The Economics of RMB Internationalization∗

Liqing Zhang Central University of Finance and Economics 39 South College Road Beijing 100081, China [email protected] Kunyu Tao Central University of Finance and Economics 39 South College Road Beijing 100081, China [email protected]

Abstract The rapid internationalization of the RMB since 2009 raises many interesting questions, including: Why has this change been so fast? What is the rationality behind this new process? What economic consequences will it produce? What kinds of policies should China adopt to make the process smooth and sustainable? In this paper, we ﬁrst describe the main developments of RMB internationalization and discuss the rationality of the process, by comparing its beneﬁts and costs. Then, based on the historical experience of the main international currencies, we use a Size-Liquidity-Credibility analytical framework for understanding the determinants of being an international currency. Us- ing this framework, we then provide some policy suggestions for making RMB internationalization a sustainable process.

1. Introduction

The United States’ ﬁnancial crisis of 2007 has created a new wave of discussion about the reform of the international monetary system. The U.S. dollar–centered reserve system has been strongly criticized for its exorbitant privileges, which not only causes ﬁ- nancial instability but also gives rise to inequality between rich and poor countries (Stiglitz 2009; Zhou 2009). Although various reform proposals have been repeatedly presented, including a return to the gold standard, the creation of a single world currency,

∗ The paper is sponsored by the Chinese Ministry of Education project “China’s Capital Account Liberalization: Sequences and Risks” (approval number: 14JZD016). The authors are grateful to Anwar Nasution, Chalongphob Sussangkarn, Jayant Menon, Naoyuki Yoshino, Wing Thye Woo, and other participants for their valuable comments and discussions at the Asian Economic Panel Meeting, 15–16 September 2014, Tokyo.

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special-drawing-rights-based proposals, and an improved U.S. dollar standard, many economists believe that a multipolar currency system is the most realistic development in the coming decades (Eichengreen 2011). It is further argued that, through currency competition, any reserve currency–issuing country would become more disciplined in its monetary and other macroeconomic policies, which could eventually lead to a more stable international monetary system (Zhang 2015).

Until 2009, many economists believed that either the Japanese yen or a sort of synthesized currency (called the Asian dollar) could become one of the pillars of the multipolar system. Thus, the U.S. dollar, the euro, and the Japanese yen or Asian dollar may together build up a three-pillar global reserve system. The rapid development of RMB internationalization since 2009, mainly reﬂected in the increasing usage of RMB in cross-border trade settlements and other ﬁnancial transactions, indicates that the currency structure of the multipolar system may take a different form, however.

Despite an increasing recognition that the RMB may eventually become a key global currency, several important questions need to be answered. Among them are: How far has RMB internationalization gone? How should we interpret the rapid development over the past ﬁve years? How should we think about the beneﬁts and costs of the RMB becoming an international currency? What kinds of risks might China encounter during the process of RMB internationalization? And how can the process become a sustainable one? This paper attempts to answer these questions.

2. Main developments and reasons of RMB internationalization

2.1 Main developments since 2009 Although some researchers early in the 21st century argued that China should promote the internationalization of the RMB (Zhao 2001), and more recently some have argued that the internationalization of the RMB should become a new driver of deep economic reform and opening up, the Chinese government has never ofﬁcially declared RMB internationalization as a formal strategy. Because of various market-oriented forces, however, the removal of restrictions on trade settlements in RMB in 2009 has largely spurred a de facto process of RMB internationalization. In the ensuing ﬁve years, the scale of RMB use and holdings beyond the borders of China has increased rapidly.

The rapid increase in the use of RMB in trade and direct investment settlement is probably the most important indication of the currency’s internationalization. Before 2009, almost all cross-border trade transactions were settled in U.S. dollars and other foreign currencies. Since July 2009, when the Chinese authorities decided to liberalize its trade settlement, the amount of trade settlements in RMB has increased dramatically. According to a report on RMB internationalization released by the People’s Bank of

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China,1 the amount of cross-border trade and services settled in RMB reached China Renminbi (CNY) 6.55 trillion in 2014, about 25 percent of China’s current account transactions. Since 2011, cross-border direct investments settled in RMB have also increased rapidly. The value of RMB settlements for overseas direct investment was about CNY 186.56 billion in 2014, with an increase of 117.9 percent over the previous year; and the value for foreign direct investment settled by RMB amounted to CNY 862.02 billion, with an increase of 92.4 percent over 2013.

Another important indication of RMB internationalization is the rapid increase of RMB- denominated financial assets in recent years, in both onshore and offshore markets. RMB deposits held by non-residents in China’s onshore market (excluding Hong Kong and Macau) amounted to CNY 2.28 trillion in 2014 after gradually increasing for years. In the inter-bank bond market—the outstanding balance of RMB denominated bond held by foreign banks and other institutional investors—reached CNY 634.61 billion. By April 2015, through qualified foreign institutional investors (QFII), RMB-qualified foreign institutional investors (RQFII), and the Hong Kong-Shanghai Connect Program, foreign institutional investors have possessed over CNY 1.38 trillion in RMB-denominated assets, including shares and bonds.

