Why China will come up short in the currency battle

The internationalisation of the renminbi could be as transformative for global capital markets as the opening up of China's borders was for the global trading system, says Reserve Bank of Australia Deputy Governor Philip Lowe. 

Talking to the Centre for International Finance and Regulation conference in Sydney last week, Dr Lowe said the renminbi's internationalisation “has the potential to create a seismic shift in the international monetary and financial landscape".

The renminbi's internationalisation process could elevate it to international reserve currency status, Lowe argued, though he also pointed out that this appears to be some way off and there are risks involved. Lowe pointed to recent positive developments, but tempered his remarks by noting there is still a fair way to go.

The redback has already come a long way. According to the Economist Intelligence Unit, the renminbi had risen to become the second most-used trade financing currency and the ninth most-used currency for payments globally.

Certainly within China, there is a widely held view among institutional investors that the renminbi will eventually surpass the US dollar as the top international reserve currency, though that view is not necessarily held by their counterparts outside of the country.

According to a survey conducted by the Economist Intelligence Unit, 62 per cent of institutional investors within China think the renminbi will eventually surpass the US dollar as the top international reserve currency, compared to only 43 per cent outside China.

But it's not going to happen overnight. Just 30 per cent of onshore investors see the renminbi becoming one of the top two traded currencies in world by 2020, compared to no offshore investors holding that belief.

Although there's still a long road ahead, the renminbi has already made significant headway despite its lack of convertibility. It is already beginning to appear as part of the mix in a number of central bank reserve portfolios.

Malaysia was the first to start the trend in 2010, but has since been followed by Indonesia, Thailand, Korea, Austria, Nigeria, and Chile and, of course, Australia. It was Philip Lowe himself who announced Australia's intention to hold about 5 per cent of Australia's foreign currency assets in China in April 2013.

According to Eswar Prasad, an economist at Cornell University and author of The Dollar Trap: How the US Dollar Tightened Its Grip on Global Finance, this trend is less a sign of the inevitable rise to global dominance than it is an opportunity to curry favour with an increasingly powerful China and a low-cost bet on a currency that will likely strengthen in the long term as it internationalises.

"While there is a great deal of anticipation that the renminbi will play a very important role in international finance, the idea that the RMB can replace the US dollar is pretty far-fetched," Prasad told China Spectator.

But just as the US was able to surpass the British pound to become the world's main reserve currency by the 1950s due to its size and financial market development, couldn't China conceivably do the same?

According to Prasad, who used to head the International Monetary Fund’s China division, China's steps to aggressively promote its currency international role will likely to be held back over the medium term by the weakness of its financial system. While China is making progress on some fronts -- opening up its capital accounts, making its exchange rate more flexible among other major reforms -- its financial markets are simply not broad, deep and liquid enough.

But most importantly, there is the enormous gap that exists between the integrity of China and America's public institutions. “It all comes down to trust,” argues Prasad.

"In China they say it's a good place to make money, but not to keep it. So they take their money offshore."

The reason foreign investors have such faith in the US dollar -- despite the battering America's economy has undergone since the financial crisis -- is America's robust and transparent institutions.

"But this doesn't stop the UK and the Bank of England and everybody there to be frothing at the mouth at the thought of more RMB business" said Prasad.

While China’s institutional investors are more sanguine about the RMB's potential to supplant the US dollar eventually, they also see the immediate political obstacles as a major barrier in the immediate term.

Prasad suspects that the renminbi will end up accounting for somewhere between 5-10 per cent of all global foreign exchange reserves in the next couple of decades. But to go beyond that and become a safe haven currency, a lot more will be needed.

"You can build good financial markets in a couple of decades if you have the right sort of reforms and get things going in the right direction -- you can perhaps create an exchange rate and open the capital accounts. But building institutions that your people and foreign investors trust takes a lot more time."