Viewpoint: RMB internationalization should be stable rather than fast

The role of the yuan is likely to be much larger in the coming years, and the yuan will become a global reserve currency faster than most people expect.

Viewpoint: RMB internationalization should be stable rather than fast

Author: Bai Shipan

Recently, China is clearly ahead of the world as it has been actively promoting the development and testing of the digital renminbi (e-CNY). Coupled with the current epidemic period, the U.S. is once again implementing quantitative easing monetary policy, triggering a depreciation of the U.S. dollar and high inflation expectations, as well as causing hot money to hit and disrupt emerging markets. For a while, public opinion has linked the aggressive rollout of the digital renminbi to the internationalization of the renminbi, suggesting that China wants to replace the dollar with the renminbi as soon as possible to become an international trading and reserve currency. Billionaire Dario, founder of Bridgewater, the world’s largest hedge fund, also said in a recent interview with CNBC: “The role of the yuan is likely to be much larger in the next few years, and the yuan will become a global reserve currency faster than most people expect.”

The emergence of digital currencies can indeed help promote the internationalization of the RMB on a technical level, but to become an international transaction and reserve currency, it needs more domestic and international conditions in many aspects to cooperate. The author previously posted in the Morning Post that while China basically has the economic conditions, the financial and international conditions are not yet mature.

For one thing, the construction and thriving of China’s financial market breadth and depth is a necessary financial condition. Only a mature financial system with good governance in place and a sizeable capital market can provide a good investment channel for foreign RMB in order to preserve and appreciate its value in the long term and increase its attractiveness.

Second, China has only recently begun to expand the opening and internationalization of its financial markets. With the increasing openness, the mutual flow of domestic and foreign capital has gradually strengthened, making China’s financial sector more vulnerable to the external environment. Adjustments in monetary policies of developed countries and changes in international interest rates and exchange rates may cause large-scale capital inflows and outflows, increasing the volatility of the domestic market and affecting the stability of China’s financial market. Therefore, it is urgent to improve cross-border capital management policy tools, improve the monitoring system of cross-border capital flows, build mechanisms and accumulate experience to deal with financial market shocks and even financial crises, such as enhancing risk monitoring tools, preventing disturbances caused by large inflows and outflows of hot money, and controlling the spillover effects of international financial risks.

Third, to become an international currency, a sovereign currency requires international cooperation, not a unilateral decision by China. China therefore needs to do more in international diplomatic settings to gain more support and recognition for the internationalization of the RMB, such as promoting international understanding and respect for China’s political, economic, financial and social institutions and governance, and even the formulation and operation of laws and justice. President Xi Jinping’s recent emphasis on international communication capabilities and telling the Chinese story to help the international community understand the Communist Party of China and socialism with Chinese characteristics will not only defuse the current strategy of some Western countries to encircle China, but also contribute to the internationalization of the RMB.

Gradual opening of financial markets
The internationalization of the renminbi will not happen overnight, but rather in a gradual manner. Zhou Xiaochuan, the former governor of China’s central bank, has repeatedly pointed out that the internationalization of the yuan should be a gradual process. He stressed last month that the internationalization of the RMB depends more on institutional and policy choices, and more on the progress of China’s reform and opening up, rather than on technical factors.

We can see from how China is dealing with the “triadic paradox” (or “trilemma”) that it is not in a hurry to internationalize the yuan.

Paul Krugman, an American economist, has proposed a “triadic paradox” for the policy choices of open economies – the independence of monetary policy, i.e., the controllability of the level of domestic interest rates, the stability of the exchange rate and the free flow of capital, can only choose one of the three objectives, but not all three. It is impossible to have all three. China chose to control interest rates and exchange rates before the opening and marketization of its financial markets, but it had to restrict capital flows, so it implemented capital account controls.

