Focus – Becoming the world’s currency

　　·Reserve currency hopes for the CNY face enormous challenges
 　　·We do not understand all the fuss about the SDR
 　　·CNH may help domestic reforms, but it is unclear exactly how
 　　Big hopes are being pinned on the Chinese yuan (CNY). Some analysts, both in China and overseas, believe that it stands a good chance of becoming a reserve currency. This will take time, but many are impatient, believing that the world desperately needs a new reserve currency as long-term fiscal decline in the US and Europe undermines “old world”  currencies.
 　　On the other side of the debate, some in Beijing worry that the internationalisation of the CNY will contribute to the fall of China?s economy. They are worried by the “hot money” that could flood in and out of the country through holes in the capital account that the CNH market has created.
 　　We recently participated in a conference in Beijing at which policy makers and academics discussed these questions and more. The discussion ranged from the problem of cross-border arbitrage flows to the need for wholesale reform of the international financial system. Here, we report on the discussion and add some views of our own.
 　　Reforming the international financial system in the morning
 　　Let us start with the big picture. Many at the event expressed considerable disquiet about the dollar-based international financial system. This concern is not just heard in
 　　Beijing. Many seminar participants argued that the dollar?s status as the main global reserve currency was being undermined by the US? fiscal position and monetary policy. Most participants agreed that the Triffin Dilemma - the ability of a reserve currency to raise unlimited external debt, which eventually dooms its government to becoming too indebted - was at the root of the dollar?s current difficulties. US household savings rates might have adjusted upward in the last two years, but the increase in the government?s net borrowing more than makes up for this.
 　　
 　　Washington's “Weak Dollar” policy also complicates policy making in the current “two-speed” global economy, it was argued. If the US implements QE3 (as we expect it to in early 2012), and possibly QE4 and QE5 later, some believe the resulting global inflation would make life very difficult for still-growing emerging markets. Policy makers there are left facing a volatile world: one day they worry about a deflationary collapse in global demand, the next, an inflationary spiral fed by the printing of US dollars (and possibly euros too). Some participants argued that there was a fatal contradiction between the domestic needs of the US economy and its global responsibilities. Another noted that issuing a reserve currency was not a privilege but an “exorbitant curse”.
 　　As an aside, Lawrence Summers, then President Obama?s chief economic advisor, made the point at a Standard Chartered event in Hong Kong earlier this year that there is nothing to stop EM countries from appreciating their currencies if they are worried about importing inflation. And as Paul Krugman likes to say, no one forced EM central banks to buy so much US debt. We show China?s holdings of US government debt in Chart 1.
 　　So  what  to  do?  The  answer  is  tricky  because  at  least  two  things  are  required  from any alternative to the current global system:
 　　--The countries that print reserve currencies need to exercise restraint in the good times in order to prevent inflation.
 　　--When faced with a liquidity crisis, reserve currency issuers need to be able to act as lenders of last resort.
 　　In other words, a reserve currency needs to behave very differently at different times. The  gold  standard,  for  instance,  is  respected  for  fulfilling  the  first  requirement  but utterly fails on the second.
 　　At  least  two  participants  at  the  Beijing  conference  argued  that  consideration  should be given to an international reserve currency, as originally foreseen by John Maynard Keynes in the 1940s. Two years ago, People?s Bank of China (PBoC) Governor Zhou Xiaochuan   wrote   about   the   possibility   of   reinventing   the   IMF's   Special   Drawing Rights  (SDR)  as  an  international  currency.  The  SDR  is  currently  just  a  basket  of national  currencies,  and  is  only  used  as  a  unit  of  account  when  members  contribute funds to the IMF. This is a far cry from Keynes' idea of a truly global currency backed, in effect, by a global central bank.
 　　However, the practical difficulties of remaking the SDR are probably overwhelming. A revived SDR would require sovereign governments and their central banks to give up their independence, and an international central bank (a reinvented IMF?) to be able to print money. This would require the bank to have revenue-raising ability.
 　　Even if this was practical, one participant pointed out that the euro area - an alliance of close neighbours  -  was having more than a few problems agreeing on how to run its  central  bank.  Asking  countries  with  even  more  divergent  interests  to  run  a  global central bank would be asking for trouble, he argued.
 　　So, frustration with the current system is met with the impossibility of radical change. As far as the SDR goes, the CNY could perhaps be welcomed into the SDR basket in a few years' time. IMF rules require that SDR basket currencies be fully convertible -a reasonable requirement,  since they are supposed to  be easily used in a crisis.  But even the CNY?s entry into the SDR basket would amount to little more than a diplomatic victory for Beijing, in our view.
 　　A more practical alternative, which was widely discussed, would be a “multi-reserve-currency” world. Barry Eichengreen, author of Exorbitant Privilege, a book on the rise of the dollar, foresees such a world; on the face of it, this vision looks reasonable to us. One conference speaker argued that it was time for large EMs to provide an alternative to the dollar. In a multi-reserve-currency world, the hope is that competition to attract investors would impose some discipline on sovereign borrowers. Moreover, EMs still want to accumulate FX reserves to protect themselves in the event of a financial crisis, and many hope to diversify their risks away from the USD and the EUR. In such a context, the speaker argued that China's internationalisation of the Renminbi was a global public good.
 　　There are some problems with this argument, though. For starters, we already live in a multi-reserve-currency world, and this has not prevented the issuers of these currencies - the US, the euro area, the UK and Japan - from facing fiscal problems and implementing loose monetary policy. We also note that China's own households appear to lack confidence in the Renminbi as a store of value. They seem to put far more faith in the country?s residential housing stock. Chart 2 shows M2 growth in the major economies. Even though China's printing of money has slowed, its M2 growth was still worryingly high in 2009 and 2010. The amount of money (M2) in China today has doubled since the same time in 2008. As we have pointed out before, China's hopes for reserve currency status ultimately hinge on it having deeper capital markets, an independent central bank, and a freer capital account.
