Global adoption of a currency typically reflects the economic strength of its issuing country. Despite China’s commanding role in international trade and massive domestic market, alternative world currencies still compose approximately 98% of total global payments, while the RMB is rarely used outside of China as a vehicle currency for trade and investment. With this marked of a discrepancy, there must be more than market factors at play.
Without sufficiently robust regulatory frameworks, China’s transformation from an isolated state-owned economic system into a largely market-driven economy has exposed China to potential market shocks via large capital influxes and currency instability. Cognizant of the risks in acting too quickly to internationalize its currency, China has been slow in its approach to open the country’s capital account and allow the currency to freely float. Nonetheless, Beijing has recognized the geopolitical and economic benefits inherent in global currencies and adopted a gradualist approach to RMB internationalization by slowly juggling all three facets of economic policy. The government has attempted to thwart the “impossible trinity” by maintaining control over its currency exchange, retaining numerous capital controls, and managing monetary policy; however, to fully realize its ambitions of commanding a globally accepted currency, China will have to commit a step towards one side of the triangle.
China’s “Impossible Trinity”
The “impossible trinity” stipulates that no open economy can simultaneously allow free capital mobility, manage currency exchange rates, and set independent monetary policy. Imagine a country with free capital movement and a currency pegged to the USD, implying a managed exchange rate. If its central bank attempts to control monetary policy and sets interest rates above US Federal Reserve rates, assuming efficient markets, investors would recognize the arbitrage opportunity and flood the country’s bond and savings markets with investment. The influx of capital would put upward pressure on the currency and eventually break its peg to the USD. Similarly, should the central bank cut rates, the currency would face downward pressure. In this case, if the country wants the value of its currency to remain pegged to the USD, it must close its markets to global capital flows.
In response to international requests, China transitioned from a loose USD peg to a managed-float currency regime in 2005. This uncommon system involves a basis value pegged to a basket of international currencies and allows the RMB to float within a narrow band – permitting for no more than 2% appreciation or depreciation throughout a trading day. The managed float allowed for a relatively wider range of volatility and, as a result, opened China to a gradual increase in capital account exposure. However, China remains hesitant to let the RMB fully float due to concerns that an open currency market would limit the PBOC’s ability to intervene in times of economic crises.
To pare the unwillingness to float its currency, China has liberalized capital flows within certain industries while still maintaining relatively strict controls. In 2020 alone, China opened its life insurance, securities, and mutual fund industries to full foreign ownership and, following the onset of the coronavirus pandemic, scrapped investment limits for qualified foreign investors within the Qualified Foreign Institutional Investor (QFII) program and its RMB-based counterpart (RQFII) – two initiatives that govern foreign investor access to domestic equity and bond markets.
Nevertheless, Chinese capital controls remain strict. China maintains a negative list through the Foreign Investment Law (FIL), which outlines the industries that prohibit full (and oftentimes partial) foreign venture ownership and investment. Furthermore, while the investment limits under the RQFII and QFII were removed, China continues to bar investment in commodities and futures, initial public offerings, and private investment funds. The outlook for outbound flows is similarly constrained, with Chinese citizens limited to no more than US$50,000 equivalent of currency exchange each year and institutional investors subject to lengthy and bureaucratic approval processes for outbound investments directed towards non-developed regions or over the amount of US$300 million.
To maintain autonomy over monetary policy, China has decided to slowly ease controls on its currency exchange regime and gradually open capital accounts; however, China’s decision to attempt to thwart the “trilemma” and pursue its ambitions for a global currency merits a discussion on the inherent benefits and costs of RMB internationalization.
The RMB: Benefits of Internationalization
Navigating the ‘Dollar Trap’
Foreign exchange reserves are imperative for maintaining a floating currency’s value, offering liquidity to importers and exporters, and providing investor confidence.
Since its accession to the World Trade Organization in 2001, China has amassed the world’s largest foreign exchange reserves. WTO membership drove foreign direct investment while Beijing has historically strategically purchased large quantities of USD for RMB devaluation purposes. All the while, a natural USD surplus due to the imbalance between USD-denominated trade inflows and restricted outbound capital flows have contributed to a substantial foreign exchange reserve. In June 2014, Chinese foreign exchange reserves peaked at over US$4 trillion and currently sit at US$3.061 trillion as of March 2020.
In 2019, China set precedent by releasing its historical forex reserve composition. The report outlined that, following a buying spree in 2005, USD accounted for nearly 80% of China’s total foreign exchange reserves. At the reserve’s peak total at the end of 2014, USD composition had dropped to 58%, or US$1.8 trillion worth of USD-denominated assets, of which $1 trillion was invested in US Treasury bonds. For context, the US dollar is the most widely used currency around the globe and accounts for an average of 65% of global forex reserves.
Anxiety surrounding overexposure to USD-denominated assets has become a primary driver for Beijing to promote its own currency and safeguard against the “dollar trap.” Analogous to the danger inherent in non-diversified investment portfolios, overexposure to a single currency in foreign exchange reserves presents significant risk in the case of that currency’s sudden devaluation. If the US economy were to take a downturn and the dollar loses value, China’s foreign exchange accounts would be significantly impacted. Additionally, despite the demarcation between the Federal Reserve and the US government, Chinese policymakers fear the possibility of strategic USD devaluation by the Federal Reserve in an attempt to reduce its outstanding debt burden or for other political purposes.
