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John Ross: Clarity required on RMB internationalization


By John Ross    Source:    Published: 2015-10-27



The RMB`s trade based internationalization benefits China but premature attempts to rival the dollar would be harmful, the writer of this article argues.


Two apparently contradictory trends in RMB internationalization emerged recently. Positively, the RMB overtook the Yen to become the fourth most used currency for international payments; unfortunately, some negative trends appeared in China`s position in the international economy.

China`s foreign exchange reserves fell almost $500 billion, from slightly under $4 trillion in June 2014 to $3.5 trillion in August 2015. This is seen as evidence of exit of capital from China unconnected with fruitful overseas investment. A small 2 percent RMB devaluation in August was followed by further losses to China`s foreign exchange reserves in an attempt to stabilize the currency.

However, both trends really reflect fundamental features of China and the international economy. Examining other countries experience and economic theory explains the processes involved.

Figure 1 shows the RMB`s place in global payments. The dollar`s dominance and RMB`s peripheral position is clear. The dollar accounts for 44.82 percent of international payments. The dollar dominance is still more striking if it is understood that the Euro`s 27.20 percent primarily reflects payments within the Eurozone; without these the global dominance of the dollar is still clearer.

Global payments in dollars are 16 times greater than the RMB (2.78 percent). Payments in combined dollars and Euros are 25 times greater than those in RMB. Hence, talk of the RMB being "in fourth place" in international payments behind the dollar, without stating the gap between the two, may be correct but is misleading if the scale of this gap is not also made clear.

This gap becomes clearer if it is understood that the RMB is primarily used internationally in relation to China`s trade - functioning as a useful "hedge" against currency fluctuations. By April 2015, 31 percent of payments between China (including Hong Kong) and the Asia-Pacific region were in RMB. Such trade operations make limited foreign accumulation of RMB necessary, and are a soundly based development reflecting China`s position as the world`s largest goods-trading nation.

However, aside from this useful function, the RMB`s role in international payments is still peripheral and for fundamental reasons cannot be expanded rapidly. For example by the end of 2014, 63 percent of all countries foreign exchange reserves were in dollars, 22 percent in Euros, and 1 percent in RMB.

It is sometimes argued that the RMB`s international role could grow rapidly if, for example, later this year the IMF includes the RMB in its currency basket for its Special Drawing Rights (SDRs).

However, this argument confuses reserves for current trade transactions and capital holdings of which foreign exchange reserves are a part. Certainly, the RMB should be included in the basket of currencies in SDRs due to China`s weight in the world economy. But this will not change the fundamental situation. SDRs are neither a currency nor a claim on IMF funds - only a claim on IMF member`s currencies. SDRs can essentially only be part of countries foreign exchange reserves, constituting less than 3 percent of these. In practical terms, SDRs are essentially only an accounting unit with little role in actual transactions.

Confusion over this this difference between what is required for trade and establishing the RMB as an international capital unit has created destabilizing calls for too rapid liberalization of China`s capital account. Economic theory, confirmed by other countries experience, shows liberalisation of China`s capital account will not lead to a balanced flow of funds in and out of China, but only to large scale exit of capital from China.

This would reduce China`s economic development by decreasing funds available for investment and raising interest rates, potentially leading to further falls in China`s foreign exchange reserves if currency interventions are made to try to prevent the RMB`s exchange rate falling when faced with capital outflows.

The reason why without capital controls there is only a net one way flow of funds into the dollar is that any market, including the global economy, can only operate with a single price standard requiring a single price unit. This in turn determines the demand for foreign currencies including foreign exchange reserves. A relatively few individual companies seek to profit from relative movements in currencies, but globally this is a peripheral activity. The aim of most foreign exchange holdings is to possess the unit used to price international transactions - which is the dollar. This is not only the goal of central bank`s foreign exchange reserves but also the safest form of currency hedging by companies.

Consequently if countries capital accounts are liberalized, the net flow is always into dollars - as global experience since international capital account liberalization seriously began in the late 1970s confirms.

China can be no exception to this fundamental economic rule. Therefore as China moved to liberalize its capital account, the data shows destabilizing movements out of the RMB into dollars began. China`s foreign exchange reserves would have been increased by its trade surplus rising from $306 billion in the year to August 2014 to $540 billion in the year to August 2015. But instead of rising China`s foreign exchange reserves fell at a rate much faster than was caused by productive Foreign Direct Investment outflows. In 2015 China`s foreign exchange reserves have fallen by an average $36.5 billion a month and the decline has risen sharply - August`s fall was $94 billion. This demonstrates large scale capital outflows are taking place with negative economic consequences.

The positive effects of the RMB`s use in relation to international trade, therefore, led to it organically becoming the fourth largest currency for international transactions - a healthy process which should be allowed to continue. Failure to accurately recognize the nature of the international capital system that can only create a flow into dollars, can lead to overhasty relaxation of capital controls with negative effects for China`s economy.

The author is a senior fellow at the Chongyang Institute for Financial Studies at Renmin University of China.

Key Words: RMB   RDCY   internationalization  

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