Potential Role of The Yuan as the New Reserve Currency - Essay Example

?The Yuan as the New Reserve Currency Introduction: The Fundamental Issue For more than three decades, the U.S. dollar held sway as the top international currency in the world, and for most of that time the dollar performed its role well as currency for the world. More recently, however, as the U.S. economy is straddled by a substantially large current account deficit and increasing foreign debt, the dollar’s increased volatility have led other countries and even the U.N itself to believe that the dollar may no longer be stable enough to sustain international trade and transactions. Several predictions have come about concerning a possible substitute currency. The top candidates mentioned are the euro, the yuan or renminbi, the yen, and an invention called the SDR or special drawing rights. The latter is the unit of currency used by countries in their transactions in the IMF system. While each of these currencies presents distinct possibilities that would favourably work for its adoption, there also exist negative factors that would work against endorsing that currency. For the purposes of this paper, however, there is only one currency to consider the merits of – the Chinese yuan or renminbi, which Chinese officials have announced they intend to make into an international reserve currency within two decades (Levine, 2009). This essay will thus try to determine whether or not a shift to the yuan (renminbi) is feasible in the next ten years as a replacement for the U.S. dollar, and whether or not such substitution is capable of stabilizing the global economy and avoiding the crisis of recent years. Necessary conditions for an international reserve currency The international reserve currency performs three vital functions of money – that is, as medium of exchange, as unit of account, and as store of value. These are essentially true of all money, but applied in a cross-border context, such that it is a medium of exchange accepted as legal tender by all political jurisdictions, it is a unit of account recognized by all countries, and it stores value that is stable not given to sudden and extreme changes in value (Cohen, 2007, p. 26). Because the currencies market is a market driven by confidence, the international reserve currency must necessarily be susceptible of international acceptance, and for this it must possess certain necessary attributes. These are large economic base, political stability, and a low rate of inflation (IMF, WB & World Bank Group, 2009). It should also be backed by a joint international monetary authority that is capable of asserting compliance among its member states, which must in turn comprise a significant number of nations in the world (Finance and Development, 2009). The currency must be sellable or tradable without limitation (Levine, 2009). Since the currency is supposed to be, according to Levine, a “safe haven” for other currencies, they should be able to have access to huge sums of it without restriction. This is because inadequate reserves of the currency would compromise the ability of that country to trade in that currency or participate in international transactions denominated in it. The international currency’s home economic and political systems must also be stable enough and fundamentally sound to support international transactions among countries. In order to engender confidence in the reserve currency, the valuation of said currency must be transparent to all for them to consider holding that currency in significant quantities. Because the determination of value is for the most part subjective, the matter of the country’s governance may not be concealed from the world, and therefore the political ideology of the country must be supportive of full disclosure (Cohen, 2007). Recent developments that triggered the search for a substitute It has already been mentioned that the large current account deficit and huge public debt of the United States are primarily responsible for the weakness of the dollar as the primary medium of exchange. Ordinarily, this development alone will not have caused the sudden change of sentiment to seek a substitute for the dollar, because after all, all trading countries in the world hold the dollar in substantial reserve, and its place is still ensconced in the international consciousness as the currency of choice. Several events in the recent past have given rise to the debate about a possible substitute for the dollar. 1. The emergence of the BRIC group (Brazil, Russia, India, and China) has created a politico-economic power bloc that has the potential of undermining whatever vestiges of economic ascendancy the United States still wields. China and Russia recently have arrived at agreement to allow their currencies to trade in the spot inter-bank markets, a sign that both countries are fast evolving into mature and competitive global currency markets. The move is meant to promote bilateral trade and minimize conversion costs, but it also reduces both countries’ dependence on the US dollar (Wagner & Tam, 2010). 2. If the dollar is ever to be replaced, this is admittedly not in the foreseeable future as there is still no present realistic alternative to it; at present, no other currency admits of the same degree of acceptance and use. In the meantime, however, the growing strength in bilateral trading relationships and increasing flexibility for Chinese firms is advancing the yuan as a likely candidate sometime in the distant future (Wagner & Tam, 2010). 