Sunday, November 23, 2014
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The Renminbi Challenge

SEOUL – Last month, China unveiled its first aircraft carrier, and is gearing up to challenge the United States in the South China Sea. By initiating a plan to internationalize its currency, China is similarly seeking to challenge the dollar on the international stage.

In carving out a global role for the renminbi, Chinese policymakers are proceeding deliberately. In the words of the venerable Chinese proverb, they are “feeling for the stones while crossing the river.”

The authorities’ first step was to authorize Chinese companies to use the renminbi in cross-border trade settlements. As foreign firms exporting to China accepted payment in renminbi, the currency piled up in their bank accounts in Hong Kong. That led to the next step: Foreign firms wishing to invest in China were allowed to tap those deposits by issuing renminbi-denominated bonds, and eligible offshore financial institutions were permitted to invest renminbi funds in China’s interbank bond market.

Then, last summer, China announced plans to allow banks in Hong Kong to lend renminbi to companies in Shenzhen, opening that city financially to the rest of the world. The expectation is that if financial opening works in Shenzhen, it will be implemented more widely.

Finally, as a step toward making the renminbi a reserve currency, China signed currency-swap agreements with the Philippines, South Korea, Japan, and Australia. Meanwhile, Malaysia, Nigeria, and Chile have already acquired modest amounts of renminbi reserves. Other central banks are expected to follow.

So, will China’s plan for transforming the renminbi into an international rival to the dollar succeed?

The answer, in my view, turns on how China addresses four challenges. First, China will have to build more liquid financial markets. Its bond markets remain small, and trading volume is low, because the majority of bonds are held to maturity by domestic investors. This is a matter of considerable importance to central banks, which value liquidity when deciding which currencies to hold as reserve. After all, it is the liquidity of US Treasury bonds that makes them the world’s leading reserve asset.

Second, much will depend on how China navigates the transition to a more open capital account. History is littered with financial crises occurring in the wake of precipitous capital-account liberalization. Falling prey to a crisis would not exactly encourage international use of China’s currency.

Third, the renminbi’s international and reserve-currency prospects will be shaped by how China handles its growth slowdown. The key will be whether it manages a smooth deceleration, in which case renminbi internationalization will proceed, or suffers a hard landing, in which case social unrest will intensify and all bets are off.

The last challenge can be stated as a question that is rarely posed: Is China’s political system an obstacle to renminbi internationalization?

The pound sterling and the dollar, the principal international and reserve currencies of the nineteenth and twentieth centuries respectively, were issued by democracies. Britain and the US had contested elections and political systems that limited the arbitrary exercise of executive power – institutions that are absent in China’s political system.

One reason why democracy might matter for international currency status is that democratically elected governments are best able to make the credible commitments needed to develop deep and liquid financial markets. They can commit not to expropriate creditors, since the latter will vote them out of office if they do. And the same respect for creditor rights that reassures domestic investors reassures foreign investors – both official and private – as well.

Might it be possible for China to establish limits on arbitrary executive power and strengthen creditor rights sufficiently without undertaking a full-fledged transition to democracy?

Until now, constraints on decision-making by the general secretary of the Chinese Communist Party, the country’s highest-ranking official, have been – how to put it politely? – limited. But that is beginning to change. The general secretary is increasingly constrained by the CCP’s other institutions. The deliberations of the National People’s Congress, for example, are becoming less ceremonial and more substantive.

Other bureaucratic decision makers, for their part, are increasingly constrained by requirements of transparency and disclosure. Internet-based movements are forcing Chinese policymakers to strengthen labor and environmental standards. Why not creditor rights?

Since the early nineteenth century, the leading international currencies have been those of countries with democratic political systems, where arbitrary official action is constrained and creditors are well represented. This does not imply that China must have a Democratic Spring before the renminbi becomes a leading international and reserve currency. But it does suggest that it will have to strengthen the powers of the National People’s Congress further and create a more transparent rules-based bureaucracy in order to achieve its monetary goals.

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    1. CommentedHenry Chan

      China's market has three different interest level. The first level is the bank deposit formal layer which is the one most people are familiar with. The second is the shadow banking entrusted loan or wealth management product,this sector is run by the bank and the interest rate is more than double the first layer's. The third is private Wenzhou sector whose interest rate is again double the second layer. Until China work out a structure to handle this problem, it is difficult to open capital account. The risk of arbitrage disruption is simply to great.

