Authors: Arvind Subramanian and Martin Kessler, PIIE
China might already be the number one economy in the world on a purchasing power parity basis, but, so far, this position has only been translated very partially into a strategy of currency internationalisation.
Some have predicted that a full internationalisation of the renminbi (meaning use of the renminbi as a reserve asset, fully convertible, and usable in international transactions) could happen in the next two decades — but China will need drastic reforms of its capital account and of its domestic financial system before it acquires a global status. A third dimension, however, has often been overlooked.
This is the ‘reference currency’ dimension, meaning that the exchange rate of a given ‘dominant’ currency is tracked by other exchange rates, either by virtue of being pegged to it, or because of the forces of the market, or in intermediate regimes between those two possibilities. The renminbi long held a fixed peg against the US dollar, but China allowed its currency to float within a band, first from July 2005 until the wake of the financial crisis, and then again after June 2010.
Since the global financial crisis, with the United States and Europe struggling economically, the renminbi has increasingly become a reference currency: emerging market exchange rates now move more closely with it. In fact, since June 2010 when the renminbi resumed its flexibility, the number of currencies tracking the renminbi has increased compared to the earlier period of flexibility between July 2005 and 2008. Over the same period, the number tracking the euro and the US dollar declined.
East Asia is now a renminbi bloc because the currencies of seven out of 10 countries in the region — including South Korea, Indonesia, Taiwan, Malaysia, Singapore and Thailand — track the renminbi to a greater extent than the US dollar. For example, since the middle of 2010, the Korean won and the renminbi have appreciated by similar amounts against the US dollar. In contrast, only three economies in this group — Hong Kong, Vietnam and Mongolia — still have currencies that follow the US dollar more closely than the renminbi.
This shift stems from China’s rise as a trader: its share of East Asian countries’ manufacturing trade has risen from 2 per cent in 1991 to about 23 per cent today. Countries that sell to the growing Chinese market or are locked in supply chains centred around China see the advantages of maintaining a stable exchange rate against the renminbi.
The renminbi is still dominated by the US dollar as a global reference currency, but this too is changing. The renminbi is the dominant reference currency in four cases in the most recent period (that is, post-2010), compared to one previously; and it is a dominant reference currency in more cases than the euro. For example, the renminbi moves more closely with the national currencies of India, Chile and South Africa than any other in the latest period, and comes second in Israel and Turkey. In some ways, the renminbi has displaced the euro as the second most dominant global reference currency in the sense that there are more currencies outside East Asia that track the renminbi most closely compared with currencies outside Europe and the Middle East that track the euro.
This is a new, historic phenomenon. In the 1980s and early 1990s, Japan made well-documented efforts to internationalise its currency, and managed to increase the use of the yen in trade settlement and in foreign exchange transactions (roughly to the level of the British pound) thanks to important reforms of its capital account. But regardless of those efforts, Japan’s currency never played a significant role as a reference currency, even at the height of its economic dynamism. America boosters invoke the rise and fall of Japan over the past few decades to suggest that China’s rise today will go Japan’s way, ensuring the continuation of American dominance. But ‘boosterism’ should be restrained because during the years of the Japanese miracle the yen never came close to rivalling the US dollar as a reference currency. There was never anything close to a yen bloc in East Asia.
Chinese weight in trade is bound to increase. As a consequence, the renminbi’s role will continue to rise and erode the US dollar’s dominance in the rest of the world. A back-of-the-envelope projection indicates that the renminbi’s global dominance could become reality in 20–25 years, but this process could be expedited if China were to accelerate its financial and capital account reforms. These reforms include the liberalisation of the domestic financial market to allow a greater role for the private sector, the development of additional financial instruments, and the injection of more transparency into financial markets; they also include providing foreigners with greater access to renminbi assets via the opening up of China’s capital account.
Arvind Subramanian is Senior Fellow at the Peterson Institute for International Economics and Senior Fellow at the Center for Global Development. Martin Kessler is a research analyst at the Peterson Institute for International Economics. The article is based on a working paper titled ‘The Renminbi Bloc is Here: Asia Down, Rest of the World to Go?’. An abbreviated version can be found here.