3. On the other hand, no other currency is presently more widely used or more substantially held in reserve. In Figure 1 below, the distribution of international reserve currencies are shown in the left panel; out of a total of US$6.5 trillion held worldwide, 65 percent is in US dollars, whereas the Euro, the next most widely held counter, is by proportion less than half of the US share, or 26 percent of total world reserves. The British pound, the dominant international reserve before the dollar prior to the First World War, now comprises only 4 percent, and the yen 3 percent. The yuan is but only one of the many currencies that collectively comprise the remaining 3 percent. Figure 1: World’s foreign-exchange reserves vis-a-vis China’s foreign exchange reserves Economist, “Yuan’s Small Step, 9 July 2009 Scenarios of a shift to another reserve currency The dollar may go into freefall, and if an alternative reserve currency exists, countries would no longer be constrained to hold dollars. Fitz-Gerald (2010), investment director of Money Morning and Money Map Press, surmises that consequently, dollars will be dumped in the market, further damaging the U.S. economy and creating an inflationary bubble as the price of anything transacted or priced in dollar terms instantly rises to offset the decline. The US exchange rate risks immediately rises, as with the cost of borrowing in dollars as lenders try to offset the increased risk of dollar-based transactions. Finally, with no need to hold dollars, there will be no longer any need for countries to buy dollar-denominated debt, further constricting the U.S. prospects for raising funds overseas. Resorting to domestic borrowings may crowd out private investments and further raise the cost of money (Firz-Gerald, 2010, pp. 151-152). Issues against the Yuan’s adoption as reserve currency Even if the yuan were to replace the dollar today, it could not do so quite so suddenly, because such a move would undermine China’s own economy. In Figure 1 foregoing, the panel on the right graphically depicts the proportion of China’s foreign exchange reserves by asset denomination. The country’s US$ 2.2 trillion worth of reserves is heavily invested in dollars, with 35 percent of the country’s total reserves invested in U.S. Treasuries, 23 percent in various U.S. agencies, and 8 percent in other U.S. assets, amounting to a total of 66 percent in dollar denominated assets. “There is no ‘cost-free’ way for China to disengage itself from its own reliance on dollars,” (Wagner & Tam, 2010). While the Chinese government has taken steps towards promoting the yuan as international reserve currency, it nevertheless still maintains tight and extensive capital controls (much like “having your cake and eating it, too,” according to Wagner & Tam, 2010). This tactic shall prove to be unsustainable in the long run, since international currencies should be susceptible of free and unhindered movement through the global economic system. There is also the continuing issue of China’s currency peg which has been the subject of strong and heated debate in the international economic fora. The renewed controversy was heightened by the impending US Treasury report expected to declare China a “currency manipulator” for failing to adapt currency reforms that would allow the yuan to be taken off its peg and be floated in the open market. Pursuant to its obligation under the 1988 Trade Act to report semi-annually to Congress on the currency practices of America’s trading partners, the U.S. Treasury is expected to identify those countries that were manipulating their currencies. It was supposed to have issued its report on China’s currency practices as early as the first report in April, but delayed in doing so. As of October, the date of the second report, the U.S. Treasury has again delayed its assessment of China. The Trade Act was originally targeted at Japan, but through the years only three countries have been identified as currency manipulators - Taiwan and Korea in 1988, and Taiwan and China in 1992. Taiwan and Korea’s citations lasted for two six-month reporting periods, China for five. This time around, however, the U.S. is trying to avoid making the expected citation. According to news sources, the U.S. is projecting China’s actions since early September to be encouraging indications of taking the proper direction (Kellerhals, 2010). The United States is not the only country expressing concern and urging China to devalue its currency. After a brief period of allowing its currency to gradually move upward, China returned to the peg in July 2008, causing the International Monetary Fund (IMF) and the European Central Bank (ECB) to issue stern warnings of impending global imbalances (Hirst, 2010). The ECB stated that monetary imbalances pose a risk to the stability of the global macroeconomic and financial systems, while the IMF mentioned in its World Economic Outlook report that there are dangers posed by sustained current account surpluses. Issues in favor of the Yuan’s adoption as reserve currency There are as many issues raised in favor of the adoption of the yuan – or at least express optimism in its eventual elevation to international reserve – as those issues against it. One of this is China’s standing as the country with the highest volume of trade in the world, by virtue of which it has accumulated a huge reserve position vis-a-vis the dollar. China’s massive dollar reserves are seen as a factor that tends to diminish the U.S. power