With the official launching of the Shanghai free-trade zone (FTZ) at the end of September the Chinese government has set the country off an ambitious plans for economic and financial reforms. If successful after the three-year test period, the FTZ could pave the way – among other things – to the convertibility of the renminbi, creating thus an alternative reserve currency to the dollar.
In an ironic twist of history, the FTZ was launched only a few weeks before the ‘shutdown’ in Washington which basically sent the message that the world’s main reserve currency is not anymore a fully safe haven. An op-ed by Xinhua agency on 22 October 2013 did not hesitate to call for a ‘de-Americanized’ world.
A few weeks earlier, on 10 October, the People’s Bank of China (PBOC) and the European Central Bank (ECB) had signed a bilateral currency swap agreement for a sum of €45billion (RMB350 billion), the largest ever signed by Beijing outside the region. Europe is China’s first trading partner and the euro has now become an alternative for Beijing’s growing currency reserves. In Chinese eyes, the European common currency is instrumental for the internationalization of the renminbi and the creation of a multipolar monetary order.
The China-Eurozone connection
Washington’s ‘shutdown’ in October has increased worries in China that the huge sums invested in dollar-denominated assets – a total of around $2 trillion in US government and quasi-government securities – are at risk of evaporating, after having been debased by the various rounds of quantitative easing. Any investment loss abroad would limit the financial flexibility of China at a time when it is most needed for rebalancing its domestic economy and growth model.
The greenback still accounts for more than 60% of global – and around 55% of Chinese – reserves. Yet, the euro provides China with a formidable alternative. Since the creation of the European common currency in 1999, the Chinese government has started a process of diversification of its reserves that continues today. This process has gone hand-in-hand with calls for the reform of the international monetary system. In March 2009, Zhou Xiaochuan, the PBOC governor, explicitly called for the creation of a new international reserve currency while reiterating China’s support for the euro.
In contrast to widespread scepticism vis-à-vis the euro (mainly stemming from Anglo-American banks and hedge funds), Chinese leaders have consistently been more optimistic, intervening on a number of occasions since the beginning of the euro-crisis to reassure financial markets and European leaders that they would continue to buy Eurozone bonds and bolster the common currency. This was and still is driven by the need to find new but safe investments for China’s growing currency reserves and diversify risk away from the dollar. Political considerations have also played a role: Chinese leaders have traditionally supported a stronger and more united Europe that could work alongside Beijing to counterbalance American primacy.
In the last years, China has accelerated the diversification of its holdings of foreign reserves to such an extent that, today, euro-denominated assets represent around one-third of Beijing’s total foreign currency reserves (which, at US$3.7 trillion, are the world’s largest). This means that Beijing has bought around one trillion euro.
Far from being a one-sided process, some Eurozone governments and EU institutions have courted and welcomed Chinese engagement, setting in motion an active monetary diplomacy. Since its establishment in May 2010, the European Financial Stability Facility (EFSF) – replaced in October 2012 by the European Stability Mechanism (ESM) – has actively sought Beijing’s support, obtaining concrete pledges for the purchase of Portuguese, Irish and Greek bailout bonds auctioned by the EFSF/ESM €440 billion rescue fund. Moreover, China has already showed an interest in investing in fully guaranteed and safe euro bonds. This reflects China’s growing optimism vis-à-vis the euro, in particular after Mario Draghi’s declaration in July 2012 that the ECB will do ‘whatever it takes’ to preserve the Eurozone.
Shanghai-Frankfurt monetary axis
By signing their first bilateral currency swap agreement in October 2013, the PBOC and the EBC have cemented a relationship bound to grow in the next years. It is no coincidence that the swap agreement occurred only a few weeks after the official launch of the Shanghai FTZ. The process leading to the internationalization of the renminbi takes place, in fact, in an international monetary environment which has already experienced the emergence of an alternative to the dollar.
The euro is today the world’s second most important reserve currency: by the end of 2013, euro-denominated assets accounted, on average, for around 25-27% of the holdings of the world’s major Central Banks, reaching around one-third in China. The Frankfurt-based European Central Bank is only second to the Fed in terms of assets.
Alongside the euro, there has also been an upsurge in the use of the renminbi. The latter is today the world’s second most used trade finance currency. Since 2009, the PBOC has signed currency swaps agreements with numerous Central Banks around the world. The Shanghai FTZ is but the latest development of a process aimed at the full convertibility of the Chinese currency.
The euro benefits from Chinese support. The internationalization of the renminbi takes advantage from the existence of the European common currency. There is thus a new monetary axis emerging between the Shanghai FTZ – and the Frankfurt-based ECB likely to have significant implications for the dollar.
This new axis is both complementary – and alternative – to Washington-Beijing relations. Hopefully, policy makers from the world’s three largest economies – EU, US, China – will be able to create the conditions for the smooth emergence of an international monetary order where the dollar, the euro and the renmimbi would each have its proper place.
Nicola Casarini is Senior Analyst at the Paris-based European Union Institute for Security Studies (EUISS) and the author of Remaking Global Order: The Evolution of Europe-China Relations and its Implications for East Asia and the United States (Oxford University Press).