 　　There is clearly no easy solution to the troubles of the international financial system - and as we prepare for more QE in the US and Europe, flows will become more volatile. A radical change in the current international monetary system is unlikely, and ultimately we will continue to have to rely upon central banks to act responsibly.
 　　The CNY Special Economic Zone
 　　The pros and cons for China of Renminbi internationalisation were a hotly debated topic at the conference. (We note that PBoC officials prefer to talk about “cross-border CNY settlement”, but since a CNH market is now developing in Hong Kong, this description seems a little tame.)
 　　
 　　For good or for bad, depending on one?s perspective, China did not take the orthodox advice that one should liberalise interest rates and remove capital account controls before internationalising one?s currency. Indeed, China may be the only example of a government freely pushing the internationalisation of its currency while maintaining capital controls.
 　　Some seminar participants attempted to defend this approach with claims that China always succeeded in carrying out reforms in its “own way?. Other participants wanted to understand the real costs and benefits of such an approach.
 　　On the benefits side, PBoC officials claimed that CNY internationalisation was demanded by the corporate sector - trading firms and companies investing overseas wanted to reduce their FX risk. Long-term, China would enjoy clear advantages from being able to issue a reserve currency (including seignorage, the ability to print currency and push the cost of the resulting inflation onto others), but economists debate the scale of these benefits. One participant noted that reserve currencies tend to benefit from inflows of liquidity when a crisis hits. This benefit can be significant - witness how US government bond yields have been held down despite market concerns about the US fiscal position. China?s leaders had taken note of this phenomenon, the participant claimed.
 　　The CNY internationalisation policy also has downsides for China. Most participants agreed that internationalisation requires full opening of the capital account. One concern is that global capital will then arbitrage differences between the on- and offshore markets. One paper presented at the conference detailed how the offshore CNY market is being successfully kept separate from the onshore market, at least for now. The same government bonds maturing in early 2015 yield 1.9% offshore and 3.46% onshore, which suggests that capital controls are working to some extent. But they are leaky, and indirect arbitraging is possible.
 　　Another frequently mentioned downside of CNY internationalisation is increased FX reserve accumulation by the PBoC. When importers buy USD offshore rather than onshore, more onshore dollars have to be sucked up by the central bank. Importers were motivated to do this in H1-2011 thanks to the CNH premium onshore. In recent weeks, with the CNH now in discount, exporters have had an incentive to receive CNH rather than USD offshore. This has resulted in a reversal of USD selling in China, relieving pressure on the PBoC in Q3, as Chart 3 shows. We estimate that the increase in FX reserves related to trade in CNH in the first three quarters of 2011 was about USD 83bn, some 27% of total FX reserve accumulation during the period.
 　　
 　　Another conference participant argued that there is no fundamental demand for CNY offshore at present - everyone just wants to hold an appreciating currency, and once expectations shift, the “internationalisation? process will reverse. He saw only speculative motives on the part of importers to invoice trade in CNY in H1, and for owners of CNH assets.
 　　We suspect that this view is a little too sceptical. Exporters receive real benefits from converting to CNY invoicing - most importantly, quicker payment. This is because payments in CNY from overseas do not need to be kept in a verification settlement account for 10 days, as foreign-currency payments do; administrative costs can be saved as well. Such savings can be passed on to buyers.
 　　Moreover, if China?s economy continues to grow, relative productivity differentials should result in continuing appreciation pressure on the real effective exchange rate. In such an environment, the incentive to hold CNY should not vanish. The PBoC only needs use of the CNY as an invoicing currency to reach critical mass at some point in order for the CNY to become a normal currency for trade and investment, and its job will have been done. (But as we note in the CNH market development part of The Renminbi Insider, the regulators still have some work to do.)
 　　An exceptionally cunning plan?
 　　Given the even balance between the economic pros and cons, some conference participants wondered if there might be something else behind Beijing?s push for
 　　CNY internationalisation. According to one theory, CNY internationalisation is a means of pushing domestic reform. The broad idea here is that, rather like its entry into the WTO, China's gradual integration with global financial markets will induce positive domestic change.
 　　The explanation is elegant, but how could it work in practice? We can think of a few possible mechanisms:
 　　Once reserve-currency status is agreed as a top political priority, the leadership will have to consider the need for deeper capital markets, and perhaps even greater independence for the central bank.
 　　A successful and relatively free CNH capital market in Hong Kong will induce Shanghai and other cities to lobby for financial-sector liberalisation back home.
 　　A controlled experiment offshore can demonstrate that a freer financial market does not have to be destabilising, and thus win the confidence of senior leaders.
 　　China?s financial institutions and corporate sector will get used to the freer CNH market and will also lobby for liberalisation onshore.
 　　Regulators can learn how to regulate complex CNH instruments from the Hong Kong markets.
 　　If this is indeed the thinking, we have two things to say. First, it is a long-range plan that lacks the rule-based structure the WTO provided, so it is difficult to see how it will develop. Second, we cannot help but think about the potential downsides. For instance:
 　　Opening up the capital account might make domestic interest rate reform - which implies higher interest rates - more, not less, difficult. (We discussed how rate reform should and could work in the last issue of The Renminbi Insider.)
 　　The disjointed CNY/CNH market could create incentives for arbitrage activities, which would undermine the credibility of the experiment.
 　　Holes in the capital account could introduce more volatility to the macro-economy.
 　　All the time and effort put into CNY internationalisation reforms may divert from policy makers from the serious tasks of allowing more interest and exchange rate flexibility.