Feb 01, 2012
Nobel laureate Robert Mundell once stated that “great powers have great currencies.” Few geopolitical observers today would deny that China has now achieved great power status. Yet, if the overall size of the Chinese economy, its position as the world’s leading official creditor, its stature as a powerhouse exporter, and its growing military capacity all support this claim, the international status of its currency—the yuan, also known as the renminbi (RMB)—belies it.
Despite China’s increasingly central position in the global economy over the last decade, the role of the yuan has so far not followed suit—a direct consequence of Beijing’s tight control over the currency. However, beginning in 2009, China initiated steps to promote the internationalization of its currency. Today, Beijing’s strategy has proven to be incredibly effective as the use of the yuan outside China’s borders has been steadily increasing over the last three years.
Where China has focused much of its attention, and achieved much of its success to date, is in the area of yuan-based cross-border trade settlement. The yuan’s growing role in trade is the result of a carefully executed “two-pronged” strategy led by China’s central bank, the People’s Bank of China (PBoC).
The first prong consists of a pilot program that allows banks in mainland China to settle cross border transactions with trading enterprises and investors from around the world in yuan acquired principally from the growing “offshore” financial market for the currency in Hong Kong. In 2009, the pilot program only applied to five Chinese cities; today, there are no geographic restrictions on the program, meaning banks in any province can invoice and settle international trade in yuan on behalf of trading enterprises.
The second prong involves a growing bilateral central bank currency swap scheme which now includes 17 foreign partner economies and totals more than RMB 1.2 trillion ($190 billion). Trading enterprises in partner economies can now obtain yuan via their own central banks to purchase Chinese imports or they can accept payment in yuan from a Chinese partner in exchange for their goods and then swap it for their local currency. This reduces the transaction costs to trade by eliminating the need to rely on a third-party currency, like the dollar, to complete a deal.
So, how successful has this two-pronged strategy been to date? In 2009, the first full year with the PBoC’s new efforts in place, the total volume of yuan based trade reach a meager RMB 3.6 billion ($570 million). In percentage terms of China’s total trade with the world, this amounted to little more than a rounding error.
However, 2010 saw a substantial uptick in the yuan’s role in China’s trade, reaching more than RMB 500 billion ($80 billion) or about 2.7 percent of China’s total trade that year. Last year, as the implementation of the two-pronged strategy reached further maturity, China’s yuan-based cross-border trade transactions topped RMB 2 trillion ($267 billion) and accounted for slightly over 9 percent of Chinese trade in 2011.
Concomitantly, the PBoC has been successfully promoting yuan-based foreign direct investment (FDI) by encouraging oversees firms to fund investments in mainland China using RMB, rather than dollars while also promoting yuan-based outward direct investment (ODI) by Chinese firms overseas. At year-end 2011, the PBoC reported more than RMB 90 billion ($14.2 billion) in FDI and RMB 20 billion ($3.16 billion) in ODI, both substantial increases over the previous year.
What does the rise of the yuan portend for the “almighty” U.S. dollar? Does the emergence of “redback” onto the international stage presage the greenback’s imminent decline? Should the American people fear the ascension of “the people’s currency”?
While the growing use of the yuan in international trade and investment since 2009 is nothing short of remarkable, the currency still represents only a tiny fraction of global transactions in these areas. For instance, in 2011, yuan-based trade settlement represented less than 1 percent of global trade; by comparison, the dollar is used to settle more than half of international trade transactions. In cross-border direct investment, the yuan’s role is even more negligible. In other words, the currency’s gains seem less imposing when put in a global perspective.
Furthermore, history suggests that the position of “top currency”, where the dollar sits today, is an incredibly sticky role. Britain’s pound sterling remained the world’s preeminent currency for decades after the U.S. had surpassed the U.K. as the world’s leading economy. Therefore, it is incredibly unlikely the yuan will surpass the dollar as the world’s preeminent international currency by the end of this decade, or even by the end of the next one.
Yet, it is undeniable that the yuan’s international footprint will continue to expand over the coming decade. The PBoC is likely to continue signing more central bank swap agreements with important trading partners, opening the door for more cross-border yuan-based transactions. Additionally, as the offshore yuan market in Hong Kong continues to develop, the RMB will become an increasingly important currency in financial markets as well.
The currency is also likely to play an increasingly important role in official circles as governments seek to diversify their foreign exchange reserves by adding yuan to the mix. Late last year, Nigeria announced it plans to reach a target of holding 10 percent of its foreign-exchange reserves in yuan as quickly as possible.
Rather than causing Americans concern, the maturation of the yuan should be viewed as a positive development for the U.S. economy. Why? U.S. lawmakers have been calling for the yuan to appreciate since 2003, arguing that the currency’s artificially weak exchange rate costs American jobs and contributes to the large U.S. trade deficit with China.
Part and parcel to Beijing’s plans to expand the yuan’s role in trade, investment, and financial markets is the achievement of full convertibility, meaning that all restrictions on exchanging RMB for other currencies will be lifted. China’s capital account restrictions have already been reduced as part of the yuan internationalization strategy, helping the RMB appreciate by more than 22 percent against the dollar since 2005. Achieving full convertibility will attract further capital inflows into China resulting in an even strong yuan. In short, yuan internationalization will bring about greater balance to the U.S.-China trade relationship.
When this is coupled with Premier Wen Jiabao’s statement earlier this month that “expanding consumer demand” is his first priority in 2012, American companies looking to sell their goods in China’s massive market should be especially heartened.
In the coming decade, what lies ahead for the global monetary system is not a period of wrenching transition where the global economy ditches the dollar for the yuan, leaving the American economy in crisis and American economic power in tatters. Rather, we are embarking on a period where the Chinese currency will assume its rightful place in the hierarchy of global currencies—among the euro, yen, pound, and others—but still below the dollar for many years to come.
Americans should not view the yuan’s rise as a threat to U.S. economic might; rather it should be understood as an opportunity that will pave the way for a more balanced relationship between the world’s two economic superpowers.
Daniel McDowell is a Bankard Fund for Political Economy Fellow at the University of Virginia. In the fall of 2012, he will begin an appointment as assistant professor of political science in the Maxwell School at Syracuse University.