Thursday, October 20, 2011

Jeff Frankel On The Renminbi’s Prospects As A Reserve Currency

He doesn’t think the conditions are there yet (excerpt):

The Rise of the Renminbi as International Currency: Historical Precedents

…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...

…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…

…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.

In short: close but no cigar.

The biggest hurdle I think isn’t going to be export dependence, as China’s been moving away slowly from that for some years now. It’s more the hugely underdeveloped financial system, and the relative paucity of liquid financial instruments that’s going to hold back the Renminbi. For investors and central banks to seriously consider the Renminbi as a viable alternative to the dollar, there has to be safe investible assets to put the reserve assets into. No one’s going to be willing to hold cash or cash equivalents, not if they can help it. Nor will central banks be willing to buy into risky assets. That means a steady supply of government securities – which aren’t available because China’s central government does little borrowing.

Until that changes, and until the financial system itself proves capable of withstanding open flows of short term capital, we’re stuck with the US dollar.