The rapid growth of the Chinese economy over the past decade has been led by the reforms at a structural level that have made the economy move towards being more market-oriented. Moving ever-so-slightly towards a market determined exchange rate, the country is trying to internationalise its currency (Renminbi) by increasing its role in global trade. Will Renminbi become the world's next reserve currency?
Dollar v/s Renminbi
Following the subprime crisis is 2008, the emerging market economies tried to eliminate exchange rate risk by holding reserves of currencies other than the US Dollar. These accumulated reserves have reduced the market for US Dollar. Prior to this these economies were holding dollars to insulate themselves from the exchange rate volatility of their currencies.
With China replacing USA as the chief importer of oil, the petrodollar system seems to be endangered. To explain this further, the oil producing nations preferred to hold large reserves in dollars with oil payments usually denominated in the dollar. However, with the increase in bilateral trade agreements between the Russia, Saudi Arabia and the eastern countries like China and Japan have reduced the importance of the dollar as the world currency.
Internationalisation of the Renminbi
The Chinese government has been trying hard to internationalise its currency since 2008. It has largely been encouraging cross border trade settlements in RMB. A main move has been the gradual opening up of the capital account and the development of offshore markets in cities like London and Singapore, where RMB products can be freely traded. These markets have been growing steadily over the years. China has also been increasingly entering into bilateral swaps to further their aim of internationalising their economy.
China started by pegging its currency to the US dollar in 1994 to support the growth of the export sector. Moving away from this system, China fixed its exchange rate to a basket of currencies weighted by their importance in trade in 2004. It further liberalised its economy in the past few years by expanding the fluctuation range from 0.5% up and down to 2% up and down currently. China has also increasingly liberalised interest rates and created markets for investment by small and micro enterprises in junk bonds.
The move towards internationalisation has been well supported by countries like the UK whose majority of investment (about 50%) into the Asian markets is routed through Hong-Kong.
The development of the Free trade zone at Shanghai where there will be no taxes or capital account restrictions, will help provide flexibility to banks for conducting business and will also allow free movement of currency. This is a huge step towards promoting the currency and testing the effect of moving towards a floating rate regime.
Out of the $4 trillion trade of the Chinese economy, Renminbi accounts for 20%. With China being the largest trading economy in the world that number is huge and not to forget, increasing. As compared to 2011, the number of banks transacting in the Renminbi has increased from 900 to 10,000, signifying the rising acceptance of the currency. This acceptance is also manifested in the rapid rise of the currency from being number 17 in 2010 to number 9 in terms of the average dollar daily turnover. China's bond market have also expanded over the course of the past few years.
Emerging markets account for about 70% of the Chinese imports and 56% of Chinese exports. These figures highlight the advantages of Renminbi as a world currency for the emerging world.
Challenges ahead of the Renminbi
However, the limited role of the Renminbi in world trade questions the relevance of this debate altogether. Very few global trade transactions are in Renminbi and even lesser are the import settlements.
To be called a 'world currency', a currency should be fully convertible on the capital and current account, should be freely floating and should be used for trade settlements and other transactions. A stable social, political and economic situation in the country is also a pre-requisite for a country's currency to become the reserve currency of the world in addition to well developed financial markets.
China lacks in most of the above. While it is the biggest trading economy and one of the high growth economies of the world, its bond markets are not even close to as developed as the markets in the US. China's bond markets account for a very small percentage of the total world GDP.
China runs high trade surpluses and in order to relax the capital account convertibility without letting huge currency outflows, reforms need to be enacted to create enough investment options.
Excessive capital controls prevented China from being hit badly during the global financial crisis. If it decides to move to a floating rate regime to further internationalise its currency, the risk of spill-over from other economies becomes very real. This would be a tough choice for the country and will determine the future of the Renminbi.
Moreover, the dollar, which forms about 65% of the global reserves and 85% of the global transactions, still stands way ahead of the Renminbi with the well-developed and strong bond market in the US. The stable political and economic environment in US adds to the dollar's credibility and its safe-haven status. Thus, the Renminbi is not likely to become the world's reserve currency any time soon..
- Jasmine Makkar
Jasmine Makkar is a first year PGDM- Finance Student at SPJIMR. She has completed her graduation in Economics(H) from Lady Shri Ram College, DU. She enjoys writing, dancing and is a theatre enthusiast.
Follow Jasmine at jasminemakkar.insideiim.com