Internationalization of Renminbi

By | June 23, 2013

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1.        Internationalization of Renminbi

 

The Renminbi is gradually but surely been internationalized. Explain the internationalization of a currency. Briefly comment on the measures that China had implemented to achieve this. What are the benefits? Do you think that Renminbi will become a reserve currency in the future and why? (25 marks) (Approx. 2,100 words)

 

1.1    The internationalization of a currency

 

An internationalized currency is one which performs the functions of a medium of exchange, unit of account, and store of value beyond the borders of the nation that issues it. As a medium of exchange, an international currency helps the settlement of international trading transactions. As a unit of exchange, it is used for invoicing trading transactions and denominating financial instruments. As a store of value, it is used as an investment asset by nonresidents. And it is different from the narrow concept of allowing the offshore use of a currency (International Monetary Fund 2007, p. 35). With our basic knowledge, very few currencies meet with the definition of internationalized currency, the two major internationalized currencies are US dollar and Euro while the international use of sterling and yen is largely because the importance of these two economies. Therefore, there are traditionally very few currencies could all act as a medium of exchange, a store of value and a unit of exchange. For example, in the international trade, USD and Euro are two major currencies used in the contracts even an US or European is not involved in the particular international trade business which means that these two currencies play major roles in term of a medium of exchange.

 

1.2    Measures that China had implemented to facilitate the internationalization of its currency

 

The general requirements for an international currency as highlighted in the literature include: political and military power, size of the economy, financial strength and degree of financial market development and history (Frankel 1999). According to Yin-Wong Cheung and Guonan Ma (2011), in addition to these factors, the stability and predictability of a currency’s intrinsic value and the availability of board transactional networks will also define the functional domains of individual currencies. And in particular, a currency should show a low inflation rate, a reasonable interest rate and exchange with full convertibility. In another view, according to Jeffrey Frankel (1993) the renminbi is a fresh new hopeful among the ranks of international currencies. The paper looks to history for help in evaluating the factors determining its prospects. The three best precedents in the 20th century were the rise of the dollar from 1913 to 1945, the rise of the deutsche mark from 1973 to 1990, and the rise of the yen from 1978 to 1991. The main fundamental determinants of international currency status are economic size, confidence in the currency, and depth of financial markets. The Chinese government has implemented a number of policies to facilitate the internationalization of its currency which include the following strategies.

 

1.2.1            Promotion of offshore usage of yuan

 

China’s government long kept strict limits on the availability of its currency overseas, and confined trading of the yuan to Shanghai. But China’s interest in promoting the yuan for international use expanded in the wake of the global financial crisis, as worries grew about its reliance on the dollar. China’s government has taken a series of moves in the past year to encourage the yuan’s use overseas, in an effort to become less dependent on the dollar for trade and investment. Those moves are allowing pools of the currency to accumulate in bank accounts outside of China – particularly in Hong Kong (efinancialnews.com 2010). But still, to increase the amount of yuan offshore, the Chinese government needs to further create more channels for investing in yuan overseas and offer varied yuan-denominated investment products according to Fang Fang, a member of the Chinese People’s Political Consultative Conference (CPPCC) and vice chairman of J.P. Morgan Asia Investment Banking (globaltimes.cn 2011).

 

1.2.2            New system for cross-border yuan transactions handling

 

According to the recent news, a system to settle cross-border yuan transactions and boost the convertibility of the currency is being set up in Beijing and will be rolled out by 2014. Once set up, it would allow countries to settle payments in Chinese goods in yuans instead of dollars. Over the long term, the use of the yuan, particularly in Asian trade, would take some demand away from the dollar which currently enjoys the status of both the world’s reserve and trade currency. This new system is also in accordance with the increased need to use the China yuan as contractual currency as international trade settled in yuan currently exceeds 2 trillion yuan ($317 billion) and foreign direct investment settled in yuan reached 110 billion yuan last year, according to the Central Bank (forbes.com 2012).