Since 2009, the offshore RMB bank deposit has also increased rapidly from almost nothing to over CNY 2 trillion in 2014, about half of which are in Hong Kong markets and half in other main international ﬁnancial centers, such as Taipei, Singapore, London, New York, and Frankfurt. Meanwhile, RMB-denominated bonds issued through offshore markets have also increased rapidly, particularly in 2014. By the end of 2014, the outstanding balance of RMB-denominated bonds held by foreign investors in offshore markets was over CNY 530.48 billion. RMB ﬁnancial derivatives have also emerged, although the scale is limited. Both the Singapore Exchange and Hong Kong Exchange launched RMB futures contracts in October and December 2014, respectively, indicating a growing acceptance of RMB in foreign exchange markets.

There has also been a rise in the use of RMB as a reserve currency in recent years. The RMB has become a reserve currency for some emerging market economies and developing countries such as Belarus, Cambodia, Malaysia, Nigeria, the Philippines, the Republic of Korea, and the Russian Federation. By April 2015, the total amount of RMB- denominated ﬁnancial assets held by foreign central banks and other monetary authorities reached CNY 666.7 billion. Although the scale remains small, often below 5 percent of total holdings in these countries, it is somewhat symbolic that the RMB has begun to emerge as a reserve currency. Notably, in October 2014, the British government

1 People’s Bank of China: Report of RMB Internationalization (2015), available at http://www.pbc.gov.cn/huobizhengceersi/214481/214511/214695/2879200/index.html

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Table 1. Roles of international currency

Function of money Governments Private sectors

Store of value International reserves (1) Currency substitution (4) Medium of exchange Vehicle currency for foreign exchange Invoicing trade and ﬁnancial transactions (5) intervention (2) Unit of account Anchor for pegging local currency (3) Denominating trade and ﬁnancial transactions (6)

Source: Chinn and Frankel (2005).

announced that it may consider including the RMB as a foreign exchange reserve after the completion of issuing CNY 3 billion RMB-denominated bonds.

The RMB has also played an increasingly important role in building up global ﬁnancial safety nets through the signing of bilateral currency swap agreements. By the end of 2014, China had signed bilateral currency-swap agreements with 28 countries (regions) with a total value of CNY 3.06 trillion.

2.2 How far has RMB internationalization gone? According to the latest report made by SWIFT, by December 2014, the RMB had become the second largest currency for international trade financing, the fifth largest for global payment and the sixth largest for global foreign exchange transactions.2 If we look at the RMB’s share in the global payment, financing, and reserve system, however, it is difficult to say that the RMB has become one of the main international currencies.

By deﬁnition, an international currency is one that is used and held beyond the borders of the issuing country, not merely for transactions with that country’s residents but also, and most importantly, for transactions between nonresidents (Kenen 1983). From a theoreti- cal perspective, an international currency should function as a unit of account, a means of exchange, and a store of value not only within but also outside the borders of the issuing country. Kenen (1983) provides some early thoughts on the roles that an international currency should play in both governmental and private transactions, and Chinn and Frankel (2005) develop a list of these functions for an international currency (Table 1). A typical international currency should play all the roles in the six areas identiﬁed there.

In 2013, the Institute of International Currency together with Renmin University of China developed an index for describing the extent of RMB internationalization, released on a yearly basis. The index (RII) is a weighted average based on the RMB’s shares in the global monetary system as an invoice, settlement, and reserve currency. According to this research, although the RII has increased rapidly over the past six years (from 0.02 percent in 2009 to 2.33 percent in 2014), it still accounts for limited shares in the global currency system, particularly compared with the shares of USD, EUR, and JPY (Table 2). It

2 People’s Bank of China: Report of RMB Internationalization (2015).

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Table 2. The RMB internationalization index (%)

Year RMB USD EUR JPY

2009 0.02 52.79 26.92 3.60 2010 0.23 53.33 25.58 4.34 2011 0.45 54.18 24.86 4.56 2012 0.87 52.34 23.72 4.78 2013 1.23 53.81 27.44 4.39 2014 2.33 54.67 24.49 4.18

Source: Annual Report of RMB International- ization, Various Issues (2013, 2014, 2015), and Institute of International Currency with Renmin University of China (2012).

is noted that the share of RMB in the global reserve system has been much lower than its average level as indicated by the RII. Given that the total amount of global foreign exchange reserves is about USD 11.43 trillion by the end of ﬁrst quarter of 2015,3 the CNY 666.7 billion (equivalent to USD 107.53 billion) only accounted for around 0.9 percent of global foreign exchange reserves at that time.