to dictate the future course of international monetary policy. To gain perspective, it is noted that the reserves in the U.S. banking system in the 1990s were approximately 2.5 times larger than China’s banking system reserves. Today however, the People’s Bank of China (the central bank of the People’s Republic of China) has 25 times the reserves of the Federal Reserve (Fitz-Gerald, 2010, p. 152). In fact, Beijing is reported to have the world’s largest foreign exchange reserves, at 2.648 trillion dollars (Sapa-AFP, 2010). China has taken significant steps towards internationalizing its currency. In 2009, the government has allowed Chinese companies to utilize the yuan for the settlement of international trade transactions. It has likewise promoted the use of the yuan by state-owned companies for making acquisitions, and also permitted domestic companies to transfer yuans to offshore accounts for the purpose of investing (Wagner & Tam, 2010; Palmer, 2010). In 2010, these initiatives were expanded: RMB cross-border trade settlement privileges were extended to include transactions with all of China’s trading partners, and the eligible enterprises were expanded. There were new regulations passed that allowed foreign financial institutions to offer new settlement services and reduce transaction costs for importers and exporters. As a result of the expanded RMB cross-border settlement program, banks and financial institutions operating in China will be allowed to expand their services into RMB trade settlement; furthermore, companies situated and operating in the expanded pilot areas that conduct importing and exporting activities to and from China will benefit from lower costs involved in transaction, as the urgency is diminished for hedging against foreign currency risks (Palmer, 2010). In August 2010, the PBOC for the first time allowed pre-approved foreign financial institutions to invest RMB holdings int eh Chinese interbank bond market. It has also invited foreign banks to apply for permission to conduct trading in the interbank bond market using RMB-denominated gains realized from international trade settlements in this currency. The new trading rules thus allowed banks to more expeditiously invest their RMB assets that result from the new trading rules – a more liberal arrangement from former regulations that prohibited the reinvestments of these assets. A year earlier, in 2009, China embarked on a series of currency swaps with several countries which included South Korea, Argentina, Indonesia, Malaysia, and Hong Kong, among others. The currency swap is a binding agreement that allows for two parties to exchange income and payment streams, which also involve an exchange of principal aside from cash flows (Stephens, 2001, p. 108). Also, Beijing and Brazil have a bilateral trade deal that allows them to trade in each other’s currencies. Essentially, this allows them to do away with conversion into the dollar as intermediary currency in order to execute transactions within the scope of the agreement. There are conflicting studies that tend to challenge the general perception that the yuan is undervalued by virtue of its peg to the dollar. In 2005, however, where for the peg was removed for the first time (though subsequently returned in reaction the financial crisis), it was determined by Sinnakkannu & Nassir (2006) that the yuan may actually have been overvalued against the US dollar, Japanese yen and the Euro. Therefore, as the nominal value of the yuan was determined by this study to have appreciated against these currencies, the evidence stood to indicate that international trade competitiveness of China against the United States and Europe improved significantly, contradictory to the expectations of appreciation by those detractors who called for the yuan’s removal from the peg. On the other hand, China was determined to have always maintained a favourable trade position against Japan, even before its removal from the dollar peg. These findings are, of course, contested by many others such as Thorbecke’s (2006) ordinary least squares study approach, that confirmed the IMF and World Bank group’s position that the yuan is undervalued and its appreciation would help to rebalance US-China trade. Underlying implications of an artificially devalued currency A discussion of the internationalisation of China’s currency could not be successfully achieved without tackling the artificial valuation of the yuan. China’s current account surplus has created worrisome prospects which are not limited to the competitiveness of other countries’ exports. Mindful that the currency account surplus in this case is indicative of the country’s currency undervaluation, the situation is seen to create a “demand contractionary” exchange rate policy that leads to a significant rise in American unemployment from present levels. This means that domestic demand would tend to slow down as more consumers opt for the low priced imports, presumably from the country with an artificially devalued currency such as China. Poor demand locally would tend to reduce incentives for production due to failure of local products to compete with the low imports. The result will be overcapacity in many productive facilities leading to their shut down. An naturally, when companies shut down then people are laid off and unemployment rises. The second concern is that an artificial weakening of a country’s currency performs in the manner of a protectionist policy. Its effect is similar to having installed an