Number 7/07, November 2007
China Economic Issues
The Potential of the Renminbi as an International Currency
Hongyi Chen and Wensheng Peng
This paper assesses the potential significance of the renminbi as an international currency by drawing on the experiences of the other major currencies. We estimate an empirical model relating currency shares of reserve holdings to economic determinants such as the size of the economy and financial market, stability of the currency value and network externalities. A counter-factual simulation of the model using China’s data suggests that the renminbi’s potential as a reserve currency could be comparable to that of the British pound and Japanese yen if the currency were to become fully convertible today.
An international currency is ultimately a market choice, but government policies on currency convertibility can facilitate or inhibit the process. In this respect, the authorities need to weigh the benefits and risks associated with an international role of the renminbi in policy formulation and implementation. As the size of the economy and financial market increases and the monetary policy framework including exchange rate flexibility becomes more firmly established, the benefits should increasingly dominate costs. The potential international role of the renminbi and associated benefits and costs should be part of policy considerations on the pace and form of financial liberalisation and capital account opening.
Hong Kong, being an international financial centre of China, can play an important role in the development and opening up of the Mainland financial market. The renminbi business in Hong Kong provides a testing ground for the use of the renminbi outside Mainland China.
In the longer run, an integrated and much larger financial market that includes both the Mainland and Hong Kong markets would help to promote the international role of the renminbi.
1. Introduction
China is now the fourth largest economy in the world and the third largest trading partner. In particular, China is the largest trading partner of many Asian economies, and has become an increasingly important source of investment in the region. As the rapid economic growth continues and the restrictions on international financial transactions are gradually liberalised, China’s importance in the global economy and financial system will increase further.
Naturally, this begs the question of what role the renminbi will play in international trade and finance, particularly in the Asian region.
There are already early forms of international use of the renminbi. The Chinese currency has been used in the settlement of border trade between China and some neighbouring countries, and renminbi banknotes are accepted by shops in many tourist places in the region. More significantly, banks in Hong Kong started in 2004 to offer renminbi banking services such as deposits, remittance, currency exchange and debit/credit cards. The scope of the renminbi business in Hong Kong has been expanded twice in 2005 and in 2007 respectively, with Hong Kong now possessing a renminbi bond market outside Mainland China.
The use of the renminbi in international trade and financial transactions is of course limited when compared with the major currencies such as the US dollar, the euro, the pound sterling and the Japanese yen.
But the current situation reflects the limited capital account convertibility of the renminbi and a policy of non-internationalisation pursued by the authorities, and the examples cited above are best seen as pointing to the potential of the renminbi as an international currency.
The government policies play a role to the
extent that the pace of the renminbi attaining full convertibility would affect the ability of residents and non-residents to use the currency in settling international
transactions and acquire renminbi-denominated assets. On the
other hand, currency internationalisation would have implications for domestic monetary policy and financial market development, entailing both benefits and risks. Thus, the potential international role of the renminbi would be a significant factor to consider in formulation and implementation of measures on increasing currency convertibility and financial market liberalisations.
There is an increasing literature on the potential of the renminbi as an international currency, the associated benefits and risks and the appropriate government policies in promoting, facilitating or inhibiting the growth of such a role (李稻葵 2006; 刘力 臻等 2006; Li 2006; Eichengreen 2005; He
&Li 2005; 姜波克 2005; 李瑶 2003; 巴 曙松 2003) . This paper considers some these of issues by drawing on the experiences of other major currencies.
Specifically, we estimate determinants of the shares of five major currencies (the US dollar, the euro, the British pound, the Japanese yen and the Swiss franc) in reserve holdings of the world’s central banks, and the model is then used to gauge the potential demand for the renminbi as official reserves, applying the relevant indicators of the determinants for China. Some of the policy issues related to currency internationalisation are then discussed.
The remainder of the paper is organised as follows. The next section provides a definition of an international currency and a brief review of the main determinants of the international currency status that are suggested in the literature. Section 3 estimates a quantitative relationship between the shares of the five international
currencies in reserve holdings and the main determinants such as the size of the economy and financial market, and presents a counterfactual exercise to gauge the potential share of the renminbi in the reserve holdings if the currency were freely convertible. Section 4 considers some policy issues in the international use of the renminbi, and the final section concludes.
2. The main determinants of the international use of a currency
An international currency is one that is used outside its home country. The classical three functions of money domestically—medium of exchange, store
of value and unit of account—can be transferred to the level of international money, as summarised in Table 1 (Cohen 1971; Kenen 1983). Under each function, there are examples of how official authorities and private sectors sometimes choose to use a major international currency that is not their own. These functions are distinct from each other, and their respective importance may vary somewhat depending on specific factors. For example, short-term changes in reserve holdings may be influenced by exchange rate and interest rate movements. However, in the longer term, the functions of an international currency are related and determined by more fundamental factors (see below).
