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In Chapter 9, the concluding chapter, I discuss the prospects of RMB internationalization. There are plenty of reasons to be pessimistic. First, the population is ageing, and the labor force has already begun to shrink in 2012. This hurts the economic size effect. Second, China is too wary of the risks of free capital mobility to relinquish capital controls in the onshore market any time soon. Third, the development of a deep, broad, and liquid financial market in the onshore market will probably take a long time. Fourth, in order to be a “safe-haven currency,” China must have an independent judiciary, an independent central bank, democracy, and freedom, which China still lacks. There are, however, reasons for cautious optimism as well. First, despite possible slowdown in the growth rate, China’s economy is likely going to become the largest economy before long. Second, China has a strong desire to internationalize its currency. Third, as the US share of the world’s GDP is set to fall continuously, the United States would eventually not be able to supply the assets for reserves and payments needed by the world. Some other currency(ies) is needed to fill the gap, and the RMB is a strong candidate.
In Chapter 6, I discuss the importance of financial sector reform, focusing on the banking sector, the bond market, and the stock market. The banking sector is still characterized by financial repression. The largest banks are all state-owned, the interest rates are not market-determined, and state-owned enterprises (SOEs) still enjoy preferential access to credits compared with the private sector. The bond market developed only recently. Most important developments in the Chinese bond market happened only since about 2015. China’s bond market is characterized by its relatively small size relative to its GDP, low turnover ratio, and low foreign ownership. The central government bond market, which is most important for the internationalization of the RMB, needs to be much further developed in order to the pave way for the RMB to serve as a significant reserve currency. The market capitalization of the stock market is small relative to the GDP of China. It is characterized by low fund-raising capacity, excessive government intervention, lack of transparency, capital controls, and other issues. The good news for the financial market is that market opening and integration with the rest of the world did not slow down in recent years.
Chapter 7 explains the importance of the offshore RMB market. Historically, an international currency had to be fully convertible in the capital account. However, China wants the RMB to be convertible only in a controlled manner, as its institutions are still immature. Thus, making use of offshore RMB centers is a crucial part of the RMB internationalization strategy. Through this strategy, China sets up a firewall between the onshore and offshore markets, allowing full convertibility of RMB in the offshore market but partial convertibility in the onshore market. I study the operation of the offshore RMB centers, in particular that of Hong Kong, which is by far the largest offshore center. I describe in detail the difference between the onshore and offshore FX markets. I discuss the settlement and clearing of offshore RMB payments. Importantly, I describe in detail the Cross-Border Interbank Payment System (CIPS) and compare it with the Clearing House Interbank Payments System (CHIPS) of the United States. I explain the economics behind the operation of the Hong Kong offshore market—in particular, the determination of the interest rates and exchange rate in the offshore market. Finally, I compare the offshore USD market and the offshore RMB market.
In Chapter 5, the importance of capital account liberalization is discussed. I explain how the “coalescing effect” and “thick market externalities” effect determine the use of a currency for trade invoicing and denominating financial assets and use the theory to explain why capital account opening, in addition to financial development and the size of the economy, is essential to RMB internationalization. I ask two questions: Given that capital account opening carries risk, should China open its capital account just because it want to internationalize the RMB? Do the benefits of capital account opening outweigh the costs of it regardless of whether China pursues RMB internationalization? To answer these questions, I discuss the benefits and costs of capital account liberalization, including the loss of exchange rate stability due to the open-economy trilemma. I explain the theoretical basis of the trilemma and the empirical evidence for it. I then point out that there is a positive feedback effect between capital account opening and financial market reform. Thus, the initiative to internationalize the RMB, which calls for capital account opening, can set forth a chain reaction that facilitates capital account opening and the financial market in tandem in a gradual and interactive manner.
In Chapter 8, I carry out a quantitative study of the determinants of RMB internationalization, focusing on assessing the potential of the RMB as an international payment currency. I present an econometric study to demonstrate that financial development and capital account openness are distinctly more important than the GDP of China in determining the share of the RMB in international payments. I carry out a regression analysis to identify the determinants of bilateral inter-country payments flows by currency. Then, I use the model to predict the future share of the RMB in global payments. I find that, in the best-case scenario, the RMB can possibly become the (distant) third payment currency (behind the USD and euro) by 2025. However, despite China’s large expected economic size, it would be hard for the RMB to come even close to the status of the euro as a payment currency because it would be hard for China to attain the required levels of financial development and capital account openness, given the underdevelopment of China’s institutions. I also carry out a very simple exercise to estimate the impacts of the Belt and Road Initiative on the payment share of the RMB and its share in denominating international debt securities.
