Will China’s Renminbi Become a Reserve Currency?

1. Will China’s Renminbi Become a Reserve Currency? Dr Robert S Gay Fenwick Advisers February 15, 2013

2. The Rationale for Globalization of RMBChina’s Perspective • China’s trade flows now represent 15% of world total. • As the world’s most populous country and second largest economy, China will need deeper and more liquid debt markets to finance its transition to domestic-led growth. • Current model of households subsidizing state banks is not sustainable; negative deposit rates are a source of popular angst. • Local government subsidies and financing are wasteful and inefficient; • Massive consolidation of industrial sector already is underway; large companies will need more sophisticated financing options. • Housing price bubble has exacerbated public backlash against income inequality; mortgage financing is a high social priority that will crowd out corporate lending if debt capital markets are not expanded. • Financial liberalization is one of the few priorities in the new 5-year plan that does not involve a major tradeoff between social goals and vested interests. • Serious flaws in euro’s institutional infrastructure and global interbank markets as well as concerns about Western sovereign indebtedness and Quantitative Easing has opened the door for another prominent reserve currency.

3. Goals Versus the Arduous Task of Building Requisite Financial and Legal Infrastructure • Dual goal of developing capital markets and globalizing RMB are intrinsically linked. • Roadmap to reserve currency status is the same as that to deeper capital markets. • IMF’s formal SDR evaluation review (2010) of RMB is such a roadmap. • China’s strategy is to introduce deliberate experimental reforms in local markets and use the experience to broaden their scope.

4. China’s Challenges in Making RMB a Reserve Currency • Build more liquid financial markets – both local debt instruments and market for CNY international bonds • Navigate transition to a more open capital account without opening door to a financial crisis (asset bubbles, excessive leverage, fraud) • Manage inevitable slowdown in potential growth and the shift toward domestic-led growth • Make legal and enforceable commitments to liquid capital markets, including strong creditor rights and credible limits to arbitrary use of executive power to circumvent functioning of capital markets Creditorrightsand open capital markets will take time.

5. Steps toward Globalization of RMB: Requisite Attributes of Reserve Currencies • IMF uses concept of ‘freely usable’ as criterion for including a currency in SDR basket. To be ‘freely usable’, a currency must be ‘widely used’ and ‘widely traded’ • Measures of ‘widely used’ include: i) currency composition of official reserves held by CBs; ii) currency denomination of international debt securities; iii) share of world exports denominated in a currency • Measures of ‘widely traded’ include: i) volume of a currency’s transactions in FX spot markets; ii) existence of forward markets (deliverable); iii) regular quotes; iv) low transaction costs (bid-ask spread); iv) volume of turnover in FX derivatives (forwards, swaps, options) based on market interest rate

6. ‘Official’ Reserves Currencies(as designated by IMF) Rank order Value of ‘official’ reserves 2012 2001 held in: (billions US$) Percent • US dollar $3,580 61.8% 71.1% (of $1,936 bn) • Euro 1,500 26.0 18.3 • Sterling 238 4.1 2.8 • Japanese yen 220 3.8 6.1 • Swiss franc 6 0.1 0.3 • Other 310 5.3 1.4 Of which new official currencies: • Aussie dollar 60 1.0 • Canadian dollar 60 1.0 Prospective candidates: Swedish krona, Chinese RMB ---------------------------------------------------- US dollars Total value of reported reserves $10,500 bn $1,936 bn Unreported composition (including China’s) $ 4,700 billion (mostly China and other Asian nations) ‘Official’ reserves (2012) $ 5,800 billion

7. Milestones on the Road to Full CNY Convertibility • 2010 SDR valuation review by IMF sets a roadmap for financial liberalization. • Authorities first allowed Chinese companies to use RMB in cross-border trade settlements. • As foreign companies exporting to China accepted payment in RMB, the currency accumulated in their Hong Kong bank accounts. • Next step was to allow foreign firms to tap those funds by issuing RMB-denominated bonds. • Eligible offshore banks then were permitted to invest RMB funds in China’s interbank bond market. • In 2013, China will allow Hong Kong banks to lend RMB to companies in Shenzhen Province. • In a clear step toward reserve currency status, China has signed currency swap agreements with the Philippines, South Korea, Japan and Australia. • About 10-15 central banks now hold RMB as reserves including Malaysia, Nigeria, Chile and Peru.

8. Conclusions • A realistic expectation is Chinese yuan will become a widely used reserve currency on a par with sterling or the yen (i.e. 4% of reserve holdings) within the next 10 years. • The key prerequisite for reserve status is financial reforms including development of both external and internal debt markets for Yuan-denominated instruments. • Currency appreciation is likely to proceed hand-in hand with financial liberalization and adjustment to positive real deposit rates. • Local markets in turn will require stronger creditor rights and legal safeguards against arbitrary executive actions in capital market transactions. For a similar vision of the evolution of reserve currencies, see commentary of Dr Jin, Head of the Research Institute at The People's Bank of China, in the February bulletin of the Official Monetary and Financial Institutions Forum at http://www.omfif.org