import tariff and export subsidy. Strong and developed economies may weather this barrier but effects on emerging and developing countries are seen to be disastrous, in terms of a long-term loss of trade (Hirst, 2010). Domestic problems are also attendant an artificially undervalued currency. At first, economic growth is phenomenal because of the strong competitiveness of its lower-priced exports. This the Chinese economy experienced in the first quarter of 2010 with a GDP expansion of 11.9 percent, which is hailed as the country’s phenomenal recovery from the economic crisis (Hirst, 2010). The exceedingly high budget surplus, however, causes inflationary pressures because there is more money chasing a limited number of goods in the system. The inflationary tendencies would lead to the possibilities of an asset bubble which the country would find difficult to contain. It would be to the benefit of China, therefore, to allow for a gradual appreciation in value of its currency and greater flexibility of its exchange rate, in order to ease inflationary pressures and cool down the overheated economy. This is not to say, however, that the correction in the economy should be immediate and substantial, as this may create destabilization in China’s economy and disrupt its near-term growth, as well as create shocks that could likewise cause instabilities in other countries’ economic systems. Benefits of internationalization for China Internationalisation is seen to be contributory to China’s accelerated development, and in this regard commercial banks are seen to play a vital role. China’s commercial banks form the major conduit by which the yuan may be circulated and its use expanded across China’s borders. With the cross-border trade settlements mechanism in place, the country’s banking industry can hereafter leverage their advantages in geographic locations, service outlets and customer base, by culling traditional financial services. Aside from international trade transactions, there are the prospects of consumer banking services such as trade financing, overseas savings and lending, currency exchange. Other interbank services may be explored, among which are renminbi clearing, interbank lending, fund buying and selling, and account management. The increasing volume of renminbi transactions is seen to expand acceptability for the currency, paving the way for China’s banks to be issuers and underwriters of investment products, as well as investors themselves (Siqing, 2010). There are a number of other advantages for currencies regarded as international reserve currencies. One important advantage is international seigniorage, which is the gain in real resources resulting from the fact that a country’s currency is acquired and held abroad. Another advantage is the more flexible macroeconomic policy the country that comes with the ability to finance deficits in one’s own currency. This flexibility of macroeconomic policy impacts on the financial system in terms of reduced costs and currency risks. Finally, there is the geopolitical influence the home country may have over those countries that hold its currency in reserve (Cohen, 2007). An assessment of China’s financial power and political intent China’s economic standing as the world’s top trading nation is built upon an economic system that is still the subject of debate as to its merits and weaknesses. The economic system established by Deng Xiao Ping is based on factors which free market economists consider distortionary, and other Keynesian theorists view as a new economic paradigm combining elements of capitalism and socialism. The Chinese economy thrives in a regime of cheap labour and cheap capital, set through heavy government intervention, as its competitive advantage in the world market. Exports continue to be heavily subsidized even today, through direct loans to businesses and favourable exchange rates to foreign importers of China’s products (Miller, 2010). Indirect subsidy is also provided by so-called “financial repression” in the form of government controls imposed on investments of Chinese citizens and currency movements. It is through this system of government controls that the People’s Bank of China have accumulated a major portion of the trade inflows and profits resulting from the strong export volumes. It is expected that the PBOC’s reserves (not including those held by the commercial banks) would have reached close to US$ 3 trillion as of the end of 2010. China’s financial strength cannot be viewed without its implications on its political power and how it wields it to give substance to its financial foreign policy, which is to create jobs and stimulate further growth. China’s trade profits may be substantial, but its one-billion strong population is still for the most part suffering from poverty and unemployment. Its pursuit of this goal earns for the government a status of legitimacy that tends to overlook, even forgive, the pervasive corruption, increasing inequality, restriction of freedoms, and damage to the environment (Miller, 2010). In August 2010, the interest of the financial community was triggered by the launching of McDonald’s renminbi-denominated bond issue. There are as many who expressed optimism about its significance (Miller, 2010) as those who expressed pessimism (Lo, 2010) that the first international non-financial company to issue debt in China’s currency will eventually lead towards full and substantial internationalisation of the yuan. This is not likely, according to Chi Lo, author