The Future of the Renminbi – Becoming a Global Reserve Currency

19 Jul 2016

The way to get started is to quit talking and begin doing – Walt Disney

Summary

  • In addition to the three basic functions of money, empirical research has established a number of other critical factors that determine a currency’s reserve status, including the size of a country’s economy, the depth of its financial market and the global share of its foreign trade.
  • Combining these economic factors with a country’s cultural, scientific and military strengths and sound legal system will give its currency an “exorbitant privilege” in commanding international confidence.  Brexit or not will not alter these requirements of the renminbi to be a global currency.
  • China’s biggest challenge is to instill global confidence in the renminbi when it does not have most of these characteristics that create the necessary and sufficient conditions for its currency to serve as a store of value, an international medium of exchange and a unit of account.

Logically, Brexit (which happened on 23 June) looks like the 2007-08 subprime crisis that opened up a window of opportunity for advancing the renminbi’s global reserve currency status.  But practically, it will not make much difference.  This is because in addition to the three essential functions of money as a store of value, a medium of exchange and a unit of account, the renminbi needs to acquire other attributes to become a global currency. 

Academic research has established that the currency of a country that has a large share in international output, trade and finance and an open capital account has an immediate advantage over other countries in commanding international confidence in its currency.  This will generate network externalities by drawing more and more countries to trust and use this country’s currency as a global reserve currency.  Once when a currency has acquired a global status, there is a strong inertial bias in keep on using it for a long time despite changes in its fundamentals and in the global environment[1].

Among these criteria, preeminent financial power is probably the most crucial because the reserve-currency host country should operate the biggest and deepest financial markets so that it can have the financial capability to issue debt that establishes the world’s risk-free rate.  This risk-free rate will then serve as an anchor for other countries to issue debt denominated in the reserve currency, thus enabling them to obtain liquidity at times of financial stress.  So it is clear that even a country with a sizable economy but lacks well-developed and deep financial markets, like China at this point, will be handicapped in its effort to acquire a reserve currency status.

[1] See: Chinn Menzie D. and Jeffrey Frankel (2007), “Will the Euro Eventually Surpass the Dollar as Leading International Reserve Currency?” in R. Clarida (ed.) G7 Current Account Imbalances: Sustainability and Adjustment, University of Chicago Press, pp. 285-322 (http://www.ssc.wisc.edu/~mchinn/chinn_frankel_euro.pdf), and Chinn Menzie D. and Jeffrey Frankel (2008), “Why the Dollar Will Rival the Euro”, International Finance 11(1): pp. 49-73   (http://www.ssc.wisc.edu/~mchinn/Chinn_Frankel_IntFin2008.pdf), and Hall, James (2015), “China’s Plan to have an International Reserve Currency linked to Gold”, Global Research, 12 March (http://www.globalresearch.ca/chinas-plan-to-have-an-international-reserve-currency-linked-to-gold/5436119)

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