Limitations of the International Monetary System and the Rise of China's Renminbi
Visiting Fellow, RIETI
Whether and how to reform the post-war Bretton Woods international monetary system has been a topic of debate in recent years. That also means that the U.S. dollar's current dominant position has been questioned. Will the current dollar-centric system continue as it is? Or, could the renminbi of China, the world's second-largest economy, replace the role of the dollar with a new system?
Three problems with the international monetary system
Observers say that the current international monetary system has the following three problems.
First, the current dollar-centric system bears the risk of destabilizing the economy of the issuing country (i.e., the United States) and taking the world economy down along with it. Overseas investors and central bankers around the globe prefer holding dollar-denominated assets because they have such massive and extremely liquid markets. That means that the U.S. government and companies can get finances from international financial markets relatively cheaply, leaving the economy more susceptible to boom-and-bust cycles like what happed in the mid-2000s. Once a bust of a financial bubble occurs in the United States, that could drag down the entire world economy as we recently observed in 2008.
Second, the current system provides developing countries with seeds for instability as well. Due to low creditworthiness, developing countries usually have difficulty in securing funds externally in their own currency. Hence, they tend to issue external debt in a major foreign currency, especially the U.S. dollar. That means U.S. monetary policy affects the financial conditions of borrowing countries, making it hard for borrower countries to undertake stabilizing measures for their own economies even if they experience a recession. As of this writing, the United States is planning to raise its policy interest rate (i.e., the Federal Funds rate) in the near future. That could cause capital to flow back to the United States while depleting it in developing countries. Pressured by a high dollar (caused by the high demand for it), developing countries' currencies could weaken, making it difficult to pay back dollar-denominated debts and thus causing macroeconomic instability.
Third, the current system does not reflect the rise of newly emerging economies such as China. The International Monetary Fund (IMF) and the World Bank, which were the core of the Bretton Woods system, still allocates voting rights based on the political power balance as of the 1940s. They do not give newly emerging economies such as Brazil, Russia, India, and China (the so-called BRICs) a voice that reflects their economic size.
Hence, under the current system, if a financial crisis happens—possibly caused by the dollar's own intrinsic unstable characteristics—investors and central banks would hoard more of dollar-denominated assets as a "safe haven," thus making the world economy continue to be dollar-dependent and thereby susceptible to instability.
Under these circumstances, since the Global Financial Crisis of 2008, China has been trying to build a new international monetary scheme using the renminbi as one of the major international currencies. From the crisis, China learned that, as a nation aiming to become an economic, diplomatic, and military hegemon, it is demeaning for its monetary authorities to have to follow the monetary policy of its biggest rival nation as it does now. That has made China consider building a new system with its own currency at the core.
Since 2009, China has made efforts to "internationalize" the renminbi. It started with liberalization of the use of the currency for settling trade transactions. In 2010, China liberalized renminbi-denominated foreign direct investment, and since 2011, it has been rapidly developing an offshore renminbi market in Hong Kong. Moreover, as one IMF reform agenda, China has been advocating that the renminbi be included in the basket for the special drawing rights (SDR), the IMF's virtual currency used for rescue funds for crisis economies, as a major currency along with the U.S. dollar, the euro, Japanese yen, and the British sterling. This is China's attempt to push its currency to become viewed as a major reserve currency.
Barry Eichengreen (2010) asserts that if the renminbi were to become a major international currency alongside the dollar and the euro, a resultant multi-currency monetary system would help stabilize the world economy since the key currency-issuing countries would check each other's fiscal conditions. One might say the renminbi becoming a major reserve currency would benefit the international monetary system.
What is an international currency?