Table 1: The International Use of a Currency
Official Use Private Use Medium of Exchange Vehicle currency for foreign
exchange intervention
Invoicing trade and financial transactions
Store of Value International reserves Currency substitution (dollarization) Unit of Account Anchor for pegging local
currency
Denominating trade and financial transaction
Full convertibility is required for a currency to play any significant role in international trade and financial transactions, but it is not a sufficient condition. The international use of a currency is ultimately determined by market forces. What follows briefly discusses four main economic determinants that are often listed in academic research and policy discussions (Lim 2006; Yam 2005, 2007; Eichengreen 2005; Mundell 1998; Talvas & Ozeki 1992; Tavlas 1991).
The size of the economy
International currencies are usually associated with large, competitive economies with far-reaching trade and financial ties. A large domestic economy allows exploitation and reinforcement of
economies of scale and scope involved in using a currency over a wider domain. A common measure of the size of an economy is the gross domestic product (GDP).
Based on times series estimates, Eichengreen and Frankel (1996) find that every one percent of GDP in the world total leads to 1.33 percent of central bank reserve holdings in the corresponding currency.
This is a point estimate rather than an average ratio, and it explains variations in the relative role of a currency such as the US dollar, but not its actual proportion.
However, cross-country evidence also confirms a positive relationship between the share of GDP in the world total and the share of central bank reserve holdings in the corresponding currency, although the relationship is likely to be nonlinear (Chinn
and Frankel 2005).
The economic size matters first through the share of the country in international trade.
Large scale trade activities usually generate a large market in foreign exchange transactions with at least one leg in the domestic currency. Also, well diversified economies can often rely on their own currency for settling transactions with non residents as they offer the latter a high density network of trading relationships potentially involving the same currency, thereby lowering foreign exchange transaction costs. Thus, economic size brings a de facto limitation of the convertibility of small economies’
currencies.
The economic size of the Euro area is close to that of the US, in terms of GDP as well as
population, and share in international trade.
Japan is the third largest, but is significantly smaller than the U.S. and the Euro area.
Mainland China is the fourth largest economy in terms of market exchange rate measured GDP, but is already the third largest by the measure of purchase power parity (PPP) based exchange rate and in terms of the volume of international trade (Table 2). As China is expected to grow faster than the other more developed economies, her economic weight in the world should continue to increase. Thus, as policy restrictions on the convertibility of the renminbi are increasingly lifted, it would be reasonable to expect the currency to play some role in international trade and finance, even though it is unlikely to challenge the position of US dollar and the euro in the foreseeable future.
Table 2: Currency Share of Reserve Holdings and Determinants: Some Indicators
US Euro Area UK Japan Switzerland Mainland
China
Hong Kong
SAR Date Currency Share in
Foreign Reserves (%)
64.2 26.1 4.5 3.1 0.2 N.A. N.A. Apr, 2007
Size of economy and financial market GDP
(US dollar, bn) 13,202 10,527 2,345 4,340 380 2,668 190 2006 GDP (PPP, bn) 11,651 8,700 1,845 3,737 244 7,642 212 2004 Foreign Trade
(US dollar, bn) 2,958 3,478 976 1,230 274 1,761 651 2006
Stock Market Capitalisation (US dollar, bn)
19,919 10,231 3,854 4,721 1,246 3,089 2,276 Aug, 2007
Government Bond Outstanding (US dollar, bn)
6,415 6,805 835 6,854 114 915 20 Mar, 2007
Foreign Exchange Turnover (Total = 200%)
86.3 37 15 16.5 6.8 0.5 2.8 Apr, 2007
M2 (US dollar, bn) 7,257 9,660 3,051 5,901 366 5,067 701 Jul, 2007
Monetary Stability 10-year Average
Inflation (%) 2.54 1.91 2.64 -0.06 0.82 0.88 -0.37 1997-2006 Exchange Rate
volatility 4.49 5.44 5.02 8.15 5.98 4.40 4.58 1997-2007 Average Annual
Appreciation of Exchange Rate against SDR (%)
-1.2 2.7 0.7 -0.4 1.4 -1.3 -0.8 1997-2007
Data Sources: World Bank, IMF, BIS, CEIC, Bloomberg, WEF and staff calculation.
Notes:
1. Government bond outstanding is the outstanding amount of international and domestic debt issued by the governments, and that for the Euro area does not include Luxembourg and Slovenia due to data limitation.
2. Exchange rate volatility is the annualised standard deviation of daily percentage change of the exchange rate against SDR over the 10-year period.
3. For the Euro/SDR exchange rate, the sample period is 1999-2007.
Size and development of financial markets Size also matters in terms of financial development, and international currencies are usually associated with large, liquid and open financial markets. Large and developed financial markets give access to more investment and borrowing opportunities and allow effective arbitrage owing to low transaction costs. In particular, a deep and liquid secondary market of a wide range of securities would attract international investors, including central banks to do asset allocation in their reserve management according to their risk, liquidity and return requirements. Such markets would offer a wide range of financial services, which can help international investors to effectively hedge currency risk and manage their portfolio more efficiently (Greenspan 2001).
Because of the limited size and underdevelopment of the market, it is sometimes more cost effective for some market participants to borrow or invest abroad in an international currency and then exchange the proceeds for domestic currency, rather than conduct the transaction directly at home.