In sum, the internationalization of RMB is still in an early stage. Using the analytical framework presented by Chinn and Frankel (2015), we ﬁnd that the RMB only plays a role in the areas of being an invoicing currency and a denominated currency in the private sector (i.e., roles (5) + (6) from Table 1). In the remaining areas, particularly in the public sector (i.e., roles (1) + (2) + (3) from Table 1), the RMB plays almost no role.

2.3 Reasons for the rapid development of RMB internationalization The rapid development of RMB internationalization since 2009 can be attributed to a number of factors. First, it is obviously a reﬂection of China’s rise as a large globalized economy. China has become the second largest economy and the largest trading country since 2014. When China plays an increasing role in the world economy and trade, it is natural for its currency to be used in global economic and ﬁnancial transactions.

Second, the liberalization of financial services and the reduction of restrictions on capital flows since 2009 have played an important role in pushing forward RMB internationalization. Among others, the decontrol of trade settlement is probably the most important change. Before 2009, authorities encouraged using foreign currencies in settling cross- border trade, although there was no explicit document to codify that. After July 2009, the RMB had an equal position with the main foreign currencies and was even encouraged to be used in trade settlement. In the following years, Chinese authorities launched various measures in allowing qualified overseas RMB investors (including foreign central banks that deal with RMB transitions) to invest RMB-denominated assets in the

3 IMF: International Finance Statistics, ﬁrst quarter, 2015.

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Figure 1. The cross-border RMB index (CRI) and the RMB–USD exchange rate

Source: Wind data set. Wind Information Co., Ltd., Shanghai, China.

domestic inter-bank bond market and stock exchanges, such as RQFII and offshore loans provided by foreign banks in the Qianhai ﬁnancial pilot district. The Shanghai free trade zone was established in 2014 and the Shanghai-Hong Kong Stock Connect program could accelerate China’s capital account liberalization and boost the RMB internationalization even further.

Third, the continuous appreciation of the RMB not only encourages foreign exporters to settle their trades in RMB but also drives the rise of RMB deposits in Hong Kong, which surged after 2009, reaching 1 trillion by the end of 2014. This link is evidenced by the sig- niﬁcant correlation between the RMB exchange rate and the cross-border RMB index issued by the Bank of China (Figure 1). RMB appreciation will not last forever, however, and with the IMF recently claiming that the currency is no longer undervalued (in an of- ﬁcial press release after the Article IV Consultation Mission to China), cross-border usage of RMB may decline in the future.

Fourth, the increased trade between China and Southeast Asian countries has played an important role. There has been a rapid increase of trade with ASEAN and other Asian countries since the China–ASEAN free trade agreement in 2009, creating a signiﬁcant opportunity for both sides to use the RMB as a settlement currency. In particular, China has experienced rising current account deﬁcits with ASEAN countries, making it easier fortheRMBtogoabroad.

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Fifth, many emerging economies have suffered from capital outﬂows and liquidity short- ages since the American subprime crisis and the European sovereign debt crisis. To improve their ﬁnancial safety nets, many countries have decided to sign currency-swap agreements with China, promoting the acceptance of the RMB as an international liquidity instrument and reserve currency (Woo 2010).

Finally, the rapid development of RMB internationalization should be partly attributed to the volatility of the main currencies, including the U.S. dollar, euro, and yen. To some degree, RMB internationalization is the result of currency competition because more and more international investors, including central banks from many emerging economies, have substituted the RMB to reduce exchange risks.

3. The economics of RMB internationalization: A cost–beneﬁt analytical framework

There has been much discussion relating to the pros and cons of RMB internationalization in the literature. Chen, Peng, and Shu (2007) stress the need for cost–benefit analysis to underpin the Chinese government’s decision to promote RMB internationalization (or not). Gao and Yu (2010) suggest a road map for RMB internationalization and argue that regardless of whether it becomes an international or a regional currency, the process would be beneficial for the whole economy. Hai and Yao (2010) compare the benefits and challenges of RMB internationalization, arguing that cross-border circulation of the RMB would likely have a small impact on the effectiveness of China’s monetary policy. Zhang (2013) points to the arbitrage risks during the process of RMB internationalization. Li and Liu (2008) suggests that, owing to China’s high savings rate, the benefits of borrowing internationally may be low, and the benefits of seigniorage income after China’s capital account liberalization might be small, when one takes into account financial repression (including interest rate controls, credit constraints, capital controls, and so on). In the following, we add some new points to supplement this literature.

3.1 The benefits 3.1.1. Reducing exchange risk By using the RMB as an invoicing and settlement currency, Chinese firms may reduce the exchange risks of international trade and investment, thereby reducing transaction costs. Similarly, the internationalization of the RMB should be helpful in reducing currency mismatch for financial institutions. It would alle- viate the problem of “original sin”—a situation in which a country is not able to borrow from abroad in its domestic currency and one that many emerging economies have to live with.4 China is a typical emerging market economy, with underdeveloped financial

4 Currency original sin is a commonly used metaphor in international ﬁnance, proposed by Eichen- green and Hausmann (1999) and Eichengreen, Hausmann, and Panizza (2002).

