International Monetary Reform and the Future of the Renminbi

Since People’s Bank of China Governor Zhou Xiaochuan’s proposal for reforming the international monetary system was published on March 23, there have been new developments with regard to the international use of the Chinese currency Renminbi (RMB). The historical context of Governor Zhou’s proposal and the prospects for the international use of the RMB are interrelated. In spite of the generally negative press reports in the United States, Zhou’s proposal was couched in careful, professional and non-provocative language. Although the proposal may have been partly motivated by domestic politics, it does reflect deep-rooted concern in China that the international financial crisis and subsequent U.S. responses to it could undermine the purchasing power of the dollar. Since most of China’s $2 trillion plus reserves are invested in dollar-denominated financial assets, Beijing’s concerns are understandable. While some in the United States argue that China should not fret about excessive dollar exposure—because that is the result of its controversial exchange rate policy—it should be recognized that China’s worries about the future of the U.S. dollar are widely shared and that Zhou’s proposal appears to have been well received in many quarters around the world.  

Background to Zhou’s Proposal

China is afraid that the vast increase in U.S. fiscal deficits combined with the Federal Reserve’s efforts to keep interest rates low by injecting large amounts of liquidity in the economy will leave the Federal Government overleveraged and unable to maintain macroeconomic stability while at the same time protect the international value of the dollar. China is also concerned that continuing uncertainty surrounding resolution of the toxic asset problem of U.S. and European banks will slow global economic recovery. It is too early to know whether U.S. Treasury Secretary Timothy Geithner’s plan (announced on the same day as Zhou’s proposal) will work, but China would have preferred more drastic, coordinated trans-Atlantic action to remove the toxic assets from the banking system once and for all. In their view, this could have been done in ways similar to what the Chinese government did a decade ago in removing huge amounts of non-performing loans from the balance sheet of its banks. The Chinese realize that such action might have required the temporary nationalization of many banks, which would have been highly controversial and problematic in practice [2].      

Although international agreement on Zhou’s proposal seems highly unlikely, its launch may set in motion a process of gradual change in the global monetary system, including the growing international use of the RMB.

China’s central bank and other government-owned financial institutions, including China’s sovereign wealth fund (CIC) hold an estimated $1.5-1.6 trillion in U.S. dollar-denominated financial assets. The rest is denominated in other convertible currencies. Official gold reserves amounted to 1,054 tons at the end of March 2009, accounting for about 1.5 percent of total reserves at the current gold price. China is not only the largest foreign creditor of the U.S. Federal Government, but also of government-sponsored enterprises (GSE) Fanny Mae and Freddie Mac. To protect the value and the liquidity of its reserves, China has been quietly changing their composition from GSE bonds to Treasurys and from long-maturity Treasurys to short-maturity ones [3]. China continues to buy newly issued Treasurys and there is no evidence yet that it is diversifying its reserves away from U.S. dollars [4].

“In the interest of international financial stability,” Zhou proposed the creation of a new international reserve currency that is disconnected from individual nations, issued in accordance with agreed rules and stable in value. For this purpose he proposed to modify the IMF’s Special Drawing Right (SDR), a synthetic reserve asset and unit of account created by international agreement in 1969 to supplement official reserves of member countries and to support the Bretton Woods fixed exchange rate system.  

A Brief History of the SDR

SDRs were created in light of serious concern at the time that a shortage of gold and gold-linked U.S. dollars (or dollar-denominated financial instruments) to finance international trade would slow global growth. The IMF was given authority to issue SDRs to central banks of member states to supplement their reserves in accordance with an agreed-upon formula.

The creation of the SDR marked the most significant international financial agreement since the emergence of the Bretton Woods system at the end of World War II, which was based on the gold-backed U.S. dollar. That system was created against the advice of Keynes who, at the Bretton Woods conference of July 1944 proposed the creation of a synthetic reserve and settlement currency (which he named the Bancor), based on the weighted average value of a basket of 30 commodities. In addition, Keynes proposed the establishment of an international financial clearing house with rules aimed at automatically redressing large international trade imbalances.

