The Rise of the Renminbi as International Currency: Historical Precedents
All of a sudden, the renminbi is being touted as the next big international currency. Just in the last year or two, the Chinese currency has begun to internationalize along a number of dimensions. RMB bank desposits are now available in Hong Kong. A RMB bond market has grown rapidly there as well, with the issuers including major multinationals such as McDonald’s. Some of China’s international trade is now invoiced in the currency. Foreign central banks have been able to hold RMB since August 2010, with Malaysia going first.
Some are now claiming that the renminbi could overtake the dollar for the number one slot in the international currency rankings within a decade (especially Subramanian 2011a, p.19; 2011b). The basis of this prediction is, first, the likelihood that the Chinese economy will surpass the US economy in size and, second, the historical precedent when the dollar overtook the pound sterling as the number one international currency during the period after World War I.
It used to be thought that international currency status was subject to much inertia (e.g., Krugman, 1984). There was said to have been a long lag between the date when the US economy had passed the UK economy with respect to size (1872, by the criterion of GNP) and the time when the dollar had passed the pound (1946, by the criterion of shares in central banks’ holdings of reserves).
The “new view,” represented in particular by Eichengreen (2011) and Eichengreen and Flandreau (2010), is that the lag was in fact rather short. It took until World War I for the dollar to fulfill the criteria of an international currency. Furthermore, the date when the dollar is said to have challenged the pound in importance has now been moved up to the mid-1920s. The first point is right. If trade is the measure of size, the US first caught up with the UK during World War I. The US did not even have a permanent central bank until 1913. The other important criteria came soon thereafter: creditor status for the country; the perceived prospects for the currency to remain strong in value; and deep, liquid, open financial markets. (I have discussed the criteria in earlier papers. Chinn and Frankel, 2007, evaluate them econometrically and give further references.) The second point seems a matter of whether or not one wants to distinguish between the concept of “coming to rival” / “catching up with” the pound (1920s) versus the phenomenon of definitively “pulling ahead” / “displacing” the pound (1945). Under either interpretation, the dollar’s initial rise as an international currency was indeed rapid, once the conditions were in place.
The dollar is one of three national currencies to have attained international status during the 20th century. The other two were the yen and the mark, which became major international currencies after the breakup of the Bretton Woods system in 1971-73. (The euro, of course, did so after 1999.) In the early 1990s, both were spoken of as potential rivals of the dollar for the number one slot. It is easy to forget it now, because Japan’s relative role has diminished since then and the mark has been superseded. In retrospect, the two currencies’ shares in central bank reserves peaked as the 1990s began.
The current RMB phenomenon differs in an interesting way from the historical circumstances of the rise of the three earlier currencies. The Chinese government is actively promoting the international use of its currency. Neither Germany nor Japan, nor even the US, did that, at least not at first. In all three cases, export interests, who stood to lose competitiveness if international demand for the currency were to rise, were much stronger than the financial sector, which might have supported internationalization. One would expect the same fears of a stronger currency and its effects on manufacturing exports to dominate the calculations in China.
In the case of the mark and yen after 1973, internationalization came despite the reluctance of the German and Japanese governments. In the case of the United States after 1914, a tiny elite promoted internationalization of the dollar despite the indifference or hostility to such a project in the nation at large. These individuals, led by Benjamin Strong, the first president of the New York Fed, were the same ones who had conspired in 1910 to establish the Federal Reserve in the first place.
It is not yet clear that China’s new enthusiasm for internationalizing its currency includes a willingness to end financial repression in the domestic financial system, remove cross-border capital controls, and allow the RMB to appreciate, thus helping to shift the economy away from its export-dependence. Perhaps a small elite will be able to accomplish these things, in the way that Strong did a century earlier. But so far the government is only promoting international use of the RMB offshore, walled off from the domestic financial system. That will not be enough to do it.
[This RIETIperspectives note summarizes the argument in "Historical Precedents for the Internationalization of the RMB," a paper that I have written for a workshop directed by Sebastian Mallaby, for the Council on Foreign Relations and the China Development Research Foundation.]
Chinn, Menzie, and Jeffrey Frankel, 2007, “Will the Euro Eventually Surpass the Dollar as Leading International Reserve Currency?” in G7 Current Account Imbalances: Sustainability and Adjustment, edited by Richard Clarida (University of Chicago Press).
Eichengreen, Barry, 2011, Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System (Oxford University Press).
Eichengreen, Barry, and Marc Flandreau, 2010, “The Federal Reserve, the Bank of England and the Rise of the Dollar as an International Currency, 1914-39,” BIS WP no. 328, Nov.
Eichengreen, Barry, and Jeffrey Frankel, 1996, “The SDR, Reserve Currencies, and the Future of the International Monetary System,” in The Future of the SDR in Light of Changes in the International Financial System, edited by M. Mussa, J. Boughton, and P. Isard (International Monetary Fund).
Krugman, Paul, 1984, “The International Role of the Dollar: Theory and Prospect,” in Exchange Rate Theory and Practice, edited by J. Bilson and R. Marston (University of Chicago Press), 261-78.
Subramanian, Arvind, 2011a, “Renminbi Rules: The Conditional Imminence of the Reserve Currency Transition,” (Petersen Institute for International Economics), September.
Subramanian, Arvind, 2011b , Eclipse: Living in the Shadow of China’s Economic Dominance (Petersen Institute for International Economics), September.