The Yuan as International Currency - Research Paper Example

The Yuan as International Currency Introduction In June 2009, China’s State Council announced its objective to develop Shanghai into an international financial center in 2010. For some observers, this is a hopeful sign that China will soon be adopting a program of currency and financial market liberalization, a necessary precondition for it to become an international financial center. Some analysts, however, feel that the designation “global financial center” is viewed with a different connotation than that which the conventional image brings to mind. In the meantime, even now, China has again become the target of strong political pressure from the U.S. and European political leaders who are calling for the removal of the currency peg the country imposed at the height of the 2008 financial crisis, and in so doing allowing the currency to appreciate to its normal level. There is no question that while the country has adopted economic reforms and no longer abides by a centrally planned economy, China’s currency remains tightly controlled and its financial markets stringently regulated. While authorities agree that a loosening of monetary controls is necessary, the political will to effect the necessary changes seems lacking. The elevation of the renminbi to international currency status is seen to be advantageous to Chinese exporters and importers in so far as it eliminates currency risk, but it entails exposure of the tightly controlled Chinese economy to external shocks and market fluctuations. This essay shall consider the proposition of whether the Chinese renminbi may conceivably attain the status of an international currency, let alone replace the American dollar as international currency of choice, within a period of ten years. To do so, it will delve into the nature and function of currency, the implications of currency becoming an accepted medium of exchange for international trade, and whether or not China’s situation shall allow those conditions necessary for the renminbi to become an international currency. If the answer is plausible, then the study shall determine whether or not the adoption of the renminbi in place of the dollar is capable of stabilising the global currency markets and preventing the crises of recent years. Background on the function of currency The history of money may arguably be traced to the ancient times when commodity money with intrinsic value was used as mediums of exchange. For the purpose of this study, however, the function of money shall be the focus, beginning with the use of gold coinages in Europe. At or about 1252, gold coinage was reintroduced in Florence with the minting of the gold florin (gold coins were last used in the seventh century with the end of the Roman empire, silver coins being used in the interim). The return to gold coinage was largely due to the Crusades and the subsequent commercial success of Florence, Venice, Pisa, Genoa, and other autonomous states that sprang up in Europe. The establishment of the system of gold coinage marks the era of commercial expansion among the Italian republics, and at about the mid-14th century the general liberty of coining gold was under the control of Emperor Charles IV. States and free towns either purchased or were accorded the right to mint free coins, with general stipulations concerning their quality and weight in relation to the florin of Florence. Thus this early, it has been understood that particular standards are required to establish the comparability and, it is presumed, convertibility of one state’s currency to that of the other. The practice thereafter was carried over to other nations such as Germany, France, and Spain, with corresponding standards in weight and value, again for comparability (Shaw, 1967). The exchange rates for foreign coins were established by proclamation, and the office of the exchanger was assigned to one specific place. This of course proved insufficient. The exchange rates varied suddenly and offensively, partly because of the matter of the coins’ value, but also because the rulers in the 14th and 15th centuries sought to hoard their stash of gold and silver by attracting the supply of the neighboring states. These developments were the early indications that where money is linked to the political power that created it, there is a need for a conversion standard and mechanism where such monies may be exchanged for value in goods and services that are traded across borders. Thereafter, at around the middle ages, bills of exchange and the general use of credit became common in European trade. The use of notes and bills as evidence of value, rather than coins with intrinsic worth, eventually led to the adoption of fiat money and development of systems of currencies that are taken as legal tender within their political borders, but must be accepted as stores of value to be used outside for external trade. The more recent significant developments have to do with the post World War II international agreements on monetary regimes. The United Nations Monetary and Financial Conference was attended by representatives from 44 Allied countries in July of 1944, in Bretton Woods, New Hampshire, and in three weeks signed what came to be known as the Bretton Woods Agreement. The terms of this document provided for an international monetary system that called for each country to maintain a system of fixed monetary value, varying only to within one percent, in terms of gold. This came to be known as the gold standard, and on this basis a system of fixed exchange (“pegged”) rates was implemented (Mason & Asher, 1973). Bretton Woods prevailed for a quarter century from 1946 to 1971, during which time it provided the world