The Rise of the RMB as an International Currency:

Learning from Historical Precedents

Jeffrey FrankelHarpel Professor of Capital Formation & Growth

• The possibility that the renminbi is joining the ranks of international currencies has generated much excitement.

• Indeed some claim that the RMB could even overtake the $ by 2020:

• Subramanian (2011a, b).

• But there are good reasons to doubt it.

Rise in Use of Yuan for Trade Settlement (reported)from 2.5% of China’s international trade in 2010 to 9% in 2011

2010 Q1 2010 Q2 2010QIV 2010Q4 2011Q1 2011Q2

0 2

79

263

311

493525

587

2011Q3 2011Q4

Sources: PBoC (2011), Yu (2012, p.12, 15), Zhang (2012).

billion RMB

• We can look to the past for help in evaluating the RMB’s prospects in the future.

• The three best precedents in the 20th century:

– the rise of the $ from 1913 to 1945,

– the rise of the DM from 1973 to 1990,

– and the rise of the ¥ from 1984 to 1991 .

• But first: what is an international currency?

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What is an international currency?

• Definition: An international currency is used by non-residents.

• The prospects for a country’s 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 hand-wringing.

– And yet its international currency use rose during that period.

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Roles of International CurrencyTable B Adapted from tables of Kenen and Cohen

Function of money:

Governments Private actors

Store of value

International reserve holdings

Currency substitution (private dollarization)

Medium of exchange

Vehicle currency for foreign exchange intervention

Invoicing trade and financial transactions

Unit of account

Anchor for pegging local currencies

Denominating trade and financial transactions

Central bank holdings of reserves is the most easily quantified,

and probably the most important, of the various measures.

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International reserve currency determinants What suits a currency for international use?

Determinant

1. Size

2. Rate of return

3. Depth of financial markets

Empirical proxy:

GDP (or trade)

inflation,(or trend depreciationor exchange rate variance)

FX turnoverin main financial center

8

Determination of international currency status, continued

• People use a given currency – when everyone else is using it,– not just because of its intrinsic characteristics.

• English became the international lingua franca– not because of its beauty (French), – nor its simplicity (Esperanto),

– nor even the number of native speakers (Chinese).

• => Network externalities.

9

Determinants of reserve currency standing, continued

Network externalities

=> Tipping captured by:

1) Inertia lags

2) Nonlinearity logistic functional form in determinants or

dummy for leader GDPSource: Chinn & Frankel (2007)

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Currency share vs. GDP (market rates). The relationship is not linear, but “ogive.”

-.1

.0

.1

.2

.3

.4

.5

.6

.7

.8

.0 .1 .2 .3 .4 .5 .6

RATIOY

SHARE

SHARE vs. RATIOY

(GDP using market rates)

Sharesof major currenciesIn central bank reserve holdings

Size of currency’s home economy

} Tippingpoint

Source: Chinn & Frankel (2007)

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Historical illustration of the lag: £ ‘s loss of premier international currency status

in 20th century

• By 1919, US had passed UK in

1. output (1872)

2. trade (1914)

3. net international creditor position (1914-19)

• But the $ passed £ as #1 reserve currency only with a lag

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Explaining currency shares econometrically  [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     -1.10trend     [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  

  [0.16]  

Lag logit: 0.85 0.85 0.96log(share t-1 / 1 - share t-1) [0.03] [0.03] [0.01]

logit, pre-euro, 1973-98

Source: Chinn & FrankelBoldface = statistically significant: size, returns, turnover, and lag

Does China have the will for financial liberalization that would be necessary to achieve the rapid RMB internationalization it seems to want?

• Dissecting China’s internal politics is hard.– The officials may not know the answer themselves.

• Let’s look to the historical precedents.

Precedent (I): The Rapid Ascentof the Dollar after 1913

• In 1913, the £ was on top,

• the same as in 1899:– ≈ 60 % of the world’s trade invoicing– ≈ 2/3 of known forex holdings of official institutions,

• > twice the total of the next nearest competitors,

• the French franc & German mark.

• The $ was not even in the top 3.

The international status of the $ rose rapidly after 1913

• The traditional view is that, due to inertia, the $ did not surpass the £ until after World War II, – a half-century

+ after the US economy passed the UK economy– E.g., Krugman (1984).

• Eichengreen (2011) now claims it happened earlier: 1924.

• Either way, the $’s rise to major international currency status was fast, once the conditions were in place.

