Reform of Global Reserve System and RMB Internationalization 1

Reform of Global Reserve System and RMB Internationalization 1 Liqing Zhang Professor and Dean, School of Finance, Central University of Finance and Economics, Beijing Email: zhlq@cufe.edu.cn Abstract The paper starts with a discussion of the main flaws of the current international monetary system. Then it gives a brief overview of the proposals for the reform and their viability. It then elaborates the policy agenda at global, national and regional level. Finally, it analyzes the internationalization of the Chinese RMB, focusing on the latest development and the reasons behind it, its benefits and pitfalls, and its prospect. RMB s internationalization will continue as long as China can maintain a strong pace of economic growth while keeping its exchange rate stable or mildly appreciating. Since China may not remove all its capital control in the near future, the internationalization of RMB will mainly take the way of offshore market. 1 Draft paper for the international conference 70 YEARS AFTER BRETTON WOODS: THE INTERNATIONAL MONETARY SYSTEM, May 17-18, 2014, Hangzhou. 1

1. Why the Global Reserve System should be Reformed The main feature of the current international monetary system is that it is still a US dollar-centered reserve regime, though the Bretton wood system has collapsed at the beginning of 1970s. The reserve regime is not only unstable but also unequal. Basically, the dollar-centered reserve regime has three flaws. The first one is its inherent instability, which was correctly described as Triffin Dilemma by Robert Triffin in 1961, i.e. the issuing countries of reserve currencies cannot maintain the value of the reserve currency or the stability of its exchange rate while providing sufficient liquidity to the world. The financial history in the past four decades indicates that it has been very difficult to keep the US dollar stable as a main reserve currency. With the large current account deficits of the United States, the US dollar repeatedly suffered significant depreciation, particularly at the beginning to 1970s, the middle of the 1980s and the period of 2002-2005. Almost in each period, the large depreciation of the US dollar is related to the global financial turmoil and even economic recessions. The second one is that there is a conflict between the target of domestic macroeconomic stabilization of the reserve-currency issuing country and the global need for reserve currency supply (Zhou, 2009). Moreover, any significant changes and mistakes in monetary policy of the reserve-currency-country may have an unexpected and very often negative consequence to the rest of the world. Actually, the conflict may also be interpreted as a serious failure of policy coordination between reserve-creating countries and reserve-holding countries. Under the dollar-centered regime, basically neither any single country nor the IMF can have any significant impacts on the US monetary policy or on other macroeconomic policies in the US. The failure of policy coordination has repeatedly brought financial instability to relevant countries or even the entire world. For instance, the surge of US interest rate in the early 1980s resulted in the great shortage of liquidity and eventually triggered the international debt crisis in Latin America. In contrary, the easing of monetary policy during the 2002-2005 created a lot of the dollar reserve supply and accordingly caused the continuous dollar depreciation. The global imbalances, which reached their peak in 2006-2007, are possibly the latest example of this conflict. Among the main interpretations for the recent global imbalances, the most important ones include excessive consumption in the United States, excessive savings in China and other East Asia countries which are basically 2

results of unsophisticated domestic financial markets and other structural weaknesses, and the new framework of international trade pattern, etc. (Eichengreen, 2005). However, it should be noted that the dollar-centered reserve system does play an important role. With the exorbitant privilege of the dollar (to borrow abroad in domestic currency), the United States has been keeping its monetary policy lax and accordingly running large current account deficits since the turn of the new century. Actually, the loose monetary policy adopted by the Fed Chairman Alan Greenspan not only caused global imbalance but also became one of the main reasons for the sub-prime crisis. The third flaw is that the dollar-centered reserve currency system has a tendency to encourage capital flows from poor countries to rich countries, as correctly discussed in the Stiglitz Report (Stiglitz Commission, 2009). Though it is not necessarily always the case, the United States has been a net capital importer since the late 1980s.. After the financial crisis in 1997, Asian emerging market economies tended to hold more precautious foreign exchange reserves in the form of American treasure bill for preventing themselves from speculative attacks. The ratio of non-gold reserves to GDP rose from 3% in the end of 1980s to more than 30% in recent years. Among them, China is most impressive. By the end of 2011, the ratio is about 55%, amounting to USD 3.2 trillion in absolute value. In addition to the weaknesses with the reserve currency system, the current international monetary system has been encountering many other problems, including the failure to avoid persistent global imbalances, high volatility of exchange rates among the major currencies, volatility and sudden reversal of the capital flows often triggering boom-and-bust cycles in emerging economies, shortages of liquidity during crises, and the inadequacy and lack of representativeness of the global financial governance. 2.Proposals for Reform and Their Viability For a long time, there has been an argument that the international monetary system should return to the gold standard. It is true that the gold standard has many merits, such as exchange rate stability, automatic adjustment of balance of payments, and fiscal discipline. However, we all know that the reasons behind its collapse in the early 20th century was the significant shortage of Gold production and supply, and the necessity of governments to fully abandon macroeconomic policy interventions when faced with an economic recession. These problems are surely not avoidable if the 3