The SDR in its original form was a much simpler instrument than Keynes’ still-born Bancor. It was not a currency, but a unit of account, initially linked to gold at the fixed rate of 1 SDR per 0.888671 grams of fine gold—the same as for the U.S. dollar at that time—to be used as reserve asset and for settlement between member central banks only.

The SDR became largely redundant a few years later when the United States, under the Nixon Administration, was forced to abandon the gold standard in 1971. That marked the beginning of the present floating exchange rate system for major currencies, with the U.S. dollar—since then a fiat currency—serving as the world’s premier reserve asset and settlement currency. The value of the SDR was redefined as a basket of four currencies, which today consists of the U.S. dollar (44 percent), Euro (34 percent), Japanese Yen (11 percent) and British Pound Sterling (11 percent). Under the current international monetary system, there is no “natural” limit to the issue of U.S. dollars as there was under the Bretton Woods system when the dollar was backed by gold at a fixed rate of exchange. Under the floating rate system, the U.S. is under no obligation to protect the international value of the dollar, but the system is nonetheless stable, at least in principle, as long as the rest of the world is willing to hold all Treasurys not held by Americans.  

Zhou’s proposal brings the limits of that willingness into view, but there is at present no viable alternative to the U.S. dollar as the global reserve currency. The significance of the Euro—accounting for about 26 percent of international reserve holdings at present—is unlikely to increase much, because, in the absence of a European ministry of finance, the market for Euro-denominated bonds will remain segmented. Buyers of Euro bonds have to choose between bonds issued by 16 different EU member countries using the Euro as their national currency; the pricing of Euro bonds differs with market perceptions of the credit worthiness of issuing countries. The Euro bond market is large, but not nearly as deep and liquid as the market for Treasurys. Other convertible currencies are too small to serve as reserve currency on a large scale.

Zhou proposes to enhance the use of the SDR as a reserve asset and to make it usable as an invoicing and settlement currency in international trade and financial transactions. With those objectives in mind, he proposes  to: 1) make the SDR convertible into other currencies, 2) promote the use of the SDR for commodity pricing, investment and corporate book-keeping, 3) create SDR-denominated tradable financial instruments, 4) update the formula used for the allocation of new SDRs by the IMF, 5) update the valuation base of the SDR by including other currencies in its base (presumably including the RMB), and 6) promote confidence in the value of the SDR by shifting from a purely unit-of-account system to a system that is backed by real assets such as a reserve pool. The U.S. dollar would undoubtedly remain the most important component of the new SDR for many years and would continue to serve as a reserve currency, depending on country preferences. Zhou believes that his proposal would also serve the long-term economic interests of reserve currency countries such as the United States, as it would promote international financial stability.    

At the end of his proposal Zhou suggests that countries with large dollar reserves should be permitted to delegate the management of part of their reserves to the IMF. This suggestion aims at reviving the IMF “substitution account” idea that was negotiated in the late 1970s, but never implemented. Under that concept, countries with a lot of dollar reserves would be permitted to convert part of their reserves into SDRs, reducing the exchange risk to which they are exposed. It would allow reserve-rich countries such as China to off-load a portion of their dollar reserves without depressing the market value of the U.S. dollar or increasing the market value of alternate reserve currencies such as the Euro.  

None of Zhou’s proposals are unworkable in principle—his main idea echoes efforts by Keynes in the 1940s to create a synthetic reserve and settlement currency—but they require international agreement, which will be extremely difficult, if not impossible, to obtain. As custodian of the world’s premier reserve currency, principal beneficiary of the present international monetary system and largest debtor country, the United States has little incentive to change the system and de-facto veto power over proposals such as Zhou’s. Besides, many in the United States see Zhou’s proposal as an attempt to undercut U.S. global power and are opposed to it for political reasons.  Although the U.S. dollar will probably remain the world’s premier reserve currency for a long time, the use of the RMB as trade settlement currency is likely to increase.