The conditions for international currency status

• Prior to 1913, – The US satisfied Criterion #1 (Size)

– Criterion #2 was in some doubt due to history of financial crises

• It lacked a central bank.

– And Criterion 3 was definitely lacking:

deep, liquid, dependable & open financial markets.

.

Putting the conditions in place

• These conditions for $ internationalization were put in place– without political support for greater global stature,– nor business support for an internationalized $.

• To the contrary, popular opinion was highly suspicious of the “Eastern banking conspiracy.”

• So a tiny elite quietly mid-wifed the new international currency.

The conspirators

• Sen. Nelson Aldrich convened the meeting of 6 “duck hunters” on Jekyll Island in 1910(the Aldrich Plan produced the Fed in 1913),

• chaired by Paul Warburg, • incl. Benjamin Strong (representing John Pierpont Morgan),

– who later became the 1st NY Fed president, 1914-28,

– nurtured the dollar in the 1920s, & promoted American lending to Europe.

• & Frank Vanderlip, president of Nat. City Bank of NY, opened international branches & expanded $ lending.

• Little government representation– Treasury Asst.Secy. (A.Piatt Andrew)

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Sources: Ahamed (2009), Broz (1997, 99), Eichengreen (2011), Eichengreen & Flandreau (2010), Karmin (2008).

Precedent (II): The Ascent of the DMafter 1973

• Short life of the DM:– The Bundesbank was not founded until 1957,

– though Erhard had created the DM in 1948 currency reform.

– The DM disappeared into the euro in 1999.

• In between, the DM was pressed into service as an alternative to the $, – after US inflation rose – & Nixon took the $ off gold in 1971. – The DM met the criterion of keeping its value.

• unlike the $.19

20

Central banks’ reserve holdings

45

50

55

60

65

70

75

80

65 70 75 80 85 90 95 00 05 10

USD share

USD + 0.6 Unalloc.share (COFER)

The $ share has been on a downward trend since 1975(with the exception of the 1990s).

Source: Chinn & Frankel (2007)

• But Germans were not pro-internationalization. – Leaders were averse to strutting the world stage.– The powerful manufacturing sector feared

upsurges in the demand for DM• => real appreciation => lost export competitiveness.

• Frankfurt as a financial center never developed like London.

• DM share in CB reserves peaked in 1989– at ≈ 20 %.

• In the 1990s Germany euthanized its beloved currency. 21

Looking back, one might wonderwhat the fuss was about

22

.0

.1

.2

.3

.4

.5

.6

.7

.8

1965 1970 1975 1980 1985 1990 1995 2000

USD

DEM EUR

JPYFFR SFRNLG

ECU

GBP

Precedent (III): The Brief Ascentof the Yen after 1984

• 1980s: international use of ¥ trended up– as Japan reluctantly opened financial markets,

– though domestic politics were opposed

– and government policy was at best neutral: – Again, Japan feared that increased demand

for its money would hurt export competitiveness. 23

The Brief Ascent of the Yen

•

• After 1990s: policy sought actively to promote internationalization.

• But it was too late: – economic fundamentals had already turned around,

dominated by the shrinking economy.

• Today, the ¥ only ranks similarly to the £.

24

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How does China rank, by determinants of international currency status?

1. Size• Chinese economy passed Japan in 2010,

to attain 2nd ranking.• Some projections claim it will pass the US soon.• But

– What matters here is GDP (& trade) compared at market exchange rates, not PPP-adjusted.

– Euroland’s GDP is still substantially bigger than China.– Chinese growth will slow down,

• well before it reaches per capita equality with the West.

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China’s rank, by determinants of international currency status, cont.

2. Rate of return

• A financial crisis probably still lurks – somewhere down the road.

• Nevertheless, it is likely that the rate of return to holding RMB over the next ten years will be high.

• Indeed that is the reason since 2004 for the strong portfolio capital inflows.

– Prasad & Wei.

• As of 2012, the PBoC appears to have met successfully the inflation threat that had revived in 2010.

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China’s rank, by determinants of international currency status, concl.

3. Depth of financial marketsOne the one hand…• China is starting to use RMB in international trade

• The IFC & ADB can issue “panda bonds,” since 2005.

• Foreign central banks can hold RMB since Aug. 2010– Malaysia’s CB went first, buying RMB bonds for its FX reserves.

– Swap arrangements with 13 emerging-market CBs (Yu, July 2012).