Currencies recognized as "international currencies" share certain characteristics. First, they trade at a high volume in the foreign exchange market. Second, they have a high share among the currencies in which trade is invoiced or settled. Third, they are used frequently as an issuing currency in the international bond markets. Fourth, large volumes of these currencies are held as foreign exchange reserves by central banks. The U.S. dollar has established an overwhelmingly dominant status in every one of the four markets: its share in foreign exchange trades is 43%; about 50% in trade invoices; and about 70% in the international bond markets. The dollar also has a dominant role as a major reserve currency (about 65%-70% market share), the toughest market to dominate. The euro has only about one-third to one-half as much shares as the U.S. dollar does in each of these markets. Following the two major currencies, such third-ranked currencies as the Japanese yen, British pound, and the Australian dollar even have much lower shares.
As for the renminbi, its use for international transactions has grown rapidly since the start of liberalization. Nonetheless, its share in the foreign exchange market is no more than 1.1% as of 2013 (seventh in the world). In other markets, its share is even lower. The U.S. dollar dependence is overwhelmingly high even within Asia where China is the biggest hub for the supply chain; on average, about 90% of exports from Asian countries are dollar-denominated (Ito and Chinn, 2014). The use of the renminbi is still limited in the region.
So, what factors are necessary for a currency to become an international currency?
In general, the issuer country of an international currency has a large economy and engages in large-scale international trade. It is also important to maintain macroeconomic stability such as stable inflation and sustainable levels of gross debt. Naturally, major foreign currencies such as the dollar are preferred as a transaction medium when the use of the domestic currency is limited because the above conditions are not being met. "Inertia" is also an important factor in selecting a currency for financial transactions, trade, or foreign currency reserves. That is, once a currency becomes established as a medium of transactions, it is very difficult for that to be replaced with another currency because of the transaction cost of altering transaction currencies.
As financial globalization has proceeded in recent years, other determinants of international currency are drawing more attention such as the level of development of financial markets and the degree of market openness to overseas investment and investment by foreigners. Naturally, if a country has highly developed or open financial markets, the transaction cost of its currency would be lower both at home and abroad. As a result, such a currency should be used more frequently and prevalently for foreign trade and financial transactions, allowing the country to become less dependent on major foreign currencies.
If China further develops its financial markets and becomes more open to investors at home and abroad, the renminbi would become a more oft-used currency for both financial and trade transactions, most probably becoming a major international currency. The biggest question, however, is how much and how prevalently central banks will hold the currency as part of their foreign reserves. If the renminbi rivals the dollar and the euro as foreign currency reserves, it could become a key currency in a multi-currency international monetary system.
The dollar-centric system will continue
However, Eswar Prasad (2013) argues that the renminbi will not become a vehicle currency that can provide a safe haven (as the U.S. dollar does now). Typically, major countries including the United States and Germany and international organizations such as the IMF impose a list of strict conditions for a crisis-inflicted country to receive rescue funds called "conditionality" as we see in the case of the current crisis in Greece. Conditionality usually reflects the political will of not only the countries providing emergency funds but also of the countries that issue the currencies included the rescue package. If China, for example, were to provide emergency funds in renminbi, the financing conditions would reflect its political intensions. However, considering that China will mostly likely continue to have a non-democratic system such as one-party rule and arbitrary or non-transparent policy decisions, and that it continues to withhold geopolitical or diplomatic ambitions, countries considering to request emergency rescue funds from China could be unwilling to receive them because they may not feel comfortable with China's political intentions behind them. In contrast, it is highly possible that countries would prefer receiving rescue loans in the dollar since they view the United States as a mature democracy with a relatively good deal of transparency in its policy decision making and regard the geopolitical and military roles it plays as amicable or least unwelcoming. Therefore, even if the renminbi ever achieves the same level of market size and liquidity as the dollar, it would still not threaten the status of the dollar as long as China's political intentions are not well-perceived in countries with funding requests. Ultimately, whether the renminbi can become a key currency that can provide a safe haven is less of an economic issue than of a political and diplomatic one.
In conclusion, while a multi-currency system may prevail with the renminbi as one of the key currencies during non-emergency, or "tranquil," times, the dollar would still remain as the only currency that provides a safe haven at the times of a crisis. The dollar-centric system will continue, either as a proactive choice or through a rather passive process of elimination.
August 17, 2015
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