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The RMB as an international currency


Jeffrey Frankel Harpel Professor of Capital Formation and Growth, Harvard University Club de CEPII, Paris, 12 January, 2011 The RMB as an international currency – PowerPoint PPT presentation

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Title: The RMB as an international currency

The RMB as an international currency
  • Jeffrey Frankel
  • Harpel Professor of Capital Formation and
    Growth, Harvard University

Club de CEPII, Paris, 12 January, 2011
Questions to be addressed
  • What is an international currency?
  • Empirical determinants of international reserve
    currency status.
  • The Renminbi
  • Why should a country care if its currency is
    used internationally?
  • 5 reasons why appreciation is in Chinas
  • Appendices
  • China-U.S. currency conflict
  • Technical addenda

What is an international currency?
  • Definition An international currency is used
    by non-residents.
  • The prospects for a countrys status as an
    international currency is not the same as its
    exchange rate prospects.
  • Example 1993-95
  • The dollar depreciated strongly, reaching an
    all-time low against the yen, among much
  • And yet its international currency use rose
    during that period.

Roles of International Currency
Determination of international currency
status What suits a currency for international
  • People use a given currency
  • when everyone else is using it,
  • not just because of its intrinsic
  • English became the international lingua franca
  • not because of its beauty (French),
  • nor its simplicity (Esperanto),
  • nor even the number of native speakers
  • gt Net work externalities

International reserve currency determinants from
the literature on reserve currencies
  • Determinant
  • Size
  • Depth of financial markets
  • 3. Rate of return
  • Empirical proxy
  • GDP
  • FX turnover
  • inflation,
  • trend depreciation, or
  • exchange rate variance

Determinants of reserve currency standing,
  • Network externalities
  • gt Tipping captured by
  • Inertia lags
  • Nonlinearity logistic functional form
  • in determinants or
  • dummy for leader GDP

Historical illustration of the long lag s
loss of premier international currency status in
20th century
  • By 1919, US had passed UK in
  • output (1872)
  • trade (1914)
  • net international creditor position (1914-19)
  • passed as 1 reserve currency only with a lag
  • by 1940-45
  • though Eichengreen says a little earlier.

Figure 1 Currency share vs. GDP (market rates).
Is the relationship linear or ogive?
Shares of major currencies In central bank
reserve holdings

Tipping point
Size of currencys home economy
Explaining currency shares, logit, pre-euro
  2 4 7
GDP 2.77 3.69 1.04
0.64 0.92 0.29
Inflation -2.64 -2.86  
1.16 1.16  
Depreciation     -1.10
Trend     0.59
Ex rate variance -0.98 -1.40 -1.25
0.57 0.64 0.34
FX turnover 0.45 0.58 0.43
0.29 0.30 0.15
GDP leader dummy   -0.22  
Lag logit 0.85 0.85 0.96
log(share t-1 / 1 - share t-1) 0.03 0.03 0.01
Boldface statistically signficant size,
retruns, turnover, and lag
How does China rank, by determinants of
international currency status?
  • 1. Size
  • Chinese economy famously passed Japan in 2010,
    to attain 2nd ranking.
  • Some projections claim it will pass the US soon.
  • But
  • What matters here is GDP (and trade) compared at
    market exchange rates, not PPP-adjusted.
  • Eurolands GDP is still substantially bigger than
  • Chinese growth will slow down,
  • well before it reaches per capita equality with
    the West.

Chinas rank, by determinants of international
currency status, cont.
  • 2. Depth of financial markets
  • One the one hand
  • China is starting to use RMB in international
  • Foreign central banks can hold RMB since Aug.
  • Malaysias CB went first, buying RMB bonds for
    its FX reserves, in Sept.
  • RMB market is now developing in Hong Kong
  • Since 2007, RMB 62 b RMB bonds (27 batches)
    issued off-shore
  • including by MacDonalds.
  • Bank of China HK launched an index Dec. 31, 2010.
  • In November, RMB deposits reached RMB 280 b.

In Hong Kong banks, yuan-denominated deposits
have quadrupled over the last year but from a
low base.
RMB goes viral, Financial Times, Jan. 4, 2011
Chinas rank, by determinants of international
currency status, cont.
  • On the other hand
  • RMB bonds and deposits in HK are small as a
  • And of course HK is itself still firmly tied to
  • Development of Chinas financial market has just
  • It ranks far behind other major currencies.
  • Still very highly regulated
  • Domestic system still financially repressed.
  • Cross-border capital flows still subject to heavy
  • Foreign companies still cannot borrow in China.
  • Liquidity, breadth, openness still have a long
    way to go.