world returned to the Gold standard. Thus, the proposal is completely unrealistic. Some economists, such as Richard Cooper (1987) argued that the aim of the international monetary system is to create a world currency. The world currency should be issued by a world central bank and backed by a single monetary policy. In the transitional period, periphery countries may peg their exchange rates to the major international currencies. Eventually, the unification of major currencies may evolve into a single currency. This proposal is good for overcoming the problems of the current system. But there is surely a long way to go for building up an institutional framework that makes the single world currency viable. Wether this proposal is realistic will depend largely on the political will of the major economies. More recently, a similar proposal was presented. According to Zhou (2009) and Stiglitz (2010), special drawing rights (SDR) should play a role as a global reserve currency in parallel with other major international currencies, and gradually replace the US dollar as the dominant reserve currency. It is supposed to be realized under the IMF framework and does not need the establishment of a new institution. But realizing this proposal is not easy as well. The main problem with the SDR proposal is that US has no incentive to help realizing it. Given the current voting rights in the IMF, i will hardly get support from the institution unless its governance can successfully be reformed. Another proposal gaining wide support is that of a multi-polar reserve currency system. According to this proposal, several reserve currencies (most likely, US dollar, euro and yuan/yen/acu) will play equally important roles in the global reserve system (Eichengreen, 2009). The most important merit of this proposal is that competition among the world s major reserve currencies can make the macroeconomic policy in reserve currency countries more disciplined. But, for realizing it, the euro needs to develop into a solid sovereign backbone through forming a common fiscal policy. RMB, the Chinese Yuan s international usage and/or the Asian monetary integration needs to be developed as soon as possible. Among various proposals, the New Dollar Standard approach is also an influential one. The advocates of this proposal argue that US dollar could continue to play a dominant role in the global reserve system, and the Fed could continue to provide sufficient liquidity, a kind of public good, to the rest of the world during international financial crises. Under the New Dollar Standard, US should strictly maintain non-inflationary growth and fiscal sustainability domestically. The US and non-reserve currency countries should timely pursue policy adjustments to correct 4

persistent current account imbalances. If US economic policy could be more disciplined, the New Dollar Standard might be the easiest option for reform. However, it would be very difficult for US to give up the freedom of policy-making. And actually, neither the non-reserve currency countries would like to give up their policy space.. In conclusion, none of the proposals described above can be easily realized. The world single currency approach and SDR approach are probably most ideal, but they can only be reached in the long run. The new dollar standard is also good if the US can be fully disciplined in policymaking. But the probability to achieve this precondition seems to be very low, neither in the short run nor in the long run. The multi polar reserve currency system could be a more realistic and second-best choice, but it takes time to develop. 3. Policy Agenda for Dealing with the Current Problems The purpose of the reform of the international monetary system is to create a new institutional framework for more effective macroeconomic policy coordination among the main economies. While such a reform is difficult to attain, recent experience with the current system shows its necessity and we thus need some policy agenda which does not only serve as a short-term policy response, but also as a part or a first step of the process of the long-term fundamental reform. The key issue of the policy agenda is how to improve international policy coordination, which should include various efforts accordingly at the global, national and regional level. At the global level, it is important to enhance the role of SDR even though we cannot expect a single world currency or SDR-based reserve currency to emerge in the near future. Whether SDR can become a principal reserve currency will depend on its supply and demand. In the supply side, a regular augmentation should be foremost important. After the SDR was initiated in 1969, its total supply was increased twice through new allocations, in the 1970-72 and 1979-81 periods, amounting to a total increase of USD 21.4 billion. In 2009, IMF decided to greatly enhance SDR allocation by an equivalent to USD 250 billion, following a suggestion of the G-20 London summit. Even including the amount newly allocated, the stock of SDR is only an equivalent to about 5% of the global non-gold reserves. If the SDR can be issued and allocated in equivalence of USD 150-300 billion each year according to the proposal by the Stiglitz Report, then its stock will reach a level of about 50% of the non-gold reserves ten years later. 5