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markets. As its economy becomes more deeply integrated into the global economy, particularly through a more open financial sector and a more internationalized banking sector, Chinese banks may find currency mismatch problems to be a greater challenge. RMB internationalization may help these banks to reduce exchange risks. In addition, the increased weight of RMB-denominated assets in financial institutions would reduce the effects of foreign exchange risk in the Bank for International Settlements’ computation of capital adequacy requirements.

3.1.2. Promoting the development of domestic financial market RMB internationalization would go hand in hand with a larger, more sophisticated financial sector in China and would benefit the transformation of its economic growth model. Some scholars argue that financial development should be a precondition of currency internationalization (see, for example, Tavlas 1997; Dobson and Masson 2009). However, the increased use of a domestic currency for international trade and investment would increase the breadth and depth of the financial market by attracting more market participants and strengthening the linkages with the global financial market. Chen, Peng, and Shu (2007) use the currency internationalization experiences of Germany and Japan to illustrate the importance of financial development and the possible gains produced by currency internationalization. Papaioannou and Portes (2008) also argue that currency internationalization would promote the development of financial markets, both domestically and globally. Taking Europe’s economic and monetary union following the introduction of the euro as an example, they find that private credit in participating countries increased by roughly 1.15 percent more than in other countries, and that these welfare gains resulted from the internationalization of the euro.

In the case of China, it is recognized that a more developed financial market is a precondition of RMB internationalization. On the other hand, if RMB internationalization is wide and deep, it would inevitably push forward the development of the financial sector through international trade settlements in RMB and financial services related to RMB- denominated international bond transactions. Indeed, RMB internationalization may become an important driver of China’s bond market. In addition, as some researchers have argued, RMB internationalization will benefit the rise of Shanghai as an international financial center (Gao and Yu 2010; Ranjan and Prakash 2010). Furthermore, RMB internationalization may actually become a new catalyst for financial reform if Chinese authorities believe that a more internationalized currency is in the national interest (Maziad et al. 2011; McCauley 2011).

3.1.3. Reducing financial expenses RMB internationalization would allow Chinese firms and financial institutions to borrow in RMB, which may reduce financial costs in two ways. First, Chinese firms and financial institutions may borrow in domestic financial markets at a lower cost, because of increased foreign demand for RMB-denominated

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securities. Second, Chinese ﬁrms and ﬁnancial institutions may obtain loans or issue bonds at a lower cost in offshore RMB markets if the restrictions on borrowing abroad are loosened.

Similarly, RMB internationalization would allow the Chinese government to borrow at a lower cost and thus to maintain higher fiscal deficits than it can at present. This benefit is akin to so-called monetary privilege or macroeconomic flexibility (Cohen 2012). By selling RMB-denominated government bonds and treasury bills to foreign investors, China may obtain low-cost funding from the rest of the world. Looking forward, as a consequence of the aging of the population, China may in the future face more fiscal deficit pressure than it does today. RMB internationalization may provide China with a new channel for dealing with these challenges. Of course, such a benefit will largely depend on how sophisticated China’s financial market (particularly the bond market) is in the future. And it would certainly be a big mistake for China to abuse such a benefit and lose control of its fiscal deficits.

3.1.4. Helping the overseas expansions of China’s firms and financial institutions RMB internationalization would benefit the overseas expansion of Chinese firms and financial institutions and would increase the ability of Chinese firms to invest abroad. Generally, investors prefer to operate in their domestic currency where it is allowed, because it is more convenient and less expensive for them to hold. In the future, the RMB will not only increasingly be used in foreign direct investment but will also increasingly function as an international currency in contracts and claims documents. Accordingly, China’s capital and financial accounts may show large deficits, something both the United States and Japan have experienced in the past. For instance, from 1953 to 1971 (except for 1968 and 1969), U.S. capital and financial account deficits increased dramatically; the deficit in 1971 was 51 times the deficit in 1953. Likewise, since 1981, when Japan began to promote the international use of the yen, Japan’s capital and financial accounts have been in deficit, with the deficits from foreign investment increasing from 4.71 trillion in 1981 to 21.35 trillion in 1998 (International Monetary Fund 2012).

As the RMB becomes an increasingly important currency in global financial markets, financial institutions will conduct more and more RMB business, and in comparison with foreign banks, China’s banks could be more competitive in this area. Therefore, it is reasonable to speculate that RMB internationalization would push forward the overseas expansion of China’s financial institutions; in the early stages, this would be particularly true of commercial banks.

