Why doesn’t the currency of the second largest economy in the world play a consequential reserve currency role? The share of China’s renminbi (RMB) in global reserve portfolios, at 3%, pales in comparison with those of the dollar (60%) and the euro (20%). What explains the difference?
A common response is that the RMB cannot develop as an international reserve currency without full liberalisation of China’s capital account (Frankel 2011, Prasad 2021). This view is based on the assumption that countries will not hold RMB reserves if they cannot easily purchase and sell them on international markets. It is supported by the history of the rise of the pound sterling and then the dollar as leading international currencies in the 20th century, both of which were traded on deep and liquid markets.
As we argue in Eichengreen et al. (2022), it cannot be excluded that internationalisation of the RMB may unfold in a very different way. Even in the absence of full financial liberalisation, it is possible that the renminbi could play a more important international role in the future, and especially as a form of central bank reserves. The Chinese approach to currency internationalisation would not lead to the dominance of the RMB, but rather to a multipolar world of key currencies, in which the dollar, euro, and renminbi would coexist.
The Chinese way
Despite gradual financial liberalisation and the explicit objective of internationalising the renminbi, China is reluctant to move to capital account convertibility. Chinese leaders fear that an open capital account could lead to imported crises and weaken control of their economy (Mercurio et al. 2021). The People’s Bank of China characterises its cautious approach as affording a “balance between development and security” (PBoC 2021: 37).
But unlimited access to deep and liquid Chinese capital markets may not necessarily be essential for RMB internationalisation. Rather, the renminbi can acquire that role through its use in invoicing and settling China’s foreign trade and payments. China has established a global network of clearing and payments, such that it is now possible to undertake cross-border transactions in RMB in a wide variety of different jurisdictions. Our research shows that the development of the RMB as a reserve currency has kept pace with the expansion of trade invoiced in RMB, notwithstanding China’s limited capital account openness.
But ability to accumulate RMB-denominated reserves is not the same as willingness to hold them. For the latter, offshore RMB markets and central bank swap lines are key. Swap lines engender confidence that RMB can be obtained from the Chinese central bank, while the offshore market reassures central bank reserve managers and other investors that they can convert RMB into dollars at stable and predictable rates.
Renminbi as a reserve currency has kept pace with the expansion of trade in renminbi
Historically, currencies first acquired a role in trade invoicing and settlement before also assuming reserve currency status. The RMB can similarly acquire a more important international reserve currency role via China’s trade links. Using data on reserves in RMB by country, we document a significant correlation between a country’s trade with China and its holdings of RMB as reserves. Invoicing transactions and accepting payment in RMB, the currency that is the natural habitat of Chinese banks and firms, is a way of encouraging Chinese entities to do business with a country’s domestic counterparts.
Indeed, the ratio of total RMB reserves to trade invoiced in RMB (at the world level) is close to the ratio of total euro reserves to total trade invoiced in euro (see Figure 1 below). This observation is striking, given China’s low degree of capital account openness.
Figure 1 Reserves to imports ratio: Global estimates by currency (as a percentage)
Sources: IMF, national sources, and authors’ calculations.
Notes: We measure global imports denominated in USD and EUR by taking country-level observations from the Boz et al. (2022) dataset on USD and EUR shares. See more details in Eichengreen et al. (2022).
More evidence of this pattern can be seen in Figure 2 below. Using a dataset on trade invoicing in RMB, the figure juxtaposes reserves held in RMB in months of imports invoiced in RMB against the share of China in the imports of the countries in question. The pattern is clear: countries that trade more with China hold more RMB reserves, measured in terms of months of imports invoiced in RMB. This suggests that the share of RMB in total reserves may increase in the future along with invoicing and settlement in the currency.
Figure 2 Reserve to imports coverage: Country-level evidence (as a percentage)
Sources: Boz et al. (2022), IMF Direction of Trade Statistics (DOTS).
Notes: The figure plots the share of bilateral imports from China against the share of reserve to imports in RMB ratio for selected economies for which data on both variables are available. The vertical axis scale is in percentages, the horizontal axis scale is months. The 45-degree line is shown as a black line.