Since the increase of allocation of SDR may significantly challenge the current global reserve currency structure, it is necessary to accelerate the reform of the IMF and make its governance more reasonable, more representative and more democratic. On the demand side, the big challenge is how to make the SDR more attractive. Since its inception, the SDR has been a kind of credit given by the IMF that can be converted into dollars and other currencies at the IMF, and be used in official transactions among member countries. For making the SDR more attractive, Eichengreen (2009) argued, it is useful for IMF itself or by encouraging member countries to issue SDR-denominated bonds. Furthermore, creating an active SDR market by extending the use of SDR into the commercial area might be a useful step. In addition to enhancing the role of SDR, it is important to strengthen the IMF s surveillance over systemically important economies. Particularly, it would be crucial to have the Mutual Assessment Process really work, not only for emerging economies but also for the main developed economies. Besides, the main economies should make G-20 summits a productive mechanism for macroeconomic policy coordination. At the national level, avoiding permanent global imbalances and keeping exchange rates at reasonable levels have always to be in the center of macroeconomic policy coordination. Although both the current account deficits in US and the current account surplus in China have dramatically declined since 2009, the global imbalances may rebound if the macroeconomic fundamentals changes. In order to reach a permanent global balance, both deficits economies and surplus economies should continue to work together. US should return to normal monetary policy as soon as possible, strengthen its mid-term fiscal consolidation and accelerate various structural reforms. Through persistent efforts of enlarging domestic demand and extensive structural adjustments, including a switch to a more flexible exchange rate regime, China and other surplus countries should avoid a fundamental external disequilibrium. Since the main reasons behind the external imbalance in China are structural weaknesses, it is important for China to largely push forward its structural reforms, such as domestic financial liberalization and the social security system reform, in addition to the exchange rate regime reform. At the regional level, both the EU and Asia should strengthen their regional integration since multi-polar reserve currency system will be the most realistic choice in the coming years or even decades. EU countries should strengthen their mechanism of European macroeconomic policy coordination, including creating a common fiscal 6

policy through fiscal union and a more efficient crisis rescue mechanism, in order to defend its achievements of regional monetary integration. Although not very realistic in the short run, Asian countries should gradually push forward their monetary and financial integration process, by strengthening the role of the ASEAN +3 Macroeconomic Research Office (AMRO) and making the Chang Mai Initiative Multi-lateralization (CMIM) more effective. 4. The Internationalization of the RMB Since 2009, the Chinese RMB has been increasingly used in its cross-border trade settlement, financial transaction and foreign direct investment. The scale of RMB deposit in offshore financial markets has also increased rapidly. Besides, RMB has become a reserve currency in some emerging market economies and a denomination currency in bilateral currency swap agreements. Basically, although still in a very limited scale, within three or four years, RMB has gradually emerged as an international currency with modest functions of being units of account, means of exchange and store of value. RMB Deposits in Hong Kong Banks Rapid increase of RMB s offshore deposits in Hong Kong banks might be one of most important developments in the internationalization of RMB. Although Hong Kong banks were awarded license to run RMB deposit business in 2004, the amount of RMB deposit just increased rapidly in the past three or four years, due to the significant increase of cross-border trade settlement in RMB. As of March 2014, the scale of RMB deposits in Hong Kong was 944.91 billion yuan. Trade Settlement in RMB In April 2009, the Chinese government announced a pilot scheme of cross-border trade settlement in RMB. As a result, the amount of trade settlement in RMB has increased dramatically since then. In the first quarter of 2014, the quarterly amount of trade settlement in RMB through Hong Kong banks has reached 1.49 trillion yuan, increased by 79.2% on y-o-y base, or around 23 % of China s total trade settlement in 2013. Cross-border Direct Investment in RMB 7