The U.S. financial system is the most advanced one with deep and diversified financial markets, and with New York being a dominant financial centre. This is an important factor underlying the US dollar’s position as a reserve currency. The pound sterling used to be the world dominant reserve currency in the late 19th century and early 20th century, and Britain then had the world’s most developed financial system and London was the most important financial centre. The introduction of the euro has helped to integrate the financial markets within the euro area, and in particular, the euro area has seen a strong growth of the bond market. The development of China’s financial markets lags behind other major economies mainly in two ways. First, the domestic financial
markets are still subject to some restrictions including the remaining floors and ceilings on bank lending and deposit interest rates.
Second, the market is by large closed to international investors. However, important reform efforts are under way, and the rapid growth of the stock market and short-term corporate bond market in recent years had shown the potential for China to develop into one of the largest financial markets in the world in a not too distant future (see below).
Stable value of the currency
Confidence in the value of a currency is important for an international currency to be held as a store of value. Two possible indicators of currency stability are often considered. One is inflation, the higher the inflation, the bigger the loss in the purchasing power of the currency. Often, a measure of the inflation differential from the average of developed economies is taken to indicate the relative stability of a currency.
The other one is exchange rate volatility, which is often measured with reference to the SDR. The more volatile the exchange rate, the higher risk it is to hold reserves in that currency.
Over the past ten years, the average annual inflation rate in China is about 0.9%, which is much lower than that of 2.5% in the US, 1.9% in the Euro area and 2.6% in the UK.
Japan, on average, recorded a price decline during the period. The renminbi’s volatility against the SDR was close to that of the US dollar, and lower than that of the Euro, the British Pound and the Japanese yen. This of course reflects the relatively close link of the renminbi with the US dollar.
Overall, it is probably fair to say that the stability of the renminbi in both the domestic and external value has been comparable to other major currencies in the past decade, following relatively high
inflation and exchange rate depreciation in the earlier reform period.
Network externalities
It is often argued that once a currency becomes an international currency, this status is unlikely to be lost in a short period of time (Greenspan 2001). This can be explained by persistence and network externalities. An international currency is usually associated with a deep and flexible financial market, and a good market infrastructure brings loyalty. Market participants in general would like to stick to the platform that they know well as they have invested substantially over time to accumulate the knowledge of the platform.
Another factor that supports the currency status is network externalities. Once more market participants use a currency to conduct transactions, more people will find it convenient to use that currency. This becomes a reinforcing process, which generates positive network effect (Eichengreen 2005).
3. Data and Empirical Estimates 3.1 Data and stylised facts
Ideally the international use of a currency should be assessed on each of the functions listed in Table 1. The empirical analysis of this paper focuses on reserve currency holdings, as data are much more limited on indicators of the other international roles.
The assumption is that reserve currency holdings are a good proxy for the overall international role of a currency. While interest rate and exchange rate movements may have an impact on the currency allocation of central banks’ reserve holdings in the short run, in the longer term, the international roles of a currency tend to be related and jointly determined by more fundamental factors. There are economies of scope in this case. If a currency is widely used to invoice trade, it is more likely to be used to invoice financial
transactions. If it is used as a vehicle currency, it is more likely to be used as a currency to which smaller economies peg, and it is more likely to account for a larger share of reserves holdings by the central banks.
The data on reserve holdings are from the IMF Currency Composition of Foreign Exchange Reserves (COFER) database.
The currencies identified in the COFER data are the US dollar, euro, pound sterling, Japanese yen, Swiss franc, and a category of all “other currencies”. In September 2005, the IMF changed the way it reports the reserve data and released revised statistics extending back to 1995. The main change is to separate the total reserves into allocated reserves and unallocated reserves.
Because some member countries choose not to report the currency compositions of their foreign reserves, the IMF used to estimate the currency composition for these countries.
After the change, the IMF includes the reserves of these countries in a category called “unallocated reserves”, which is the difference between the total world reserves and “allocated reserves”. The share of allocated reserves in total world reserves is about 70%1. For our purpose, the currency composition of the allocated reserves is taken as the variable of reserve currency share.
This study uses quarterly data covering the period of 1999-2006. The relatively short sample period is dictated by the data break
1 All industrial countries report to COFER database, but some developing countries choose not to do so.
Thus, all the unallocated reserves are attributed to developing countries. Currently the allocated reserves account for about 52% of developing countries’ total reserves, and the ratio has been declining in recent years. This probably reflects that the foreign reserves of those developing countries choosing not to report to COFER databse have been increasing. Nevertheless, the allocated reserves still take up a majority share of the total reserves, and the currency shares of the allocated reserves for developing countries is similar to that of industrial countries.
due to the introduction of the euro in 1999.
In some way, this study is complementary to Chinn and Frankel (2005) who used annual data before 1999. It is noted that the reliability and accuracy of data on reserve currency shares should be much improved in recent years, as an increasing number of central banks have disclosed information on reserve holdings.
The determinant variables discussed above such as GDP and trade share, inflation differentials and exchange rate volatility are computed using data obtained mainly from the IMF International Financial Statistics (IFS), supplemented by the CEIC and Bloomberg. It is difficult to find a good measure of financial market development that covers all the aspects such as depth, breadth and efficiency of a market.
