The rise of a currency as the intervention currency, anchor currency and the reserve currency is not an accident. There were clear reasons why the dollar emerged as the uncontested leader among other international currencies such as the pound, yen and the deutsche mark after the Second World War.
Firstly, the US economy surpassed the UK economy in size in 1872. Secondly, the two World Wars pushed the US from being a net debtor to a net creditor. The emphatic claims of dethroning the dollar after the breakdown of the Bretton Woods regime did not result in the same. The current account surpluses and low inflation rates constituted an obvious set of explanations as to why the dollar retained its supremacy into the nineties.
Will these reasons play out once again and help the yuan become an international currency? The attempt by the Chinese authorities to make transactions using the yuan more prevalent suggests that policy efforts to internationalise the yuan has been initiated.
If the past were to be an indicator of the determining factors of internationalisation, much of it on the yuan remains to be done. On the trade front, the currency of a country that has the largest share in international output, trade and finance has a natural advantage. Being the manufacturing hub for the world and racing ahead to become the world?s largest economy, China has clearly made headway on this front. Furthermore, early this year, Hong Kong was the first city outside Mainland China to have been allowed to start trade settlement using the yuan. The three-year swap lines worth 650 billion yuan ($95 billion) with Hong Kong, Argentina, Indonesia, South Korea, Malaysia and Belarus since the start of the year has increased the access to the yuan for trade settlement.
Earlier this month, the Chinese Ministry of Finance began to issue six billion worth yuan-denominated bonds in Hong Kong. Although Bank of China and Export-Import Bank of China have been issuing such bonds for a couple of years now, this was the first time government bonds were issued. All these point to the policy intention of internationalising the yuan.
In order to use the yuan as a vehicle currency, quotation currency and as a currency in which investment into debt is possible, capital and money markets in China should be open and free of any controls.
Comparing the development on this front, the Chinn-Ito and Lane-Milesi Ferreti databases measuring de jure and de facto openness of economies allows one to take a snapshot of relative openness across economies.
In 2007, on the de jure front, China scored -1.13 compared with 2.53 for Hong Kong, the United States and other advanced economies. On the de facto front, China scored relatively better than its own de jure score at 1.12 compared with 2.78 for the United States and 23.90 for Hong Kong. Clearly, much work remains to be done to make the yuan convertible. A fully liberalised capital account is not a sufficient condition to create an enabling environment for internationalisation of the yuan. Deep and liquid markets, debt and otherwise, are far more crucial. Domestic financial development is also an integral part of going global as markets that cannot provide sufficient liquidity and depth will not be able to support its currency going global.
The policy challenge for the authorities to tackle is that of simultaneity: deep and liquid markets cannot happen without greater liberalisation of the capital account, while liberalisation of the capital account may yield no result without deep and liquid markets. The Chinese authorities have some homework to do to develop its financial sector before an international yuan is present in the global markets.
Another important determinant of an international yuan is to do with network externalities. The value of the yuan as an international currency is derived from the number of people who use it. Given that the currency is tightly managed, and that the PBOC decides who gets to use more of the currency, internationalisation comes in direct conflict with the goal to manage the currency, and to prevent any erosion of value of its external assets.
In other words, a currency cannot be a reserve currency unless it is international, and the currency cannot be international when confidence in the value of the currency is not high because of intervention and poor domestic inflation management. Once again, China needs to take its stance on this matter before the goal of an international yuan is materialised. The dollar, euro, yen and the pound have been on the centre stage for many years. The rise of the yuan and even the Indian rupee is certain. The Chinese have started making their moves for internationalisation of the yuan although the euphoria over the baby steps towards internationalisation has no economic significance until macroeconomic policy challenges are resolved.
India, with similar macroeconomic policy issues in this regard, will eventually have to start thinking about putting the rupee on the global platform.
?The author works with NIPFP