The internationalization of the Chinese Renminbi (hereafter RMB, or Chinese Yuan, CNY) is a relatively new topic that has been gaining more traction in recent years due to the Global Financial Crisis (GFC, 2008~2010) as well as a rapid expansion of China’s economy, especially in terms of global trade. The recent inclusion of the RMB in the IMF currency basket known as Special Drawing Rights (SDR) in November 2015 (but formally in place in October 2016) brings additional strength and credibility to the currency.

Given the ongoing reforms taking place in China aiming at rebalancing the economic model from an investment/exportation-led model to a consumption/service-led one, the IMF’s decision is a blessing and demonstrate the confidence of a well known international financial institution towards China and its leadership. The country is indisputably at a crossroad and the RMB internationalization might be a crucial component to achieve this transformation.

I chose to study this issue for my Master thesis, successfully defended in June 2015. However, given the width, depth, and technicality of this topic, this article will be divided in several parts. The first part which follows, although quite theoretical, lays out the foundation of a comprehensive analysis that stems from it. First of all, I will start by introducing the background of the topic. This will be followed by a definition of currency. Lastly, I will do an assessment of the cost and benefits of currency internationalization. The next article (Part II) will focus on the development of Hong Kong as an offshore RMB center with the latest data available.

Introduction

In the wake of the 2008 financial crisis, the Chinese government initiated the ambitious project to internationalize the Renminbi (人民币, hereafter RMB). Indeed, during the 2008 financial crisis, the shortage of U.S. dollar hampered growth of international trade and financial transactions. The Fed Reserve (hereafter the Fed) had to inject a huge amount of liquidity in order to keep the system stable through ultra-expansionary monetary policies known as Quantitative Easing (QE) and set interest rate close to zero also called the Zero Interest Rate Policy (ZIRP) in order to revive the economy. In 2015, the Fed has started to lift interest rate by 0.25% to 0.5%. This increase is meant to be gradual and data-dependent, as the Fed suggests.

In other words, the crisis showed us that an international monetary system based on a single global currency can ultimately lead to global instability. Given the increasing frequency at which economic and financial crisis occur, something has to be done in order to limit the impact of future crisis at least and prevent them at best.

According to the a large array of literature and observers (i.e. “The Role of the Renminbi in the International Monetary System” by Joseph Yam; “Strengthening the International Monetary System: Taking Stock and Looking Ahead” by the IMF) the structural weaknesses of the current international monetary system are the following: (1) Ineffective global adjustment process, (2) Financial excesses and destabilizing capital flows, (3) Excessive exchange rate fluctuations and deviations from fundamentals, and (4) Excessive expansion from of international reserves.

In light of this assessment, the head of the People’s Bank of China (PBoC) suggested to reform the current international monetary system. His essay (Dr. Zhou Xiaochuan, Governor of the PBoC (2009): “Reform the international monetary system”) highlights the need to reduce the reliance of the U.S. Dollar and implicitly promote the role of the RMB. This suggestion is also based on the facts that given China’s impressive economic development over the last 30 years and China’s current share of world trade, the RMB should gain traction and be more widely used to reflect China’s world position.

Indeed, the RMB is currently underutilized internationally. There is no doubt that China’s attempts to internationalize the RMB have significant implications for the international monetary system and for economies across the world. The guiding philosophy for reform and liberalization to build a socialist market economy in China is “crossing river by feeling the stones” (Deng Xiaoping), more recently articulated by former Chinese Premier Wen Jiabao as “gradualism, controllability and the taking of initiative” (渐进, 可控, 主动).

The particularity of China is that its currency is being internationalized despite of being not fully convertible yet. Instead of fully liberalizing its capital account and exchange rate, China’s strategy is to promote the RMB internationalization through two main channels: namely the RMB in cross-border trade settlement and the creation of the offshore RMB market which include a lot of hub (Subacchi, 2010).

1. Currency internationalization

1.1 Definition

According to Cohen (1971) and Kenen (1983) a currency performs the following three functions of money: a medium of exchange, a unit of account, and a store of value. An international currency also has the same functions. These functions are performed under two distinct levels which are public and private. The six roles are summarized in the table below.

testA currency might still be regarded as an international currency although it doesn’t fulfill all the six functions mentioned above. As a matter of fact, there are different degrees for which a currency is internationalized: a currency is typically considered “international” when it is used as a unit of account (for example corporate invoices), a medium of exchange (to settle cross-border trade) and a store of value (deposits, reserve currency).

It is important to mention that the usage of the currency by the private actors come along with more volatility compared to the public actors. Indeed, governments don’t change their foreign-exchange reserves overnight nor often change their domestic currency peg. However, this does not apply to private actors. Their decisions are subject to sudden shifts and they need more flexibility. As a result, being an international currency involves both benefits and costs.