3.1.5. Earning international seigniorage RMB internationalization would allow China monetary authorities to collect seigniorage from the rest of the world, although this should not be considered a primary benefit. Seigniorage is defined as the profit resulting

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from the difference between the nominal value of a currency and its cost of production. A government that issues a specific currency can gain seigniorage by exchanging its paper money for goods and services. Cohen (2012) points out two components in seigniorage: The first results from foreign accumulations of actual cash bank notes and coins; the second derives from foreign accumulations of financial claims denominated in the local currency. The latter actually means an increase in effective demand for assets, which drives the cost of borrowing below what it might be otherwise. At present, seigniorage gains are small according to the estimation of Hai and Yao (2010). For example, in 2012, current account transaction settlements in RMB were valued at roughly CNY 3 trillion. Because of appreciation expectation, more than 70 percent of these transactions related to the import of goods or services, so the net import transaction share was 40 percent, equating to around CNY 1.2 trillion in net outflows. Supposing that these funds remained outside China for one year in the form of bank deposits or various financial assets, and that the zero-risk interest rate of RMB in the offshore market was 3 percent, the seigniorage on these RMB could be CNY 36 billion. If the RMB plays a more important role in trade settlements and becomes a more attractive store of value, then its seigniorage would be more significant.

3.1.6. Reducing reliance on the U.S. dollar RMB internationalization may help China reduce its reliance on the U.S. dollar. China is an emerging market economy with a large and sometimes volatile export sector, and financial reform and liberalization of its capital accounts is listed on the country’s policy agenda. To avoid external shocks and to maintain financial stability, it is reasonable for China to accumulate sufficient foreign exchange reserves for insurance purposes, though it should also seek to avoid excessive holdings. Because the U.S. dollar is currently the main reserve currency, however, China may have no choice but to hold U.S. dollars in large amounts, and it is clear that over-reliance on U.S. dollar–denominated assets not only offers low returns but is also risky.

Developing countries that have not carried out currency internationalization must hold large foreign exchange reserves as a safety net against external shocks. Central banks in developing countries cannot be the lenders of last resort for foreign currency, because they have no power to print it. They can play a limited role as quasi lenders of last resort in foreign currency, if they have large foreign reserve holdings. Even if they hold massive foreign reserves, however, they can use only a limited amount of those reserves in the event of a crisis, because of their fear of losing those reserves (Aizenman, Chinn, and Ito 2008). Therefore, RMB internationalization and the emergence of the RMB as a main reserve currency may help China reduce its demand for foreign exchange reserves and thereafter reduce its reliance on U.S. dollar holdings.

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3.2 The costs The costs of RMB internationalization mainly focus on the challenges in the long run. This is in terms of the general costs that may accrue to any international currency, whether it is the pound sterling, the yen, the U.S. dollar, or any other currency. As long as a national currency plays a role as an international currency, such costs may always exist.

3.2.1. Declining effectiveness and independence of China’s monetary policy RMB internationalization may complicate China’s monetary policy and reduce its effectiveness and independence. This cost, which may be the main challenge for an international currency, is similar to the problem that Mundell (1961) described as the “impossible trinity” of an open economy, meaning that no country can simultaneously reach the policy goals of free capital movement, exchange rate stability, and independent monetary policy. Nor- mally, 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.

Some economists argue that the effectiveness and independence of China’s monetary policy may not currently be a big problem, because the country still maintains relatively strict capital control. As the RMB becomes a leading international currency, however, China’s monetary policy may become less effective at keeping its exchange rate stable. For instance, Aizenman, Chinn, and Ito (2008) argue that with a reduction in the effectiveness and independence of China’s monetary policy as the RMB becomes an international currency, China’s position in the impossible trinity will move from its current status to a more extreme point. Similarly, Hai and Yao (2010) indicate that although RMB internationalization would not have a signiﬁcant inﬂuence on the effectiveness of China monetary policy in the short to medium term, in the long term, the growing scale of RMB cross- border circulation and enhancement in other currency functions that follow from RMB internationalization might affect the independence of China’s monetary policy through endogenous monetary transmission mechanisms.

Note that RMB internationalization does not necessarily involve the removal of all restrictions on capital movements. The Chinese government may continue to impose restrictions on residents’ ﬁnancial transactions in foreign currency instruments. Never- theless, RMB internationalization will broaden the scope for residents and nonresidents to buy and sell domestic currency instruments, which will limit the ability of the People’s Bank of China to inﬂuence domestic interest rates and the money supply through open market operations.

Speciﬁcally, the rapid development of Hong Kong, China, the offshore RMB market, and its increasingly close links with ﬁnancial markets in mainland China (Maziad and Kang

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2012) could make it harder for the People’s Bank of China to control monetary aggregates and maintain its autonomy in setting domestic interest rates. To some extent, the Hong Kong, China, offshore RMB market is a pool of hot money. At any point it could present a shock to mainland China’s monetary policy.

