Reserve renminbi not worth the price

China's only clear benefit from fostering the renminbi as an official reserve currency is one of prestige, but the real issue is whether China can outperform in its deregulation process.

Lowy Interpreter

*This is the second article in a two-part series. The first article can be found here.

Even if China was prepared to abolish capital controls and accelerate the creation of deep capital markets in order for the renminbi to become a reserve currency, the renminbi would probably remain a small part of official reserve holdings. The Japanese yen, for example, has never become a significant reserve currency, despite having the preconditions.

Not that this matters much. Persuading some foreigners to buy renminbi bonds would mean some inconvenient upward pressure on the exchange rate and a very marginal lowering in foreign borrowing costs, for a country that has no need to borrow overseas.

Thus the advantages of being a reserve currency simply aren't worth the price. The only clear benefit from consciously fostering the renminbi as an official reserve currency is one of prestige. Hence we are likely to see renewed efforts to have the renminbi included in the IMF's Special Drawing Rights basket: a symbol that China has 'arrived' in some sense, but of no practical significance.

But besides being the major reserve currency, the US dollar has other valuable international functions. Most international trade is denominated in dollars. The paperwork for imports and exports are made out in dollars, which makes things easier for Americans, with smaller transaction costs and less risk of being caught in exchange rate shifts. Commodity prices are usually denominated in US dollars, again with some short-term accounting advantages for Americans, although the fundamental price is set by the overall world demand/supply relationship.

China can get many of these 'convenience' benefits without ever being a reserve currency. Already, some regional trade is denominated in renminbi; the extensive Asian supply chains give special impetus to this renminbi invoicing. Payments settlement can take place in renminbi without going through intermediate dollar transactions. Asian countries may tend to keep their exchange rates informally linked to the renminbi.

Longer-term supply contracts can be denominated in renminbi. China can denominate loans made and received in renminbi (and is already doing so). The People's Bank of China can offer renminbi swap facilities to other central banks, to be used in balance of payments crises (as it did for Korea and Indonesia in 2008). Foreigners can hold renminbi deposits in some foreign banks.

But the important story lies in the implications of China opening up its capital account, which it is clearly doing, albeit cautiously. Will China do better than other countries in handling the deregulation process, in softening the large potential portfolio adjustments, and in buffering itself from the characteristic volatility of international capital flows?

China's foreign investment (inward and outward) so far is tiny. As this changes and China integrates into international financial markets, it will alter the Chinese economy in ways likely to be beneficial on balance, but with disadvantages as well as advantages. This will alter the way China interacts with the rest of the world, creating dependencies and obligations, conflicts and differences of opinion. The sheer bulk of the potential flows risks triggering sensitivities abroad.

Will China be able to use its foreign capital to gain diplomatic advantage in the context of the current euro problems? This seems to be a second-order issue, but there may be other opportunities for international leverage.

One oft-voiced concern is that China will use the threat of unwinding its US bond holdings; those with long memories recall how the US used the balance of payments weakness of the UK to enforce the Suez settlement in 1956. But this threat seems a two-edged sword that would damage China as much as the US.

International capital flows create moments of weakness and strength, open to exploitation. All this will be far more important than the trivial issue of the renminbi as a 'reserve currency'.

Originally published by The Lowy Institute publication The Interpreter. Reproduced with permission.