China was severely impacted during the Great Recession, with total Chinese exports falling by over 16% between 2008 and 2009 due to a decline in global demand and credit freezes in many importing countries. Without easy access to trade financing, many multinational corporates are limited in their ability to conduct high levels of international trade. In the case of the Great Recession, many organizations struggled with credit freezes from a global shortage of USD deposits that ultimately led to a liquidity crisis – devastating the trade finance environment. As the world’s second largest economy, largest exporter of goods, and largest trading nation in the world, any disruptions to the global trade finance community will have a multiplier effect on the Chinese economy.
An internationalized RMB could help Chinese exporters manage this risk. In instances of heightened volatility or systemic shocks within Western currency markets, importers would still have the means to seek RMB-denominated financing and continue to trade with minimal disruption. Furthermore, a globally-accepted RMB would allow Chinese exporters to hedge against currency risk in settlements. In the current trade environment, significant fluctuations in major settlement currencies (USD, EUR, GBP) valuations can expose Chinese exporters to large profit discrepancies, whereas transacting in the RMB would minimize their risk of profit loss between the invoicing, settlement, and currency exchange stages.
Global Forex Reserves Composition (left) vs. IMF Voting Share % (right)
With great currencies come great power, and China seeks the strategic benefits that come with commanding a global currency. While currency is, at its core, a payment tool to be used for trade, it also can be leveraged to extend its issuing country’s global influence. For example, the USD accounts for the largest share of global foreign reserves and, as a result, grants the US the largest single-country voting share in the IMF at 16.5%. The Euro accounts for 20.5% of total global foreign exchange reserves and holds 9.4% of IMF voting share. The RMB, by contrast, only accounts for 2% of total global foreign exchange reserves – though due to China’s sheer economic size and trade influence, the country holds a disproportionately large IMF voting share at 6.1%. Should global demand for RMB-denominated foreign exchange reserves increase, China’s voting share would subsequently rise and eventually enable Beijing to rival US influence on key global financial decisions.
The RMB: Costs of Internationalization
The Challenge of Choices
According to the impossible trinity, if China continues to loosely manage the RMB’s exchange rate instead of easing it into a pure float system, the country’s ability to open capital accounts will remain limited as large capital flows would push the RMB outside of its trading bands. A liberalized capital account typically coincides with more robust markets, heightened economic stability, and diverse industries – all of which are general prerequisites for the global adoption of a currency. While the benefits of an open capital account are worth consideration, a free float currency is deemed to be too liberal for China’s current economic model.
Freely floating currency regimes largely lose the ability to maintain strategic control over currency valuations. Since 2005, China has been known to accelerate the RMB’s drop in value in times of pressure to boost the global competitiveness of Chinese exports. Should China let the RMB freely float, the PBOC will lose a historically important tool in their policy toolbox during times of economic turbulence.
Furthermore, as freely floating currencies are more likely to be selected as the underlying value to which smaller countries peg their local currency, the PBOC will feel further constraints to its flexibility in crafting unorthodox monetary policy. Studies have shown that for each 1% increase in the value of the US dollar against the RMB, China’s export share increases by roughly 0.123%. Within the scope of today’s trade totals, a 1% decrease in RMB value in relation to the USD in December 2019 would have equated to an approximate boost of US$2.94b in additional monthly export revenues for China. As an export-driven economy, China is greatly incentivized to maintain all avenues to stimulate trade until it effectively diversifies from its trade-reliance – currently about 20% of annual GDP – towards stronger domestic consumption.
Policy Transition Risks
While an internationalized RMB would unlock unprecedented economic and geopolitical opportunity for China, the required transition in monetary policy to achieve its ambitions would introduce significant risk into the Chinese economy.
An internationalized currency requires an open capital account and, were China to take measures to pursue their RMB ambitions, the PBOC would be forced to relinquish stringent control over the market and gradually transition to a looser policy stance. Meanwhile, periods of capital account liberalization and low interest rates are accompanied by large capital influxes, during which time banks endogenously fail to keep up with equity issuings. This swift buildup of capital could lead to over-concentrate in particular asset classes and creating a bubble.
Additionally, as there are significant pockets of RMB concentrated in international economic hubs like Hong Kong, London, and Singapore, the value between the “onshore RMB” and “offshore RMB” oftentimes diverges due to differences in monetary policy and capital constraints between the Mainland and offshore locales. Should the RMB transition towards a free float currency system and the onshore and offshore RMB markets merge, this price divergence would present a significant arbitrage opportunity for offshore traders that could drive violent price volatility. For example, amid a budding financial crisis in Thailand in 1997, large hedge funds began speculating on the offshore Thai Baht exchange rate following the removal of its USD peg. The subsequent short positions rapidly plunged the value of the Baht by more than 60% and exposed the region’s economic fragility. Given China’s economic strength and influence within the global trade community, the RMB would likely recover its value over the long-term through boosted foreign demand; however, if uncontained, the violent shocks during the initial float could alternatively send shockwaves throughout the Chinese trade environment and collapse the region into economic crisis – similar to how the Thai Baht induced the Asian Financial Crisis in 1997.
China has decided to gradually internationalize the RMB in an attempt to thwart the impossible trinity and mitigate many systemic risks associated with free float currency systems and open capital accounts. To aid in its ambitions, China has introduced important steps through an RMB incentive scheme to extend the currency’s influence. While these efforts have been successful in driving RMB adoption for Chinese-related trade, however, the RMB still sees lackluster support for global trade non-related to Chinese exports. Should China continue to pursue its ambitions of developing a globally accepted currency, Beijing will have to consider where to properly position itself within the “impossible trinity” before it can see the true rise of the RMB.