China’s Currency Challenge

Gregory Chin
Senior Fellow, CIGI

Statements from the Chinese representatives that it would be “normal” for currency issues to be discussed at the G8 Summit has set off a reaction from the established members of the Club. Japanese representatives have retorted that the currency issue is a side issue that can be discussed at ‘side meetings’ of the emerging economies, holding tight to the view that ‘only one currency is needed’ – blocking the issue from the agenda.

Regardless of whether or not the currency issue is ultimately put on the agenda at L’Aquila, the reality is that the currency challenge has become a systemic issue that is demanding the attention of the truly global powers. The “G7”, like it or not, will be meeting this year, in an atmosphere of global uncertainty, as leaders from Russia, Brazil, China, and other countries, have expressed concerns about the value and stability of the U.S. dollar, and the world economy’s dependence on the dollar as the reserve currency. What makes the currency question an issue of systemic relevancy is that Chinese authorities have undertaken a series of measures that indicate that Beijing is interested in gradually expanding the role of the Chinese renminbi (RMB) as an international currency.

Beijing has become increasingly nervous about maintaining its large dollar denominated holdings. In response, it has started to take hesitant steps to “internationalize” usage of the RMB. The longer-term concern of those resisting the currency debate is the prospect of the RMB rising to challenge the preeminence of the U.S. dollar as the world’s reserve currency. Although its is premature to discuss China’s RMB as a reserve currency – a possibility that is still far in the distance – it is not out of the realm of the possible for a more “international” RMB to become a major settlement currency for international trade, vehicle currency for financial and money traders, or unit of account in commodities pricing.

Turning the RMB into a principal reserve currency would arguably be the most advanced function for it as an international currency, and the Euro, and arguably the Japanese yen, are further ahead in meeting the high bar of becoming reserve currencies. The transformation of a national currency into an international reserve currency has historically followed an incremental process of currency internationalization, in which a national currency gradually takes on the following functions: 1) a settlement currency; 2) a vehicle currency for foreign exchange transactions; 3) a unit of account, in particular for commodity pricing; and finally 4) a reserve currency.

While the renminbi as a reserve currency is still a ways off, Chinese authorities have taken the following steps to expand the international usage of the Chinese currency: 1) currency swap agreements worth $95 billion with Indonesia, South Korea, Hong Kong, Malaysia, Belarus, and Argentina; 2) an agreement with Brazil to encourage trade settlement in each other’s currencies; 3) plans to buy SDR-denominated bonds; 4) “settlement trials” to allow a small number of export firms in the trade-heavy Shanghai and Guangdong areas to settle their trade in RMB; 5) a “net settlement system” to increase liquidity and trading volume in the domestic interbank currency market and for select Hong Kong-based banks to sell RMB-denominated bonds in Hong Kong.

Not unlike the most recent Chinese statements, on 23 March 2009, about one week before the London G20 Summit, China’s measured and careful central bank governor, Zhou Xiaochuan fired a rhetorical shot across the bow by calling for diversification beyond the US dollar in international trade and foreign reserves toward a supra-national reserve currency based on the IMF’s Special Drawing Rights. So far these diversification steps have been rather tentative. If Beijing was just talking, or if it was alone in raising the currency concerns, it would be easier for the G7 to try to divert. But China is not alone. And currency markets have already reacted. Even if the G7 have yet to…

Disclaimer: This blog is solely intended to spur discussion, while the opinions expressed are those of the author(s) and do not necessarily reflect the views of CIGI, Chatham House or their respective Boards of Directors.