The People's Money: How China is Building a Global Currency

The People's Money is a book I have written, published by Columbia University Press, and which is to be released at the end of November 2016. It is written for the general public. In it, I tried to translate difficult economic concepts into accessible language. It is in story form, and the story makes a number of points.

China, unlike other trading nations that have developed over the years, has managed to become the second largest economy—possibly the largest, depending on how it is measured—and the largest exporting country without having an international currency. That is very unusual in economic history. Britain developed as a preeminent trading nation by developing the sterling as the key international currency of the time. The same has been true of the United States. We also see something similar in the development of Germany and Japan.

In 1975, at the time of the rapprochement between the United States and China, the United States sent a large delegation to China to write a long report on conditions in the country as a way of better understanding it. It was very thoroughly done. One of the statements in the report was that China was the largest country in the world but remained an enigma. I believe that is still true. American economists said at that time that China would develop as an industrial power by the end of the century, but they said that it would never reach the level of other advanced or trading nations. It would remain a small developing economy. This has been proven completely untrue.

Why look at the renminbi (RMB)? What is its paradox? I will look at what China has done over the past five years to build a market for the RMB. I will discuss the concept of managed convertibility, which will remain China's policy for the foreseeable future. I will conclude by asking whether we are in the age of Chinese money.

Until 2010, almost zero Chinese trade was settled in RMB. Today, depending on the method of calculation, 25%-28% is settled in RMB. That is settled, not invoiced, so whether trade settled in RMB is also invoiced in RMB remains a big question. This mystery has been the source of endless discussions.

The point is that until very recently China didn't have any international currency to use for its own trade. This became a problem around 2009. In 2009, just before the G20 London Summit, the governor of the People's Bank of China said that it was time to change the international monetary system to end reliance on a single currency, i.e., the dollar. In my book, I examine the Chinese growth and development model, which originally relied on the U.S. dollar for many reasons. China decided to open its economy, and switch from a planned to a market system, but it had to do it while keeping several different balls in the air. It reformed the currency quite substantially, but it had to use the dollar in order to push this development.

After the banking crisis in the United States in 2009, there was a very clear problem in terms of liquidity for trade, and China was affected by this crunch. Also, China experienced problems due to the value of the dollar due to its large foreign exchange reserves, which were mainly in U.S. dollars. China was exposed to the fluctuations in the value of the dollar so it wanted to rethink the international monetary system. The G20 took up this suggestion. Many discussions took place, but nothing conclusive occurred.

China, meanwhile, was very active in developing its RMB strategy: using international trade to build traction for the use of the currency. In 2008, China launched a pilot cross-border trade settlement scheme which was made permanent in 2010. The idea was to promote the use of the RMB in international trade, particularly in neighboring countries, but this wasn't enough to solve the fundamental problem of the RMB: that it was, and remains, a fundamentally inconvertible currency. The capital movements are no more open now than they were in 2010. If China controls capital movements, how can the RMB be an international currency? If the currency is non-liquid and cannot be held as an asset, fulfilling the third function of money—that is, storing value—why should people hold it?

China realizes that its strategy was flawed and that trade settlement was insufficient. The money could move in a loop, but it would never stay outside China in the hands of foreigners. In response, it launched the RMB market in Hong Kong: the second track of this two-track strategy. The idea was to create a pool of RMB outside China. International investors could hold assets in RMB, trade in RMB, sell RMB-denominated assets, etc. to avoid any kind of movement that could affect the very fragile banking and financial system in China. This actually worked. It was a way of building the RMB as an international currency. It also created some arbitrage between the off-shore market and the on-shore market.

The result of this was that the most recent estimates for the use of the RMB now have it as the second most used currency in trade settlement. This is a very good result for China; in 2010, the RMB was at the bottom of the list.

This RMB market in Hong Kong has really exploded. Services and products have been developed to assist trade in the RMB. Market infrastructure has been established to develop the so-called dim sum bond market. The first private issue was in 2010. Singapore is the next largest trading center for RMB, followed by Taipei, chosen for the amount of trade between China and Taiwan, but Hong Kong is by far the largest.