1.2 Benefits & Costs

First of all, the ultimate stage of currency internationalization is the status of reserve currency: this implies that various domestic central banks around the world as well as other domestic financial institutions hold significant amounts of this currency in their reserves.

This reserve currency acts as a buffer when other domestic currencies drastically and suddenly lose their value. In this scenario, the reserve currency can be sold out in order to defend the peg (under a fixed exchange rate) and avoid a large depreciation (under a floating exchange rate). Usually, central banks hold interest bearing debt instead of just holding cash (e.g.: US treasuries bonds).

Second, a reserve currency is widely used to pay domestic debt and affect the exchange rate. Finally, commodities are priced in the reserve currency.

However, only a very few countries have succeeded to internationalize their currencies over time. It takes a certain set of conditions (that we will discuss later) for a country to successfully internationalize its currency. Yet as we just mentioned, currency internationalization brings benefits but also comes at price.

Let’s analyze the benefits of having an international currency. The first obvious benefit would be convenience for the country’s residents: exporters, importers, borrowers, and lenders are able to deal in their own currency rather than dealing with foreign currencies. Transactions cost for international trade and financial transactions are greatly reduced and hedging cost drops to zero with no exchange rate risks and no interest rate risks.

The second benefit (Seigniorage through debt monetization), which is in reality both a blessing (in the short run) and a curse (in the long run) is that the fiscal deficit can be financed by foreigners holding the domestic currency. The well known example is China massively buying US Treasuries over the last decade to manage its own exchange rate and get interest on US Dollars earned through trade. Since cash is a non-interest rate bearing asset but bonds are, USA has been able to run a large fiscal deficit by issuing low interest rate debt.

Third, currency internationalization gives more business opportunities for country’s banks and financial institutions as well as promoting external trade and overseas investment. Internationalization may spur the development of the domestic financial system and enrich the menu of financial assets available to domestic investor.

Fourth, it may also allow domestic firms and financial institutions to borrow abroad at lower cost and in significantly larger amounts than may be available domestically.

Fifth, from a geopolitical standpoint, having its domestic currency acting as international currency gives certain leverage and influence. China might be able, to gain and exercise a greater influence in the Asian region by dethroning the US dollar. As shown, an international currency brings without a doubt strategic advantages. However, this idyll has a price. The Capital Asset Pricing Model (CAPM) model suggests that an excess return comes along with an excess of volatility. In other words, the more one is willing to pay and to put him at risk, the greater the benefit might be.

This arbitrage to make must be solved by the political dimension. We could wonder: should China open its capital account for the sake of RMB internationalization given the risk of potentially losing control on its currency and at worst losing control of the country itself? As said previously, there are different degrees for currency internationalization and there is no certainty that reaching the ultimate stage of reserve currency is in China’s best interest given the current position.

This leads us to analyze the cost of having an international currency.

The first drawback of an international currency for the issuing country is the loss of control of macroeconomic policies. Indeed, the offshore market plays a significant role and might therefore affect the natural pricing power of the onshore market (i.e. volatility in January 2016). As the Eurodollar market has shown, it has significantly weakened control over national economic and monetary policy leading to a greater instability and volatility in exchange rates, which directly affects those trading and investing internationally.

In the case of China, currency internationalization implies to fully liberalize the capital account and interest rate (the deposit rate is not yet liberalized) in the long run. One must recall that the Chinese leadership used to define a specific target for money supply (rather than targeting a specific interest rate) in order to adjust credit expansion, one of the most powerful tool to unleash growth during the last fifteen years in China.

Interest rate is fundamental within an economy since it gives the price of capital and determines the price of risk premium. As a result, a market based interest rate is required in order to let the market to allocate the credit efficiently. A rapid liberalization of the Chinese economic structure is both a chance to address some imbalances but also a risk that can undermine growth in the short run. The Chinese leadership, fully aware of what is at stake, is proceeding with extreme caution but in the right direction.

The US dollar highlights another major issue related to currency internationalization, more precisely the reserve currency status, which is illustrated by the Triffin dilemma that creates a divergence between short term domestic objectives and long term international ones. The issuer country of the reserve currency keeps running a current account deficit (including trade deficit) because it has to provide enough liquidity to meet the worldwide growing demand. Growing demand comes from greater international trade, emerging markets growth and sophistication of the financial products to name a few.

However, the constant trade deficit and current account deficit can undermine the credibility of the reserve currency in the long run. The USA has run a current account deficit since early 1990s meaning that the country has been a net borrower to the rest of the world since then. If USA is not able to generate enough growth every year, the debt burden will grow and will eventually asphyxiate growth in the long run. As for creditor’s standpoint, it would also undermine the country ability to meet its obligation and repay its debt servicing.

