The Chinese authorities have been talking about internationalizing the RMB for a decade or so. Rising – but in our view unwarranted – concerns about the viability of the USD as the world’s dominant reserve currency combined with a string of reforms aimed at increasing the cross-border use of the RMB have led to expectations that the Chinese currency might soon replace the USD as the global reserve currency.
The internationalization of the RMB and, even more so, the emergence of the RMB as a reserve currency require China to put in place a number of far-reaching reforms. For the RMB to emerge as a, let alone the, “major” reserve currency capable of rivaling the USD, China needs to (1) open the capital account to both foreign official and private investors and, for all practical purposes, (2) allow greater exchange rate flexibility and (3) reform the domestic financial system. Financial sector reforms would need to create safe, liquid, transparent and market-driven bond and derivatives markets. The opening of the of the capital account would, in turn, require the re-capitalisation of the banking system in order to enable it to cope with the potential loss of a captive depositor base, while the liberalisation of domestic interest rates would also make broader governance and regulatory reforms necessary. For the RMB to become partially “internationalized”, allowing the RMB to become a “minor” reserve currency (like the JPY), less far-reaching reforms are required.
An important question that is less frequently discussed is what domestic political interests are behind the drive to internationalise the RMB. A complete internationalization of the RMB, a pre-condition if the RMB is to become a global reserve currency, would have important domestic political, economic and financial consequences. It is therefore worthwhile exploring which domestic actors support and which oppose the internationalization of the RMB and the accompanying economic-financial reforms.
The push for RMB internationalization and all this implies, such as capital account liberalisation, greater RMB flexibility and, ultimately, broader domestic financial reforms, has come from reform-minded technocratic groups affiliated with or residing in the People’s Bank of China (PBoC), including the State Administration of Foreign Exchange (SAFE), and the regulatory agencies such as China Banking Regulatory Commission (CBRC) and the China Securities Regulatory Commission (CSRC). These institutions have been the major force behind financial modernization in general. The PBoC, for instance, is fully aware of the potential risks continued FX reserve accumulation poses to domestic financial and economic stability (e.g. asset price bubbles, inflation). Concerns about macro-stability and its own balance sheet explain why the PBoC was a major supporter of breaking the RMB-USD peg and the move towards greater, albeit limited RMB flexibility in 2005.
In terms of bureaucratic mandate and intellectual outlook, the PBoC is most inclined towards financial reform and modernization, which ultimately comprises RMB internationalisation. The ultimate goal is to move towards a more market-based system, allowing for greater efficiency in terms of capital allocation, and one less prone to the build-up of large economic and financial imbalances. Similar motives explain the general support for modernisation by the regulatory agencies. Both the PBoC and the agencies find ready political allies in regional political and financial interests in Shanghai, which support both financial modernization and RMB internationalisation with a view of establishing Shanghai as a major global financial centre. All these groups regard the move towards RMB internationalization and the reforms it will engender as part and parcel of a broader modernization agenda.
The Ministry of Finance (MoF) has in the recent past been a bureaucratic rival of the PBoC, as the wrangling over control of the large state-owned banks in the context of the recapitalisation efforts and the establishment of the China Investment Corporation (CIC) demonstrated. More importantly, the MoF is tasked with ensuring the financial viability and stability of the Chinese public sector. To the extent that the PBoC is ultimately backed by the MoF, the sharp rise in US government debt since 2008, Fed quantitative easing and the continued rapid accumulation of US assets by the PBoC have at the very least increased concerns about the financial value of Chinese foreign assets. This has made the MoF more receptive to laying the groundwork for a greater international use of the RMB, that is, a lesser reliance on the USD. If internationalization were to turn the RMB in a widely accepted reserve currency, it would reduce its dependence on USD asset accumulation, thus at least reducing currency risk.
