Author: Peter Drysdale, Editor, East Asia Forum
As China’s share of regional trade has grown so too has the importance of its currency, the renminbi, in international transactions.
Since 2002, China’s share in East Asia’s trade has leapt from 10 per cent to 23 per cent, while the share of US trade has gone in exactly the other direction, from 23 per cent to 10 per cent.
Of course, growth in trade share alone does not automatically make it attractive for countries to use the currency of the trading partner as the currency through which transactions are traded or in which assets are held. As Japan’s trade share grew in the 1970s and 1980s, the yen grew in importance as an international currency but not in parallel, nor nearly commensurately with trade. This was for a number of reasons: first, because there were restrictions on the Japanese capital account that limited the movement of yen in and out of Japan; and secondly because Japanese financial markets were not entirely open, distorting the relationship between the returns on yen investments and investments in dollars, UK sterling or other European currencies. In the 1980s and 1990s, Japan tried to internationalise its currency, and the use of the yen in trade settlement and in foreign exchange transactions rose because of important reforms that led to opening of the Japanese capital account. Yet despite those efforts, Japan’s currency never played a significant role as a major international currency, even at the height of its importance in the global economy, partly because the process of capital account financial market liberalisation came late, and was incomplete, and also because of the continuing attractiveness of the dollar.
In this week’s lead essay Arvind Subramanian and Martin Kessler argue that the rise of the renminbi is unlikely to peak out as did the rise of the yen. They point out that, ‘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 (against the US dollar), 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, Subramanian and Kessler suggest, is now a renminbi bloc because the currencies of 7 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.
The rise of the renminbi as a reference currency is not confined to East Asia. While it is still dominated by the US dollar as a global reference currency, this too, Subramanian and Kessler point out, 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’.
Being increasingly used as a reference currency is only one aspect of the renminbi’s rise as an international currency. An international currency is also distinguished, like the US dollar, by its use as a reserve asset and its widespread use in international transactions. Some predict that the full internationalisation of the renminbi 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 that global status.
China’s global trade share is bound to continue to rise. As Subramanian and Kessler argue, the renminbi’s role is likely to rise and erode the US dollar’s dominance in the rest of the world, although that won’t happen automatically or without policy change. What is needed is 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; these measures will allow foreigners greater access to renminbi assets via the opening up of China’s capital account.
In the normal course of events, as Subramanian and Kessler suggest, the renminbi’s global dominance could become reality in 20–25 years. But if China accelerates its financial and capital account reforms, this could happen much more quickly.
Peter Drysdale is Editor of the East Asia Forum.