According to prominent scholars Reinhart and Rogoff, economic growth potential is severely impacted when the debt over GDP ratio goes beyond 90%. The dynamic of the debt should also be analyzed carefully through the current and expected deficit in the coming years. In the case of Spain, the debt-over-GDP ratio was around 40% before the GFC (2007) and is currently around 90% (2014). This shows that it might be misleading to only focus on debt: current and expected deficits must also be taken into account. In any case, the worst situation is when a country is not even able to generate enough growth just to repay the interest of the debt. In 2015, Japan was currently allocating about 42% of tax it collects just to pay off debt interest.

The sixth risk is about the currency backflow channel: inflow of liquidity that can lead to inflation and thereby destabilizing the country’s financial stance. In the case of the RMB, holders of offshore RMB are keen for more RMB backflow channels since high return opportunities exist in onshore market. The backflow channel is a critical issue and can be established by China’s policy authority. In 2012, for instance, the State Council authorized Qianhai, Shenzhen, which is an innovation experimental zone, to deal with the offshore RMB business, to pilot cross-border loaning RMB and to issue RMB bonds by domestic enterprises in Hong Kong.

Qianhai will greatly promote the development of Hong Kong offshore RMB financial center as a new channel of RMB cross-border backflow was established. The Hong Kong offshore RMB market remains relatively small and it is separated with the domestic onshore market, so the RMB backflow from Hong Kong’s offshore market does not affect the onshore market too much so far. Similarly, the exchange rate in offshore market does not significantly affect the one in onshore market.

However, deepening and widening the role of offshore market will significantly affect the onshore market. Because there are no restrictions on the RMB in most of the offshore market, the interest rate and exchange rate of RMB formed in the offshore market basically reflect the real supply and demand of the market. There is therefore certain reference for the onshore market-oriented reform of interest rate and adjustment of exchange rate formation mechanism.

In theory, the offshore money multiplier (i.e. the amount of deposits bank don’t have to hold as reserves and can therefore lend) that is not controlled by the monetary authorities may interfere with the onshore money multiplier along with the expanding of backflow channels. Offshore money multiplier often measures the maximum amount of commercial bank money in offshore market that can be created by a given unit of the initial offshore money.

Just as the principle of onshore money multiplier, offshore money multiplier is roughly equivalent to the offshore reserve requirement ratio. As the offshore market often has less constraint due to lower regulation, the deposit reserve requirement also is lower than that in domestic. Therefore, like domestic non-bank financial institutions, the presence of the offshore market may also reduce the effectiveness of onshore reserve requirement ratio, which is equivalent to increasing the credit multiplier.

If channels between onshore and offshore market are free enough, it is possible to interfere with onshore monetary policy through offshore money creation when the offshore money multiplier is greater than that of the onshore market. As a result, it can put at risk the domestic management of monetary policy, although the risk is limited in the early stage due to relatively small amount in circulation.

Nevertheless, along with the further increase of the offshore market scale and further broadening of RMB backflow channels, the speed and quantity of RMB backflows might gradually get rid of the control of central Bank. Hence, the independence of monetary policy could be challenged and management costs could rise. It will also pose challenges for the central bank to monitor the speed and quantity of RMB backflow.

In general, the scale of onshore market is often larger than that of the offshore market, thus the onshore market can dominate the price discovery function. However, with respect to the capital controls and size of market, the risk of losing pricing right for onshore market is increasing with the development of the offshore RMB market. The changing tendency of the RMB NDF (non-deliverable forward) market rate will lead the changing tendency of the RMB onshore forward market rate. Below the summary of the four RMB markets.

rmb marketFrom the perspective of the size of the market, although the RMB stock is quite limited in the offshore RMB market, mature financial markets, such as Hong Kong, have a lot of financial tools with high leverage. Lower regulation and transaction costs can increase market risks. Moreover, with the rapid development of the offshore market, the value discovery function of the offshore market will be exerted more and more while the one of the onshore market will be eroded.

The recent events in January 2016 highlight this risk. The spread between CNY and CNH has reached more than 1000 pips (0.1%) letting the door open for arbitrage and call into question the real value of the CNY. Eventually, the PBoC had to step in the offshore market to buy CNH and to reduce the spread. This came at a cost: 1) undermine credibility and 2) soaring interest rate, especially overnight one. Clearly the PBoC will not be able to massively intervene in the offshore market in the long run without meaningful collateral damages.

Therefore, PBoC should continue to promote onshore reforms, let the market play a bigger role but also closely monitor and intervene in case of extreme and/or non justify volatility in the offshore RMB market. Otherwise, eventually the onshore market may be marginalized, putting at risk the RMB stability and by extension China’s economic stability. The RMB internationalization is a double edge sword and should therefore be handle very carefully.

The next article (Part II) will focus on the development of Hong Kong as an offshore RMB center with the latest data available, along with the recent substantial move of the CNY/CNH engineered by the PBoC.

About Steve Nguyen

Analyst based in China for 4 years, with significant analytical skills in Macroeconomics, Financial Markets and the Chinese economy.