the exchange rate risk with the demand risk still remaining. The weight associated with renminbi-dominated assets will increase reducing the impact of foreign exchange risk associated with BIS capital adequacy requirements.


(b)Expansion of financial sector in China:It will improve the funding efficiency of financial institutions and thus increase international competitiveness. This will lead to expansion of financial sector.

(c) Boost to cross-border transactions: Internationalization of renminbi would boost cross-border transactions. The rise in cross-border transactions may lead to an effective settlement in bilateral transactions. It may also encourage bilateral trade and economic co-operation by promoting development frontier regions which are primarily inhabited by minority nationalities.

(d) Preserving the value of foreign exchange reserves: China is the biggest holder of foreign exchange reserves in the world. But, more than 70% of its foreign exchange reserves is in US dollar. China may suffer huge capital losses on its foreign exchange reserves in case US government’s debases US dollar. Presently, United States owes China more about $1.2 trillion as dollar denominated debt in bills, notes and bonds, according to the Treasury. China is almost a t the mercy of the United States after giving massive debt to a country whose currency is international currency.

Costs of Internationalization of the renminbi

 Apart from the above mentioned advantages , the disadvantages are also obvious. Capital account liberalization and full account convertibility though not compulsory, yet are a prerequisite to a significant degree for internationalization of any currency.Chinese government’s reluctance to give up capital control stands as the biggest impediment for internationalization of this currency. It is imperative to maintain such maintenance controls over cross-border capital flows because of following reasons:

(a)Fragile financial system: China’s financial system is suffering from over-monetisation and is still fragile.

(b)Huge capital outflows: China has an M2/GDP ratio of 180% which implies that capital outflows may be huge if capital controls are dismantled Also , lack of capital controls implies that foreign exchange requirement may be large and costly.

(c)  Fluctuations in asset prices: China’s capital markets is still not very strong . Any significant changes in cross-border capital flows will easily lead to large fluctuations in asset prices.

(d)Inflexible capital structure: Enterprises in China are slow to adjust to exchange rate and interest rate changes. Hence, they need capital controls to provide them space. The entire economic structure is inflexible.

(e)Infant industry: The financial institutions in china lack competitiveness and some protection is needed to the infant industries.

(f)Vulnerability to speculative attacks: Keeping aside concerns of liberalization of capital account controls, if renminbi is made fully convertible, then also internationalization can be a problem. The country with international currency becomes usually vulnerable to speculative attacks from international speculators as it can be easily obtained in international financial markets. The experience faced by Malaysia and Hong Kong are two contrasting cases in this point. The Malaysian ringgit was internationalized and hence the speculators were able to collect ringgit from financial markets outside Malaysia and launch an effective attack on it. In contrast, though fully convertible, the Hong Kong dollar was not internationalized. So, before launching a decisive attack on the Hong Kong dollar, international speculators had to raise Hong Kong dollars from the interbank money market in Hong Kong. The unavailability of the Hong Kong dollar abroad gave the Hong Kong Monetary Authority the policy space to dramatically raise the interest rate in the money market and successfully beat back the attack.

Conclusion

It can be observed by the above arguments that US Dollar is not sustainable as the world currency in long run. The current global financial crisis has hampered prospects of US dollar as well as Euro as the reserve currencies. They are no longer the safe-haven stores of value. renminbi(RMB) currency is challenging US Dollar’s position as the world currency due to the exponential growth of Chinese economy and its impact on trade with other trading partners. It has already made a mark as trading and investment currency. The capital account convertibility will help RMB in the attempt to achieve status of world currency.

It is imperative to create a more stable and equitable global reserve system which will depend heavily on international trade and capital flows.  Remninbi seems like the way ahead to maintain financial stability at a global level and ensure growth.

The article has been authored by Anuradha, PGP 2013-2015 , IIM Raipur

Bibliography


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