Renmimbi on slow track to reserve currency

Five years after the renminbi was allowed to float more freely, the Chinese currency is on the way to becoming a global asset class

If there were an economics road map, China would be found at the Mundell-Fleming crossroads. This is where the path for financial policymakers divides into three: fixed exchange rate, independent monetary policy or capital mobility.

Economic theory has it that, at this point, policymakers must make a trade-off. Implementing any two policies implies that the third is out of the question, according to the Mundell-Fleming model. China seems to be currently stalled at the crossing, preferring to find a way to combine all three paths with a slight preference for an increasingly flexible capital market.

Five years ago in June, the People’s Bank of China (PBC) took a decisive move towards liberalizing its currency. By basing the renminbi exchange rate on a basket of currencies, it ended the two-year-old peg to the US dollar introduced in response to the financial crisis.

“This was important for China to play a more influential role in the global financial architecture,” says Franklin Allen, professor of finance at Imperial College London, on leave from the Wharton School at the University of Pennsylvania.

“While the volume of renminbi used in international trade is still not huge relative to the dollar or euro, the absolute amounts are becoming more significant.” Trade settled in renminbi has increased from CNY500 billion ($80 billion) to CNY4 trillion ($640 billion) in, according to Deutsche Bank.

“China’s yuan is heading for the currency major league, with trading volumes more comparable to the euro, sterling, Australian dollar and Swiss franc than its emerging market peers,” Reuters reported in early. If the renminbi’s liberalization continues, it is more likely to appreciate over the long term

FEELING THE WAY

However, China maintains a tentative approach to opening its economy, aptly described by Deng Xiaoping’s saying that the country is “crossing the river by feeling out the stones with our feet.”

Despite ending the dollar peg in, the PBC retained control over the exchange rate by introducing a daily rate as well as a trading band, which limits the fluctuation of the renminbi. The trading band has been widened a number of times, more recently in March, when the bank announced it would allow a fluctuation of 2% above and below a midpoint it sets on a daily basis.

This step-by-step approach is the right way to go for China, according to Franklin Allen: “It makes sense to proceed in this experimental style, to give firms and authorities a chance to practice for the next big step, which is the opening of capital accounts.”

Helen Lam agrees. “The past five years have been remarkable in terms of the renminbi’s flexibility. Liquidity in the offshore renminbi markets amounts to CNY2.5 trillion ($400 billion) as of March. The currency is well on its way to become a global asset class, offering significant opportunities for foreign investors,” says the head of Hong Kong fixed income with Allianz Global Investors. She expects Chinese authorities to widen the trading band further but doubts there will be a big bang of reforms: “Capital account liberalization will only happen gradually.”

As China is reforming its economy to shift from export-led growth to increasing domestic demand, authorities seek to maintain a stable currency environment. “We don’t think China will depreciate the renminbi, as this would have more downsides than upsides to the economy,” says Lam. She expects the renminbi to stay flat over the course of. “If the renminbi’s liberalization continues, it is more likely to appreciate over the long term.”

This makes the currency attractive to investors. “Renminbi bonds can increase investors’ yields while helping them to diversify their portfolio. At the same time, renminbi volatility will be lower than that of many emerging market currencies.”

NEW RESERVE FOR THE WORLD

Over the very long-term horizon, the renminbi might be able to provide means of diversification in a different dimension. During the financial crisis, as investors sought to increase their exposure to foreign currencies, many flocked to the US dollar and the euro. “That created significant distortions and we are better off with three or more reserve currencies,” says Allen.

Maurice Obstfeld (University of California, Berkeley) and Kenneth Rogoff (Harvard) even went as far as claiming that China’s currency policy contributed to the financial crisis. “Exchange rate and economic policies followed by emerging markets such as China contributed to the United States’ ability to borrow cheaply and thereby finance its unsustainable housing bubble,” they write in Global Imbalances and the Financial Crisis: Products of Common Causes.

It will take another 20 to 30 years for the renminbi to become a reserve currency, says Allen, “But eventually, it will challenge the dollar’s position as the world’s currency.”

Renmimbi on slow track to reserve currency

Five years after the renminbi was allowed to float more freely, the Chinese currency is on the way to becoming a global asset class

Renmimbi on slow track to reserve currency

Five years after the renminbi was allowed to float more freely, the Chinese currency is on the way to becoming a global asset class

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