The Prospect of RMB Internationalisation in the Post-Covid World
By Zachary Cameron (Runner-up in the Monetary Economic Competition)
The frequency and severity of financial crises in the post-Bretton Woods era have precipitated numerous critiques of the United States-led, neoliberal-based, international economic system. Lesser-developed countries have viewed the 1997 and 2008 financial crises, in particular, as being indictments of laissez-faire economics, specifically gleaning from these experiences an acute understanding of the fallibility of unrestricted capital flows and the dangers of an overreliance on the U.S economy. The 2008 crisis, in particular, drove home the latter of the two points, as this crisis caused more than 4 trillion dollars in losses for other countries (Fang, 2019). The disenchantment with the U.S-led economic order engendered by this experience prompted Zhou Xiaochuan, China’s former central bank governor, to propose replacing the dollar as the international reserve currency in 2009 (Zhou, 2009). Zhou’s statement emanated from an understanding of the world’s modern-day “Triffin Dilemma”: countries have increased their desire for liquidity due to the increased risk of financial crises, but because the dollar maintains a hegemonic position as the world’s reserve currency, this demand for liquidity becomes synonymous with a demand for dollars, which lowers U.S interest rates and encourages credit-financed booms, rising asset prices, and a deterioration in credit quality, thereby exacerbating the fragility of the international economic system and increasing the likelihood of financial crises in the first place. The theoretical remedy for this ‘vicious cycle’ would be the increased internationalisation of other currencies, as this would mitigate the aforementioned risks and would also hedge other countries’ risks against a dollar crisis.
An understanding of this phenomenon undergirded Beijing’s desire post-2008 to internationalise its currency, the RMB. However, while Beijing was explicit in vocalising this desire, over a decade later it remains clear that the RMB has failed to challenge the dollar’s hegemony in any significant sense. For example, the RMB accounts for only 2.02% of global reserves, 4.32% of global FX turnover, and 1.76% of world payments (Cheung, 2020). These percentages pale in comparison to the corresponding dollar shares- 60%, 80%, and 40%, respectively. Given this lack of progress, many pundits have simply given up on the prospect of RMB internationalisation, willing to accept that the dollar’s dominance will remain unchallenged for the foreseeable future. While this attitude may indeed be appropriate, unprecedented amounts of fiscal and monetary stimulus unleashed by the Western world as a result of the coronavirus pandemic have many government officials and economic pundits reigniting the dialogue regarding the need to democratise the world currency order. Perhaps most notably, Yi Gang, China’s current central bank governor, called for a new SDR allocation to cushion the world monetary system following the coronavirus-induced global liquidity crunch (Yi, 2020). Likewise, the People’s Bank of China (PBOC) explicitly stated that it will strengthen its efforts to internationalise the RMB in 2021 (Chen, 2021). Given this seemingly revitalised desire for currency multipolarity, an analysis of the factors that inhibited previous internationalisation efforts must be undertaken in order to assess the plausibility that renewed calls for RMB internationalisation will yield different results.
However, before analysing the factors that inhibited previous attempts at RMB internationalisation, it is first important to note the variables that caused government officials and economic pundits around the world to believe that the RMB would indeed threaten the dollar denominated monetary order post-2008. Most notably, the One Belt One Road Initiative (BRI), the New Development Bank (NDB), and the Asian Infrastructure Bank (AIIB) were commonly cited as evidence that Beijing was in fact pursuing the internationalisation of its currency (McDowell, 2017). Adding credibility to this belief was the fact that the Third Plenum of the 18th Chinese Communist Party Congress in 2013 laid out a specific financial liberalisation agenda. The reforms outlined in this agenda included the establishment of private financial institutions, expansion of capital markets, market-determined interest rates, and a reduction of restrictions on capital flows (Borst & Lardy, 2015). In addition, the CCP stated in its 13th 5-year plan (2016–2020) that one of its core objectives was to “open up” it’s economy by attracting foreign investments and integrating it’s economy regionally through the Belt and Road Initiative (BRI) and the building of multilateral development banks (Aglietta & Bai, 2016). This plan further stated that the country’s financial strategy must be supported by the full convertibility of the renminbi as a world currency (Aglietta & Bai, 2016). These measures had scholars comparing the BRI, the NDB, and the AIIB to the United States’ Marshall Plan in 1948, which is widely considered as having expedited the internationalisation of the dollar through the massive exportation of dollar-denominated loans (Power, 2015). Eichengreen (2011) went as far as to suggest that the RMB would surpass the dollar as the top international currency in the following ten years. In short, many scholars and government officials believed that Beijing was well on it’s way to internationalising the RMB. However, today we know that this has yet to manifest, thus begging the question: Why?