The cross-border direct investment in RMB has increased rapidly since 2011. The scale of RMB settlement for foreign direct investment (FDI) was much higher than the one for overseas direct investment (ODI). In 2012, the total amount of cross-border direct investment reached 284 billion yuan. Among them, FDI was about 253.6 billion yuan while ODI was about 30.4 billion yuan. More impressively, the amount of FDI settled in RMB has reached 36% of the total FDI inflow into China. Cross-border Financial Transactions in RMB Chinese authorities permitted domestic financial institutions to issue RMB denominated bonds in Hong Kong early in 2005. Since then, many Chinese financial institutions, foreign financial corporations and multinational enterprises have been allowed to issue RMB-denominated bonds abroad. Actually, the Chinese government has launched a series of polices aiming at promoting the usage of the RMB in financial transaction since 2010, including RQFII, an institutional arrangement that allows the qualified overseas portfolio investors purchase RMB denominated assets in China s domestic capital markets with certain kinds of restriction in holding duration and share for a specific stock or bond. According to SAFE, the amounts of RQFII have increased rapidly since its introduction in 2011, reaching to 215.6 billion yuan by April 30, 2014. Currency Swaps with Foreign Central Banks Over the past few years, the RMB has become a reserve currency for some emerging market economies and developing countries, such as Nigeria, Malaysia, Korea, Cambodia, Belarus, Russia and the Philippines. Although the scale is very small, often below 5% of the total holding in these countries, it has some symbolic relevance that the RMB is now becoming a reserve currency. More impressively, at the outbreak of the American subprime-mortgage crisis in 2008, as a part of RMB internationalization, China signed eight currency swap agreements with six Asian countries and two countries from the rest of the world. Since then, the total amount of RMB swap agreements with foreign central banks has increased rapidly, reaching over 2 trillion yuan by the March of 2013. 1) The Benefits and Costs of Internationalization of RMB Regarding its benefits, first of all, the international usage of RMB should be beneficial to mitigate the flaws of the existing global monetary system and therefore enhance global financial stability. If the RMB eventually becomes a part of the 8

multi-reserve currency regime, the problem of the Triffin Dilemma could be alleviated to some degree. In addition, when more currency competition is present, the country issuing the main reserve currency might become more careful with its monetary policy, particularly concerning a reckless use of loose monetary policy. Secondly, the international usage of the RMB is likely to be a new vehicle of Asian monetary and financial integration, which could be an important part of the ongoing reform of the global monetary system. While more and more currency swap agreements, intra-regional trade and investment are denominated in RMB, Asian countries will have an increasingly strong motivation to use the RMB as a nominal anchor and keep their currencies pegged to the RMB, which may eventually make the RMB an important reserve currency in this region. When the RMB becomes an important currency for denomination, pricing and store in value, the chance for Asian countries to create a fixed exchange regime or single currency zone will largely increase. Thirdly, at the national level, China may also reap some benefits. One, China may largely reduce its currency mismatch in its external trade and investment, which would reduce the transaction costs. Two, RMB internationalization would go hand in hand with a larger, more sophisticated financial sector and would benefit China s transformation of its economic growth model (Zhang and Tao, 2014). Three, RMB internationalization would allow Chinese firms and financial institutions to borrow in RMB globally, which may reduce their funding costs. Similarly, it may give more macroeconomic flexibility to the Chinese government as long as it needs to enlarge fiscal expenditure. Four, RMB internationalization would benefit the overseas expansion of Chinese financial institutions since they surely have more advantage in RMB business. Five, RMB internationalization would allow Chinese monetary authorities to collect seigniorage from the rest of the world, although this should not be considered a primary benefit. Six, as Yu (2012) mentioned, the internationalization of RMB may reduce China s demand of US dollar reserves and therefore reduce seigniorage paid to the United States. There are certainly some costs involved in the internationalization of RMB. Firstly, RMB internationalization may complicate the China s monetary policy and reduce its effectiveness and independence. This cost is similar to the problem that Mundell (1961) described as the impossible trinity, since a highly internationalized currency must be combined with a convertible capital account. In such a circumstance, the country must forgo its domestically oriented monetary policy if it wants to keep its exchange rate stable. 9

Secondly, RMB internationalization could similarly reduce the autonomy of exchange rate policy. As the RMB becomes an international reserve currency, it is very likely to become an anchor currency for other countries and thus the exchange rate of the RMB against that currency may lose its flexibility. As the related experience in the United States indicated, it has often suffered from such exchange rate inflexibility, particularly from its inability to devalue the dollar (Bergston, 1975). Thirdly, should the RMB become a key international currency, the China would bear more responsibility in the rest of the world. A key reserve currency issuing country is usually responsible for keeping the international financial and monetary system in order. Among others, it should play the role of being a lender of last resort, meaning that it will have some responsibility to provide liquidity support during periods of global financial stress, even though such support may have an adverse effect on its domestic economy. 2) The Future of the Internationalization of RMB Although China has become the leading trade country and the second largest economy in the world, it is convinced that the internationalization of RMB with a high degree should be a relatively long term process. The main reason for this judgment is that China s domestic financial market is still very immature and its capital account is still under relatively strict control. According to the related experiences in developed countries, a highly developed financial market, particularly with high liquid bond markets, is the most important precondition for a process of internationalization of the domestic currency. Building up a highly liquid financial market will significantly push forward the process of internationalization of RMB and will facilitate it in the long run. Therefore, China should accelerate its domestic financial reform, especially the liberalization of interest rates, improve the liquidity of financial market through strengthening financial innovation in instruments and institutional arrangement and increase the openness of the financial sector through allowing a freer entry of qualified foreign banks and non-bank financial institutions. A more open capital account should certainly facilitate the internationalization of RMB. However, it could be wrong to argue that the internationalization of RMB is unlikely to make any further progress until China fully liberalizes its capital account. In fact, early experiences with the internationalization of currencies in developed economies have shown that a fully opened capital account is not necessarily a precondition. For instance, during the 1950s, 1960s and 1970s, though the UK had 10