Swap lines engender confidence that renminbi can be obtained easily
Swaps are lending agreements between central banks, whereby they trade their own currency against that of a partner (Bahaj and Reis, forthcoming). In the present instance, swap lines engender confidence that RMB can be obtained from the Chinese central bank even in absence of liquid markets in RMB securities. The People’s Bank of China has negotiated bilateral currency swap agreements with at least 39 central banks, totalling some RMB 3.7 trillion ($550 billion). In contrast to Federal Reserve swap lines, however, these are not permanent lines available in unlimited amounts (Perks et al. 2021). Moreover, there is little evidence that RMB swap lines have been used to date. And unlike the swaps of the Fed, the People’s Bank of China tends to use them to increase RMB-denominated trade, not as emergency liquidity for foreign banks.
Yet despite their low use, these swap lines represent a consequential share of output of the countries involved, as Figure 3 below shows.
Figure 3 Currency swap agreements with the People’s Bank of China (as a percentage of recipient country GDP)
Sources: International Monetary Fund, national sources, and authors calculations.
Notes: The map shows the countries with which the People’s Bank of China as has established a currency swap line. Differences in the size of the swap lines (scaled by GDP) are mirrored in the spectrum of colours on the map.
The offshore market reassures investors that renminbi can be converted into dollars
China must concern itself not just with providing RMB to the rest of the world. In addition, it must enable foreign countries to sell RMB for dollars when they wish. This is where offshore markets for exchanging RMB in financial centres outside mainland China come in.
Since 2010, when China first authorised RMB trading in Hong Kong, offshore markets have opened in 24 other cities. As of July 2021, some RMB 1.25 trillion ($200 billion) was deposited in offshore accounts. So far, these markets remain small compared to offshore markets for dollars, in Europe and elsewhere. Offshore dollar deposits (or Eurodollars) are estimated at $14 trillion in 2016, or close to 130% of national deposits at that time. The comparison suggests that offshore markets in RMB still have a long way to go.
But it also suggests that central banks that hold reserves in RMB can expect that they will be able to convert them into dollars on offshore markets at predictable and stable prices – provided that not all of them decide to do so at the same time, that is, given the limited liquidity available offshore. Stability and predictability further require the Chinese authorities to regulate the RMB/USD exchange rate. And regulating the exchange rate in turn requires those authorities to hold dollar reserves.
This observation suggests that an enhanced role for the RMB as a reserve currency will not automatically eliminate that of the dollar. Rather, China will have to hold dollar reserves in order for other countries to willingly hold RMB reserves. The two reserve currencies will be complements, not substitutes.
In terms of historical comparisons, the RMB today is not unlike the dollar in the 1950s and 1960s. Convertibility of RMB into dollars today is limited by capital account restrictions, while convertibility of dollars into gold was restricted by US monetary law under Bretton Woods. The 1950s and 1960s were the decades of the Bretton Woods System, when the dollar had to be backed by gold but was not convertible into the metal in the US. The offshore gold market in London then and the offshore RMB market today are products of a similar phenomenon, namely the imperfect convertibility of an international currency (the dollar then, the RMB now) into the ultimate reserve asset (gold then, the dollar now).
Just as the London gold market was a safety valve for dollar holders in the 1960s, the offshore RMB market in Hong Kong is a safety valve for RMB holders today. In both cases, the offshore markets in question are or were closely monitored by the relevant monetary authorities, since adverse developments in those markets could undermine the credibility of the reserve currency.
The prospective role of the RMB as an international currency is the subject of active of policy debate. We show that, contrary to conventional wisdom, lack of capital account openness may not fully prevent the RMB from playing a stronger role as an international and reserve currency. This is not to deny that, in order to overtake the dollar as a leading international and reserve currency, China will have to further liberalise its capital account. But with the help of import financing, debt payments, payment infrastructures, currency swap lines, and offshore markets, the RMB can still gain a more important role. Holding dollars may have disadvantages for China, insofar as this creates mutual dependence with the US. But this peculiar relationship between the world’s two largest economies is the only way for China to make the RMB a significant reserve currency without embarking on full capital account liberalisation. That said, the question of how many dollars China needs to hold in order to support its economic expansion and encourage its economic partner to hold RMB remains open.
Authors’ note: The views expressed in this paper do not necessarily reflect the views of the Banque de France, the European Central Bank, or the Eurosystem.
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