Put simply, while Beijing does indeed possess the necessary tools for RMB internationalisation, and while Chinese leadership clearly does desire the internationalisation of the RMB in an idealistic sense, domestic vulnerabilities continue to inhibit the actualization of this desire. Most notably, a liberalisation of China’s capital account, which is widely regarded as a prerequisite for currency internationalisation, would bring the country immense financial risks (McDowell, 2017). China had “first row seats” to the devastation caused to its East Asian neighbours in the 1990s by speculative cross-border capital flows, and it escaped the brunt of both the 1997 and 2008 crises in large part because of its relatively closed capital account (Xiaohong, 2014). As Stiglitz (2002) points out, capital account liberalisation was the single most important factor leading to the Asian Financial Crisis. Stiglitz (2002) specifically notes that capital flows impose significant risks by exacerbating speculative real estate lending: he claims that this lending is a major source of economic instability because it creates inflationary bubbles which “always burst”. One can infer from this conclusion that capital account liberalisation would be particularly threatening to China, as the country possesses a sizable real estate bubble (Zhao, Hongyu, Yanpeng, & Wenjun, 2017).
Illustrating the severity of this bubble is the fact that the average Chinese citizen spends more than 160 times annual income to purchase a home (He, 2017). This poses a danger to China’s economy, as the widening gulf between housing prices and personal incomes has caused Chinese residents to borrow unreasonable amounts of money to buy property for fear of being “locked out” of the market (He, 2017). Because many prospective homebuyers do not have enough money to afford the 30% down payment that is typically required when purchasing property in China, illicit mechanisms are commonly utilised to acquire the necessary capital. At the forefront of these mechanisms are “yin-yang” agreements, in which multiple purchase agreements are drafted to enable people to borrow money from banks at a rate that would otherwise not be legally allowed (Tham, Jim, & Chen, 2017). This phenomenon, and others similar to it, have caused many pundits to draw parallels between China’s present-day real estate bubble and the United States’ 2008 “Subprime Mortgage Crisis” (Chao, 2018). In sum, if China were to liberalise its capital flows, the increased inflow of speculative capital would in all likelihood exacerbate the inflationary vulnerabilities in the country by increasing property values beyond what people can reasonably afford, thereby precipitating a financial crisis.
These domestic vulnerabilities have clearly caused consternation within the upper echelon of Chinese leadership. For example, China’s President, Xi Jinping, stated in his 2017 19th Party Congress that, “Houses are built to be lived in, not for speculation” (Xi, 2017, as cited in He, 2017). Xu Zhong, head of the research bureau at the People’s Bank of China, similarly stated that, “We must be very aware that rapidly rising housing prices could not only hamper our economic development, but could easily result in systemic risks and negatively impact the macro-economy” (Xu, 2017, as cited in Tham, Jim, & Chen, 2017). Furthermore, in 2017, PBOC governor Zhou said at a meeting of the Communist party, “If we are too optimistic when things go smoothly, tensions build up, which could lead to a sharp correction, what we call a ‘Minsky Moment’. That’s what we should particularly defend against” (Zhou, as cited in Glenn & Yao, 2017). As these quotations illustrate, Chinese leadership is well aware of the country’s domestic vulnerabilities. Although the opaque nature of CCP decision-making necessarily leaves one to speculation, it is likely that an understanding of these real estate centred domestic vulnerabilities has caused Beijing to maintain restrictions on capital flows, despite public declarations and idealistic desires to do otherwise.
Adding further support to the claim that China has been, and will remain, inhibited from liberalising capital flows is the concept of the “trilemma.” The “trilemma”, as is commonly understood in economics, is a phenomenon whereby a country cannot maintain control of its exchange rate and monetary policy while it has open capital flows — i.e. a country can only choose two of these three options (Cohn, 2016). As such, if China desires to liberalise capital flows, the country would need to allow its exchange rate to float- assuming that Beijing desires monetary policy sovereignty. However, loosening controls on the exchange rate is particularly unattractive to the CCP, as the country’s balance of payment surplus would cause the value of the RMB to appreciate. This would damage the competitiveness of Chinese exports, which still account for nearly 20% of the country’s GDP (Shan, 2019). Evidencing the unwavering desire of China to control it’s exchange rate, the PBOC stated just this year that the current exchange rate system is “an institutional arrangement fit for China at present and in the foreseeable future” (Zhou, 2021). Thus, as the PBOC’s recent comments illustrate, exchange rate control is a non-fungible issue- thereby rendering capital flow restrictions non-fungible as well. As RMB internationalisation requires unrestricted capital flows, one can glean from this narrative an understanding of not only why the RMB did not make significant inroads into the world currency order post-2008, but also why this result will likely not change in the post-COVID world.
