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 internationaliza- tion 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 sys- tem 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 pre- sented, 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. Asian Economic Papers 15:1 C 2016 by the Earth Institute at Columbia University and the Massachusetts Institute of Technology doi:10.1162/ASEP_a_00410 Downloaded from http://www.mitpressjournals.org/doi/pdf/10.1162/ASEP_a_00410 by guest on 24 September 2021 The Economics of RMB Internationalization 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 sys- tem. 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 internation- alization 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 cur- rency, 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 inter- nationalization 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 prob- ably 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 for- eign 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 105 Asian Economic Papers Downloaded from http://www.mitpressjournals.org/doi/pdf/10.1162/ASEP_a_00410 by guest on 24 September 2021 The Economics of RMB Internationalization 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 trans- actions. 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 in- stitutional 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 bal- ance 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 de- veloping 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 authori- ties 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 106 Asian Economic Papers Downloaded from http://www.mitpressjournals.org/doi/pdf/10.1162/ASEP_a_00410 by guest on 24 September 2021 The Economics of RMB Internationalization 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