The first offshore trading center outside Asia was created in London in 2013, but it remains quite tiny. The problem is the liquidity of the currency. It's ultimately the People's Central Bank that guarantees the liquidity of the RMB. The Bank of England signed a swap agreement about 10 months after the establishment of the offshore market in order to give investors and market players confidence in the liquidity of the market.

Interesting, for geopolitical reasons as well, is the fact that the only country without an offshore market is the United States. There are two in Canada. The dollar is the most used currency in international trade. Developing these offshore markets, which are the RMB's infrastructure, means developing active policies. The United States hasn't pursued any active policies vis-à-vis China.

In researching potential links with the new the Belt and Road Initiative, it was found that market participants are still not comfortable enough to invest in the RMB in London. Hong Kong is a different story.

Trying to write a book on the RMB is like trying to hit a moving target. Policies are in constant flux. The first five years of the RMB as an international currency, from 2010 to 2015, culminated in the RMB's inclusion in the Special Transaction Rights (STR) Basket in 2015. This is an obscure basket of currencies used by the International Monetary Fund (IMF). China's inclusion was a stepping stone to making the RMB an international currency. It had to comply with a series of indicators, some of which it may not yet meet, certainly with regard to trade.

Other issues are affecting the RMB. One is the fact that China continues to manage the exchange rate, though it has become much more flexible than in the past. This allows the RMB to move inside a much larger band. In August 2015, China changed the way the daily price was calculated. However, it remains a managed currency, which makes it different from other currencies in the STR Basket—U.S. dollar, euro, yen, and sterling—which are all pure, floating currencies. It is the first currency from an emerging country to be included in the basket, and the only one without an independent central bank. Much has to be fixed to increase the confidence that non-residents of China have in holding this currency in their portfolio.

The internationalization and opening up of the RMB are strictly dependent on financial and banking reforms in China. The banking and financial system is dysfunctional. There are many distortions. The entire Chinese model of development is predicated on what we call financial repression. People have saved a lot but have had very low returns in terms of interest rates paid on what is mainly held in the form of bank deposits. People's deposits were then channeled mainly into state-owned enterprises (SOE). That was the model for Chinese development, a model which is not suitable anymore and which has put a heavy burden on savers.

Things need to change. China needs to have a deeper and more diverse and liquid banking and financial sector. One reason is that the Chinese would like to earn greater returns on their money. They could look outside China for investments, meaning that China would see a considerable outflow of capital if there was a totally flexible opening, which is not possible yet.

I noticed that until the change in leadership in China in 2013, the idea promoted by the central bank was to force financial and banking system reforms by opening up the capital account. The leadership would have to embrace the necessary reforms to ensure financial stability. That was a very risky strategy. The Shanghai financial community people were saying that they needed to open up and force reforms. People in Beijing were saying they couldn't do that because it was too dangerous.

In 2012, people were absolutely sure that Shanghai would become China's key financial center by 2020 with the RMB being a fully convertible currency. Things changed with the change of leadership. Now, the idea is that everything needs to be done very slowly and gradually.

I was in a meeting last week in China which included a lot of discussion of the new five-year plan, which has some heavy chapters on financial reforms. Everyone agreed that reforming SOEs and eliminating the link between the big commercial banks and the SOEs are key reforms for China. They create a great deal of distortion in the system. Also, a proper bond market needs to be developed with greater independence from the big banks. This is all very clear. In the view of the Chinese authorities, the way forward is very clear. Implementation is another matter.

The creation of the free trade zone in Shanghai enables China to simulate open capital accounts and free capital movement. The Shanghai-Hong Kong Stock Connect was also inaugurated: a channel between the two stock markets with the possibility of opening one with London.

The offshore market may not remain forever, but many other policy schemes will be used to help the RMB become more international without completely opening up the capital account.

The governor of the central bank made it very clear in 2015 that managed convertibility will continue. There are two stories here. The first is China's assertion that it has opened the capital account, with a few exceptions, which is true. It introduced many new schemes that allow many more international investors to have assets in the Chinese market, but it is a system of quotas. Registration is necessary, special status is necessary, etc., and then trade can be done, but within limits. Then there are the free trade zones. These are all ways of opening. The Chinese monetary authority remains in control.