3.2.2. Declining autonomy of China’s exchange rate policy RMB internationalization could similarly reduce the autonomy of exchange rate policy. As the RMB becomes an international reserve currency, it could become an anchor currency for other countries, and the exchange rate of the RMB against that currency would lose its flexibility. Without this exchange rate flexibility, China could lose its macroeconomic flexibility and trade competitiveness. Since the 1944 Bretton Woods agreement, the United States has often suffered from such exchange rate inflexibility, particularly from its inability to devalue the dollar (Bergsten 1975).

3.2.3. More responsibility to the rest of the world Third, if the RMB becomes a major international currency, China will be increasingly 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.

Therefore, any reserve currency–issuing country must be careful about its policies. Al- though we should not forget the notion made famous by U.S. policymakers that “the dollar is our currency, but your problem,” it is more important to remember that any persis- tent misuse of macroeconomic policies will lead to a signiﬁcant depreciation of a currency and, sooner or later, a country will lose its currency privilege. Under the multipolar reserve currency system, such a risk could be much greater than in other situations.

3.3 Weighting the benefits and costs This discussion on the benefits and costs of RMB internationalization helps us understand the rationality of RMB internationalization. The question that remains is how to judge the likely economic consequences of RMB internationalization in the future. For a few reasons, it is fair to speculate that the benefits of RMB internationalization should surpass its costs, particularly in the long run. First, most of the benefits elaborated here, such as reduced exchange rate risks, development of the financial sector, and increased economic openness to the rest of the world, are related to the real economy and could be more significant if the RMB becomes a leading international currency. Second, although the costs should not be ignored, most of them could be alleviated by some appropriate policy mix. For instance, a more flexible exchange rate regime and/or optimal capital account man- agement may increase the independence of monetary policies. Third, transitional costs

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Table 3. Determinants of international currency: SLC approach

Size (S) • Share in the global economy • Share in the global trade (especially the share and pricing ability in staple commodity market) • Share in the global financial market Liquidity (L) • Types and availability of financial assets • Availability of Treasury bill (highly liquid government bond) market • Openness of capital account Creditability (C) • Sustainability of economic growth • Discipline of macroeconomic policies • Equilibrium of Balance of payments • Flexibility of exchange rate regime • Independence of central bank • Soundness of financial regulation • Confidence for political and legal system

Source: Authors’ summary.

will be reduced as RMB internationalization expands. The current limited variation in the RMB’s exchange rate against the U.S. dollar and the underdeveloped financial market are probably the main factors that explain the concern about the potential destabilizing effect of the external demand for the RMB. Nevertheless, increased exchange rate flexibility and progress in financial sector reform and development should help increase the domestic economy’s resilience to external shocks over time and reduce the transitional cost of RMB internationalization.

4. The determinants and future of RMB internationalization

4.1 The determinants of being an international currency: An analytical framework of Size-Liquidity-Credibility Eichengreen (2013) argues that scale, liquidity, and credibility are the main determinants for a national currency to be an international currency, which we describe as the Size- Liquidity-Credibility (SLC) approach, summarized in Table 3.

The historical experiences of the British pound sterling, U.S. dollar, euro, and Japanese yen indicate that it is necessary to be good enough in all of these three dimensions if a national currency is going to be signiﬁcantly internationalized. Any lack of size, liquidity, or credibility may hinder the transition.

Because of its unprecedented industrial revolution, the United Kingdom became the center of the world economy in the 19th century. Owing to its dominant roles in global man- ufactory production, international trade, and world ﬁnance, the British pound sterling was the leading international currency prior to 1914. Between 1860 and 1914, about 60 percent of world trade was invoiced and settled in sterling, as was a similar share of holdings in global foreign exchange reserves (Eichengreen 2011). The hegemony of the British pound sterling provides supportive evidence of the SLC approach.

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The story of the U.S. dollar’s becoming the leading international currency is a more interesting case, and it indicates that “size” does matter, but is not the only thing that should be considered. In 1914, although the U.S. economy was already more than twice the size of Britain’s, the dollar played almost no international role. No central bank held its foreign reserves in dollars. No one issued foreign bonds in dollars. In- stead, these all went to London, allowing British banks to underwrite their transactions and conducting their business in sterling. One of the main reasons for this is that the United States did not have a highly liquid financial market. The situation changed significantly after the creation of the Federal Reserve System in 1914. One of the new central bank’s first actions was to encourage the development of a trade acceptance market. Mainly because of the emergence of an active and liquid financial market, in the mid 1920s the U.S. dollar successfully started to play an important role in the global monetary system. This was significantly strengthened by the Bret- ton Woods agreement at the end of World War II and eventually evolved into a new global monetary hegemony, which the U.S. dollar maintained for almost 70 years. In addition to its position as the world’s largest economy, the most important reason was that American financial markets, particularly the highly liquid Treasury bill market, were the world’s largest and thereby contributed to the dollar’s widespread use (Talvas 1997).

