Can the renminbi displace the dollar as the world’s international money?
Writing in the FT last week, Arvind Subramanian argues that, “sooner than almost anyone thinks,” the renminbi will begin to take the dollar’s place in that role.
[T]he renminbi could displace the dollar as the premier, reserve currency within the next decade or soon thereafter. Sceptics will scoff for two reasons.
First, even if China’s economy overtakes America’s, the renminbi’s rise could be delayed…
Second, China is far from creating the policy and market environment for the renminbi to become a reserve currency. China’s capital account is still largely closed…
In other words, loyalty to the dollar and China’s lack of the policy prerequisities seem to make the renminbi’s rise a distant possibility.
Count me with the skeptics, though I do not scoff: the question is laden with difficult economics, not to mention politics, and no simple outcome is likely. In his newsletter, Michael Pettis responds to Subramanian that, first, growing RMB deposits in Hong Kong are more likely to be an attractive one-way bet on appreciation than reserve diversification; and second, that a widespread move from dollar reserve holdings into RMB would have to be absorbed on the balance sheet of the PBoC, adding to pressure on China’s exchange rate and growth model.
I agree with Pettis, but my focus is distinct enough that it warrants being spelled out.
To answer a question about money one should start with banks, since a bank is an entity whose liabilities are money. A successful bank must make a liquid two-way market in those liabilities. Insured checkable deposits do the trick for transactions at the retail level, and our collective willingness to depend on them is a measure of banks’ success in market-making. Liquidity is ensured because there are liquid markets for USD assets that banks can buy and sell as needed to manage their balance sheets.
At the interbank level, reserves at the Fed do the trick, and monetary policy during normal times helps ensure that this market also remains liquid. This in turn supports liquidity at the retail level, since reserves are what is needed to clear those transactions.
International money, in turn, needs an international “bank”. The dollar is international money because the US financial system, as international bank, makes a global, liquid, two-way market in dollar liabilities. The Fed helps ensure this in normal times, by ensuring the liquidity of the market for US Treasuries, and in crisis times, by supplying dollar liquidity outside the US via swap lines with other central banks.
The eurodollar market achieves this for the USD by allowing non-US entities to take dollar deposits. Correspondent balances with banks in the US ensure that the connection back to the US is maintained. The consequence is that every dollar, domestic or international, is an obligation of the US financial system. These circulate as money because of the world’s volume of dealings with the US, and because the liquidity of the market makes it a good choice, even in dealings between third parties.
What would be needed for China to take on this role? For China to allow international banking in RMB would not just require liberalization of the financial sector and of the capital account, as Subramanian seems to suggest. It would also test the capacity of the Chinese financial system to make a worldwide liquid market in its own liabilities. This system, in aggregate, would have to buy and sell RMB deposits to all comers, giving up a measure of control over its own balance sheet. Liquid RMB asset markets would also be needed to support deposit-market liquidity.
China could do this with only limited capital-account opening, but it would mean at least allowing the creation of something like a eurorenminbi, which Chinese banks would need to be able to freely create and destroy as they accept and extinguish RMB liabities. Aside from its being a linguistic abomination, the eurorenminbi would be many steps beyond the limited liberalization China has already permitted. The alternative would be onshore RMB deposits, which seems even less likely.
Least likely of all is the prospect of the PBoC as RMB lender of last resort. Only the PBoC can create the highest-powered RMB liabilities, and so only it could resolve a major liquidity crisis in RMB. In the depths of the crisis in 2008, and now again in the depths of the eurozone crisis, the Fed has backed the dollar. It is not easy to pitcture the PBoC doing the same.
My reading of this situation could be mistaken; perhaps liquid markets for RMB deposits in Hong Kong and London can be developed quickly and with limited flexibility on the part of Chinese policymakers. I doubt it, but either way, let us understand the issue—if China wants to be bank of the world, it will have to become a market-maker, and be willing to do all that is necessary to keep that market running.