Reserve Currencies and Internationalization of Chinese Yuan

Introduction

Chinese economy has grown at a very fast pace in the recent past. As a result, the government has worked on mechanisms that would facilitate the categorization of Chinese currency among international currencies that can be used for international trading. This approach has resulted in different points of view regarding the step taken by China. This paper seeks to assess the reason why different debates have been created, and the strengths and challenges involved in the internalization process of Chinese RMB. Furthermore, the current paper seeks to analyze the role of capital market and A-shares in assisting the realization of full convertibility of the Chinese currency.

Debates on Internationalization of Chinese Yuan

The role of Yuan (Or the Chinese RMB) has been hotly debated amidst China’s strict control over the liberalization of its currency. China would aim several issues to internationalize the RMB. First, it would want to reduce the overexposure to other international currencies. Secondly, making the currency dominant at the world market would assist China to leverage its political power (Eichengreen & Kawai, 2014).

RMB has continued to change in its role and has led to the widespread debate (Zhang & Chan, 2011). It is also expected that China will be the largest economy in the world. The value of the Chinese currency has overtaken the dollar in several key areas of the world including India, South Africa, Chile and East Asia. In these areas, Yuan has been rated as the dominant reference currency (Zhang & Chan, 2011).
The Chinese authorities have always wanted Chinese RMB to be included in the list of the world currencies that have the capability to determine the SDRs (Special Drawing Rights), issued by the IMF as a reserve asset. In the long run, it is estimated that the Chinese currency is expected to become one of the dominant currencies (Eichengreen & Kawai, 2014).

The debate has been provoked by the many controversial issues surrounding the internationalization of the Chinese currency. The People’s Bank of China needs to be completely detached from local political influences so that it can make autonomous decisions regarding the economic progress of the country. Accountability and transparency in policy should be put in place to facilitate the democracy of the political regimes. These are some of the steps that are likely to assist the RMB in becoming a truly international reserve currency (Eichengreen & Kawai, 2014).

There are a lot of active debates about the internationalization of the Chinese Yuan. Some of the observers think that the Chinese Yuan can be internationally recognized alongside the dollar while others oppose this stand. There are several reasons for this issue. Some of them are factors concerning the Chinese community while others are external ones. Another argument has also appeared regarding the emerging international currencies such as the Brazilian Real, Russian Ruble and the Indian Rupee. They are likely to join the ranks of the international currencies but they have not yet reached the value that allows them to compete favorably in the international arena to facilitate the disruption of the status quo. Furthermore, pegging has also acted to prolong the status quo of the dollar as a global reserve currency (Ravenhill, 2005).

Some of the most prominent debates attacking the Yuan against becoming a global reserve currency highlight pertinent issues with regard to the implication brought about by certain steps. For instance, Chinese capital markets have been rated as illiquid and shallow. Secondly, it exercises rigid controls on Yuan. Thirdly, currency pegging is likely to have serious implications and thus cannot be fully recognized as an international reserve currency which demands flexibility in the exchange rates (Prasad & Ye, 2012). On the one hand China has tried to carry out pegging of Yuan against the United States dollar.

The value of the Chinese Yuan has been increasing with time. Chinese Yuan is rated as the currency that has continued to increase in value more than any other currency. Furthermore, it has been very consistent and risk-free. Although the Chinese Yuan has not been fully active in the international market, its growth rates have been overwhelming and are likely to cause a considerable change in the Forex markets. Most of the emerging markets are known to be directly competing with China. In addition, most of the world economies have tried to intervene on daily basis in the Forex markets to ensure that their currencies appreciate faster than the RMB (“Is the Chinese Yuan the most reliable Forex trade?”, 2011).

Other countries in Asia and Latin America have also shown positive trend towards making their currencies recognized at the world stage. On the one hand, the Asian currencies have been undervalued for a very long time. On the other hand, there have been very viable efforts that are likely to make their economies converge with those of the G8 countries. These efforts are estimated to lead to appreciation of these currencies. Most of upcoming activities are predicted to cause a decrease in the value of the dollar, something that is also anticipated to bring a lot of debates in the process because it is widely used across the globe (Lardy, 2012).

The growth of the Chinese economy, extending to other regions of the world is a great risk for the value of the dollar. For instance, it has been estimated statistically that the increased value of the Yuan in the Asian region by approximately 7% annually may result in the corresponding decrease of about 3% annually in the trade-weighted dollar worth (Perkowski, 2012). This is expected to cause a lot of loss in the value of the dollar across the world. With these kinds of expectations, debates are likely to arise.

