April 10,2009

Zhou Xiaochuan's Proposal and the Future of the RMB

By Pieter Bottelier
(This is an abbreviated version of a longer paper for members of The Conference Board’s China Center)  

Since the publication of PBC Governor Zhou Xiaochuan’s proposal for reforming the international monetary system on 23 March 2009, discussion on the future of the RMB as an international settlement currency has intensified. The two subjects are related.
 
Zhou Xiaochuan’s proposal
 
The proposal is couched in careful, professional, non-provocative language. It reflects deep concern by China and other significant holders of dollar assets that the US response to the current crisis could undermine the purchasing power of the dollar.  Although acceptance of Zhou’s proposal, or variants thereof, is unlikely in the foreseeable future, it will undoubtedly be the subject of much international discussion and it may indirectly contribute to accelerated internationalization of the RMB. 
 
China’s assessment of the shortcomings of the current international monetary system, as expressed in Zhou’s paper, is shared by many.  China is concerned about instability of the international value of the world’s main reserve currency and about the possibility that, given the large volume of additional liquidity that is being injected in the US economy by the US government to fight the recession, high inflation may be hard to avoid once the US economy turns around in positive direction. These concerns, which are shared by Germany and other surplus economies, are legitimate. China’s central bank and other government-owned and controlled financial institutions such as CIC and the major commercial banks hold an estimated $1.5 -1.6 trillion in US dollar-denominated financial assets. The rest is denominated in Euro, Japanese Yen, Pound Sterling, Swiss Francs and other convertible currencies. China is not only the largest foreign creditor of the US Federal government, but also of the GSEs (mainly Fanny Mae and Freddie Mac). China’s official gold reserve is small.
 
Zhou proposes to significantly modify the SDR (Special Drawing Right), a synthetic reserve asset and unit of account created by international agreement under IMF auspices in 1969 to supplement official reserves of member countries and to support a Bretton Woods-style fixed exchange rate system. At the time that SDRs were created there was serious concern that a shortage of gold and gold-linked US dollars (or dollar-denominated financial instruments) to finance international trade would slow economic development around the world. The IMF was given authority to issue SDRs to member central banks in accordance with an agreed formula to supplement their reserves. 
 
The current system is in principle stable as long as the rest of the world is willing to hold US dollars and dollar-denominated liabilities as financial assets.  Zhou’s proposal brings the limits of that willingness into view, but it does not mean that there will be major change in the international monetary system any time soon. There is at present no viable alternative to the US dollar as reserve currency. The significance of the Euro as international reserve holdings ?currently accounting for about 26% of the total international reserves - is unlikely to increase much, because, in the absence of a European Ministry of Finance, the market for Euro-denominated bonds will remain segmented. Other floating currencies are too small to serve as reserve currency on a large scale. The Euro is a currency without a country. Buyers of Euro bonds have to choose between bonds issued by the 15 EU member countries using the Euro as their national currency and the pricing of their Euro bonds differs with market perceptions of the credit worthiness of those countries. Making the Euro comparable to the USD as an international reserve currency would require significant further European political, economic and fiscal integration.
 
Zhou proposes to enhance the use of the SRD as reserve asset and to make it usable as an invoicing and settlement currency in international trade and financial transactions. With those objectives in mind, he proposes  to: (1) make the SDR convertible into other currencies, (2) promote the use of the SDR for commodity pricing, investment and corporate book-keeping, (3) create SDR-denominated tradable financial instruments, (4) update the formula used for the allocation of new SDRs by the IMF, (5) update the valuation base of the SDR by including other currencies in its base (presumably including the RMB), and (6) promote confidence in the value of the SDR by shifting from a purely unit-of-account or calculation-based system to a system that is backed by real assets such as a reserve pool.
 
Zhou believes that his proposal would also serve the long-term economic interests of reserve currency countries, as it would promote international financial stability and relieve the monetary authorities of those countries of the need to also take the international value of their currency into account in the conduct of monetary policy. Since there is little evidence that US monetary authorities feel constrained by such a need (perceived by Zhou and others around the world), they are unlikely to be impressed by his argument.
 
Zhou’s proposals aimed at creating a new international reserve and settlement currency are sound in principle ?in some ways they echo Keynes?proposal of 1944 - but they require international agreement which will be extremely difficult if not impossible, to achieve. The US government, as custodian of the world’s premier reserve currency and largest international debtor country, has de-facto veto power. The US is unlikely to cooperate, because implementation of Zhou’s proposal would diminish the advantages of reserve currency status that are presently enjoyed by the US. Besides, many in the US see Zhou’s proposal as an attempt to undercut US power and are opposed for political reasons. Zhou’s proposal would probably have been met with less resistance in the US, if it had included an admission that China’s relatively fixed exchange rate policy contributed significantly to the accumulation of huge reserves and large exposure to the USD, especially since 2003.
 