In Chapter 3, I discuss why China wants to internationalize the RMB. First, the international monetary system, which is dominated by the USD as the major reserve currency, is asymmetric, in the sense that as developing countries like China try to peg to the USD, they lose the autonomy in monetary policy, but the United States has total autonomy in conducting its monetary policy. Second, as China wanted to safeguard the dollar peg, it accumulated a huge USD foreign exchange reserve, which earned a very low rate of interest and was subject to losses due to USD depreciation. Third, the global financial crisis in 2008 caused a shortage of the dollar all over the world. This further motivated China to promote the use of RMB internationally so as to escape from the “dollar trap”. Fourth, for ideological, historical, and cultural reasons, there is a strong desire for China to become independent of the United States and an international monetary system dominated by the USD. Fifth, there is a desire to use external commitment to force internal reforms, which is called “daobi” in Chinese. I also discuss the pros and cons of RMB internationalization to China and to the world, and why Japan did not internationalize the yen.
In Chapter 4, I discuss China’s strategy of internationalizing the RMB. China’s financial system is still immature compared with that of the most advanced countries, and still needs to improve on reliability, efficiency, breadth, depth, and liquidity. Its currency is still not fully convertible in the capital account, and there are capital controls. Thus, market forces alone would not be able to make the RMB a significant international currency, and government policy is required. Borrowing the “one country, two systems” idea, the Chinese government decided to create an offshore RMB market that is not completely integrated with the onshore one. They facilitated the formation of offshore RMB centers in Hong Kong, Singapore, Taipei and London. The CNH (offshore RMB) is a fully convertible currency in the offshore market. In the offshore centers, the markets for CNH bank deposits and CNH-denominated bonds, loans, and other financing gradually developed. Other policy measures taken include: encouraging RMB trade settlement in RMB, bilateral currency swap agreements with foreign countries and various capital account opening schemes. At the same time, China has gradually built up its international interbank payment system, called the Cross-Border Interbank Payment system (CIPS). I also discuss an “RMB Internationalization Index”.
In Chapter 2, I explain why China desires a stable exchange rate. International trade has been very important to China’s economic development ever since reform and opening started in 1978. China had a huge rural labor surplus (underemployed rural labor force) that had to be absorbed by the economy. Thus, it needed to keep its labor employed by expanding external demand through exporting. In order to sustain export-promotion, during 1996-2005, China had been maintaining a stable and under-valued exchange rate versus the USD. As a result of this exchange rate policy, China rapidly became an important player in international trade. A stable and undervalued exchange rate with the USD has therefore become the cornerstone of China’s initial development strategy. Besides, China has a fear of floating its exchange rate, because of historical experiences, such as the Plaza Accord and the Asian Financial Crisis. In fact, results of academic studies are ambiguous about whether exchange rate management is economically inefficient. The stable exchange rate policy, however, becomes an obstacle in RMB internationalization, which requires that China allows much freer capital mobility. The two cannot be achieved at the same time if autonomy in monetary policy is to be maintained, according to the open-economy trilemma.
Chapter 1 is the introduction. I discuss the current state of the international monetary system (IMS), the “exorbitant privilege” of the United States and the history of the IMS. I explain how the United States seized the opportunity in the Bretton Woods conference to establish the USD as the reserve currency, and how the Bretton Woods system collapsed in 1972. Today, under the post-Bretton Woods system, developing countries like China adopt the “dollar standard” and peg their currencies to the USD. In doing so, China accumulates huge amounts of USD foreign reserves. It falls into the “dollar trap”. However, the global financial crisis sounded an alarm for China that the dollar-based IMS could be quite unreliable, e.g., there might be a shortage of the USD for trade finance. Thus, China began to accelerate the pace of RMB internationalization, aiming to make the RMB an international unit of account, medium of exchange, and store of value. However, this implies that its capital account has to be open, the financial market must be liberalized, and its exchange rate has to be more volatile. Is China ready to meet this challenge? This book investigates the necessary conditions for RMB internationalization to succeed and its prospects.