Lastly, it is important to note that the significant concentration and exertion of political authority in China has inhibited- and likely will continue to inhibit- the ability of the RMB to be used as a reserve currency. Exemplifying the breadth of the CCP’s political authority and the resultant retardation of RMB internationalisation is the fact that China still lacks an independent central bank. For example, China’s central bank- the PBOC- lacks the authority to set interest and exchange rates without the government’s approval (McDowell, 2017). This overreach harms the prospects for RMB internationalisation as central bank independence is commonly viewed as an important institutional device that enhances a country’s anti-inflationary credibility. This credibility increases the confidence of international investors who worry about the debasement of their currency reserves. In fact, it was only when the United States created an independent central bank in 1913 that the dollar became the most widely used international currency (Eichengreen, 2011). Demonstrating the validity of these concerns is the fact that China’s inflation rate in the early 1990s reached 24% (Xiaohong, 2014). Furthermore, although the CCP has ostensibly implemented some interest rate liberalisation measures in the past decade, a closer look reveals that the government’s overreach has rendered this effort moot. For example, China removed a ceiling on lending interest rates in 2013 and eliminated the floor on deposit rates in 2015; however, interest rates have not been significantly affected. This is because the CCP continues to informally pressure the country’s state-owned banks into maintaining interest rates at levels that the government prefers, threatening to punish bankers that do not comply (McDowell, 2017).
The importance of this example reaches outside the specific case of interest rate liberalisation by illustrating the difficulties that foreign investors face when deciding whether to trust China’s stated policy goals and the country’s overall political-economic stability. Namely, there is a persistent worry that Beijing is liable to “change the rules of the game” at a moment’s notice- the CCP’s recent crackdown on domestic “tech giants” serving as a reminder of this facet. This concern gives pause to international investors (e.g. foreign banks) who are looking for “safe haven” currencies to store as reserves. While the RMB has the possibility of granting its holder larger median annual returns than the dollar, central banks tend to place a higher value on asset stability and therefore will likely continue to give preference to currencies that originate from governments with more stable, conservative financial institutions (Xiaohong, 2014). As such, the transparency and (relative) reliability of the United States’ government and central bank, in contrast to China’s opaque and unchecked political rule, continue to make the dollar a more desirable asset to hold. Recent actions towards Hong Kong, as well as numerous financial market interventions in the past year, illustrate that this particular inhibiting factor of RMB internationalisation is unlikely to change in the post COVID world.
In sum, although idealistic desires for currency multipolarity have motivated government officials and economic pundits around the world to discuss the possibility of RMB internationalisation, an analysis of China’s economic vulnerabilities and political risks makes clear that this process was simply not feasible following the 2008 financial crisis. As the recent Evergrande debt crisis and numerous examples of political overreach illustrate, these inhibiting factors remain- and arguably have strengthened. While it is to be expected that increasing debt to GDP ratios and loose monetary policies of Western economies would reignite calls for currency parity, it nonetheless remains clear that the RMB will not be able to provide the antidote to dollar hegemony in the foreseeable future. As Eichengreen & Kawai (2015) point out, the economies that provide international currencies share two key features: 1. They have eliminated capital flow restrictions; 2. They have maintained social and political stability. As the previous analysis has illustrated, China remains far from fulfilling these requirements.
This article was written by Zachary Cameron as his submission in the Monetary Economic Competition 2021/22.
This article was judged by Sir Charles Bean, the Former Chief Economist and Former Deputy Governor for Monetary Policy at the Bank of England.
“This essay is very nicely written and convincingly argued and I agree with the thrust of the author’s argument. It would have been worth noting that even if the preconditions for RMB internationalization are met, that in itself will not guarantee that the RMB becomes a significant reserve currency. History suggests that there is usually a single dominant international currency and that network effects mean that it usually takes a lot to dislodge the hegemonic currency. As well as China satisfying the necessary preconditions, the US probably also needs to do something so that other countries lose trust in the dollar.”
A short excerpt of comments by Professor Charles Bean
This article was reviewed by Anna Clarey (President of the Central Banking Society).
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