A Road Map for the Future of the Yuan  

There has been a lot of talk of late about the internationalization of the renminbi into a globally traded hard currency, but no one has yet designed a clear-cut road map on how to achieve that task. China needs to incorporate this goal within a much wider and more comprehensive financial strategy corresponding to the full potential of its economic and monetary ambitions. 

One important component of this approach would be to enhance the use of the renminbi in international bond issues, including those done by foreign governments. This would be a positive and stability-orientated method of recycling China’s current account surplus abroad in a way that - in contrast to the amassing of dollar reserves by the People’s Bank of China - does not build up unnecessary foreign exchange risks for Chinese creditors. The issuing activity would be concentrated in Shanghai. There would be an important side effect in enhancing both the profitability of Chinese banks and Shanghai ’s status as an international financial center.  

There are some interesting parallels here with the expansion of borrowing in D-Marks through bond issues by foreign governments and corporations in Germany during the 1970s. Particularly after the 1973 oil crisis, issuance increased markedly as the West German authorities liberalized the market to allow the Federal Republic’s current account surplus to be siphoned off abroad, culminating in the landmark issuance of ‘Carter bonds’ in D-Marks by the US Treasury under the administration of President Jimmy Carter in 1979.  (This was also an excellent source of earnings for German banks, one that has greatly subsided since economic and monetary union in 1999, since German banks now share their previous D-Mark issuing monopoly with other banks throughout the Euro using nations.)

Partly with this parallel in mind, I would recommend that the US government should issue renminbi-denominated bonds in Shanghai and then convert the proceeds into dollars. Such high-grade renminbi bonds would be attractive assets both for private Chinese investors and for official bond-holders (including those outside China).  Encouraging the US to borrow in renminbi rather than in dollars would lower the Chinese authorities’ potential currency risks inherent in China ’s large foreign exchange reserves. The corollary is, of course, that the US would be exposed to a new source of vulnerability, as the Treasury would build up liabilities in renminbi instead of in dollars.   But, surely, in any international capital markets system, over time, the debtors and not the creditors will have to bear the brunt of foreign exchange risks - especially if the asset- liability gap continues to grow.

Among all these considerations, China needs to bear mind that international reserve money status requires formidable preconditions. The GDP of a currency area must be comparable to that of the Dollar and Euro areas. Financial markets must be liquid and transparent. Supervision and regulation must be strengthened. Banks, along with the rest of the financial industry, must be commercialized and opened up to domestic private as well as international investors. Monetary and fiscal policies must be sound, stable and responsible. The currency must be fully convertible. Domestic and foreign investors must have full freedom to trade assets across national boundaries.  Foreign exchange markets must be well developed for investors to hedge exchange risks, yet currency rates must be stable enough to prevent speculative capital flows from becoming uncontrollable.

So the Chinese people will have to overcome many hurdles in order for the renminbi to become a fully-fledged international reserve currency.  By the end of 2009, China ’s GDP accounted for only about 8% of the world’s GDP, against 25% for the US   and 22% for the euro area. The renminbi is only partly convertible, reflecting restrictions on capital flows. China ’s financial markets are extremely under-developed. China ’s financial sector is almost fully controlled by state-owned enterprises protected by prohibitive barriers to entry for both foreign banks and domestic private entrepreneurs seeking to participate in financial innovation.

At the root of the challenge is the aim of modifying China ’s growth model and development strategy, which relies strongly on the state-controlled financial sector and on fiscal measures to maintain an extremely high ratio of investment to GDP.  This model is unsustainable and inconsistent with the aim of renminbi internationalization. Chinese leaders have accordingly decided to speed up transformation by shifting the emphasis of growth strategy away from exports towards domestic demand; away from labor, energy and resources towards technological innovation and human capital; and away from secondary industry towards the tertiary sectors led by services.

The key to achieving these objectives is financial deregulation to promote competition and innovation. Without consumer finance, it will be impossible to build up a long-term mechanism to stimulate domestic demand. Without venture capital, private equity and a range of other financing measures, the road toward independent technology innovation and entrepreneurship will remain sealed. Without a liquid securities market, particularly for bonds, local governments will continue to rely on tax revenue and land-sales to finance their infrastructure investments and other expenditures.

Financial deregulation will above all require measures to open up the financial sector to domestic private investors. Domestic entrepreneurs must be allowed to operate banking, securities businesses, insurance, trust and other financial services.  Domestic companies and local governments must have freedom to issue bonds which domestic and foreign investors can trade freely. Interest rates must be liberalized to create an equal playing field for all banks, and a legal framework must be set to encourage innovative financial services such as venture capital and private equity.

Additionally, the overriding quest of internationalizing the renminbi will require the opening of China’s financial markets to foreign investors and borrowers. With regard to possible issuance of renminbi bonds by foreign borrowers such as the US government, some people worry that permitting foreigners to issue renminbi-denominated bonds would put at risk the Chinese development model by diverting investment abroad. That’s a misguided concern because Chinese people have huge bank deposits and they are eager to find increasingly attractive alternatives. Even more important, in its own interest, China needs ways of dispersing its huge stocks of foreign exchange reserves among a much larger and more diversified variety of private sector savers. All this entails that China’s financial corporations should aggressively expand their services into foreign markets.  Chinese individual investors and institutional investors should not simply be allowed, but should even be encouraged, to invest their money into foreign assets.

There is a now a large task ahead for the Chinese authorities to bring together all the elements of a renminbi internationalization strategy into a cohesive and realizable strategic road map.  This will then of course need to be implemented.  But the first step is to assemble the initial package. Until a comprehensive strategy is designed and announced, all talk of the renminbi eventually coming of age will remain a pipe dream.