Several measures such as foreign exchange turnover, stock market capitalisation have been used in the literature (Chinn and Frankel 2005). This study makes use of the stock market capitalisation as a share of five major financial centres combined (New York, London, Tokyo, Euronext, and Zurich).2 It is expected that the stock market capitalisation would be positively related to the share of that market’s home currency in total world reserves. The data on stock market capitalisation is obtained from the World Federation of Exchanges (WEF).
As the sample period is short, there is a concern that variations in the data were too limited to derive a significant relationship using a regression analysis. Charts 1 and 2 show that reserve shares of the major currencies did have material changes over the eight years. The US dollar’s share fell from 71.1% to 65.6%, while that of the euro increased from 18.1% to 25.2%. The share of the British pound rose from 2.7% to 4.3%,
2 These are the major international financial centres, which correspond to the five major reserve currencies studied in this paper. The total market capitalisation of these five centres accounts for about 80% of the world total.
while that of the yen dropped from 6.0% to 3.2%.3 Overall, the increase in the share of the euro is mainly at the expense of the US dollar and the Japanese yen.
Chart 1: Reserve currencies shares:
U.S. dollar and euro
0 10 20 30 40 50 60 70 80
%
0 10 20 30 40 50 60 70 80
%
U.S. Dollar Euro
1999 2000 2001 2002 2003 2004 2005 2006
Chart 2: Reserve currencies shares:
British pound and Japanese yen
0 1 2 3 4 5 6 7
8 %
0 1 2 3 4 5 6 7
% 8
Pound Yen
1999 2000 2001 2002 2003 2004 2005 2006
Chart 3 plots the panel data points and shows that a higher reserve currency share is generally associated with a higher GDP share. It is often argued that reserve currency shares are not sensitive to changes in the determinant variables when the share is at a very low or a high level, reflecting the inertia or persistence feature noted above.
Only when the reserve currency share reaches a certain threshold level will changes in the determinant variables have a significant impact. To capture this “tipping phenomenon”, the logistic transformation of the reserve currency share is used in the literature (Chinn and Frankel 2005) 4 . Chart 4 plots the logistic transformation of the reserve currency share against the GDP
3 The Swiss franc’s share fell marginally and there was little change in the share of all other currencies.
4 The logistic transformation of reserve currency shareSis log(S/(1−S)).
share, which also shows a positive relationship.
Chart 3: Reserve currency share vs. GDP share
-10 0 10 20 30 40 50 60 70 80
0 5 10 15 20 25 30 35
GDP Share
Reserve Currency Share
%
%
Chart 4: Logistic transformation of reserve currency share vs. GDP share
-7 -6 -5 -4 -3 -2 -1 0 1 2
0 5 10 15 20 25 30 35
GDP Share
L-Share
%
Similarly, the reserve currency share and share of stock market capitalisation are also positively correlated (Charts 5 and 6).
Chart 5: Reserve currency share vs. market cap share
-10 0 10 20 30 40 50 60 70 80
0 10 20 30 40 50 60 70
Market Cap Share
Reserve Currency Share
%
%
Chart 6: Logistic transformation of reserve currency share vs. market cap share
-7 -6 -5 -4 -3 -2 -1 0 1 2
0 10 20 30 40 50 60 70
Market Cap Share
L-Share
%
The relationship between the reserve currency share and exchange rate volatility and inflation differential (with the average inflation in G-7 economies) is not obvious (Charts A1-4 in the Appendix). This suggests that exchange rate volatility and inflation differential are unlikely to be significant variables in explaining variations in reserve currency shares over time and across currencies in our sample. It probably reflects the limited variation in inflation and exchange rate volatility across currencies and over time during the short period. The logistic transformation of currency shares of reserve holdings seems to be positively correlated with the trade shares, but the relationship seems not as strong as that for the GDP share (Charts A5-6 in the Appendix).
3.2 The empirical model and estimation The empirical estimation follows closely the model used in Chinn and Frankel (2005).
That paper uses annual data from 1973 to 1998 to regress currency shares of reserve holdings on different combinations of explanatory variables, and finds that the share of GDP and inflation differential are statistically significant in explaining variations in the dependent variable.
The model to be estimated can be represented by the following equation
it it
it it
it it
i it
SHARE TRADE
VOL CAP
MARKET
INDIFF GDP
SHARE
ε β
β
β β
β β
α
+
− +
+
+ +
+ +
=
) 1 ( _
6 5
4 3
2
1 (1)
Where i refers to the different reserve currencies, including the US dollar, euro, Japanese yen, British pound and Swiss franc.
SHARE denotes a currency’s share in the total allocated world reserves. GDP and
CAP
MARKET _ are GDP share in the world total and the share of stock market capitalisation in the total of five financial centres respectively. INDIFFdenotes the difference between inflation in a currency and the average inflation of the G-7 economies. VOL is the annualised standard deviation of daily percentage change of the exchange rate of a currency against the SDR over the past five years.
TRADE denotes the share of international trade in the total world trade.5 The lagged dependent variable is included to capture the persistence effect, whereby the impact of shocks to the other explanatory variables accumulates in the equilibrium value of the dependent variable. To capture possible specific characteristics or conditions of each reserve currency, a cross section fixed effect model is used in the panel regression. It is expected that β1,β3,β5,β6 have positive signs and β2,β4 have negative signs.
