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Over the last few years, use of China’s currency for international trade has been growing steadily. Some argue this is the start of a journey that will see the renminbi displace the dollar and become the international reserve currency within a decade. This column asks whether such prophecies are realistic by looking at how other international currencies established themselves.
All of a sudden, the renminbi is being touted as the next big international currency.
Just in the last year or two, the Chinese currency has begun to internationalize along a number of dimensions.
A renminbi bond market has grown rapidly in Hong Kong, and one in renminbi bank deposits. Some of China’s international trade is now invoiced in the currency. Foreign central banks have been able to hold renminbi since August 2010, with Malaysia going first.
Some are now claiming that the renminbi could overtake the dollar in the number one slot in the international currency rankings within a decade.
The basis of this prediction is, first, the likelihood that the Chinese economy will surpass the US economy in size and, second, the historical precedent when the dollar overtook the pound sterling as the number one international currency during the period after the First World War.
It used to be thought that international currency status was subject to much inertia (e.g. Krugman 1984, Goldberg 2010). There was said to have been a long lag between the date when the US economy passed the UK economy with respect to size (1872, by the criterion of GNP) and the time when the dollar passed the pound (1946, by the criterion of shares in central banks’ holdings of reserves).
The “new view,” represented in particular on this site by Eichengreen (2011) and Eichengreen and Flandreau (2010), is that the lag was in fact rather short.
It took until the First World War for the dollar to fulfil the criteria of an international currency. Furthermore, the date when the dollar is said to have come to rival the pound in importance has now been moved up to the mid-1920s.
In recent research (Frankel 2011), I argue that the first point is right. If trade is the measure of size, the US first caught up with the UK during the First World War. The US did not even have a permanent central bank until 1913.
The other important criteria came soon thereafter: creditor status for the country; the perceived prospects for the currency to remain strong in value; and deep, liquid, open financial markets. (I have discussed the criteria in earlier papers.
Chinn and Frankel 2007 evaluate them econometrically and give further references.) The second point seems a matter of whether or not we want to distinguish between the concept of “coming to rival” / “catching up with” the pound (1920s) versus the phenomenon of definitively “pulling ahead” / “displacing” the pound (1945). Under either interpretation, the dollar’s initial rise as an international currency was indeed rapid, once the conditions were in place.
The dollar is one of three national currencies to have attained international status during the 20th century. The other two were the yen and the mark, which became major international currencies after the breakup of the Bretton Woods system in 1971-73. (The euro, of course, did so after 1999.) In the early 1990s, both were spoken of as potential rivals of the dollar for the number one slot. It is easy to forget that now, because Japan’s relative role has diminished since then and the mark has been superseded. In retrospect, the two currencies’ shares in central bank reserves peaked as the 1990s began.
The current renminbi phenomenon differs from the historical circumstances of the rise of the three earlier currencies in that the Chinese government is actively promoting the international use of its currency. This was something that neither Germany nor Japan, nor even the US, did – at least not at first. In all three cases, exporters, who stood to lose competitiveness if international demand for the currency were to rise, were much stronger than the financial sector, which might have supported internationalization. We might expect the same fears of a stronger currency and its effects on manufacturing exports to dominate the calculations in China.
In the case of the mark and yen after 1973, internationalization came despite the reluctance of the German and Japanese governments. In the case of the United States after 1914, a tiny elite promoted internationalization of the dollar despite the indifference or hostility to such a project in the nation at large. These individuals, led by Benjamin Strong, the first president of the New York Fed, were the same ones who had conspired in 1910 to establish the Federal Reserve in the first place.
It is not yet clear that China’s new enthusiasm for internationalizing its currency includes a willingness to end financial repression in the domestic financial system, remove cross-border capital controls, and allow the RMB to appreciate, thus helping to shift the economy away from its export-dependence. Perhaps a small elite will be able to accomplish these things, in the way that Strong did a century earlier. But so far the government is only promoting international use of the RMB offshore, walled off from the domestic financial system. That will not be enough to do it.
Chinn, Menzie, and Jeffrey Frankel (2007), “Will the Euro Eventually Surpass the Dollar as Leading International Reserve Currency?” in G7 Current Account Imbalances: Sustainability and Adjustment, edited by Richard Clarida (University of Chicago Press).
Eichengreen, Barry (2011), “The Dollar: Dominant no more?”, VoxEU.org, 10 January.
Eichengreen, Barry, and Marc Flandreau (2010), “The Federal Reserve, the Bank of England and the Rise of the Dollar as an International Currency, 1914-39“, BIS Working Paper No. 328.
Eichengreen, Barry, and Jeffrey Frankel (1996), “The SDR, Reserve Currencies, and the Future of the International Monetary System” in M Mussa, J Boughton, and P Isard (eds.), The Future of the SDR in Light of Changes in the International Financial System, International Monetary Fund).
Frankel, Jeffrey (2011), “Historical precedents for the internationalization of the RMB“, written for a workshop organised by the Council on Foreign Relations and the China Development Research Foundation.
Goldberg, Linda (2010), “What is the status of the international roles of the dollar?”, VoxEU.org, 31 March.
Krugman, Paul (1984), “The International Role of the Dollar: Theory and Prospect”, in J Bilson and R Marston (eds.), Exchange Rate Theory and Practice, University of Chicago Press, 261-278.