Prospects for Greater International Use of the RMB

Initially, international use of the RMB for transaction purposes was more the result of spontaneous developments in the region than of deliberate actions by the Chinese government, except in Hong Kong and Macao, where local RMB use is governed by inter-governmental agreements. Local use of the RMB in some neighboring countries in Asia—mainly for transaction purposes—has been growing for years (e.g. in northern Thailand, northern Vietnam, Myanmar and eastern Russia). Driven by considerations of convenience, it was neither encouraged nor discouraged by the Chinese government as no policy on this appears to have been articulated. In areas where the local use of the RMB is spreading, it is usually at the expense of the U.S. dollar as transaction currency, not as reserve currency.

In response to the current international financial crisis, the Chinese government is taking steps to facilitate the use of the RMB as a settlement currency for trade and other current account transactions in Asia and beyond. RMB-denominated lines of credit have been extended to several neighboring countries and bilateral local currency swaps totaling about $95 billion have been negotiated with Malaysia, South Korea, Indonesia, Hong Kong, Argentina and Belarus. Banks in 6 eastern Chinese cities have been assigned to try out RMB trade financing. On May 18, 2009, it was announced in Beijing that the central banks of China and Brazil will work out an arrangement under which China’s imports from Brazil can be paid in RMB, while Brazil’s imports from China can be paid in Brazilian real, bypassing the use of the U.S. dollar as settlement currency, as in the case of local currency swap agreements.  

Because of the large accumulation of RMB balances in Hong Kong banks in recent years, one mainland commercial bank, the Bank of China (BOC), has been issuing RMB-denominated bonds there since 2007. It is expected that Chinese corporations will be allowed to open RMB accounts in Hong Kong and elsewhere before long. The potential for increased international use of the RMB as local transaction, invoicing and international settlement currency is significant. The increased regional use of the RMB for invoicing, transaction and settlement purposes will probably also enhance its potential use as a store of value, even before full convertibility has been reached.

Increased use of the RMB as trade settlement currency will make it easier for China to promote exports and to protect its exporters from exchange risk. It also reduces transaction costs and avoids the need for hedging. Potential benefits for corporations will vary, depending on their underlying business model.

Another important aspect of increased international use of the RMB is that it would make it easier for China to “flexibilize” its exchange rate management and thus reduce the need for large-scale domestic sterilization of excess liquidity in domestic banks. Greater exchange rate flexibility would in turn facilitate the gradual opening of China’s capital account and movement toward full convertibility. It would also reduce the need for U.S. dollars and other reserve currencies for transaction purposes.

All in all, it seems likely that the financial crisis will lead to more hedging by Beijing of the U.S. dollar through increased international use of the RMB and accelerated movement toward full RMB convertibility. Once that milestone has been reached, which could happen in 5-10 years, one big obstacle to the use of the RMB as an international reserve currency will have been removed. Another requirement is that China’s domestic capital markets become much larger, diversified and liquid than they are at present and free themselves from government intervention. This will probably take decades, even if China continues to develop at a high rate.

Notes

1. Zhou Xiaochuan is (since 2002) governor of China’s central bank, People’s Bank of China (PBC). He has been actively involved in designing and managing China’s economic and financial reforms since the mid-1980s in several senior positions. His monetary reform proposal was published on the website of PBC: www.pbc.org.cn
2. These observations are based on meetings with senior financial officials in Beijing in January and March 2009.
3. Keith Bradsher, China grows more picky about debt, New York Times, May 21, 2009. Because of its large dollar holdings, China cannot diversify away from the dollar without risking a drop in its value.
4. China does not publish the composition of its reserves; the dollar component is generally estimated at 65-70 percent.
5. Fred Bergsten of the Peterson Institute for International Economics made a similar proposal in How to solve the problem of the dollar, Financial Times, December 10, 2007. In We should listen to Beijing’s currency idea, Financial Times, April 8, 2009, Bergsten explains why Zhou’s currency reform proposal has to be taken seriously and why the creation of an IMF substitution account is a good idea.