The data are of quarterly frequency covering the period of 1999 Q1 to 2006 Q3.
As noted above, there might be a “tipping phenomenon” in changes in the currency shares of reserve holdings. To capture this non-linear relationship, the model is also estimated using the logistic transformation of the reserve share (LSHARE) as the dependent variable. Equations (2) and (3) are the final estimates obtained after dropping the insignificant variables from the preliminary estimates.
5 In calculating the share of the euro area’s trade in the world total, the intra-euro area trade is taken out in both the numerator and denominator, so that the definition of trade share is consistent with that for the other four currencies.
) 1 ( 910
. 0 _
044 . 0
080 . 0 001 . ˆ 0
) 00 . 0 ( )
00 . 0 (
) 01 . 0 ( ) 82 . 0 (
− +
+
+
−
=
SHARE CAP
MARKET
GDP RE
A
SH (2)
) 1 ( 912
. 0
935 . 0 365 . ˆ 0
) 00 . 0 (
) 03 . 0 ( ) 01 . 0 (
− +
+
−
= LSHARE
GDP ARE
H
LS (3)
The numbers in the parentheses are p-values of the estimated coefficients, and the equations are estimated over the mean of the fixed effects.
In the linear model, only the coefficients of GDP share, share of market capitalisation, and the lagged reserve share are statistically significant. In the nonlinear model, only GDP share and the lagged dependent variable turn out to be significant.6
The two models suggest that the size of the economy as measured by the share of GDP in the world total is more important than other fundamental variables in determining the currency shares of reserve holdings. In particular, the trade share variable is not significant, consistent with the results in Chinn and Frankel (2005). A possible explanation is that the GDP and trade shares are correlated and the former better captures the size effect.
The lagged dependent variable is significant and its estimated coefficient has a value of 0.9. This supports the hypothesis that the currency shares of reserve holdings tend to be persistent and a shock arising from say a change in GDP share leads to a change in the reserve share only gradually.
Specifically, our linear model estimates suggest that a rise in the GDP share by 1 percentage point would lead to an increase in the reserve currency share by 0.9
6 The use of the market exchange rate in calculating both the dependable variable and some explanatory variables such as GDP and market capitalisation shares may raise concern about endogeneity.
However, it is not necessary so since exchange rates do not enter the equation directly on the right hand side, see Chinn and Frankel (2005).
percentage point in the long run. But, it takes about 7 years for half of the impact to complete.
The share of stock market capitalisation is significant in the linear model but insignificant in the non-linear model. This probably reflects the difficulties in finding a good and comprehensive measure of the size of the financial market.7 To take our linear model estimates literally, an increase by 1 percentage point in the share of stock market capitalisation would raise the reserve currency share by 0.5 percentage point in the long run, and it takes about 7 years for half of the effect to complete.
Neither inflation differential nor exchange rate volatility is statistically significant, probably reflecting the short sample period.
In the long run, the stability in the value of a currency should be a significant factor affecting the international demand for the currency. In Chinn and Frankel (2005), inflation differential and exchange rate volatility are statistically significant in some of the regression models.8
3.2 Counterfactual exercise for the renminbi
Currently there are restrictions for renminbi capital account transactions, especially portfolio investment, although liberalisation measures have been taken through schemes of Qualified Domestic Institution Investors (QDII) and Qualified Foreign Institution Investors (QFII). If the renminbi were to be become fully convertible, some economies might choose to hold part of their foreign reserves in renminbi assets, especially those having close trade and
7 In Chinn and Frankel (2005), the foreign exchange turnover is used as the indicator of the financial market development. It turns out that only in one of the seven regressions it is statistically significant.
In our case, quarterly data on foreign exchange turnover are not available.
8 Chinn and Frankel (2005) tried the long run depreciation trend of the exchange rate against SDR and found it is insignificant.
investment ties with Mainland China. To gauge the potential significance of the renminbi as a reserve currency, we conduct a counterfactual simulation using the estimated models presented above.
Applying the current levels of China’s share of GDP (at the market exchange rate) in the world total and that of the stock market capitalisation in the total of the six markets, which is 5.6% for GDP and 3.5% for stock market capitalisation, the renminbi’s share in the world reserves would be about 5%
according to the linear model, and 3% based on the nonlinear model. The relatively low estimate from the non-linear model partly reflects the “tipping phenomenon” whereby the reserve currency share increases slowly when it is at a low level.
