China’s Efforts to Internationalize its Currency

It is a well know fact that China undervalues its currency, by pegging the renminbi (RMB) to the dollar at an artificially low level.  This, along with other subsidies and mercantilist trade policies, keeps Chinese exports cheap, and thus more attractive to consumers in the U.S. and Europe.  Because China is the manufacturing hub for South-East Asia, where most assembling and export happens, China’s artificially undervalued currency is also impacting trade throughout the region.  As a result, other countries in the region have pegged their currency to the RMB (Singapore, Taiwan, Malaysia, and of course Hong Kong) in order to compete with Chinese exports, but also to align their production pricing with China.

Furthermore, China and most of the other regional economies (in particular Japan, S. Korea, and Taiwan) pursue aggressively export-led growth strategies, relying on growth through exports and not through domestic consumption.  The combination of Chinas currency policy and the regional growth strategy has significantly contributed to the global trade imbalance, where the U.S. and the EU do most of the consuming while South-East Asia does most of the producing/exporting!

The U.S. and the EU have repeatedly tried to put pressure on China to let the RMB appreciate, or at least trade freely.  So far, China has not been very responsive to any demands for currency appreciation or a meaningful increase in domestic (Chinese) consumption.  On the contrary, instead of letting the RMB float freely, Beijing is actively pursuing the ‘internationalization’ of its currency.

Many Chinese leaders and experts seem to believe that one of the major causes of the global financial crisis was the deregulation of the international monetary system and the dominance of the dollar since the Bretton Woods agreement.  Therefore, if the international economic environment is to be stabilized, the international monetary system needs to be reformed and the power of the U.S. dollar must be reduced.  Beijing is hoping to achieve this by advancing the goal of a supranational reserve currency (IMF’s Special Drawing Right’s), and by promoting the internationalization of the RMB.  This strategy has come to clearer focus recently, on both fronts.

Multilateral Internationalization through the IMF –

China has been pushing for some time for further integration of the RMB into the basket of currencies that fix the value of the IMF’s Special Drawing Rights (SDR’s) – a ‘paper gold’ created by the IMF back in the 1960’s that could replace the U.S. dollar as a reserve currency if the dollar should ever fail.  Every five years the nature and relative weighting of the component currencies that make up the SDR is revised.  The next revision is due in 2015, and Beijing intends to demand that its currency be included in the basket of currencies.

However, under IMF rules and regulations, including the RMB in the SDR basket is technically inappropriate.  The RMB does not meet the two criteria for including a currency in the SDR basket.  The RMB is not a ‘traded currency’, meaning it is not a currency that is being used for international trade, and it is not a ‘freely usable currency’ that is available on the exchange markets.  To overcome these obstacles, Beijing is reaching out to individual countries and making bilateral deals.

Bilateral Internationalization through Offshore Centers –

Recently, Beijing has been accelerating efforts to push the RMB deeper into world markets by allowing for the establishment of offshore trading center besides Hong Kong.  China’s central bank is moving ahead with new rules that make it easier to bring RMB funds raised offshore back onto the Chinese mainland, in an effort to create a new financial ecosystem with the RMB at its center.

Currently, Chinese officials have to approve bringing any sizeable amount of currency (foreign or domestic) into the country.  This has been Beijing’s policy ever since the Asian Financial Crisis of 1997, to closely manage the exchange rate and prevent speculation on the RMB.  The new rules make it easier and more attractive for global companies to access cheap funding in Hong Kong’s RMB-bond markets and then use that money to boost their Chinese business.

Now Beijing is expanding the use of the RMB in other financial centers, to allow for foreign holdings of the currency to be used for direct investment in China.  According to Arvin Subramanian of the Financial Times, “the process is micro-managed, interventionist, and enclave-based – not a day seems to pass without some foreign entity, or country being granted greater but selective access to the renminbi.”  Last week, the Financial Times reported that “China is for the first time to give formal backing to moves by British banks to turn the City of London into an offshore trading center for the renminbi.”  Furthermore, the Economist reports that “in Singapore, banks now offer yuan deposits and bond funds.  Its central bank is one of a dozen that have agreements with the Peoples Bank of China to swap their currencies for yuan.”