To the extent that RMB internationalization implies greater currency flexibility, export interest interests are concerned about possible significant RMB appreciation. No doubt, the export sector and its bureaucratic allies (esp. Ministry of Commerce or MOFCOM) prefer to stick to the status quo. This is all the more true as the labour-intensive Chinese export sector has only a limited ability to pass on price increases. Domestic consumers favour currency appreciation. However, losses stemming from currency appreciation would be more concentrated in the politically well-organized/ -connected export sector (including foreign MNCs) than the gains accruing to domestic consumers. True, currency flexibility against the backdrop of greater capital account convertibility will not necessarily lead to currency appreciation. Greater exchange rate flexibility would nonetheless raise the prospect of currency appreciation and export interests therefore support the status quo policy of limited, controlled RMB appreciation.
The National Development and Reform Commission (NDRC) is in charge of formulating and implementing macroeconomic policies. Leaving aside the issue of currency flexibility and export-led growth, capital account opening would need to be preceded by the creation of a sound, market-driven financial system, lest liberalisation substantially increase the risk of capital-flow-related instability. With foreign investors gaining access to on-shore capital markets, domestic banks would also be exposed to greater competition. This will require their recapitalisation (which is one of the reasons why the MoF is not a more outspoken supporter of RMB internationalization). Even a partial opening of the capital account would make it more difficult to control resident capital outflows, which carries the risk of limiting the amount of (or raising the price of hitherto) captive funding in the form of domestic deposits available to domestic banks. This would increase the cost of credit and weaken government control over it. The NDRC is surely aware of the potential risks and the loss of state control that capital account liberalization implies. It perhaps also understands that over the medium- to long-term, the model is not sustainable. The NDRC is therefore supportive of a gradual, for now only limited approach to RMB internationalization.
Last but certainly not least, there is the State Council, effectively the Chinese government, headed by the premier. The State Council represents broader economic and political interests and has the authority to veto ministry-level initiatives. The Chinese government exercises significant control over the economy in the interest of economic development and of maintaining political stability. RMB reform would undermine government control. China’s successful economic development model has relied on a combination of factors: state playing a central role in the economy, state-directed capital allocation, capital controls and a stable, undervalued currency supporting export-oriented growth underpinned by large investment in infrastructure and manufacturing. Capital account liberalization, greater RMB flexibility and reducing state control of the financial system will hence not look like an attractive proposition in the eyes of the senior Chinese political leadership. From a short-term perspective, little political incentive exists fundamentally to transform the foundations of a hitherto successful development strategy, whatever the longer-term benefits might be.
First, the opening of the capital account would translate into the government losing significant control over the financial system, even in absence of further market-oriented reforms of the financial system. Large cross-border capital flows would expose the Chinese economy to potentially destabilising capital flows – not least given relatively shallow and underdeveloped domestic financial markets. As capital account liberalization ultimately requires greater exchange rate flexibility and a more market-driven financial system, complete capital account liberalization is unlikely to be welcomed by the political leadership. In addition to carrying potential short-term risks, it would also undermine China’s economic development strategy. Politically, an “if it ain’t broke, don’t fix it” attitude will prevail – after all, the Chinese continues to grow at 9% annually, for the time being.
Second, throwing open the capital account would make further flexiblisation of the exchange rate highly desirable in order to limit the sensitivity of the domestic economy to capital flows. This would further undermine China’s export-oriented development strategy based on moving cheap labour out of agricultural sector into a higher-productivity export-oriented manufacturing sector, supported by significant foreign direct investment and massive domestic investment. Greater exchange rate volatility and, more so, greater nominal RMB appreciation would make the pursuit of this policy more difficult. True, there are many reasons why China should adjust its strategy given concerns about its longer-term economic and political viability. Politically, abandoning the present development model won’t be seen as a very palatable option, however, for the time being.
Third, and most importantly, wider reforms of the domestic financial system would reduce government control over the largely state-directed financial, and especially, banking system. Increasing the size and depth of local capital markets and further developing derivatives markets would not cause the political leadership much concern. The necessary re-capitalisation of domestic banks may also be acceptable. However, the loss over state-directed lending and investment would be hard to stomach. Just imagine how the authorities would have fared in 2008-09 without being able to get the banks to extend massive loans and without banks being able to rely on captive, low-cost deposit funding!