For comparison purposes, we calculated the potential reserve share of the renminbi using the estimated models in Chinn and Frankel (2005). Specifically, we employed two models presented in Table 1 and 2 in the appendix of that paper:
) 1 ( 956
. 0 028
. 0
071 . 0 098
. ˆ 0
) 00 . 0 ( )
16 . 0 (
) 17 . 0 ( )
02 . 0 (
− +
−
−
=
SHARE EXVOL
INFDIFF GDP
RE A
SH (4)
) 1 ( 879
. 0
445 . 0 565
. 1
285 . 2 506 . ˆ 0
) 00 . 0 (
) 34 . 0 ( )
09 . 0 (
) 00 . 0 ( ) 00 . 0 (
− +
−
−
+
−
=
LSHARE
EXVOL INFDIFF
GDP ARE
H LS
(5)
Where INFDIFF denotes inflation differential and EXVOL denotes exchange rate volatility. In the calculation for the share of renminbi, the differential of China’s average inflation over the past ten years from that of G-7 countries is used for INFDIFF , and the annualised standard deviation of the log first difference of the renminbi-SDR exchange rate over the past ten years is used for EXVOL. Equation (5) is the non-linear version of equation (4), using the logistic transformation of the reserve currency share as the dependable
variable. Chinn and Frankel (2005) use foreign exchange turnover to measure the size and development of financial market and it turns out to be significant in only one of the models. Considering that the foreign exchange turnover in the case of renminbi is limited by the restrictions on the capital account transactions, we choose the two models in which the foreign exchange turnover is not included.
Applying China’s data, the renminbi’s share in the world reserve holdings would be 12.7% according to the linear model and 4.4% based on the nonlinear model. Again, the non-linear model gives a lower estimate.
Overall, our estimates are broadly in line with the estimates derived from the models of Chinn and Frankel (2005). They suggest that the renminbi’s potential as a reserve currency would be comparable to the case of the Japanese yen and British pound should the renminbi become fully convertible today.9
4. Some policy considerations
It is perhaps not unreasonable to say that the renminbi has potential to play a role in international trade and investment transactions, owing to the large size of the Chinese economy. The limited convertibility of the renminbi and partial opening of China’s financial market are restrictive factors for the international role of the renminbi. The liberalisation of the restrictions on currency convertibility should of course obey the overall development and reform strategy, not necessarily for the purpose of promoting the international use of the renminbi, but a higher degree of currency convertibility may lead to an increased use of the renminbi in
9 Li and Liu (2007) use a similar approach and estimate an empirical model of reserve currency share using annual data from 1967 to 2004. Their simulation suggests that the renminbi would be the third major reserve currency behind the US dollar and euro in 20 years, assuming China’s rapid economic growth continues.
international transactions, which brings both benefits and risks.
Thus, the international role of the renminbi and the associated concerns would be part of the consideration by the authorities in determining the pace and form of attaining the capital account convertibility of the renminbi. As summarised in Table 3, the main benefits of an international role include increased business for domestic financial institutions, reduced transaction costs and avoiding of exchange rate risks for residents in conducting international trade and investment activities, and the ability of domestic institutions to issue foreign debt in the domestic currency at the prevailing interest rates. The risks are mainly associated with the external demand for renminbi assets, which may vary significantly over time, complicating the domestic monetary policy formulation and implementation (Hai 2007).
Table 3: Benefits and Risks of the International Use of Renminbi
Benefits Risks (1) Seignorage: foreign holdings
of renminbi are essentially low interest loans to China, and allow China to borrow in the international market in its own currency.
(1) Fluctuations in the international demand for the currency would complicate domestic monetary policy making by increasing exchange rate volatility under a flexible exchange rate regime and variations in the demand for money under a pegged exchange rate arrangement.
(2) Increase of business for
domestic financial institutions: the international
demand for renminbi assets would bring business for
domestic financial institutions, which are the
main sources of renminbi liquidity.
(2) Increase in the average demand of the currency. This in general will put appreciation pressure on the exchange rate, which is especially the case in an environment of strong expectations of renminbi appreciation.
(3) Avoiding exchange rate risk:
the use of its own currency in international trade and finance allows domestic residents to avoid exchange rate risk.
(3) Burden of responsibility: internationalisation of renminbi would increase China’s responsibility and obligations to maintain financial stability in the region, which would limit the freedom of using monetary policies for domestic objectives.
(4) Convenience and prestige:
an international currency will bring convenience and prestige for domestic residents.
It is beyond the scope of this paper to provide a comprehensive analysis of the policy considerations in relation to the process of potential internationalisation of the renminbi. Drawing on the international experiences, three issues are considered here, namely the implications of an international role of the renminbi for domestic monetary policy, the relationship between currency internationalisation and domestic financial market development, and the importance of promoting regional integration and cooperation in trade and finance.
Domestic monetary policy
The implication for domestic monetary policy is often cited as the main reason for caution in promoting or facilitating an international role of the renminbi. There are two concerns. One is related to the volatility of the international demand for the
renminbi which complicates the central bank’s task in assessing monetary conditions and pursuing domestic monetary stability objectives. Furthermore, considering the general market expectation of renminbi appreciation, an increase in the access of international investors to renminbi assets could lead to a trend of increasing demand for the currency, exacerbating the appreciation pressure on the currency.
However, there is potentially an offsetting force. As renminbi becomes increasingly convertible, domestic investors may move part of their assets out of China for diversification purpose.
