The Limits of RMB Internationalization

By+JOHN+ROSS

RMB internationalization is one of the most im- portant issues for Chinas economy. Owing to the real factors affecting it， however， its development will be slower than media speculation can envisage.

There is an exaggerated perception of RMB internationalization when considered according to percentage growth statistics， because calculations of them start from extremely low levels. For example， the proportion of RMB payments in the U.S. in April 2014 rose 100 percent compared to a year earlier. This sounds spectacular， until taking into account that the rise constituted only 0.04 percent of worldwide currency transactions. In April 2014， the RMB accounted for just 1.4 percent of all international payments.

From an international perspective of Chinas strongest area， at the end of 2013， 8.7 percent of world trade was RMB denominated， but around 80 percent of this emanated from Hong Kong. The U.S. dollars global share was 81 percent. By the second quarter of 2013， only 0.3 percent of international bonds were in RMB， according to the European Central Bank. At the beginning of 2014， 60 percent of foreign exchange reserves were in dollars， 25 percent in Euros and only 0.01 percent in RMB.

These fi gures are low enough to provide huge scope for percentage increases， so yielding profi table business for individual fi nancial institutions without altering the RMBs peripheral position in global fi nance.

Such are， in addition to these miniscule numbers， the fundamental structural reasons why the RMB will not play a central role in global fi nance in the near future， and why the dollar will remain dominant for a prolonged period.

Only two global currency systems have existed in the last 300 years. In 1717 the pound sterling was linked to gold， so establishing the international gold standard. This system lasted for 200 years. Its collapse can be pinpointed to either 1914， when it was temporarily suspended， or 1931， when the pound formally broke its previous parity with gold. The second global system， a de facto dollar standard， has lasted for the almost seven decades since 1945. The interregnum between the two –1931 to 1945 – encompassed the biggest catastrophe in world economic history.

There is， therefore， a prolonged lag between the economic rise and fall of states and changes in international monetary systems. The U.K. fell behind U.S. as the worlds largest market economy in the 1870s， yet maintained global monetary dominance for another half-century. There was also a 70-year lag between the U.S. becoming the worlds largest economy and the dollar becoming the dominant international currency.

This extreme rigidity in international payments structures is an inherent characteristic of a market system. An efficient market can only operate if there is a single measure of prices， as different prices in different parts of the market， uncontrollable arbitrage and/or fragmentation destroy it. Gold initially provided a single measure for international markets， and then the dollar did. The sole period when there was no single price measure， 1931 to 1945， occurred because the world economy was disastrously fragmented， and with catastrophic results – the Great Depression and World War II.

A necessary condition under which a single price standard functions is that of substantial international holdings of whatever the price unit is – large gold holdings under the gold standard or large dollar holdings under the dollar standard. The scale of these reserves thus becomes a powerful factor maintaining the dominance of that monetary unit.

This is why periodic predictions， which ignore economic fundamentals， that the dollar is about to be superseded or challenged by some other monetary unit， invariably turn out to be false. For example， there were predictions that the Euro could replace the dollar. But， as statistics show， the dollar continues to dominate international payments.

What are the implications of these fundamental economic realities for RMB internationalization？ The RMB can certainly become a minor international currency， but it cannot challenge the dollars dominance. That could only occur if the “dollar system，” as a global price unit， were replaced by an “RMB system” – which would entail a revolution in the global economy， which is unrealistic in the coming period.

This， in turn， has major implications for any liberalization of Chinas capital account. As it is impossible， for a prolonged period， to replace the dollar as the main international currency， it remains the dominant and hence preferred unit. The inevitable result of global capital account liberalization since the 1970s， therefore， has not been a multilateral fl ow between currencies but merely a net infl ow into dollars. This has strengthened the dollars international position and enabled the U.S. to fi nance its huge balance of payments defi cits.

Countries that ignored these economic fundamentals， mistakenly believing that international capital account liberalization was a multilateral system rather than one that merely enables funds to flow into dollars， were hit by economic crisis. For example， Southeast Asian countries that believed they could benefi t from capital account liberalization learned a devastating lesson in the crisis of 1997 – that large scale net fl ows which the global payments system permits are solely into the dollar.

The current international monetary system is certainly unjust. Gold was produced internationally. It therefore could not be controlled by a single country， and was a multilateral unit against which all currencies were measured. In contrast， the “dollar standard” means that just one countrys currency is the unit in which all others are measured. This gives the U.S. a type of “monetary monopoly，” and hence many advantages in the international monetary system. But nothing can be done about this until another unit replaces the dollar in defining international prices. Until that happens， international crises， even those originating in the U.S. as in 2008， will not weaken the dollars position. As Eswar Prasad comprehensively documented in his book The Dollar Trap，“The global fi nancial crisis has strengthened the dollars prominence in global fi nance.”

Because the actual operation of the international monetary system inevitably allows fl ows into the dollar， capital account liberalization， which would be necessary to achieve full internationalization of the RMB， constitutes an extremely destabilizing economic force. Joseph Stilitz， Nobel Prize laureate in economics， concluded after reviewing the history of financial crises： “Capital account liberalization was the single most important factor leading to the crisis. I have come to this conclusion not just by carefully looking at what happened in the[Asian] region， but by looking at what happened in the almost 100 other economic crises of the last quarter century... capital account liberalization represents risk without a reward.”

“Risk without reward” is thus a necessary consequence of the structure of the international monetary system； also capital account liberalization that simply creates a flow into dollars. Large scale RMB “internationalization，” which would require liberalization of Chinas capital account， therefore， would lead to a large outfl ow of Chinas capital into the U.S. and dollar assets， to the detriment of investment in China. For this reason， as leading Chinese economist Yu Yongding put it： “China has to maintain its capital controls in the foreseeable future. If China were to lose control over its cross-border capital fl ows， it could lead to panic and capital outfl ows would turn into an avalanche， and eventually bring down the whole fi nancial system.”

China therefore can undoubtedly develop limited RMB internalization within a global monetary system that continues to be dominated by the dollar – particularly for trade. But any notion that the RMB could challenge the dollars position， or escape the dangers ensuing from liberalization of the capital account， is an illusion which could， at worst， seriously damage Chinas economy.