In 2005, the People’s Bank of China complied with the international pressure and decided to minimize Yuan-Dollar pegging. Since then, the Yuan has appreciated more than 27% (Naughton, 2007). These revaluation pressures at the end would act positively in terms of the value of Yuan (Chinese RMB). The observers and economists have predicted that the Chinese currency will continue to rise in value considering the current trend it has taken and the unprecedented economic growth that has been witnessed in the country. “The question will not be whether the economy can grow or not; it is about when and to what extent?” (Lardy, 2012).

Due to the rise in the economy of China, a lot of political leaders in the United States expected that it would pose a threat for the American economy and had to do everything possible to ensure that the Chinese economy did not supersede that of the U.S. Before the 2005 revaluation process, the Yuan had been undervalued by 15-40% (Lardy, 2012). By that time many politicians in the United States had proposed a 27.5% across-the-board tariff involving all the imports from China (Bonnet, 2013). However, instead of the expected devaluation caused by international pressure, the Chinese Yuan gained a lot of popularity and has continued to grow tremendously. Even with inflation, the Chinese RMB has continued to grow posing even a bigger threat to the established world economies.

According to the Bank of International Settlements (BIS), currencies that portray either of the two extremes, low yields or high yields, are likely to attract more trading since they have a great role in funding currencies in carry trade (Lardy, 2012). The most suitable reserve currencies are those that are most liquid. They are majorly those of the developed economies and those that have abnormal interest rates. With the high expectations that China’s currency can be internationalized; it may lack some of these qualities and therefore become a contentious issue for many scholars.

China has previously been blamed for the entire global economic crises by the international community. Although the unfixing of the Yuan in June, 2005, made it appreciate more than expected, for instance, by 4.5 % (Naughton, 2007). China has been pressurized for a long time to stop trying to control the Yuan. With the blames being put on the Chinese government for controlling the Yuan, it has also countered this claim from its perspective. Chinese officials have claimed that the dollar is supposed to be blamed for the global crisis (Lardy, 2012). Additionally, seeing the activities of China aimed at controlling its currency, other countries have also come up with the idea and have followed the suit to intervene in the Forex markets.

China’s economy is perceived to be growing at a great rate; causing many debates concerning the importance of its currency for the global economy. From another dimension, the attempts of the Chinese authorities to internationalize the Chinese RMB may have been sparked off by several factors. For instance, most of the powerful nations try to internationalize their currencies so that they can achieve greater economic freedom and political mileage at the international stage. However, because of the internal structural factors present in the country, this theory may not be valid (Zhang, 2011).

As most of the people including the Chinese perceive the issue of internationalization process from diverse perspectives, there are debates that try to explain the cause and effect of the internationalization process. For instance, from a conservative point of view, after the internationalization the Chinese RMB will significantly appreciate against the dollar. This is something that is likely to affect the progress of the Chinese-based manufacturing companies and export industries. It might act to stir up strikes within China (Murphy & Yuan, 2009).

Strengths and Constraints for Chinese Yuan to Become a Global Reserve Currency

The Chinese Yuan has been deemed to be a better global reserve currency due to a number of reasons. One of the reasons is that the Chinese economy has been growing at a very fast rate of around 10% for over 30 years. It was rated as the highest in the world. The International Monetary Fund expects that the economic output of China may be around 9% of the economy of the whole world (Murphy & Yuan, 2009).

Most of the successful economies such as Norway, Singapore and Malaysia have received very special considerations from the Chinese government that would allow them to be exposed to the Chinese currency. The Yuan has been considered as one of the major alternatives that would facilitate the diversification of the national reserves of many countries (Zhang, 2011).

On the other hand, it has been determined that as a reserve currency, the Chinese Yuan can only be attractive to the regional partners since some of the countries in the region might use a genuine currency compared to the situation when it is made a global reserve and has not attained the significant qualities that can allow it to be recognized in the international forum. In addition, there are debates revolving around the aim of making the RMB an international reserve currency. It would contradict the conventional view. The usual way is that there can only be one international reserve currency at a time. This means that RMB has to be stronger than the U.S dollar; something that has been deemed hard, though possible. However, from another perception, there can also be a possibility that two currencies dominate the world stage, especially in the 21st century. By becoming one of the grounded international reserve currencies, RMB is likely to dethrone the dollar from its monopolistic tendencies at the world stage and set a liberalized stage where market activities all over the world will be performed on the fair platform.