In this respect, it is interesting to look at the experiences of Japan and Germany. For many years leading up to the mid-1970s, the Japanese monetary authorities attempted to discourage the international use of the yen for concern that extensive foreign holdings
of their currency would reduce their degree of control over money supply and would increase the variability of the exchange rate (Tavlas and Ozeki 1992). Similarly, between the late 1960s and early 1980s, the Bundesbank attempted to limit the international use of the deutsche mark for fear that substantial swings in capital flows could interfere with domestic stabilisation (Tavlas 1991; Thimann 2007). The measures that the Bundesbank took were to control the capital inflows, such as restrictions over the issue of Deutsche mark obligations in the external bond market and international money market. Indeed, it is argued that the non-internationalisation policies pursued by the German and Japanese authorities partly explain the persistence of the dominant US dollar position despite the increased importance of Japan and Germany in the world economy (Eichengreen 2005).
In China’s case, the limited variation in the renminbi’s exchange rate against the US dollar and the early stage of the development of the financial market are probably the main factors that explain the concern on the potential destabilising effect of the external demand for the renminbi on domestic monetary conditions. However, the increasing exchange rate flexibility and the progress of interest rate deregulation and financial sector development and reform should increase the domestic economy’s resilience to external shocks over time.
Fianancial market development
This leads to the issue of the relationship between financial market development and an international role of the renminbi. In general, a large and developed financial market increases the capacity of the domestic economy in buffering against shocks arising from the varying external demand for the domestic currency. Thus, limitations in the domestic market are often taken as a risk factor in capital account opening and international use of the
domestic currency. On the other hand, an increasing use of the domestic currency for conducting international trade and investment activities would increase the depth and breadth of the financial market by drawing more market participants and increasing linkages with the international market. In considering the balance of pros and cons of an international currency, one should not only focus on the risk to the domestic financial market and understate the potential benefits.
Also, as the size of financial market increases, the influence of the financial sector on policy making would rise, with pressures for liberalisation measures to improve efficiency, including opening to the international market. After all, it is the financial sector that would benefit most from an international role of the domestic currency.
The experiences of Germany and Japan are again enlightening in this respect. In Japan, the large government budget deficits contributed to a rapid growth of the primary and secondary bond markets in the 1970s, which leads to pressures from the financial community for improvement in the efficiency in the financial market.
Beginning in the late 1970s, financial liberalisation measures were implemented, leading to development of new instruments and deregulated interest rates. In May 1984, a new phase began with the release of a report by the Yen-Dollar Committee and an accompanying report by the Ministry of Finance entitled “Current Status and Future Prospects for the liberalisation of Financial and Capital Markets and the Internalisation of the Yen”. These two documents noted the importance of financial liberalisation and internationalisation of the yen to the Japanese economy, and proposed reform measures to liberalise the international transaction of yen. The process of deutsche mark internationalisation was similar. By the mid-1980s, the Bundesbank’s position had changed
substantially, partly because German financial markets had developed markedly and were better insulated from external disturbances. It acknowledged the difficulty of inhibiting the operation of market forces underlying the demand for assets denominated in the deutsche mark.
Consequently, most restrictions on the issuance of foreign deutsche mark bonds were lifted.
China’s financial market has been growing rapidly in recent years, accompanied by significant progress of the financial sector reform including the listing of the major commercial banks. The A-share market has recorded a strong rally and as of September 2007, the stock market capitalisation increased by 4.6 times from January 2004. This year, the A-share market is likely to become one of the largest IPO fund raising centres in the world. The share redesignation reform has been largely completed, removing the previous concern on the overhang of the state holdings of non-tradable shares and improving corporate governance by better aligning the interests of majority and minority share holders. Helped by strong economic growth and abundant liquidity, the bond market has also seen strong growth, particularly in short-term commercial papers.
By the end of 2006, the total outstanding amount of bonds reached 44% of GDP.
The authorities have released this year new and much liberalised regulations on the issuing of corporate bonds, paving the way for rapid growth of the corporate bond market.
In the process of financial market development and liberalisation, China has a unique advantage when compared with other economies. Under the “one country, two systems” arrangement, China has Hong Kong, a developed and highly open international financial centre. Hong Kong is in an ideal position to develop a renminbi market outside the Mainland, which provides a testing ground for the
international use of the renminbi. This can be achieved by expanding the scope of the renminbi business in Hong Kong in terms of participants, products and services. There is also an increasing recognition of the need to strengthen market linkages between Hong Kong and the Mainland. Recent initiatives include expanded scope for the qualified domestic institutional investors (QDII) scheme and the announced pilot scheme of allowing Mainland investors to invest directly in Hong Kong listed securities.
There are discussions of arrangements under which Hong Kong listed instruments can be traded on the Mainland market and even talks of listing and trading renminbi denominated shares in the Hong Kong Stock Exchange. All these will foster the integration of the two markets over time, and a larger and more liquid financial market of China would provide a solid base for the renminbi to play an international role.
Already, combing the Hong Kong and Mainland stock markets, the total capitalisation exceeds that of Japan and is the largest in Asia.
