Can renminbi challenge the dollar? by Dr Kamal Monno

Amidst a growing trend of currency swaps between countries and especially amongst large trading partners, the rise of renminbi as an international currency is looked up with an almost breathless anticipation.

All this excitement has tended to eclipse a more sober assessment of the opportunities and obstacles the Chinese yuan realistically faces, as well as the benefits and burdens a larger international role for the renminbi would pose for China. Rarely are the questions asked: does China really want or need to manage a global currency? And if so, what price is it willing to pay?
The renminbi has already come a long way, as not that long ago it was not a fully functional currency even within China’s own borders. All imported goods, as well as services provided to foreign visitors, had to be paid for with Foreign Exchange Certificates (FEC), in exchange for hard currencies.
While the FEC were ostensibly denominated in the same yuan as the renminbi used for domestic purposes, there buying power were obviously quite different, giving rise to a vibrant black market on the doorstep of every international hotel across the country.
Gradually, the yuan’s exchange rate was allowed to depreciate nearly six-fold, from 1.5 CNY/USD to 8.2, closing the trading gap and allowing China to phase out the FEC in 1995. This opened the door for China to make the renminbi convertible for current account (i.e. trade) transactions the following year.
In practice, convertibility on the current account meant that the Chinese companies, or foreign companies operating in China, could exchange renminbi for foreign currencies to purchase imports, as long as they presented a valid invoice. Trade itself, both imports and exports, was conducted almost entirely in foreign currencies - mainly in US dollars.
It is worth pausing for a moment here and asking: why US dollars? After the US de-linked the dollar from gold in 1971, demolishing the post-war Bretton Woods system, there has been no institutional framework enshrining the US dollar as the world’s preeminent currency. The dollar retains its role because market participants prefer to use it for three main reasons:
The dollar represents a claim on goods and services in the world’s largest economy, presuming it retains its value;
The dollar can be freely used or exchanged for any (legal) purpose without restriction; and
The dollar can be held in a wide range of readily traded investment instruments and in large amounts.
The drawbacks of relying so heavily on the US dollar were driven home by the immediate aftermath of the Lehman Brothers collapse in September 2008. For several terrifying days, credit markets seized up. All over the world, exporters and importers, who needed US dollars to conduct business, could not secure financing and trade threatened to grind to a halt.
The Federal Reserve stepped in to provide dollars via “swaps” with central banks, but not every country found itself first in line to obtain relief. It was this crisis that provided the impetus for China to negotiate bilateral currency swap agreements with several of its largest trading partners.
Since few people properly understand what the central bank currency swaps actually are or how they function, the signing of these agreements by China has given rise to the misapprehension that the renminbi has already arrived as an alternative reserve currency. This is not the case, as no currency reserves are exchanged in a currency swap agreement.
The “swaps” are simply an emergency back-up in the event of another crisis like the one in 2008. It is unclear how such swaps, if implemented, could be unwound, except through careful stage management, since there is no global market for banks to replenish their renminbi balances (or for that matter of any other currently non-reserve currency), once deployed.
For now, however, this is a bridge nobody is too worried about having to cross! And the much touted currency swaps that China or any other country has entered into represent merely a tailored response to a specific set of concerns. Importantly, in China’s case, this in no way heralds the renminbi’s arrival as a fully functional global currency.
In the 1960s, the American-Belgian economist, Robert Triffin, observed an interesting dilemma involving the dollar’s role as the dominant global currency. In order for the dollar to be a desirable currency to possess, it has to buy things that everyone all over the world wants. To meet such a need, it has to be readily obtainable that means the US must run a balance of payments deficit. In other words, it has to export currency either by running a trade deficit, or by channelling a very large amount of investment abroad.
For the dollar to be a global currency, there has to be some way for people around the world to get their hands on it. Up until very recently, China has been running surpluses on both the current and capital accounts. The result is that, far from the renminbi accumulating abroad, China itself has accumulated a massive stockpile of $3 trillion in foreign currency reserves.
Foreign buyers can’t pay for Chinese exports in renminbi because, in net terms at least, they have had little chance to earn it (renminbi). And unless China starts running a trade deficit, or opens its capital account and allows a lot more investment to flow overseas, any yuan the Chinese use to pay for imports only adds to the sum of foreign currency left in the republic’s official reserves - heightening rather than reducing its dependence on dollars.
For the renminbi to take on a more prominent international role, much less emerge as one of the world’s chief reserve currencies, would require a dramatic change in China’s relationship to the global economy - a change it is far from clear China either anticipates or desires.
Opening China’s capital account is the key to another obstacle facing the renminbi: where, if investors do hold yuan, they are supposed to put them? According to McKinsey, 40 percent of global capital markets are denominated in US dollars, giving investors, including central banks, deep and liquid markets in which to maintain dollar balances. China, including Hong Kong, accounts for just 4 percent - mostly in equities, and a large part of it barred to foreign investors.
In the wake of this, the only viable solution is for China to finish the process it began in the 1980s and make the renminbi fully convertible on the capital account. Allowing free flows of capital is really the only way China can - in time - develop into the kind of global financing hub that could support a truly international currency.
The problem for Chinese leadership is that achieving this goal requires giving up a substantial amount of control over the economy. Economists call it the “trilemma” or the “impossible trinity”: no country can allow free flows of capital, support a fixed exchange rate, and manage an independent monetary policy at the same time. One of these three has to go!
And as the Japanese discovered with their “big bang” in the mid-1990s, opening China’s financial system to outside market forces would make it a lot harder to hide and quietly manage any bad debt problems lurking in the Chinese banks. So, the question is not just whether the renminbi has the potential or is likely to compete as an alternate global reserve currency with the US dollars in the short to medium terms, but whether China even wants to go down this path?
Such a path involves risks and rewards, obstacles and opportunities, but one thing is for sure that once adopted it will completely change the dynamics of the Chinese economy from what they are today - perhaps, China and the world are not ready for it just as yet!

The writer is an entrepreneur and economic analyst. Email:


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