Economics & Finance
• 9 minute read

Renminbi: On Course to Becoming a Globalized Currency

Yeh, Jason J.H.(葉家興)

All signs point to the rise of the renminbi as a major international currency, but it continues to struggle to come to its full potential. Why is that so?

By Helena Pozniack

Rather than asking why China’s RMB should become an international currency, it’s more a question of when, says a professor at the Chinese University of Hong Kong Business School.

“People might have doubts as to the suitability of China’s currency, but internationalization of the RMB is an inevitable progression for an international economic power,” says Prof. Jason Yeh, associate professor at the Department of Finance, who has researched the progress and prospects of China’s RMB becoming a trusted international currency.

China, he notes, is the world’s largest exporter and manufacturer as well as its second largest economy. Yet its currency, which is still carefully managed by the Chinese government, has a market share well behind the U.S. dollar and the euro, and is barely traded on foreign exchange markets. But volumes are climbing steadily and all signs point towards the RMB gaining greater stature as a stable reserve currency.

In December 2013, the RMB overtook the euro to become the second most used currency in global trade finance after the dollar, according to the Society for Worldwide Interbank Financial Telecommunication. And it became the ninth most traded international currency, according to a report by the Bank for International Settlements. Analysts forecast the currency will continue to rise.

“According to data monitored by chief economists of investment banks in Hong Kong, who have examined the internationalization process, they believe the RMB will soon surpass the Japanese yen to become the fourth largest payment currency in 2020,” says Prof. Yeh.

In his research paper, “Renminbi Internationalization: Progress, Prospect and Comparison,” Prof. Yeh concludes that while the potential to achieve an international currency is great, progress is severely hindered by China’s tight control on the nation’s capital account–the flow of funds both in and out of the country. While international trade can go some way to redressing the balance, China needs more efficient and open financial markets.

Path toward Becoming an International Currency

Prof. Yeh notes there is no official definition of an international currency, although several economists have attempted to qualify this. “A reasonable way of looking at it is to ask: ‘How many central banks are holding this currency as a reserve? How many companies are using this currency for international trade payments? How much is this currency used for transactions in stock and bond markets.’ If you are in the top 2 or 3 of these indices, then you have an international currency,” he says.

Traditionally, says Prof. Yeh, the currencies of countries that play a major role in world trade have tended to become reserve currencies–in other words, held in significant quantities by national banks to protect nations against currency fluctuations. In the 19th century and the first half of the 20th century, the British pound was the main reserve currency; the dollar surpassed it after the Second World War and has dominated ever since, followed by the euro, the yen and the pound. Central banks are now beginning to hold part of their foreign exchange reserves in RMB–albeit in small amounts–and the People’s Bank of China has set up 24 arrangements with international counterparts to allow it to swap the RMB in exchange for their own currencies.

There are three clear widely accepted steps toward creating an international currency, says Prof. Yeh: peripheralization, followed by regionalization and then internationalization. China’s RMB lies somewhere between the second and third stage, he says. The first–that RMB is used in peripheral countries and areas such as Mongolia, Thailand, Hong Kong and Macau as a hard currency–has already been achieved, he says. Regionalization, the second step, will be achieved when the RMB becomes the dominant currency within the Asia Pacific region. China’s trade with neighboring countries is increasingly settled in RMB, resulting in more two-way flows of the Chinese currency to and from these regions. “We are starting to see agreements with the likes of Singapore and South Korea, for example,” he says.

The next step is internationalization. Analysts expect the currency to receive a boost on the world stage in 2015, says Prof. Yeh, when the International Monetary Fund is due to review its “special drawing rights” basket, which uses four key international currencies to supplement members’ national reserves and, for the first time, might include a percentage of RMB within the mix.

Benefits of Globalized RMB

China has begun to loosen its control over its financial markets and gradually open up access to its onshore markets. In 2007, the Chinese government began issuing RMB-denominated notes, bonds and funds, known as “dim sum bonds,” in Hong Kong. Since 2009, companies in Mainland China have been able to complete cross-border trade in RMB. This allows companies to reduce transaction costs, better manage foreign exchange risks and speed up payments. In the longer term, says Prof. Yeh, this will reap wider benefits. For example, companies will be able to pass on their cost savings to the consumers.