In the case of the euro, the size of the economy, trade, and financial markets were obviously the decisive factors for its emergence as an international currency, although the credibility of the currency also played a significant role. As a predecessor of the euro, for many years the strong Deutsche Mark supported by low inflation and a huge current account surplus in Western Germany made some key contributions to its internationalization. After the creation of the euro, the EU became the largest economy in the world and accordingly laid a solid foundation for the euro’s internationalization. More notably, the strong appreciation of the euro since 2002, together with the rapid development of unified financial markets (particularly bond markets), successfully enhanced the influences of the euro as the second largest international currency. Some optimistic economists believe that the euro might even surpass the U.S. dollar and become the largest global currency in the world (Chinn and Frankel 2005).

Japan has quite a different story in the internationalization of the yen. In the 1980s, after having high economic growth and a strong current account surplus for decades, Japan became the second largest economy and the largest trading country. With such advantages, the Japanese yen started to internationalize mainly through massive overseas direct investments. In the late 1980s, the Japanese yen became one of the main international currencies, with the share of the Japanese yen in global reserve system reaching 6 percent. Since the 1990s, however, the overall inﬂuence of the Japanese yen has declined. Its share in the global reserve system has dropped to 3 percent. Japanese policymakers came to the

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conclusion that “any further attempt to internationalize the yen or the Japanese capital markets would be futile” (Takagi 2012).

Although there are a number of reasons for the unsuccessful experience of the Japanese yen’s internationalization, one of the main reasons is that Japanese financial markets have been undeveloped, particularly lacking fluidity and openness. In addition, the asset bub- ble burst in the 1990s has significantly injured the credibility of the Japanese economy and investors’ confidence for its currency.

4.2 Moving toward a sustainable process of RMB internationalization Although RMB internationalization has made much progress, being a middle-income developing country, China still faces uncertainty in the future, and the completion of RMB internationalization may take many years, or even decades. Any signiﬁcant mistakes in strategy and policy may hinder the process or even pull it back.

Using the SLC analytical framework, we can estimate what China needs to do to make the process of RMB internationalization more smooth and sustainable.

First, it is important that China maintain strong and sustainable growth in the coming decades, which is not only the key to maintaining large economic size (S) but also to pre- serving credibility (C). Economic size is probably the most important precondition for the RMB becoming a leading international currency. Although China has become the second- largest economy in the world, it is still a developing country, with annual income per capita of around US$ 7,000. After maintaining nearly 30 years of rapid growth, the present increase in labor costs, income disparity, environmental deterioration, and other social problems, as well as a declining comparative trade advantage, increasingly raise con- cerns about whether China will fall into the “middle-income trap” (Eichengreen, Park, and Shin 2012). To avoid this, China should accelerate technology innovation and industrial upgrading, deepen its market-oriented economic reform to improve economic ef- ﬁciency after the development strategy gradually switches to domestic market (Huang and Tao 2010), build up and improve the social security network to deal with the income disparity problem, and implement political reform to create a more transparent and democratic society.

Second, although China is moving toward a more domestic-oriented economic structure, maintaining a competitive trade sector and a leading role in global trade is still extremely important. Again, it is crucial to maintain economic size (S) in the dimension of trade and keep credibility of the international value of the RMB (C). To reach this goal, China should improve its capacity for technology innovation, build up new trade advantages, broaden its trade network, and further enlarge its share of global trade.

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Third, it is important for China to accelerate its financial reforms to expand the depth and scope of its financial system. Among other things, building up a highly liquid bond market (especially a short-term government bond or Treasury bill market), liberaliz- ing interest rates, expanding the flexibility of the RMB exchange rate regime, enhancing the independence of the central bank, and gradually pushing forward the liberalization of capital accounts should be the priorities of the reform agenda. Obviously, these reforms would well improve the economic size (S) in the dimension of financial market, the availability and liquidity of financial assets (L), and the credibility of the financial system (C).

China has sped up its financial reform in recent years. The People’s Bank of China has made significant progress on the liberalization of interest rates in 2012, increasing the restrictive deposit rate ceiling by 10 percent and fully removing controls on the interest rates on loans. Meanwhile, various measures have promoted the development of capital markets, particularly bond markets, to change the indirect finance-dominant and bank loan-dominant structure. After nearly ten years of effort, China has already removed many restrictions on its capital account. According to the International Monetary Fund (2012), China has fully or partly liberalized 34 of 40 items related to capital account restrictions, or 85 percent of the total. Specifically, since 2010 China has launched several liberalization measures directly linked to RMB internationalization, including introduc- ing an RMB-denominated qualified foreign institutional investment arrangement (RQFII), and allowing foreign central banks and other qualified institutions to invest in China’s inter-bank bond market.

