RMB as reserve: Rebalancing the global financial system

If the account of the 20th century was written in dollars, the account of the 21st will be bilingual, dollars and yuan.

As the center of global economic gravity moves eastward, the dollar and many of the policy assumptions that its six decades of unquestioned global supremacy have fostered are about to face their first serious challenge, but the rise of a new reserve currency will also allow investors and central banks to diversify their portfolios.

It is unlikely that the yuan, China’s “people’s currency,” will replace the dollar outright as the world’s only investment and reserve currency any time in the foreseeable future. But there is every indication that the dollar will have to make room for a second global reserve currency within the next 15 years, with profound implications for the fiscal Pax Americana that dominated the global economy for most of the last century and nurtured an unprecedented period of growth worldwide.

Despite the body blow the 2008 financial crisis dealt to the U.S. economy and the US$ 3 trillion increase in the money supply from quantitative easing, the dollar is still the only realistic safe haven in a turbulent global economy.

The euro and the yen – the obvious alternatives – are struggling to hold the attention of reserve managers. Only 13 percent of allocated global reserves are held in euro, 2 percentage points down from the beginning of the financial crisis, and the yen accounts for just 2 percent. Perhaps more tellingly, emerging economies, which hold more than two-thirds of global reserves, keep just 8.6 per cent in euros.

There is a hunger in international markets for an alternative to the monoculture of the dollar. Investors and central banks holding trillions of U.S. dollars feel vulnerable. Their concern is not focused on the dollar in and of itself, but stems from the principle that a diversified portfolio dilutes risk.

At its most basic, the emergence of the yuan as an alternative safe-haven currency would build extra latitude into reserve portfolio management. Although most economists agree that quantitative easing saved the global economy from much of the potential downside of the 2008 crisis, for example, some investors worry about the medium-term impact of the 38 percent increase in the U.S. money supply since the beginning of 2009. If there were a viable alternative to the dollar, they could spread their risk. The yuan is not yet that alternative currency, but all the signs are that it will be.

When the Chinese authorities decided in the wake of the global financial crisis to take the yuan international, they embarked on a three-stage plan. The first stage was to make it a medium of global trade settlement, then to make it an acceptable investment currency and finally to make it a reserve currency.

In just five years they have had remarkable success. Today, the yuan is the world’s second-largest trade financing currency. It accounts for 18 percent of China’s total trade settlement, and the value of offshore outstanding yuan bonds grew 50 percent last year. Central banks in countries such as Australia have added it to their reserves.

However, these numbers need to be put in context: the yuan still accounts for just 1.6 percent of global trade settlement, and the offshore market (the onshore market is only accessible indirectly) for 0.1 percent of global investment.

There are a number of hurdles that need to be cleared before the yuan can reach its full potential.

The People’s Bank of China (PBOC) has gone a long way toward making the currency more attractive. It is now fully convertible for trade purposes and has encouraged the development of a vibrant offshore market.

But the liberalization process is entering its most difficult phase. For the yuan to become acceptable to international investors, the PBOC will have to lift capital controls and free up internal interest and exchange rates, and that will mean continuing the process of weaning the country off cheap capital despite the domestic pain it is likely to cause.

But fiscal reform is only one part of the equation. As observers like Eswar Prasad, a professor of economics at Cornell University and a former head of the International Monetary Fund’s China Division, point out, investors are also looking for policy transparency, an independent central bank and strong legal protections.

Among the noise of the technical discussion of currency liberalization, it is sometimes easy to forget that the reason the dollar is the global reserve currency is not just the strength of the its institutions, or the depth of liquidity, or the absence of an alternative. Although these are all necessary conditions, the real reason for the dollar’s supremacy is that it has won the world’s trust. However well the PBOC manages the transition, it will take time for the yuan to earn that trust.

The Chinese authorities are making significant progress. The government and the PBOC have given clear and consistent signals of their fiscal intentions. They have resisted the temptation to sacrifice the move toward a more market-driven financial sector for short-term political gain. And although the Chinese legal system has yet to be fully tested in investment disputes, there is no evidence to suggest that international portfolio or fixed-income investors would be significantly disadvantaged.

No one, least of all the Chinese government, underestimates the scale and complexity of the reform process. But there is every reason to believe that the authorities in Beijing remain committed to carrying it through, and that international investors will be willing to adopt the yuan before they are fully implemented.

The growth of the offshore yuan market has echoes of the development of the eurodollar market in the 1960s, which grew strongly despite U.S. capital controls and was subject to European, mostly British, law.

And for central banks, it makes sense to retain a stock of the currency of one’s biggest trading partner both as a natural hedge against swings in the exchange rate and as a liquidity buffer. In 2012, the last year for which statistics are available, China was the biggest trading partner for 124 countries as opposed to 76 for the United States.

A second global reserve currency would mark the biggest change to the architecture of international finance since the Bretton Woods conference in 1944. We are on the cusp of a revolution that will allow investors at all levels to diversify their risk, and creating a system with greater choice and a better ability to resist shocks, and that is something to be welcomed.

 

*Peter Wong is the chief executive of HSBC Asia-Pacific. The views expressed in this article are his own.