• RMB market developing in Hong Kong – Foreigners have been able to issue “dim sum” bonds since 2007,

» Corporations including MacDonald’s & Caterpillar.» Bank of China HK launched an index Dec. 31, 2010.» Issues reached RMB 34 b in 2010, and then 54 b in 1st 8 months of 2011.

– RMB deposits reached RMB 280b by end-2010.

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In Hong Kong banks, yuan-denominated

deposits quadrupled in 2010.

“RMB goes viral,” Financial Times, Jan. 4, 2011

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China’s rank, by determinants of international currency status, cont.

On the other hand…• Liquidity, breadth & openness still have a long way to go.

• China’s financial markets still rank far behind others:• still highly regulated,

– domestic system still “financially repressed.”

– Cross-border capital flows still subject to heavy controls;– foreign companies cannot borrow in China.

• RMB bonds & deposits in HK are small as a fraction.– Of course HK itself, tho part of PRC, is still firmly tied to US$.

• There are signs that the “offshore” strategy for internationalization is running into problems.

Yuan deposits held in Hong Kongpeaked in November 2011

2007 2008 2009 2010 2011Jan.2012

Sources: Yu (2012), Zhang (2012).

Deposits reached RMB 580b ($90b) in July 2011and 622 b in September 2011, but then unexpectedly peaked..

Recent glitches in the internationalization strategy

• The big growth in RMB trade settlement was for imports – = 11 x use for exports, in Q4 of 2010.

• Explanations for this asymmetry: – (i) Foreign exporters want RMB, in expectation of appreciation; – (ii) “Importers” really want the RMB to arbitrage between CNY & CNH

• <= RMB settlement > RMB invoicing.• So the PBoC has been stuck with even more international reserves. • Has brought asymmetry down since 2011.

– Which also explains recent turnaround in Hong Kong RMB deposits .• Yu, Yongding (July 2012).

• PBoC reserve accumulation has also turned around in 2012• probably due to end of one-way bet on future RMB appreciation.

• In any case, it is a symptom of the difficulties of internationalizing the RMB if the government lets financial liberalization lag.

The Chinese government’s strategy of seeking RMB internationalization offshore

• China first established special economic zones– in a few provinces in the 1980s

– to experiment with opening to international trade.

– It worked spectacularly, and the SEZ experiment was expanded to more & more regions.

• It is trying the same with RMB:– starting with Hong Kong (then Taiwan, eventually Shanghai…)

– to experiment with international use of the currency.

• But segmentation of financial markets is harder,– because arbitrage is easier, than with merchandise trade.

My candidate who has played the role of the Jekyll Island “duck hunters”:

Zhou Xiao Chuan of the PBoC

• The internationalization of the renminbi is the will of the market rather than a government-backed move, People's Bank of China Governor Zhou Xiaochuan was quoted as saying….

• "It is the result of the growing power of the nation and its financial market boom ... though there is still much to do considering the low level of development and openness," Zhou said in an interview with China Business News.

• According to Zhou, China needs to …further open the nation's financial market. "In general, we should do our homework, and let the market decide which currency should be used," he said.

China Daily, June 5, 2012

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Conclusion: China’s ascent in the currency rankings will be gradual

• Why? Criteria #1 & #2 are in place.

• But internationalization also requires:– domestic financial liberalization,– full currency convertibility,– and a move toward floating –

• which China is probably not yet ready to accept.

• One theory: officials like Zhou want to use international liberalization to force the pace of domestic liberalization.

– David Pilling, FT, Sept. 6, 2012.

– This is the sequence Japan & Indonesia tried. – It did not work well. – The usual sequence is domestic liberalization before international,

• and for good reason.

• A guess: the RMB will take a decade to rival the ¥. and much longer to rival the €, let alone the $.

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References by the speaker underlying this talk

• Frankel, “Internationalization of the RMB and Historical Precedents,” July 2012; forthcoming, Journal of Economic Integration.

• “Historical precedents for the internationalization of the RMB,” Nov.2011 workshop in Beijing of the Council on Foreign Relations & the China Development Research Foundation. CFR Working Paper.

• Summaries at RIETI & Vox, Oct. 2011. 

 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, R.Clarida, ed. (U. Chicago Press), 2007. NBER WP No 11510.   

• 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. (IMF), 1996.

• "Still the Lingua Franca: The Exaggerated Death of the Dollar," Foreign Affairs 74, no.4, 1995

• "On the Dollar," The New Palgrave Dictionary of Money and Finance (MacMillan), 1992.