a period of currency exchange stability. This was mainly a reaction to the disorder in the currency exchange regime between the two world wars, born of a lack of a common system of rules governing relations in trade and currency (Obstfeld, 1995). After this period of relative stability, and pursuant to the intention for Bretton Woods to be effective only for 25 years, the gold standard was abandoned and the floating rate system was adopted, first by the United States. At that time the U.S. experienced a large drop in its gold reserves together with a large increase in foreigners’ claims on US dollars, for which that country suspended to dollar’s convertibility into gold and floated its currency, the same exchange rate system that is in operation for free market economies at the present day (Davies & Davies, 1999). Necessary implications of an international currency There remains to be no standard definition of an international currency, but by observing the role an international currency plays, it may be inferred that an international currency is “one that is widely used outside its home country, for trade invoicing and settlement, reserve holdings, and as an exchange rate anchor for other currencies” (Yue & He, 2008, p. 197). There are thus certain characteristics an international currency must possess in order to meet these expectations. It must be perceived as sound and stable, and market players must accept it as a store of value and willingly hold it in substantial amounts as reserve. It should also be susceptible of ready conversion to other currencies, and of course it must be capable of acquisition by non-residents. Another important determinant would be the size of the home economy. This means the home country must have a sizeable trading industry for it to hold substantial reserves of other currencies simultaneously to maintaining its own. It must likewise possess a developed and open financial market, as it will supply assets (stocks, bonds and derivatives) denominated in local currency that will be in demand by international investors for hedging and investment flexibility. Furthermore, the value of an international currency, for it to be a reliable measure of value for international financial transactions, must only vary slowly over time. Finally, the currency must be in frequent and regular use in other countries for it to derive value as an international medium of exchange (Yue & He, 2004). The foregoing qualifications shall form the basis for the following discussion on the likelihood that the renminbi shall replace the US dollar in ten years, and if so, whether or not such a development is capable of stabilising global currency markets and averting financial crises similar to those that had happened in the past. The Chinese economy and currency From the end of the Second World War until about the decade of the sixties, the value of the renminbi (RMB) remained stable because of the foreign exchange policy adopted by state officials. In 1949, the value of the RMB was ascertained through a process of comparing the prices of China’s exports, imports, and the purchasing power parity of foreign exchange remittances. However, by 1950, a trade embargo was imposed against China by the US and Western countries, effectively blocking all trade with China other than the Soviet bloc. From then, China assumed economic central planning pursuant to the Russian model, and employed a largely closed economic system characterized by import substitution and self-reliance (Yang, Yin & He, 2004). As early as the 1950s, China employed a strict regulation of its foreign exchange, requiring all foreign exchange holdings to be deposited with the Bank of China, including overseas Chinese, foreign travellers, foreign embassies and missions. From 1955, the RMB exchange rate was set at 2.46 to one US dollar, and this rate persisted until China resumed its membership in the United Nations in 1971. Inasmuch as the absence of trade during the interim years caused a distortion in price linkages between China and other countries. This caused China to revalue its currency, beginning from its level of 2.46 RMB per dollar in 1972 to 1.50 yuan to the dollar in 1979. This means that the Chinese exporters (which happens to be state-owned companies) lost 0.91 yuan for every dollar earned, amounting to a 38% loss. Seen the other way, prior to the revaluation China’s currency was actually overvalued by more than 60% on the basis of China’s export prices (Yang, Yin & He, 2004). The RMB remained generally stable with regards to inflation through the sixties and the seventies. Under a centrally planned economy, the government set wages and prices and determined production schedules. In 1978, China embarked on economic reform; price controls were relaxed in gradual increments, and market forces had gradually been allowed to play a more significant role in determining prices. Understandably, inflation initially surged to double digit figures in the eighties until the mid nineties, but eventually receded to more reasonable levels. Throughout these decades, China had maintained robust economic growth and price stability (Yang, Yin & He, 2004). Subsequent to the adoption of the open door policy in 1978, the matter of losses due to foreign exchange revaluation prompted China’s State Council to introduce an “internal settlement rate” of 2.0 RMB to the dollar starting 1980. The rate was computed as the average export cost per dollar of China, with a 10% margin added on. The “internal settlement rate” was used by China’s trading firms to settle foreign trade earnings payment with the government. The existence of the internal settlement rate of 2.0 RMB per dollar, and the official exchange rate of 1.53 RMB to the dollar formed China’s