Interestingly, there has recently been a heated debate on whether China should accelerate its capital account liberalization. Some believe that China should fully liberalize its capital account within five years; but some believe that China should be more patient in this regard. We side with the latter in recommending caution in removing the remaining capital controls, mainly because China has not finished its domestic financial reform and still lacks efficient financial regulation (Zhang and Gou 2015).

One interesting question is whether full liberalization of the capital account is a precondition of RMB internationalization. It is true that a more open capital account is good for improving the liquidity of financial assets and enhancing the credibility of the financial system, and therefore beneficial to the internationalization of the RMB, particularly when the RMB serves as an international reserve currency. It is not necessarily the case that there will be no progress on RMB internationalization until China has fully liberalized its capital account, however. The rapid development of the Hong Kong offshore RMB market over recent years has shown that RMB internationalization can progress even if China retains selective capital controls. In fact, the euro–dollar market in the 1950s and 1960s provides an interesting historical precedent for such a process. In that case, the U.S.

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dollar became much more inﬂuential as an invoice and settlement currency through the offshore market, while the U.S. domestic ﬁnancial market itself retained many restrictions, including controls on cross-border capital movement.

Fourth, it is necessary for China to further push forward the reform of its political and legal system. A more democratic political system and a more sound legal system means more institutional credibility (C) to the international currency holders, which should be crucial to the RMB internationalization in the long run. Notably, Chinese authorities have strongly emphasized the necessity of establishing modern state governance and democratic society at the fourth plenary session of the 18th National Congress of Chinese Communist Party. Without much doubt, RMB internationalization would develop more smoothly under such a political environment.

Fifth, for enhancing the credibility (C) and global inﬂuence of the RMB, China should strengthen global and regional ﬁnancial cooperation. RMB internationalization is a market-driven process and is basically a by-product of China’s steady economic growth and continuous opening up to the rest of the world, although this does not mean that the government plays no role in the process.

The U.S. dollar’s early experiences show that a government can significantly promote its currency as a key international currency. In addition to the crucial influence of the creation of the Federal Reserve Bank in 1914, the Bretton Woods system, which was driven by the U.S. government, represented another important milestone in the dollar’s becoming the dominant international currency. According to the IMF agreement, each country was requested to peg its currency to the U.S. dollar. Through this institutional arrangement, the U.S. dollar received an advantageous chance to become an official reserve currency.

China should strive to play a greater role in the G20 and other international macroeconomic coordination processes. In particular, China should actively push forward the reform of the international monetary system and work for a more representative and democratic international ﬁnancial architecture. It would be meaningful to China to have the RMB become a special-drawing-right-basket currency in 2015. Such an arrangement would increase the RMB’s chance to become an important reserve currency.

China also should actively promote Asian monetary and financial integration. Given that Asian countries, particularly ASEAN countries, have increasingly close economic and financial relations with China, it would be beneficial for both sides to push forward with monetary integration. In fact, the RMB could become a nominal anchor for most Asian economies. As more and more currency-swap agreements, intraregional trade, and investments are denominated in RMB, it would be helpful for Asian countries to keep their

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currencies pegged or partially pegged to the RMB, and eventually to make the RMB one of their main reserve currencies.

5. Conclusion

The rapid process of RMB internationalization since 2009 can be attributed to various factors. Among them, the most important ones include China’s rise to becoming the world’s second largest economy and one of its largest trading countries, the liberalization of trade settlement and the reduction of restrictions on capital ﬂows, the continuous appreciation of the RMB exchange rate, the increased trade between China and Southeast Asian countries, and the volatility of the other main currencies.

At the national level (for China), the benefits of RMB internationalization may include: reducing exchange risk, lowering financial costs, promoting financial development, helping the overseas expansions of China’s firms and financial institutions, collecting international seigniorage, reducing China’s reliance on the U.S. dollar, and enhancing China’s role in the world governance system. RMB internationalization also has some costs, however, such as the declining effectiveness and independence of monetary policy, the loss of autonomy of exchange rate policy, and a greater responsibility to the rest of the world. Nonetheless, the comparison of the benefits and costs of RMB internationalization indicates that the pros are likely to outweigh the cons, especially in the long run.

The historical experiences of the British pound sterling, U.S. dollar, euro and Japanese yen indicate that economic size (S), liquidity (L), and credibility (C) are the main determinants of being an international currency. Any shortfall in any of these determinants may hinder the process of currency internationalization. Using the SLC analytical framework, we conclude that the completion of RMB internationalization will take time. To make RMB internationalization a smooth and sustainable process, we propose several policy suggestions. First, maintaining strong economic growth and avoiding the middle-income trap; second, keeping a competitive trade sector and balance of payments equilibrium; third, accelerating domestic financial reforms, although in a cautious manner, especially in the case of capital account liberalization; fourth, further pushing forward the reform of the political and legal systems; and fifth, strengthening global and regional financial cooperation to create a good environment for RMB internationalization.

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