more or less maintained restrictions on capital movements, its currency kept an international status. Similarly, the development of Eurodollar market in the 1950s and 1960s have just provided another interesting historical precedent, where the US dollar became much more influential as an invoice and settlement currency through offshore markets even though the American domestic financial market remained burdened with many restrictions including controls on cross-border capital movement. Thus, it should be reasonable to argue that the full liberalization of the capital account is not necessarily a precondition for RMB internationalization. Actually, the rapid development of the Hong Kong offshore RMB market over the past years has just shown that the internationalization of the RMB can make significant progress even though China retains its capital controls. Basically speaking, with a limited opened capital account, if China can maintain a strong pace of economic growth, and keep the RMB exchange rate stable or mildly appreciating, the internationalization of the RMB will be strengthened mainly through offshore markets. In addition to Hong Kong, it is reasonable to predicate that Singapore, London, Tokyo and other international financial center could play important roles in the development of offshore RMB markets, since most of these cities own well-developed financial markets and institutions. Besides, learning experiences with banking facilities in New York in the end of the 1970s, China may also set up similar Banking Facility in Shanghai or Shenzhen as a special liberalized zone in the onshore market. In the medium or long run, if China can successfully accelerate its domestic financial reform and gradually liberalize its capital account, the internationalization of RMB may also be pushed through the onshore market. Particularly, the target of building Shanghai into an international financial center before 2020 could be a great vehicle to realize the internationalization of the RMB through an onshore market. However, basically, it is still unclear how far China will go toward an open capital account in the coming few years. For having a good chance to push forward RMB internationalization, it is certainly important for China to maintain a rapid and sustainable economic growth and a leading role in international trade and investment in the coming years or decades. Recently, there have been some concerns on whether China can avoid the middle income trap and continue growing. Looking forward, as long as China can successfully change its growth model and rely more on its domestic demand, and further pushes market-oriented economic reforms while making great efforts to solve the issue of income and regional inequality, there will be a big chance for China to 11

avoid the middle income trap problems. However, it is noted that a more inward development strategy may more or less lower China s productivity and international competitiveness and eventually reduce its trade surplus. If this happens, in the coming years, China may have a relatively weaker balance of payments position and even have the RMB s trend of appreciation changed, which could be a real challenge for the RMB s internationalization. References: Eichengreen, Barry (2005): The Blind Men and the Elephant, Paper for the Tokyo Club Foundation s Macroeconomic Research Conference on the Future of International Capital Flows, Kyoto, 21-22, November. Eichengreen, Barry (2009): Commercialize the SDR, Project Syndicate, April 27. Cooper, Richard (1987): The International Monetary System, MIT press, Cambridge. Frankel, Jeffrey (2009): What s In and Out in Global Money, Finance & Development, September, Volume 46, Number 3, P13-17 Stiglitz Commission (2009): Report of the Commission of Experts of the President of the United Nations General Assembly on Reforms of the International Monetary and Financial System, United Nations, September 21. Williamson, John (2009): Why SDRs Could Rival the Dollar, Policy Brief No. PB09-20, Peterson Institute for International Economics, September, Washington, DC Yu, Yongding (2012): Revisiting the Internationalization of Yuan, Research Centre for International Finance, IWEP, CASS, Working Paper No. 15, Beijing Zhang, C. (2012): The Development of the Offshore RMB Business. Presentation at ADBI OECD Roundtable on Capital Market Reform in Asia, Tokyo, February 8. Zhang, Liqing and K. Tao (2014): The Benefits and Costs of Renminbi Internationalization. ADBI Working Paper series, Tokyo: Asian Development Bank Institute. 12

Zhou, Xiaochuan (2009): Reform of the International Monetary System, People s Bank of China, www.pbc.gov.cn/english. 13