dual exchange rate system (Yang, Yin & He, 2004). Some analysts view present-day China as an immature creditor – i.e., that its currency (the renminbi or yuan, as it is known) which it has in massive amounts by virtue of its large trade surplus, could not be used to finance its foreign investments, despite the fact that China is a net lender and creditor in the international economy. This is a strange and unusual designation that does not normally occur in contemporary finance or economic theory, as those significant net creditors (mainly the US, the UK, and the EU) are able to utilize their own currencies in international transactions and investments. The Chinese Yuan (Renminbi) as international currency Negative indications. In 2008, government officials authorized for the first time some 365 Chinese companies to bill their exports in renminbi rather than in dollars. The plan was to attempt to promote the renminbi for widespread international use; however, the plan has encountered problems in implementation. It appears that one year after the government’s assent, Sassin International Electric Shanghai Co., one of the firms authorized to denominate its export billing in renminbi, has yet to write a single invoice in renminbi. Use of the local currency would have been highly advantageous for Sassin as with the other firms, because they would not have to incur bank charges for conversion and thus they would be able to avoid the currency risks involved in having to deal in dollars (Cheng, 2009). Sassin’s foreign partners, however, were reluctant to have to comply with the tight restrictions that governed the renminbi program, as well as other constraints imposed on the use of the currency. An example of such constraints is the fact that China allows the issuance of renminbi invoices by companies to their customers located only within Hong Kong and Macao (the Chinese controlled territories), and the ten ASEAN member states. This is a problem for Sassin, because their customers are primarily companies situated in Europe, Japan, and the United States (Cheng, 2009). The problem appears to be that China’s government, despite proclamations that appear to favor the liberalization of the national currency and the adoption of a system of currency convertibility, in actuality maintains a very tight control over the currency. The reason is that China’s officials fear the prospects that the Chinese currency will succumb to currency instability, in much the same way as the currencies of the other Asian countries whose rates had been allowed to float, during the Asian currency crisis that took place in the latter years of the 1990s. Furthermore, should the renminbi be taken off of its peg at the present time, this may cause adverse effects on China’s present export leadership that is the main driver of the country’s economy (Cheng, 2009). China has, in fairness, experimented in currency liberalization. However, the attempts always fall short of producing desired results before the authorities withdraw the initiative and revert back to the currency peg. The events that tend to suggest that China is not ready to internationalize its currency are as follows: 1. For two years, China had allowed its currency to adopt a floating rate system, which caused the renminbi to appreciate by 18 percent against the U.S. dollar. At this point, though, China reversed its liberalization policy in August 2008, and immediately restored the fixed exchange rate, just as the US credit crunch spread in a global financial crisis that peaked in the latter half of that year (Cheng, 2009). 2. In August 2007, for instance, the officials announced that they would allow the direct investment in Hong Kong stocks by Chinese individuals, via a financial zone to be set up in the port city of Tianjin, just north of Beijing. Before the plan could talk off, however, it was immediately terminated, reportedly due to fears by Premier Wen Jiabao of the prospect of capital flight (Cheng, 2009). 3. Another instance was in October 2008, when the government planned to allow the experimental trading of stocks on the margin and short-selling of stocks. (Margin trading involves transactions on stocks on leveraged or borrowed funds, in the expectation that the price of the stocks shall rise and the resulting selling price will be sufficient to repay the borrowed fund with interest, and still yield some profit. Short-selling, on the other hand, involves the selling of borrowed stocks with the expectation that the price will fall, so that the stocks may be bought back and returned to the true owner with a service fee). Clearly, however, the two trading maneuvers are short-term speculative techniques, and while they could provide vital hedging tools for the fund managers, they are prone to abuse and unexpected losses should the speculator lack knowledge or be unskilled in this type of trading, and the market price of the stock move in the direction opposite to the expected direction for which the trading position was taken. Because of this, the China Securities and Regulatory Commission had gone so far as to request the regulator for license applications for a selected number of companies in Shanghai as of January 2009, but no licenses were ever granted. Apparently, officials feared that the widespread use of margin trading and short selling may destabilize the China stock market. The plan has not been given up, however; it is simply not being implemented (Cheng, 2009). 4. Another indicator of China’s resistance to liberalization is in the way its stimulus package had been handled during the height of the financial crisis. A package of 4 trillion renminbi (US$585 billion) was released to spur economic growth back to the targetted 8 percent, but the greater portion of the funds was passed through state-owned banks, for the benefit of state-owner firms rather than private firms (Cheng, 2009). 