Regional integration and cooperation Finally, it is important to promote financial integration and cooperation in the region, as an international role of the renminbi starts with the use of the currency for conducting trade and investment activities in the Asian region (Yu and Gao 2007), Wu 2007). If the emergence of the euro can be considered as an extension of the internationalisation of the deutsche mark, the mark internationalisation is clearly more successful than the Japanese yen. This is in no small part owing to the cooperative arrangement within Europe. The stable value of the mark and the relatively large size of the economy had led to the use of the mark as the currency peg in the EMS before the euro was launched. In contrast, the yen experienced large swings in its exchange rate against the US dollar in the past decades while most of the Asian currencies maintained some form of a link to the US
dollar, leading to stabilising effects on the Asian economies and hurting the regional use of the yen.
China has extensive trade and investment with the regional economies (Table 4).
Financial integration and cooperation on arrangements that may prevent large swings in the exchange rates among the Asian currencies are beneficial to all economies in the region. The exchange rates of most Asian currencies have become more flexible
against the US dollar. Indeed, following the renminbi exchange rate reform in July 2005, there are signs that the renminbi has had an increasing influence on the exchange rates of the other Asian currencies (Shu et al 2007). As the renminbi’s exchange rate becomes more flexible and China’s economic links with the region grow further over time, there would be increasing need to strengthen the regional cooperation in trade and financial issues.
Table 4: Trade Linkages in the Asian Region (in percent, as of 2006)
China Japan South Korea ASEAN Hong Kong Group Total
Mainland China 11.8 7.6 9.1 9.4 38.0
Japan 17.2 6.3 12.8 3.1 39.5
South Korea 20.1 12.4 10.3 3.3 46.1
ASEAN 10.0 11.2 4.3 4.4 29.8
Hong Kong SAR 46.4 7.7 3.4 9.5 67.0
Sources: IMF Direction of Trade Statistics, HKMA staff calculation
Note: The recording economies are in the first column. For example, the numbers in the first row are the shares of trade with other Asian economies in China's total trade as recorded by China.
5. Concluding remarks
This paper assesses the potential significance of the renminbi as an international currency by drawing on the experiences of the other major currencies.
Built on the study of Chinn and Frankel (2005), we first estimate an empirical relationship between currency shares of reserve holdings and main determinants such as the economic size of the issuing country using data on five major reserve currencies. The empirical result shows that the size of the economy including market development and persistence and network- externality effects are the key determinants for a currency’s share in the world reserves in our sample. Using the empirical relationship, a simulation is conducted to gauge the potential share of the renminbi in the total world reserves if it were to become fully convertible today. According to the linear model, the renminbi’s share in the total world reserves would be 5%.
According to the non-linear model, the renminbi’s share would be 3%. These results suggest that at present the renminbi’s potential as a reserve currency would be comparable to that of the Japanese yen and British pound.
Whether the renminbi realises its potential
as an international currency that is in line with the size of the Chinese economy will be a market choice. Government policies in financial liberalisation and currency convertibility could facilitate or inhibit the process. In this respect, the authorities need to weigh the benefits and risks associated with an international role of the renminbi in policy formulation and implementation. As the size of the economy and financial market increases and the monetary policy framework including exchange rate flexibility becomes more firmly established, the benefits should increasingly dominate costs. Overall, the international role of the renminbi and the associated benefits and costs should be part of policy considerations on the pace and form of attaining capital account convertibility for the currency.
Hong Kong, being an international financial centre, can play a significant role in the development and opening up of the Mainland financial market. Indeed, the renminbi business in Hong Kong provides a useful testing ground for the expanded use of the renminbi in the region. In the long run, an integrated and much larger financial market that includes both the Mainland and Hong Kong markets would help to promote the international role of the renminbi.
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About the Author
Wensheng Peng is division head, Hongyi Chen is senior manager in the External Department. They thank Rina Suo and Brian Ng for research assistances. This paper benefits from the useful comments by Eswar Prasad, Hans Genbery, Julia Leung and other participants at a conference on
“Currency Internationalization: International Experiences and Implications for the Renminbi”, organized by the Hong Kong Institute of Monetary Research on 15-16 October, 2007. The authors are responsible for the views expressed in this article and any errors.
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Appendix:
Chart A1: Reserve currency share vs. exchange rate volatility
0 10 20 30 40 50 60 70 80
40 50 60 70 80 90 100 110 120
Exchange Rate Volatility
Reserve Currency Share
%
%
Chart A2: Logistic transformation of reserve currency share vs. exchange rate volatility
-7 -6 -5 -4 -3 -2 -1 0 1 2
40 50 60 70 80 90 100 110 120
Exchange Rate Volatility
L-Share
%
Chart A3: Reserve currency share vs. inflation differential
0 10 20 30 40 50 60 70 80
-4 -3 -2 -1 0 1 2
Inflation Differential
Reserve Currency Share
%
%
Chart A4: Logistic transformation of reserve currency share vs. inflation differential
-7 -6 -5 -4 -3 -2 -1 0 1
-4 -3 -2 -1 0 1 2
Inflation Differential
L-Share
%
Chart A5: Reserve currency share vs. trade share
0 10 20 30 40 50 60 70 80
0 2 4 6 8 10 12 14 16 18 20
Trade Share
Reserve Currency Share
%
%
Chart A6: Logistic transformation of reserve currency share vs. trade share
-7 -6 -5 -4 -3 -2 -1 0 1 2
0 2 4 6 8 10 12 14 16 18 20
Trade Share
L-Share
%