and CEO of a top investment company in Hong Kong, who states that “any significant progress in renminbi internationalization would mean a significant shift away from the U.S. dollar as the world’s reserve currency (Lo, 2010. p. 31). He points out that internationalizing the yuan will tend to create a large offshore renminbi market, similar to the creation of the offshore U.S. dollar (termed “eurodollar”) market. This is something that Beijing does not want, if one may look to China’s past monetary history. The creation of an offshore renminbi market will necessitate the relinquishment of controls, something China has shown no indication of doing. Also, officials fear the unforeseen events that could negatively impact the domestic currency situation in ways unintended. A highly likely scenario is that banks operating in the offshore market would be free from regulations mandating reserve requirements. This takes the currency further from the control of Beijing, and may expose the currency to the chance of a possible liquidity shock as offshore banks exercise greater discretion in expanding their foreign currency offerings. A further consideration is that for the renminbi to attain the status of hard currency used internationally as medium of exchange and reserve currency, China must rethink its trade policy and become a net importer of goods and exporter of capital, to enable its trade partners to accumulate sufficient renminbi assets in large volume. A strong financial system to support massive capital flows, as well as creditable economic policies to foster the confidence discussed earlier. To accommodate these changes, the economy must be restructured, a long-term (probably decades-long) process. Conclusion This paper set out to determine whether or not the renminbi would provide a viable substitute for the dollar as principal international reserve currency within the next ten years, and whether such a substitution will stabilize the global currency market and prevent further recurrences of financial crises as the world had experienced in the past. There are many reasons for the yuan to be considered as a possible alternative, the most important of which is its position as the top trading country in the world. It has amassed some 3 trillion dollars worth of international reserves, two-thirds of which is in U.S. dollars, thus this country is capable of exerting economic pressure on the United States, as it was rumoured to do when it allegedly threatened to sell out its huge hoard of U.S. Treasury securities. Yearly it experiences record current account surpluses, compared to the U.S.’s accumulating current account deficit and public debt. Moreover, China has taken significant steps in freeing up its currency, allowing it for international trade settlements and investment, and issuing recent currency swaps and bonds denominated in renminbi. The most significant recent development is the renminbi-denominated bond issued by McDonald’s, the first ever bond issued in China’s currency by a non-financial foreign company. Despite these positive factors, there are also serious concerns about the state of the yuan. China’s financial markets are still highly restricted, and its currency is still unable to trade in the open market, let alone be freely converted into other currencies. The renminbi is still generally felt to be undervalued, giving China an unfair trading advantage over its partners. The currency is not held in large quantities by other countries, which at once compromises its standing as an international reserve. Furthermore, there is serious reservation that China could quickly revalue its currency at its true level, because this would cause destabilizing repercussions on the Chinese economy. Neither could China immediately sell out its dollar reserves as it had threatened, because the sheer volume of its dollar assets, if released into the market, will send the dollar value down precipitously, compromising China’s position as holder in bulk. Other than currency concerns, China’s economic and political infrastructure are in need of a fundamental change. Corruption must be addressed, and the system made more transparent, in order to afford investors and fund managers a clearer view by which to assess the political risks of the currency. Basic human rights and environmental concerns are likewise important considerations, as any controversy in these areas may affect the trade in renminbi and put it in danger of sudden and unforeseen volatility. As international reserve, the renminbi must be stable and move slowly, so as not to cause frequent changes in the value of portfolios held in renminbi. The greatest concern of all is the utter absence of any history of the renminbi as a free currency. China is in the very early stages of internationalising its currency, and moving slowly and surely may eventually allow it to attain international reserve currency position, but that will take a long, long time. Speeding up the process will cause destabilization, and a host of errors the currency may not be able to recover from. In conclusion, I would say that while the renminbi, and even the euro for that matter, may eventually stand side by side with the dollar as international reserve, ten years is too short for it to do so, and to do so in a manner that creates stability in the global currencies market. Bibliography Cohen, B J 2001 “The Future of Reserve Currencies” in Finance and Development, IMF, WB, World Bank Group. 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