Foreign companies such as MacDonald’s and many other multinationals have taken advantage of this relaxation to issue RMB-denominated bonds in Hong Kong. “This could save companies a lot of money in terms of transaction and interest costs,” he explains. “Issuing RMB bonds is a good way to hedge currency risks, and it pays to take advantage of any new openings–firstcomers usually get the best deal.” “RMB bonds are a good way for companies doing business in China to protect themselves against fluctuations in currency values in the future.”

In addition, an internationalized RMB would serve international investors well, according to Prof. Yeh. He explains that sovereign states, large and small corporations as well as private investors would benefit through a greater choice and a reduced influence of the U.S. dollar.

“The modern portfolio theory asserts that as long as you have more unrelated assets, you will be better off through diversification,” he says. “Just as in any democracy, you need at least two parties [to achieve balance]. The same holds good for international currencies. Nowadays the dollar is the dominant currency. But U.S. domestic monetary and fiscal policy has a significant effect outside the United States. If we have a more international currency, then there are more choices and investors are less vulnerable to U.S. policy decisions.”

While the impact of the 2008 global economic crisis has not been officially quantified upon Chinese investors, anecdotally, the fallout has been severe, commented Prof. Yeh, as values of savings have plummeted.

“The financial crisis has had a big impact on the mindset of investors, namely, about how safe the dollar is,” he says. National banks, including China’s, have seen the value of their substantial foreign currency reserves fall as the dollar and euro weakened in the wake of the meltdown. “More choices in international reserve currencies could provide greater checks and balances, which are very important to monetary policymakers around the world. These could bring benefits to individuals, corporations and governments worldwide.”

A more international RMB would allow China, which holds hefty dollar reserves, to be less dependent on holding foreign currency reserves, and thereby be less subjected to currency fluctuations, according to Prof. Yeh. “We will no longer be dependent on a government that arrogantly decides policies for domestic reasons, ignoring the wider international fallout.”

As well as wider benefits for investors, an international RMB could bring direct financial gains for China in the form of seignorage–the profit made by printing money minus the cost of physically making it–so if the market value of the money is higher than the cost of producing it, then China will gain, says Prof. Yeh, who notes that economists estimate this could amount to some US$2.5 billion a year.

Weighing the Risks

While there are obvious benefits from the RMB challenging the dollar’s dominance, there are undoubtedly risks associated with achieving a more international currency. “The Chinese economy has grown relatively smoothly over the past 30 years, and Chinese policymakers have nearly total control over the whole economy,” he says. But a more widely held and traded currency on an international level will remove some of China’s ability to manage the economy.

“More RMB held by foreign investors and companies create potential risks for policymakers and the Chinese economy as well,” he explains. “But if China’s authorities can make the best use of the opportunities, I believe the benefits will outweigh the cost.”

According to Prof. Yeh, smaller companies within China might suffer from a more volatile currency in the future. While larger corporations might have the expertise and resources to hedge against future fluctuations in the RMB, smaller or weaker companies may not be able to afford the resources for protecting themselves against potential exposures to external markets. “Currency fluctuations might destroy these companies’ profit margins,” he says.

And with more liberalized financial markets, smaller companies might have to pay higher borrowing costs. “Some financially sound companies might enjoy the same beneficial interest rates. But smaller companies might risk defaulting in corporate bond markets, and that could dent investors’ confidence,” says Prof. Yeh.

If potential currency instability in the future contributes to job losses and company failure, then policymakers might be forced to slow down the process of creating a more international currency. “Stability will be one of the key factors,” he says.

Not Built in One Day

Currently volumes of trade in RMB on foreign exchange markets are relatively low, and investors would benefit from a greater range of financial instruments, which would boost trading volumes and lift confidence in the market, says Prof. Yeh.

“It gives the corporations and individuals the ability to trade, hold and use the currency–the so-called impossible trinity,” he says. He notes three steps in the process of opening up capital markets. “Aim to open up the long term capital flow, so that investors– companies and pension funds–will retain your currency in the longer term. Then trade will move to short-term currency markets as well—this is what we’d call ‘hot money.’ Subsequently, the market will open up for high-risk, RMB-denominated derivatives. The processes we’ve witnessed in the past few years make sense. But Rome was not built in one day–there’s a way to go.”


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