One component in Zhou’s proposal should be less controversial and could be implemented relatively quickly, if IMF members agree.  It is his suggestion that member countries should be permitted to entrust the IMF with the centralized management of part of their reserves, which would involve the purchase of SRDs by surplus countries such as China. Such transactions would permit China to reduce its exposure to the USD without having to sell USD-denominated financial instruments in the open market, which would tend to depress the value of the USD. By the same token, such transactions would avoid putting upward pressure on the Euro (and/or other reserve currencies) which would be welcomed by the Europeans.
 
Internationalization of the RMB
 
The growing international use of the RMB for transaction purposes is more the result of spontaneous developments in the region than of deliberate actions by the Chinese government, except in Hong Kong and Macao, where local RMB use is governed by inter-governmental agreement. Local use of the RMB in some neighboring countries - mainly for transaction purposes - has been growing for years. Driven by considerations of convenience, it was neither encouraged nor discouraged by the Chinese government ?no policy on this appears to have been articulated. In areas where the local use of the RMB is spreading, it is presumably at the expense of the local use of the US dollar, except in Hong Kong where the RMB replaces the HK dollar for approved transactions. China’s policies concerning the international use of the RMB have recently become more pro-active. Recent announcements about the establishment of a branch office of ICBC in Taipeh could mean that a broader agreement to facilitate financial transactions between the mainland and Taiwan will follow. That would be excellent news, especially if further progress can also be made with regard to air traffic across the Strait and other mutual interests. 
 
Partly in response to the current international financial and economic crisis, the Chinese government is taking steps to facilitate the use of the RMB as settlement currency for current account transactions in the region and elsewhere in the world. RMB-denominated lines of credit have been extended to several countries and bilateral local currency swaps have been negotiated with Malaysia, South Korea, Indonesia, Hong Kong, Argentina and Belarus. More such bilateral agreements are likely to follow. According to recent press reports, the total amount of local currency swap agreements between China and trading partners currently outstanding is close to $100 billion equivalent. Local currency swaps reduce the need for using the USD for international invoicing and transaction purposes, thus reducing the exposure of international trade to exchange risk.
 
Because of the large accumulation of RMB balances in Hong Kong banks, one mainland commercial bank (Bank of China) began to issue RMB-denominated bonds there, in 2007. Eventually, Chinese corporations may be allowed to open RMB accounts in Hong Kong and elsewhere. BOC has been designated to oversee and implement these new initiatives. The potential for increased international use of the RMB as transaction-, invoicing- and international settlement currency is significant. Such uses of the RMB will also promote its use as a store of value, even before full convertibility has been reached.
 
Local currency swaps and increased use of the RMB as a settlement currency for international trade will make it easier for China to promote exports and to protect its exporters from exchange risk. It also reduces financial transaction costs and avoids the need for hedging. Potential benefits for corporations will vary, depending on the underlying business model. 
 
Increased use of the RMB as international settlement currency should make it easier for China to flexibilize its exchange rate management and thus reduce the need for large-scale domestic sterilization of excess liquidity in domestic banks. It should also facilitate accelerated opening of China’s capital account and movement towards full convertibility of the RMB.  Increased use of the RMB in the region will reduce the need for US dollars and other reserve currencies for transaction purposes. Once the settlement in RMB of international trade in the region becomes more common, the question arises what to do with RMB balances accumulating in economies that typically have a current account surplus with China such as for example Taiwan. There is as yet no policy on this, but it would be easy for China to offer such economies to convert their RMB balances into a convertible currency or to offer some kind of guarantee. 
 
All in all, it seems likely that the current international crisis will promote the international use of the RMB and accelerate movement toward full RMB convertibility. Once that has milestone has been reached, which could happen relatively soon - say 5-10 years - the main obstacle to the use of the RMB as an international reserve currency will have been removed. If by then no agreement has been reached on Zhou Xiaochuan’s proposal for international monetary reform, or possible variants thereof, it is likely that we will see the spontaneous emergence of the RMB as a reserve currency, but that would also require ?in addition to full convertibility ?substantial further development of China’s domestic capital markets. A reserve currency system based on several competing reserve currencies, including US dollar, Euro, RMB and some smaller currencies, though theoretically less perfect than an SDR-based system, may well be an improvement on the present system.
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