In the meantime, China has very sound ambitions for the role of its currency. For the moment, the RMB remains mainly a regional currency. In finance, it's more developed in Asia than in other financial centers. Will the RMB replace the dollar? No, that is not the intention. China doesn't want it to become the key reserve currency. It understands that having such a currency has privileges, but also that it entails duties and obligations; for example, to maintain a stable value. Clearly, a country which still manages its exchange rate would find it very difficult to adopt such a currency. China prefers a multi-currency system which reflects the complexity of the global system. The international monetary system should move from dominance by a single currency to a more balanced presence of a plurality of currencies to enable market players to choose which currency to use according to their own needs and preferences.

The idea is to enable the RMB to be used in international finance. However, the RMB will need to become a mature currency—a currency that can be used in lending money—in order for that ambition to be realized. China has been very involved in providing loans and international aid to many countries, but this entire flow of capital has been denominated in dollars rather than in RMB.

I recently visited Zambia and Zimbabwe, where China has been very actively investing. It is involved in building airports, infrastructure, etc. It has a very strong presence, but the key currency is the dollar. I inquired in a local market, and traders were happy to trade in dollars. They gave me classifications for the acceptability of currencies in the market: U.S. dollar—everywhere, they even use it among themselves; euro—yes, it is rather liquid; local currency—preferably not, as it not a very good currency; sterling—the colonial currency, not very well regarded because it can only be exchanged at major banks; RMB—what is that? It's not a serious currency. That's after being admitted to the STR Basket. This reflects the contradiction of the RMB. We are talking about the structure, what the RMB aims to become, but in practice, it lags far behind.

My views are not that different from those of Dr. Subacchi. I have a few questions. First, RMB internationalization has made a great deal of progress, but for some reason, this progress peaked between 2013 and 2014. Since then, in 2015 and 2016, there has been a decline. What is your interpretation of this? During this period, massive capital outflows took place from China and the RMB began to depreciate. Perhaps this expectation of a weak RMB may be behind it. Is there a significant structural issue behind this turning point? Has RMB internationalization already peaked?

Second, capital outflows have been taking place along with RMB depreciation. China's balance of payments shows net capital outflows although they seem to be shrinking this year. The foreign exchange reserves have been declining as the RMB exchange rate has been depreciating. We saw several RMB devaluations in August 2015 and then the global economy was thrown into chaos again at the beginning of this year. This is a very serious issue. I believe that behind this capital outflow and exchange rate depreciation phenomenon lies great concern about China's growth prospects and excess capacity, in particular in the major heavy industry sector. Zombie farms are now a problem, and large and rising corporate sector debt has been observed. China appears to have many problems that place the future of the RMB in doubt unless they are addressed.

Although Dr. Subacchi talked about managed convertibility, what China needs now is capital outflow control. In the 1970s, when Japan had a balance of payments deficit, it needed capital inflows so it relaxed inflow control and tightened outflow control. When the situation reversed and a balance of payments surplus existed, Japan liberalized capital outflow and tightened capital inflow control. These inflow and outflow controls existed until Japan passed a foreign exchange control law in 1980. In principle, this made all foreign exchange transactions free.

The IMF's judgment in including the RMB in the STR was that the RMB had become sufficiently convertible for IMF authorities but not for the private sector. How far can China progress in its RMB internationalization efforts under the current managed convertibility system? This is the main difference between Dr. Subacchi and myself. I doubt that RMB internationalization can proceed in a significant way and that the RMB can become even a regional currency. Can the RMB become a regional currency with this managed convertibility?

Dr. Subacchi mentioned SOE reform. I think that is needed, in addition to other institutional reforms. In your view, what types of institutional reforms would be needed even under this managed convertibility system?

As I said, the first five years of the RMB internationalization were between 2010 and 2015. Joining the basket was symbolic and is a technical issue. It doesn't mean that the RMB is a currency that can go into private pockets very easily. The next phase has been much, much slower. The authorities haven't even set a target for themselves. It will take a long time. There are many reasons, including some that Dr. Kawai mentioned. There are concerns about the growth of the economy, the ability to shift the model from export to domestic demand and particularly consumption, reining in the growth, shadow banking, creating transparency, and the level of debt in the provincial governments, in many companies, and in many banks. The situation is not great.