The political leadership, concerned about economic development and economic stability as a pre-requisite for political stability, is unlikely to support full-scale internationalization, for this would imply the wholesale transformation of the very economic model that has served China very well for more than three decades. Once the political leadership realises that complete RMB liberalization implies loss of control over the financial system, they will slam the brakes. This may also explain why the authorities are laying the groundwork by way of a controlled and gradual capital account opening, RMB flexibilisation and, to a lesser extent thus far, domestic financial reform. The authorities pursue what could be termed a reversible reform strategy, allowing them to push forward or reverse the reform as it sees fit, without losing control. This applies to both gradual, but reversible RMB flexiblisation and capital account liberalization.
Another strand of thought sees RMB internationalisation and flexibilisation as instrumental and inevitable in terms of moving the Chinese economy towards greater domestic consumption and away from a model relying on ever-increasing domestic investment and large external imbalances that will ultimately prove unsustainable. This may be so. But this scenario will not materialize in the short term given the political economy of RMB internationalization sketched out above. The short-term political incentives at the highest political level militate against the short-term inevitability of reform. But granted: A declining sensitivity to currency appreciation on the back of a declining trade share and/ or declining price sensitivity of exports will increase the incentives for greater RMB flexibility. A declining capacity of the state-controlled financial system to generate high growth will make greater market-based credit allocation more palatable. This would make full-blown capital account liberalization less unpalatable.
A longer period of economic stagnation (say, below 5% growth) would by changing the economic benefits/ political cost trade-off and convince the political leadership make a shift away from state-directed lending and export-led growth diminish a more palatable, even desirable option. In this scenario, RMB appreciation would help move China away from its investment-heavy, export-led development towards a more consumption-driven, service-oriented economy. The move from a heavily state-directed financial system to a more market-oriented one would allow a more efficient allocation of capital less focused on heavy industry and manufacturing. Once these reforms have been successfully implemented, the actual and potential political and economic costs of full-blown capital account opening would be very small. In short, RMB internationalization would both bring about and facilitate the transition from state-led development to a market-based model. That said, the political incentives to bring about the demise of “Beijing consensus” model are very limited.
Where does this leave things? If China does not open its capital account for private-sector capital accounts transaction, private sector demand for RMB and hence the incentive of central banks to primarily hold reserves in RMB is much diminished, even if foreign central banks are granted (unfettered) access to onshore RMB market. (In this context, it is worth recalling that both the German and the Japanese authorities were reluctant to see their currencies play a larger global role, mainly for fear of losing control of monetary policy.) Foreign central banks may end up holding a small share of their reserves in RMB, mainly for (limited) trade settlement and risk diversification purposes. The bulk of global FX reserve holdings will remain invested in USD. None of this is meant to suggest that the RMB will not eventually become a more important currency. It does, however, look unlikely that the RMB will become a major reserve currency rivaling the USD or the EUR (equivalent) over the next decade or so; for China will be taking a gradualist approach to capital account liberalization, RMB flexibilisation and domestic financial reform. The Chinese authorities will stick to what Deng called “fording the river by feeling for the stones.”
The domestic political economy of RMB internationalization suggests that the process of RMB internationalization will slow down, once it dawns on the political leadership what it means in terms of state control of the economy, including the government’s ability to respond to potentially politically destabilising economic-financial shocks. RMB internationalization requires the effective dismantling of the main pillars underpinning China’s economic development strategy: capital controls, domestic financial repression, state-directed credit allocation, a non-market-determined exchange rate and export-led industrialisation. Complete RMB internationalization would spell the demise of the Chinese development model. Sooner or later, this will (have to) happen. But it is unlikely to happen this decade. To paraphrase Mark Twain, the reports of both the imminent demise of China’s development model and the emergence of the RMB as the global reserve currency as are greatly exaggerated.