After liberalizing the current account in 1996, China started to open the capital account. It has not yet been fully realized because the international and domestic financial and economic environment has changed so much, and it has been subject to some severe tests in the meantime. The best example is the announcement by the Chinese central bank on August 11, 2015 (the “811” exchange rate reform) to make the RMB exchange rate more market-oriented by changing the centralized quotation of the RMB to the US dollar from the market maker to the closing rate of the previous day’s interbank foreign exchange market. However, in the face of the domestic economic slowdown and the strong interest rate hike of the US dollar, the RMB suffered from huge downward pressure after the announcement of the “811” exchange rate reform and the massive outflow of domestic capital, which prompted the authorities to reconsider the speed of marketization of the RMB exchange rate, while continuing to control the outflow of domestic capital but increasing the relaxation of the inward flow of foreign capital (lenient entry and strict exit). Public opinion, including the official media, generally believed that the focus of China’s exchange rate policy at that time should be on stability, rather than on hasty change, and that the priority should be on the overall situation, i.e., managing the macroeconomy well to promote sound economic growth.

So to this day, China’s policy response to the triple paradox is to maintain an independent monetary policy, implement a controlled and gradual opening of the capital account, and implement a managed floating exchange rate system that allows the RMB to fluctuate within a reasonable range. In other words, rather than choosing one or the other, China has now achieved one goal (control of interest rates) while gradually opening up capital account controls in a controlled manner and also gradually allowing market supply and demand to shape the exchange rate. Such a sequential and gradual opening gives policymakers time to build mechanisms and experience in dealing with financial shocks and even crises, provides opportunities for the foreign exchange and financial derivatives markets to thrive, and gives financial players a valuable opportunity to practice and build their financial risk management capabilities. However, this also means that the internationalization of the RMB needs to be carried out in a step-by-step manner, corresponding to the progress of capital account liberalization.

Controversy of Sovereign Credit Currency as an International Currency
Furthermore, the use of a sovereign credit currency as a currency for international transactions and reserves has the inherent disadvantage that it cannot take into account both domestic and foreign objectives. Like today’s U.S. dollar, it cannot transcend U.S. economic conditions and interests, but can be adjusted up or down in a timely and flexible manner in response to changes in global liquidity needs. That is why Zhou Xiaochuan, the former governor of China’s central bank, after the outbreak of the financial crisis and the dollar’s over-issuance in 2009, has expressed the global need to create an international reserve currency that is decoupled from sovereigns and can maintain a stable currency value in the long term, thus avoiding the inherent defects of sovereign credit currencies as reserve currencies and being the ideal goal of international monetary system reform.

Mark Carney, former governor of the Bank of England and chairman of the European Financial Stability Board, also said at an annual global central bank conference in August 2019 that the dollar’s status as a global reserve currency must end in order to weaken the spillover effects of the dollar’s unilateralism. But he believes it should be replaced by some form of global digital currency – similar to Facebook’s proposed Libra (renamed Dime) – because that would be better than having the dollar’s reserve currency status replaced by another sovereign credit currency such as the yuan.

In other words, for the RMB to strive to be an international trading and reserve currency, in addition to the subjective obstruction by the US, UK and other Western powers, the objective developments in the medium to long term including the lack of confidence in the international community in sovereign credit currencies and the various possibilities that digital currency technology may generate in the future, all bring a certain amount of uncertainty.

Instead of irrationally overestimating and shouting about the imminent internationalization of the RMB, it is better to be more pragmatic and solid in practicing “internal strength” and doing a good job within its capacity. For example, China’s participation in a regionalized project announced in February this year by Hong Kong, Thailand, the United Arab Emirates and China in the m-CBDC Bridge is a good example. It will explore the application of central bank digital currencies in cross-border payments and facilitate the exchange of local and foreign currencies in cross-border trade scenarios. This will materially help the internationalization of the RMB.

The author, Dr. Pak Shi Pan, is a Visiting Professor at the National University of Singapore, Director of the Li Pak Finance Institute and former Director of the Monetary Authority of Singapore Institute

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