Over the last 30 years, China has been moving to a free market system, which it sees as a way to create discipline that they cannot create internally. I agree that great reforms will be required. Managed convertibility is the second-best approach. We won't see a big leap forward in terms of RMB use regionally and internationally while it remains. However, China is very determined to overcome the limits of its currency. I look at the Belt and Road Initiative and this new involvement of China in development finance as a way in which China can harness its own financial resources and its position in these new institutions to really try to push the RMB throughout the region.

The capital outflow issue is huge; you are absolutely right. China cannot manage the outflows. The problem is its continued management of its currency. It would be better able to control capital movement if it ceased to manage its currency. This is a currency which has the ambition to become an international currency, and China cannot constrain the outflows because it would be very badly received domestically and internationally. Its banking system is also too porous. Even when it tries to control movement, it struggles. The currency and its value remain big issues. Why does a country with a current account surplus need a weak currency for years that does not reflect its international trade position? China is shifting its growth model and rethinking its position.

It is possible that RMB internationalization has already peaked in terms of market growth. When the RMB was appreciating up to December 2014, it provided a great deal of traction to internationalization. In the meantime, the cost for China of this constant management of the exchange rate was a very large accumulation of foreign reserves. In September 2014, they amounted to something like $4.2 trillion. The cost of controlling the depreciation of the RMB in the various episodes over the last 18 months was a depletion of these reserves. One wonders whether China, which is still an emerging economy, should really squander its money just trying to manage its exchange rate. In that sense, internationalization has peaked. What we see henceforth will be much more gradual. We should focus on how much China is able to push the RMB into the pockets of neighboring countries in the form of loans, investments, and project finance.

Q1. It seems the Chinese authorities have managed to maintain control as they desire, but if the offshore market continues to grow, moving towards greater flexibility, would it become more difficult to control the RMB in the future? What might happen?

Paola SUBACCHI
My sense is that China will move to a more flexible exchange rate. The band now is much broader than it was in the past. The message they need to send if they really want to internationalize the RMB is that there is no control, and to clarify when they will intervene. It might not take long to achieve this. China normally goes through these long periods during which it thinks about policies and then tests, discusses, and announces them. It was the same with the interest rate. It knows the next step is exchange rate reform. Will that make the RMB an international currency? It won't give this huge traction, but it will send the right signals to markets.

Q2. I have two questions. First, the RMB began to depreciate in 2014 before the China shock in August 2015. What do you think is the main reason for the depreciation at that time? Second, the Japanese government could not maintain a fixed exchange rate after the Nixon shock, and was forced to abandon it within 10 or 20 days. It tried to maintain the fixed rate using capital controls but was forced to give up because of an attack from the market. How long do you think the Chinese government can maintain controls on the exchange rate of the RMB?

Paola SUBACCHI
The depreciation in 2014 was quite clearly the result of capital outflows. The authorities did not intervene at that time to stop it. They felt that a weaker currency was desirable. Flexibility and abandonment of management might happen sooner than we expect. It is on the authorities' radar. My understanding is that the exporting companies are still very much against the letting go of control. They are very concerned about fluctuations. However, they understand the cost of these policies and particularly the impact on the rest of the world of allowing this currency to remain managed.

Q3. What symbolic events would you expect in the near future? For example, the IMF included the RMB in the STR Basket. Maybe the Chinese authorities will start to denominate project finance in RMB. What are your expectations?

Paola SUBACCHI
It will be interesting to see examples of countries that would be happy to accept RMB loans. In terms of institutional architecture, the creation of the Asian Infrastructure Investment Bank is an interesting step forward. It is also interesting that China, after some skirmishes with the United States, decided to play within the current architecture. The capital is in U.S. dollars. It would really be interesting to see whether the RMB can be accepted. For example, the capital of the European Bank for Reconstruction and Development is in euros. It is possible. That would be an event signaling the RMB's maturity.