Chinas rank, by determinants of international
currency status, cont.
  • 3. Rate of return
  • Inflation in China is again a danger currently.
  • A financial crisis probably lurks
  • somewhere down the road.
  • Nevertheless, it is quite likely that the rate of
    return to holding RMB over the next ten years
    will be high.
  • Indeed that is the reason for the strong
    portfolio capital inflows since 2004.
  • Prasad Wei.

Chinas rank, by determinants of international
currency status, cont.
  • Inertia suggests that Chinas ascent in the
    currency rankings will be very slow.
  • The rest of Asia will probably be no keener on a
    yuan bloc than it was on a yen bloc in the 1980s.
  • A guess It will take the RMB a decade to
    surpass the CHF and rival the .
  • and much longer to rival the , let alone the
  • Nevertheless, that is the direction it is headed.
  • And the is likely to continue losing share to
    all the other international reserve assets in
    the future.

Central banks reserve holdings
The share has been on a downward trend since
1975 (with the exception of the 1990s).
The share of central bank holdings resumed its
decline in 2001.
Data 1999-2009 from COFER, IMF.
Source http//
The global monetary system may move from
dollar-based to multiple international reserve
  • The could challenge the .
  • The SDR is again part of the system.
  • Gold in 2009 made a comeback as an international
    reserve too.
  • The RMB will join the roster with .
  • a multiple international reserve asset system.

Why should a country care? Pros cons of having
ones currency used internationally.
  • (1) Convenience for its residents.
  • (2) Business for its banks other financial
  • (3) Seignorage
  • narrowly defined as willingness to hold, e.g.,
    the as high-powered money (esp. fx reserves
    held by central banks) or
  • more broadly as willingness of private investors
    to hold -denominated assets Americas
    exorbitant privilege.
  • (4) Political power and prestige.

  • The possibility of larger fluctuations in the
    demand for one's money.
  • The possibility that an increase in demand for
    the currency would cause it to appreciate
  • rendering exporters uncompetitive on world
  • In the past, the German Japanese governments
    were reluctant to see their currencies play
    larger international roles.

Five reasons China should let RMB appreciate, in
its own interest
  • Overheating of economy
  • Reserves are excessive.
  • It gets harder to sterilize the inflow over
  • Attaining internal and external balance.
  • To attain both, need 2 policy instruments.
  • In a large country like China, expenditure-switch
    ing policy should be the exchange rate.
  • Avoiding future crashes.
  • RMB undervalued, judged by Balassa-Samuelson

1. Overheating of economy
  • Bottlenecks. Pace of economic growth is
  • raw material supplies, and
  • labor supply in coastal provinces
  • Also
  • physical infrastructure
  • environmental capacity
  • level of sophistication of financial system.
  • Asset bubbles.
  • Shanghai stock market bubble in 2007.
  • Real estate prices now.
  • Inflation back up to 5.1 last year (to Nov.
  • Starting to look like 2007
  • gt price controls
  • shortages social unrest.
  • All of the above was suspended in late 2008,
  • due to global recession.
  • But it came back again in 2010.

Attempts at sterilization, to insulate domestic
economy from the inflows
  • Sterilization is defined as offsetting of
    international reserve inflows, so as to prevent
    them from showing up domestically as excessive
    money growth inflation.
  • For awhile PBoC successfully sterilized
  • until 2007-08.
  • The usual limitations finally showed up
  • Prolongation of capital inflows lt
    self-equilibrating mechanism shut off.
  • Quasi-fiscal deficit gap between domestic
    interest rates US T bill rate
  • Failure to sterilize money supply rising
    faster than income
  • Rising inflation (admittedly due not only to
    rising money supply)

2. Foreign Exchange Reserves
  • Excessive
  • Though a useful shield against currency crises,
  • China has enough reserves 2 ½ trillion by 2010
  • US treasury securities do not pay high returns.
  • Harder to sterilize the inflow over time.