5. One major drawback of China’s protectionist policy in its financial markets is the restriction it places on foreign investments in its capital markets. Foreign companies are reluctant to accumulate large renminbi reserves, which would tend to occur if they billed in renminbi. Since such reserves would not be able to be invested in capital market instruments such as stocks, the firm would not be able to realize higher than fixed interest income on its renminbi reserves. Furthermore, because of tight exchange controls, large amounts of renminbi will be incapable of immediate conversion into other currencies should the need call for it (Cheng, 2009) 6. Trade settlements in renminbi will naturally require large amounts of RMB outside China’s borders. This is clearly not the case, as it is government’s policy to keep a tight control over the amount of renminbi reserves. Moreover, foreign exporters based in China may not even freely reinvest its RMB earnings back into China, as they have to secure approval from authorities in order to bring its money back into China (Cheng, 2009). 7. Despite efforts at encouraging international use of the renminbi, there appears little chance of this happening, at least in the near future, because China’s domestic financial markets still remain largely undeveloped (McKinnon, 2010). Positive signs. Recently, there have been attempts to increase use of the renminbi outside national borders. Some of these are the following: 1. In 2009, currency swap agreements valued at $95 billion was announced to be contracted with six trading partners, namely Argentina, Belarus, Hong Kong, Indonesia, Malaysia and South Korea, and direct trade accounts will continue to be set up with more countries in the future; 2. In 2007, currency controls have been eased on people in Hong Kong, enabling individuals to buy some 20,000 RMB per day and to send up to 80,000 RMB into China without need for approval from the government regulatory agency in charge of administering the country’s foreign exchange reserves. Hong Kong residents are also permitted to send renminbi remittances back to Hong Kong from China, conditioned on their ability to provide evidence that such money had not been derived from investment gains realized in China. 3. A renminbi-denominated capital market is gradually being established in Hong Kong. A pool of savings in renminbi is building up in this autonomous region, which recently had reached some 58 billion in bank deposits. So far the Hong Kong banks hold the only significant pool of renminbi beyond mainland China’s borders. From 2007, some 38 billion renminbi have been raised by Chinese companies, principally on the basis of 11 bond issues that have been transacted in Hong Kong. In October, about 6 billion RMB worth of bonds have been sold by the mainland government’s Ministry of Finance, at 2.25 percent coupon rate with a maturity of three years. This marked the government’s first debt issue sold outside the mainland, a clear indication of the government’s resolve to gradually internationalize their currency. 4. The projected growth in liquidity is expected to encourage banks to develop forward and swap derivatives based on the renminbi. The development of currency hedging instruments is a critical factor to ensure that the renminbi settlement system will enjoy a wide take-up, in the course of becoming an international currency. Analysis and discussion In order to arrive at a grounded opinion concerning the future of the renminbi as international medium of exchange, the criteria earlier described by Yue and He (2008) are reiterated here, and evaluated in light of the foregoing research. 1. An international currency is widely used outside its home country, for trade invoicing and settlement, reserve holdings, and as an exchange rate anchor for other currencies.” From the foregoing discussion on the renminbi as international currency, it was noted that the government has embarked on serious attempts at increasing the extra-territorial use of their currency, but so far the experiments have been comfortably within their sphere of control, consisting largely of border trade and the use of the renminbi in the autonomous territory of Hong Kong. Beyond that, however, present government policies preclude the free use of the currency, because of a system of tight controls and constant need to secure government permits for substantial movement in and out of the country. 2. It must be perceived as sound and stable, and market players must accept it as a store of value and willingly hold it in substantial amounts as reserve. Earlier it was mentioned that the Chinese government has embarked on an invoicing experiment wherein some 365 selected companies have been authorized to denominate their exports in renminbi. Despite this, few takers have emerged, largely because of reluctance among foreign trading partners to hold substantial amounts in renminbi and be subjected to the strict controls imposed by the Chinese government on its deployment and conversion. Foreigners find it difficult to hold large amounts of a currency which they are forbidded from investing without having first requested and secured permission first from the government. It becomes difficult for investors to exercise discretion, to avoid risks and maximize returns. 