Some papers by others on RMB internationalization• Yu, Yongding, “Revisiting the Internationalization of the Yuan,” ADBI Working Paper Series No. 366, July 2012.• Zhang, C. 2012. “The Development of the Offshore RMB Business,” presentation, ADBI, Tokyo. Feb. • Eswar Prasad & Le (Sandy) Ye, 2012, The Renminbi’s Role in the Global Monetary System (Brookings).• Subramanian, Arvind. 2011a. “Renminbi Rules: The Conditional Imminence of the Reserve Currency Transition.” WP s No. 11-14

(Peterson Institute for International Economics, September).• Subramanian, Arvind. 2011b. Eclipse: Living in the Shadow of China’s Economic Dominance (PIIE).• Marcel Fratzscher & Arnaud Mehl, “China’s Dominance Hypothesis and the Emergence of a Tri-polar Global

Currency System.” CEPR Discussion Paper No. 8671 (London), Nov. 2011. • Chen, Hong Yi, Wenshen Peng & Chang Shu. 2011. “The Potential of Renminbi as an International Currency,” in

Currency Internationalisation: Lessons from the Global Financial Crisis and Prospects for the Future in Asia and the Pacific, BIS Papers No. 61, Dec. 2011.

• Gao, Haihong, & Yongdin Yu, 2011, “Internationalisation of the Renminbi,” BIS Papers No. 61.• Chen, Hong Yi, Wenshen Peng & Chang Shu. 2011. “The Potential of Renminbi as an International Currency,” in

BIS Papers No. 61, December, pp. 125-148.• Chen, Xiaoli, &Yin-Wong Cheung, “Renminbi Going Global,” HKIMR Working Paper No. 08/2011.• Robert McCauley, 2011. “The Internationalisation of the Renminbi.” HKIMR. • Masahiro Kawai & Shinji Takagi, “The RMB as a key International Currency: Lessons from the Japanese

Experience,” AEEF conference, Paris, January 2011.• Agnès Bénassy-Quéré & Jean Pisani-Ferry, “What international monetary system for a fast-changing world

economy,” AEEF, January 2011.• Yung Chul Park & Chi-Young Song, “RMB Internationalization: Prospects and Implications for Economic

Integration in East Asia,” 2010, Asian Economic Papers.• Jong-Wha Lee, “Will the RMB Emerge as an International Currency?” workshop, ADB & CCER, 2010.• Wu, Friederich, Rongfang Pan, & Di Wang, 2010, “Renminbi’s Potential to Become a Global Currency,” China and the World

Economy 18(1): 63-81.• Takatoshi Ito, “China as Number One: How About the RMB?”Asian Economic Policy Review, 2010, 5.• Chen Yulu, Wang Fang & Yang Ming “Currency Internationalization as a National Competitive Strategy: US Dollar's

Empirical Evidence—And a Study on the Issue of Renminbi,” Ec.Res.J., 2005.

References on yuan exchange rate by the speaker

• "The Renminbi Since 2005,"  in The US-Sino Currency Dispute: New Insights from Economics, Politics and Law, edited by S.Evenett (CEPR: London) 2010.

• “New Estimation of China’s Exchange Rate Regime,”  in Pacific Economic Review 14, no.3, August 2009.   NBER WP no. 14700.  

• “Comment on ‘China’s Current Account and Exchange Rate,’ by Yin-Wong Cheung, Menzie Chinn & Eiji Fuji,” in China’s Growing Role in World Trade,   NBER, edited by Feenstra & Wei (University of Chicago Press, 2010).

• “Comments on Cline and Williamson’s ‘Estimates of the Equilibrium Exchange Rate of the Renminbi?’,”  in Debating China's Exchange Rate Policy, M.Goldstein & N.Lardy, eds. (Peterson Institute for International Economics), 2008.  

• "Assessing China's Exchange Rate Regime," with Shang-Jin Wei,  Economic Policy 51, July 2007.  Video interview.  Vox summary.   NBER WP 13100.    

• "On the Yuan: The Choice Between Adjustment Under a Fixed Exchange Rate and Adjustment under a Flexible Rate,"  in Understanding the Chinese Economy, edited by G. Illing (Oxford U. Press), 2006. NBER WP 11274.

• “On the Renminbi,”  CESifo Forum, 6, no.3, Autumn 2005 (Ifo Institute for Economic Research, Munich).

http://ksghome.harvard.edu/~jfrankel/