 

1.2.3            Revaluation of yuan

 

In 2005, China revalued the yuan by 2.1 percent against the U.S. dollar, abandoning the peg against the dollar, and allowing the yuan to float against other currencies such as the yen, dollar and euro, and allowing it to float within 0.3 percent of the dollar a day using “baskets” of foreign currency—a technique mastered by Singapore. The reevaluation had been anticipated for a long time. It was the first revaluation in 10 years. The adjustment was minor but was regarded as a first step because the yuan was still considered way overvalued (factsanddetails.com 2008).

 

1.3    Benefits of internationalization of its currency for China

 

1.3.1            Facilitate product market and financial market reform in China

 

Evidence shows that the introduction of the euro has led to an acceleration of reforms in the product markets (Alesina, Ardagna, & Galasso, 2008) and financial sector (e.g. Hartmann, et al. 2007) in Euro zone. And with the government’s promotion of China yuan as an internationalized currency in the global business, it is anticipated that this effort would share similar benefits as perceived in the introduction of the Euro in facilitating product market and financial market reform in China which is of great importance to the long term economic development in China.

 

1.3.2            Reduced international business transactional cost for Chinese firms

 

When considering engaging in the international business, all companies would consider both cost and anticipated returns like what they do in the home country market and only when returns exceeds cost to some extent, the investment in the international business would consider as feasible. And one of the major cost and issue in the international business practices is the foreign currency exchanges. Since it is known to us that in the major business deals, international currencies such as United States Dollar and Euro are usually used as stated currency in the contracts pricing the product or service. But there could be risks when the exchange rate of the stated international currencies against the home country currency changes. For example, the USD – MYR exchange rate is not a constant. If a Malaysia based company expect the USD MYR exchange rate to be USD 1 = MYR 3.00 and price its product according to that, any movement in the exchange rate would alter the presumed calculation. That is a risk in either direction though, for the good as well as the bad. Companies do business all the time despite the risk of fluctuations. Though companies generally protect themselves by adding a small percentage to the pricing, or use FX forward contracts that lock in the future exchange rate, in general the use of the international currency other than the home country currency would add to the aggregate uncertainty and possible higher transactional costs. And therefore, in our proposed situation in China, if its currency would become an internationalized currency, it would certainly reduce the transactional cost of the companies that are engraining in the international business because when Chinese yuan become a popular and even a prevailing internationalized currency, there is higher possibility that they could persuade their business partners to use China CNY as the contractual currency to price the products. Without the necessity to do the monetary exchange, financial uncertainty would be largely reduced, so would be the relevant transactional costs.

 

1.4    Prospects of Renminbi as a reserve currency in the future

 

History shows that there is a tendency for one currency to dominate, with any change in status often reflecting a shift or rebalancing of economic and political power. The network externalities model is used to back up this view of a dominant single international currency at any given point in time. But the dominant single currency would not stay unchanged at all time. For example, The British pound sterling was the leading international currency prior to 1914. It took decades—until the end of World War II—for the US dollar to become the dominant international currency by supplanting the sterling atop the currency pyramid (Schenk 2010). As for China, it surpassed Japan as the second largest economy in the world in the fourth quarter of 2009 (thestar.com.my 2010). And according to earlier estimates, China’s GDP in 2011 was 47.156 trillion yuan, which at the current exchange rate of 6.3138 translates into roughly $7.47 trillion. In contrast, the GDP in the United States was roughly $15 trillion. That means that China’s economy is now nearly half as big as the U.S. economy which means that China’s economy could become bigger even sooner than previously thought. If the economic growth gap is 6% per year(lower than the average rate the last decade) and real appreciation is 2.5% per year (again, a lot lower than the average rate the last decade) than that would be sufficient for China’s economy to become bigger by 2020 (csmonitor.com 2012). Therefore, we can see that China is expected to surpass the US to become the world largest economy, and with the anticipated replacement, the same story happen between US and UK could happen between US and China in this century though we can not image the very detail process. Hence, a shift or rebalancing of economic and political power would push up the Chinese yuan as an increasingly important reserve currency even before China’s takeover of US to become world no.1 largest economy.

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