    2. CommentedJonathan Lam

      Gamesmith94134: Turning from green to red

      I agree with Jean Michel’s concept on how many believe how currencies should apply in term of throw weight and its balance to values that each currency must sustain a liquid flow. In addition, I also admire Strictly Speaking’s idea on the Forex that we are facing with the safe heaven and how Kyat Dronein reply to Strictly speaking. Their dialogues are the heart of the issues we must identify with how we manipulated the Forex which how we erred the currencies exchanges that we got lost in our financial disciplinary principle. Then, the exchange rate on Forex is now being challenge, and the shift to greenback to redback may not be a myth if we are loitering in the stages on deleveraging on the credits both US and Euro extended and we are under the attack of the “dirty flow”.
      First, we believed safe heaven is no longer sustainable in balance since the “dirty flow” turned into “dirty float” in a sense how we created credits and bubbles in the equity world.

      Secondly, the throw weight relatively apply to how currency are being pegged may not materialize as expected; instead, it turned into bubble in stock or capital goods that is not being supported by the local populace, it went havoc or haywire as inflation or deflation that its output is becoming deficit or deflation that its capital good is not relevant or equitably challenged.

      Thirdly, the time frame that many financial establishment like central bank or government policies are not synch with reality, in a word, their assumption to growth or restraints are not affordable.

      “At what rate will the US dollar flow back to the US? This will depend on the rate at which the Chinese Yuan will replace the US dollar for international trade. If the rate of replacement is 5 trillion dollars per year, then it means that every year the US will have to export 5 trillion dollars of products in return for the 5 trillion dollars paper money. The big question is: will the US have the capacity to produce 5 trillion dollars of products per year more than it will consume? Or, will this break the US economy.” By Jean Michel.

      It is a serious question on how EQ III may have deleverage on credit that dollar can carry but how much we will recover through growth and balance in the reality on the throw weight system and what kind of time frame the current Central banks can initiate a better future for the next generations.

      Perhaps, we must rethink how the dirty flow becoming dirty floats that inflation is under its containment of deleverage and low rates. It is the moment to reconstruct our premise of our financial world, the shift of the Red Back to the third currency by our IMF’s throw weight system; and how we can stabilize the exchange rates that are relatively comply to its output instead of credit or how we are pegged to the performance of the local economy after the clearance of the zombie bank and rouge traders and reorganize the debts that are being deleveraged.
      As an American, I was flabbergasted at the home of mine that fell to $320,000 in 2007, and it jumped to $520,000 today; while the per capita also fell from $49,000 to $46,000; and I do not even making half of it. Luckily, I do not have a son or daughter graduating from college, but I am worrying of those have children. If they must pay 40% of their earning for their rent or return home with their parents to survive, we are facing inflation that is silenced by our policies to bloom or bubble.

      Can America absorb the shock in devaluation of dollar or anemic growth over a period of time that surpass the time frame in competing with the growth from the emerging market nation or underdeveloped nations that the throw weight system is no longer relevant. Diasporas? Chinese Red Back becomes the dominated change on our present system that credit turn into deficits if we must sustain inflation, or return of inflation like 80’s in its devaluation of dollar. It is a imperil ride on the buckeroo for the global economy.

      God bless America.

      May the Buddha bless you?

    3. CommentedMichael Heng

      The recent history of the greenback that democracy does not guarantee that it can preserve its value as a reserve currency. Look at how its value has been falling vis-a-vis the Yen, Australia dollar, and Singapore dollar. Democracy is certainly better than autocracy in many ways. But is there a connection between democracy and the role of renmenbi as a reserve currency?
      Currency control has more advantages than we may be taught to believe. Had China and India allowed free flow of their capital, they would have had big problems during the recent global financial crisis.
      If the US had currency control, the few rounds of quantitative easing might have worked much better. Instead the money has moved to the emerging economies as speculative capital to blow real estate bubbles.

    4. CommentedStefan Siewert

      The development is amazing, China continues to integrate into the world of finance too. But, it is a big but, the real challenge is the necessary change of the growth model. China has a very successful growth path for the last 30 years. People and leaders are used to the export- and capital-led growth and its high rates. Somewhere in the near or far away future this will change. And it will be an outstanding stress test. Developed countries have much more experience and capacities in this, for them the growth model has changed several times, which decrease the costs of change substantially for the elites and the population. As the Euro crisis proves, it nevertheless put the political consensus to the limit. Thus I have serous doubt that a linear integration of the Renminbi will be possible.

    5. CommentedFrank O'Callaghan

      Professor Eichengreen says: "Internet-based movements are forcing Chinese policymakers to strengthen labor and environmental standards. Why not creditor rights?"

      Priorities?

        CommentedJakub Słowiński

        Yes, maybe they are, but they are not direct creditors, so I don't see your point. In Europe the cash banks have to do the lending is from individuals, too. Rights of creditors means rights of banks and other financial institutions. Labor field touches society more directly, so is the environmental issue. I agree with Mr O'Callaghan

        CommentedSiddhartha Gadgil

        One should remember that creditors in Asia are mostly individuals saving for their retirement.

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