The Balance of Payments
rate of change of foreign exchange reserves
(largely ),
rose rapidly in China over past decade, due to
all 3 components trade balance, Foreign Direct
Investment, and portfolio inflows
Source HKMA, Half-Yearly Monetary and Financial
Stability Report, June 2008
Attempts to sterilize reserve inflow
Successful sterilization in China 2005-06
High reserve growth
gt steady money
offset by cuts in domestic credit
While reserves (NFA) rose rapidly, the growth of
the monetary base was kept to the growth of the
real economy even reduced in 2005-06.
were remarkably successful in 2005-06.
In 2007-08 China had more trouble sterilizing the
reserve inflow
  • PBoC began to pay higher interest rate
    domestically, receive lower interest rate on
    US T bills gt quasi-fiscal deficit.
  • Inflation became a serious problem.
  • True, global increases in food energy
    prices were much of the explanation.
  • But
  • Chinas overly rapid growth itself contributed.
  • Appreciation is a good way to put immediate
    downward pressure on local prices of farm
    energy commodities.
  • Price controls are inefficient and ultimately

Sterilization faltered in 2007 2008
Monetary base accelerated
Growth of Chinas monetary base, its components
Source HKMA, Half-Yearly Monetary and Financial
Stability Report, June 2008
Chinas CPI accelerated again in 2010
5.1 in year ended Nov. 2010
3. Need a flexible exchange rate to attain
internal external balance
  • Internal balance demand neither too low
    (recession) nor too high (overheating).
  • External balance appropriate balance of
  • General principle to attain both policy targets,
    a country needs to use 2 policy instruments.
  • For a country as large as China, one of those
    policy instruments should be the exchange rate.
  • To reduce BoP surplus without causing higher
    unemployment, China needs both
  • currency appreciation, and
  • expansion of domestic demand
  • gradually replacing foreign demand,
  • developing neglected sectors health,
    education, environment, housing, finance,

4. Avoiding future crashes
  • Experience of other emerging markets suggests it
    is better to exit from a peg in good times, when
    the BoP is strong, than to wait until the
    currency is under attack.

Introducing some flexibility now, even though not
ready for free floating.
5. Longer-run perspective Balassa-Samuelson
  • Prices of goods services in China are low
  • compared at the nominal exchange rate.
  • Of course they are a fraction of those in the
    U.S. lt ¼ .
  • This is to be expected, explained by the
    Balassa-Samuelson effect
  • which says that low-income countries have lower
    price levels.
  • As countries real income grows, their currencies
    experience real appreciation approx. .3 for
    every 1 in income per capita.
  • But China is one of those countries that is cheap
    or undervalued even taking into account

The Balassa-Samuelson Relationship 2005
Source Arvind Subramanian, April 2010, New
PPP-Based Estimates of Renminbi
Undervaluation and Policy Implications, PB10-08,
Peterson Institute for International
Economics Undervaluation of RMB in the
regression estimated above 26. Estimated
undervaluation averaging across four such
estimates 31. Compare to Frankel (2005)
estimate for 2000 36.
Papers by the author on which this talk draws
  • RMB
  •  "The Renminbi Since 2005,"  in The US-Sino
    Currency Dispute New Insights from Economics,
    Politics and Law, S.Evenett, ed. (CEPR
    London) 2010, 51-60.
  • "Whats 'In' and Whats 'Out' in Global
    Money," in Finance Development, IMF, Sept.2009.
    Translated into Chinese, for International
    Herald Leader, Xinhua, Beijing.
  • New Estimation of Chinas Exchange Rate
    Regime,  in Pacific Economic Review 14, no. 3,
    Aug. 2009 (Blackwell Publ.), pp.346-60.
  • "Assessing China's Exchange Rate Regime," (with
    Shang-Jin Wei), in Economic Policy 51, July
    2007, pp. 575-614.
  • "On the Yuan The Choice Between Adjustment Under
    a Fixed Exchange Rate and Adjustment under a
    Flexible Rate,"  in Understanding the Chinese
    Economy,  G.Illing, ed. (Oxford Univ. Press),
  •  International Currency Rankings
  • Will the Euro Eventually Surpass the Dollar as
    Leading International Reserve Currency? (with
    Menzie Chinn), in G7 Current Account Imbalances
    Sustainability and Adjustment,  edited by
    R.Clarida, ed. (Univ. of Chicago Press), 2007.
    NBER WP No. 11510.  Chinese translation,
    International Finance, Central Bank of China,
  • The Dollar's Demise? Future of the Dollar as the
    World's Principal Reserve Asset," H.W.Brock, ed.,
    SED, 1997.
  • "The SDR, Reserve Currencies, and the Future of
    the International Monetary System" (with Barry
    Eichengreen), in The Future of the SDR in Light
    of Changes in the International Financial System,
    M.Mussa, J.Boughton, P.Isard, eds.
    (International Monetary Fund), 1996.
  • "On the Dollar," In The New Palgrave Dictionary
    of Money and Finance (MacMillan Press Reference
    Books, London), 1992.