3. It should be susceptible of ready conversion to other currencies, and it must be capable of acquisition by non-residents. The international use of a currency must be determined by market forces, and a system of tight capital and monetary controls is not compatible with this requisite. What is required is the capacity for non-resident convertibility, which provides the benefits of seigniorage, reduced transaction costs, and expansion of international trade and financial transactions; however, it also invites the risks of market uncertainties to the home country. There are costs involved to the domestic economy due to the sizeable international demand for its currency (Yue & He, 2008). 4. The home country must have a sizeable trading industry for it to hold substantial reserves of other currencies simultaneously to maintaining its own. There is little doubt that China does have a massive trading industry, and has consistently been gaining in market share, sometimes at the expense of other countries such as Japan and the South American economies (Barboza, 2009). To be able to do so, no doubt that China would be holding substantial reserves of foreign currencies to serve its trading purposes. However, unless financial markets are truly deregulated and opened to market forces, there is little basis to say that China has sufficient foreign reserves to support the requirements of an international currency and the dynamics of easy convertibility. 5. The home economy must possess a developed and open financial market, as it will supply assets (stocks, bonds and derivatives) denominated in local currency that will be in demand by international investors for hedging and investment flexibility. To be sure, there have been some optimistic signs in this area, such as the issuance of the first renminbi bonds in 2007. Furthermore, the currency swap with six trading partners in 2009 and the development of a fledgling renminbi-denominated capital market are heartening. The progress seems to be slow, however, given China’s history of commencing a liberalization initiative only to pull back to a protectionist policy even before the initiative has taken off, or failing to remove the tight controls that render the experiment ineffective. The country’s financial markets are far from being allowed to move freely, and the hedging mechanisms (short-selling and margin trading) have been attempted but withdrawn. China is still far off in terms of capital market development. 6. The value of an international currency must only vary slowly over time. It is true that the exchange rate of the renminbi remained stable and had exhibited minimal volatility over the decades; however, that is seen as the effect of the peg on the dollar that has been in place consistently through the years. It was earlier mentioned that the renminbi was allowed to float on an experimental basis for two years, but was quickly restored to a fixed rate in 2008 as the global economic crisis peaked. While the renminbi thereby maintained its stability, there is little indication that the currency will remain steady if it were again allowed to float. Some are certain that it will not, due to the status of the country as an immature creditor economy (McKinnon, 2010). 7. The currency must be in frequent and regular use in other countries for it to derive value as an international medium of exchange. In this criterion, the renminbi is farthest from the ideal situation. The circulation of the currency is still under tight regulation by the authorities; the invoice experiment that allows renminbi denomination, for instance, has been allowed only for Hong Kong, Macao, and ASEAN countries, and even then the reception has been disappointing. For it to be said that the renminbi is in “frequent and regular use in other countries” is to state the direct antithesis of the present state of the renminbi. Conclusion China’s announcement that Shanghai will be a global financial center in ten years, and that the renminbi will be an international currency, may reflect Chinese officials’ own interpretation of what a “global financial center” is. It is possible that this may refer to some hybrid version of a financial center possessing Chinese attributes. It may, for instance, admit of a large stock market with some foreign participation, but with access and attraction curtailed so that foreign institutions may not so easily sell off during financial shocks. Reportedly, the government aims to develop an exchange system that is as risk-free as possible (Cheng, 2009). However, the prospect for China’s currency to perform as a true international currency appears to be way off into the distant future. There is a need for the adoption of a truy floating rate system for the currency to find its true value, and the development of capital market infrastructure to support the holding of mass reserves of the currency. Tight regulations currently in place should be gradually loosened and then removed altogether, and China’s developing economy still strengthened further before it may support the movement of large amounts of its currency beyond its borders and throughout the globe. This study set out not only to determine whether the renminbi may become an international currency in ten years, but whether or not it may replace the dollar as the international currency of choice to create a stable global financial system free from crises. This is just not the case, at least not in the foreseeable future and certainly not in the next ten years. The country’s officials have not yet even abandoned its currency peg; without this critical first step, there is no way to literally gauge the true value of the renminbi, as well as its strength and resiliency to support international trade. “As long as China maintains capital controls, minor liberalization efforts are not likely to gain traction” (Cheng, 2009). With this, we are in agreement. Bibliography Barboza, D 2009 “In Recession, China Solidifies Its Lead in Global Trade,” The New York Times, 13 October 2009. 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