The RMB as a Reserve Currency –

Another step in internationalizing the RMB is by allowing more central banks to hold RMB as part of their reserves.  Central banks around the world are making plans to start buying RMB now that China is allowing the limited conversion of its currency for investment.  According to Bloomberg, Nigeria’s government will shift 10% of its $35 billion of foreign-exchange reserves in the RMB, and the central bank is hoping to establish the same kind of swap-line like Singapore.  The Bank of Thailand was approved by China to invest 7 billion RMB in the onshore interbank bond market.  A couple of years ago, the Peoples Bank of China signed a bilateral currency swap agreement worth 70 billion RMB with the Argentine Central Bank, and similar deals are under negotiation with Brazil, Russia, and many African banks.

Finally, in terms of trade, this gradual relaxation by Beijing of the rules on the use of the RMB in international transactions means that 7% of China’s external trade is now settled in their national currency (up from 1%, 12 months ago).  The RMB is already widely welcome in ASEAN countries and has been regarded as a hard currency there.  All this international recognition and legitimacy while Beijing is still maintaining a peg on the dollar and is enforcing strong capital controls domestically.

Understanding China’s Currency Manipulation and Capital Controls –

To appreciate China’s obsession with an undervalued currency and strict capital controls, one must first understand the implications of these policies.  When a Chinese company sells to the U.S. or any other foreign consumer, it gets paid in dollars (and other foreign currencies).  The regime in Beijing does not want all these dollars in circulation, because of fears of inflation.  Therefore, the Peoples Bank of China exchanges dollars and other foreign currencies for RMB before they can go into circulation in China.  Then, in a process designed to fight the inflation in China that otherwise would occur from so much RMB being added to the economy, the central bank issues RMB-denominated bonds.

Without the dollar purchases by the central bank, the supply of dollars in circulation in China would rise rapidly and quickly lose value relative to the RMB.  In a standard macroeconomic model, exchange rate intervention should also lead to monetary expansion, which in turn drives up domestic prices, nullifying the real effect of intervention.  China’s financial system, however, is owned and managed by the government.  Capital controls are in place for most domestic capital flows (and all large FDI has to be approved by the government).  Capital controls and bank lending policies are governed by decree, so that the government can force banks to buy trillions of low-yielding RMB bonds or alter their reserve ratios.  Deposit and lending rates are also set by the government.  This has allowed China to intervene in the foreign exchange market while retaining total control over domestic monetary aggregates.

Although this policy has worked well for both China and the United States (export growth for China and cheap imports and public debt financing for the United States), the unintended consequence of sustained currency intervention was a vast accumulation of dollar-denominated securities in the reserves of the People’s Bank of China and the State Agency for Foreign Exchange (SAFE).  At 2000 China had currency reserves of $165 billion, slightly above 10 per cent of GDP.  By the end of 2010 currency reserves had reached $2.84 trillion, equivalent to almost 50% of China’s 2010 GDP.

In the depressed conditions caused by the financial crisis, China’s dollar peg poses a major threat to the Chinese economy.  The inflows of hot money is straining the capital controls system to breaking point, the RMB-dollar peg is now contributing to a dangerous overheating of China’s economy, with inflation reaching a three year high of 6.5%.  However, since June 2010, the RMB has appreciated only 6.5% (from 6.83 to 6.38 RMB/dollar).

Inflation is the number one concern of the regime in Beijing, fearing that the only thing that could turn people against them is high prices and luck of jobs.  The recent events of the Arab Spring, where inflation and a spike in food prices played a significant role in the peoples uprising, have further focuses Beijing’s attention on inflation.  If the Chinese leadership was ones concerned about the effect of inflation on the peoples mood, after seeing the role that inflation and unemployment played in the Arab Sprig they are now ten times concerned!

Conclusion –

The Chinese government pegs the RMB to the dollar so the powerful and wealthy export sector can continue selling in Europe and America (and thus employment stays high).  The government also maintains strict capital controls in order to prevent inflation from hurting the vast lower and middle class.  China’s currency has become a modern-day opium, and the authorities have been searching for a way out of their current economic model which relies on growth from an undervalued currency and capital controls.  Internationalizing the RMB offers one such exit.

Eventually, wider use of the RMB outside China could redefine the balance of power in global currency markets, as the rest of the world begins trading more RMB-based assets and settling its bills with China in RMB instead of the U.S. dollar.  Beijing gets to keep its currency system, while gaining economic leverage and diplomatic legitimacy around the world.