One of the factors that China needs to scrutinize is the fact that with the liberalization of the currencies to compete successfully for international reserves, other currencies would also be rendered a chance to compete. Therefore, the competition will not only be set against the U.S dollar but against other upcoming and strong currencies from emerging markets.

There are several conditions that a currency must meet in order to be included in the SDR basket. First, it must be traded actively in the global foreign exchange markets. Second, the currency should be among the most held as foreign exchange reserves. Third, interest instruments rates found in the country should be market based. Fourth, there should be exchange-based active markets and over-the-counter foreign exchange derivatives. As for these requirements, China has already met only two of them. The size of RMB in the international market is deemed to be limited. For instance, it was estimated to be about 2.2% in 2013 (Murphy & Yuan, 2009).

The growth in the significance of China in the world economy derived from its trade volume and the GDP is one of the major issues that have sparked the debate in various places in the world. These debates concentrate on the significance of the Chinese currency in the global market. There are myriads of consequences that China would face if Yuan was allowed to become one of the major reserve currencies in the world. The consequences would arise because there are different strategies that China would be demanded to implement; some of which would contradict its own financial policies. For instance, the Chinese authorities would be required to implement a flexible exchange rate to facilitate greater monetary policy autonomy; something that they have shown that they are not ready for.

The Chinese authorities have not allowed full liberalization of the exchange rates for the Yuan; and it is a significant factor that has to be considered when making the currency a global reserve. China must also be willing to eliminate the laws that dictate how foreigners invest within China. Likewise, the Chinese government should be more willing to invest more in international markets. However, China has not been working in this direction. Its policies have worked to favor its export sector only.

China still depends on dollar denominations in its international activities. For instance, it has been carrying out activities aimed at diversifying its reserves in the emerging markets, which look more viable than the already developed ones. In so doing, since the Yuan is not as liquid as the dollar at the international level, Chinese authorities must be able to assess the possibility of the dependence on the dollar. Dollar-denominated assets can help China keep its reserves as it intends to use it for further international expansion.
Although China has been recognized as the second largest economy in the world, its currency functionality is different from that of the other major economies. For instance, out of the six largest economies’ currencies only Chinese currency is not recognized as a hard currency. It is not traded easily either.

The Chinese government has allowed trading activities with other countries contrary to the restrictions it used to put in the past. However, there are very strict barriers that hinder the adjustment of flexible exchange rates and free flow of capital. This means that China can take a long time before these drawbacks are overcome so that it can embark on the efforts of internationalizing the currency.

One of the significant factors that can facilitate the internationalization of the Chinese currency is the fact that the size of the economy and the increasing shares of the global output and trading activities are likely to catapult the internationalization process faster than expected.
The internationalization of the Chinese currency will depend on its use in the global market as one of the main mediums of exchange. However, this is expected to take a lot of time before the currency is fully established.

China has been holding a lot of regulations in terms of capital controls. These controls have hindered the progress of the internationalization of the RMB. These barriers are however being done away slowly and cautiously. The growth of the gross cash inflows has signified the fact that mainland China becomes a favorable destination for foreign investments. China is also opening up its capital account slowly, a factor that is likely to promote the Chinese currency towards becoming one of the internationally recognized currencies (Deutsche Bank, 2014).

From another insightful perspective, the internationalization process of the Chinese currency will also depend on its use in the international financial market apart from its use in trade (Zhang & Chan, 2011). In addition, foreign exchange turnover of the currency has been a bit lower than it was expected and this casts doubt about its viability if used as an exchange value involving cross-border transactions.

One of the factors that must help the Yuan to become a global reserve is the fact that China must run a continuous and large current account deficit. Capital inflows must balance capital outflows from China. As a reserve currency, it must be able to create enough time and space to allow foreign institutions the required ample time to amass it. However, the economic structure of the Chinese community does not create an ample opportunity like that. China continues to run a current account (Murphy & Yuan, 2009).

The Chinese economy has been rated as one of the most growing. It is estimated that more than 10% of its GDP ought to come from the foreign capital inflows for the feasibility of internationalization of Yuan to be realized. From the aforementioned facts, it is evident that the financial, economic, and the political systems of China do not factually support the increment of foreign accumulation of the Yuan (Chinese RMB) to levels that would facilitate its competition to become the global reserve currency (Murphy & Yuan, 2009). It the Yuan was to reach the level that allows it to be a global reserve currency, reforms allowing the RMB to fluctuate must be made. These are some of the most contentious issues that are likely to make Yuan a recognized international currency.

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