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Will the Yuan Challenge the Dollar as Top International Currency? Learning from Historical Precedents Jeffrey Frankel Harpel Professor of Capital Formation.

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Presentation on theme: "Will the Yuan Challenge the Dollar as Top International Currency? Learning from Historical Precedents Jeffrey Frankel Harpel Professor of Capital Formation."— Presentation transcript:

1 Will the Yuan Challenge the Dollar as Top International Currency? Learning from Historical Precedents Jeffrey Frankel Harpel Professor of Capital Formation & Growth CERK International Conference, May 22, 2014

2 Sensationalism about China Full-page headline April 30, 2014, in the FINANCIAL TIMES : _________________________________________________________________________ China poised to pass US as world’s leading economic power this year …based on the latest 6-year update from the World Bank’s International Comparison Program. 2

3 The facts On the one hand, China’s economic miracle is genuine: –Growth at 10% p.a. for 3 decades is historic. –It took the UK 58 years to double income, starting from 1780 US: 47 years, from 1839 Japan: 35 years, from 1885 Korea: 11 years, from 1966 –But it took China just 8 years, from 1987 ! On the other hand, China is still poor: –It ranks only midway among 199 countries (99 th, with Albania). The claim to rival US in size comes from multiplying a middle income-per-capita times 1.3 billion people. 3

4 Measuring GDP The dragon takes wing New data suggest the Chinese economy is bigger than previously thought May 3rd 2014 | 4 Korea

5 Recent reports that “China’s GDP will pass the US this year.” 5 But that is a mis-application of the PPP numbers from the World Bank’s ICP project

6 Use PPP rates to compare income per capita e.g., to judge if: –governments have successfully raised living standards; –a country is rich enough to cut pollution; –the currency is “undervalued,” given its income. 6 Use actual exchange rates to compare GDP e.g., to judge: –How big is the market, from the view of multinational companies? –How big should a country’s quota be in the IMF? –How many ships can its navy buy? –How big is the global role for its currency?

7 7 Measuring GDP Using actual exchange rates gives a different answer: The US is still 83% bigger than China. Thanks to Qing Yu 2014 with IMF WEO forecast

8 China has not yet overtaken the US. The cross-over may come in 2021, under reasonable projections: real growth differential = 5%; real appreciation = 3%. Author’s calculations. (Thanks to Qing Yu.)

9 The possibility that the renminbi is joining the ranks of international currencies has generated much excitement. Indeed some claim that the RMB could even overtake the $ by 2020: Subramanian (2011a, b). But there are good reasons to doubt it. International Currency Rankings

10 We can look to the past for help in evaluating the RMB’s prospects in the future. The three best precedents in the 20th century: –the rise of the $ from 1913 to 1945, –the rise of the DM from 1973 to 1990, –and the rise of the ¥ from 1984 to But first: what is an international currency?

11 11 What is an international currency? Definition: An international currency is used by non-residents. The prospects for a country’s status as an international currency is not the same as its exchange rate prospects. Example: –The dollar depreciated strongly, reaching an all-time low against the yen, among much hand-wringing. –And yet its international currency use rose during that period.

12 12 Central bank reserve holdings are the most easily quantified, and probably the most important, of the various measures. Roles of International Currency

13 13 International reserve currency determinants What suits a currency for international use? Determinant 1.Size 2.Rate of return 3. Depth of financial markets Empirical proxy: GDP (or trade) inflation, (or trend depreciation or exchange rate variance) FX turnover in main financial center

14 14 Determination of international currency status, continued People use a given currency –when everyone else is using it, –not just because of its intrinsic characteristics. English became the international lingua franca –not because of its beauty (French), –nor its simplicity (Esperanto), –nor even the number of native speakers (Chinese). => Network externalities.

15 15 Determinants of reserve currency standing, continued Network externalities => Tipping captured by: 1)Inertialags 2)Nonlinearitylogistic functional form in determinantsor dummy for leader GDP Source: Chinn & Frankel (2007 )

16 16 Historical illustration of the lag: £ ‘s loss of premier international currency status in 20 th century By 1919, US had passed UK in 1.output (1872) 2.trade (1914) 3.net international creditor position ( ) But the $ passed £ as #1 reserve currency only with a lag.

17 17 Eichengreen, Chitu & Mehlo, April 2014 Central bank holdings of FX Reserves, The US $ passed ₤ by 1955 and has been #1 ever since.

18 18 Barry Eichengreen, Livia Chitu & Arnaud Mehlo, “Stability or Upheaval? The Currency Composition of International Reserves in the Long Run.” April 201. Random effects estimates. (S.e.s in parentheses are robust to heteroscedasticity and clustered heterogeneity.) *** p=.01 ** p= Reserve Currency Shares are Affected by Size and Inflation GDP Lagged share Inflation rate Statistically significant:

19 19 Currency share vs. GDP (market rates). The relationship is not linear, but steeper in the middle Shares of major currencies In central bank reserve holdings Size of currency’s home economy } Tipping point Source: Chinn & Frankel (2007 )

20 20 Explaining currency shares econometrically [2][4][7] GDP [0.64][0.92][0.29] Inflation [1.16] Depreciation trend [0.59] Ex rate variance [0.57][0.64][0.34] FX turnover [0.29][0.30][0.15] GDP leader dummy [0.16] Lag logit: log(share t-1 / 1 - share t-1 )[0.03] [0.01] logit Source: Chinn & Frankel Boldface = statistically significant: size, returns, turnover, and lag Chinn & Frankel (2007)

21 Does China have the will for financial liberalization which would be necessary to achieve the rapid RMB internationalization it seems to want? Dissecting China’s internal politics is hard. –The officials may not know the answer themselves. Let’s look to the historical precedents.

22 Precedent (I): The Rapid Ascent of the Dollar after 1913 In 1913, the £ was on top, the same as in 1899: –≈ 60 % of the world’s trade invoicing –≈ 2/3 of known forex holdings of official institutions, > twice the total of the next nearest competitors, the French franc & German mark. The $ was not even in the top 3.

23 The international status of the $ rose rapidly after 1913 The traditional view is that, due to inertia, the $ did not surpass the £ until after World War II, –a half-century + after the US economy passed the UK economy –E.g., Krugman (1984). Eichengreen (2011) claims it happened earlier: Either way, the $’s rise to major international currency status was fast, once the conditions were in place.

24 The conditions for international currency status Prior to 1913, –The US satisfied Criterion #1 (Size) –Criterion #2 was in some doubt due to history of financial crises. It lacked a central bank. –And Criterion 3 was definitely lacking: deep, liquid, dependable & open financial markets.

25 Putting the conditions in place These conditions for $ internationalization were put in place –without political support for greater global stature, –nor business support for an internationalized $. To the contrary, popular opinion was highly suspicious of the “Eastern banking conspiracy.” So a tiny elite quietly mid-wifed the new international currency.

26 The conspirators Sen. Nelson Aldrich convened the meeting of 6 “duck hunters” on Jekyll Island in 1910 (the Aldrich Plan produced the Fed in 1913), chaired by Paul Warburg, incl. Benjamin Strong ( representing J.P.Morgan), who later became the 1 st NY Fed president, , nurtured the $ in the 1920s, & promoted American lending to Europe. & Frank Vanderlip, president of Nat. City Bank of NY, opened international branches & expanded $ lending. Little government representation Treasury Asst.Secy. (A.Piatt Andrew) 26 Sources: Ahamed (2009), Broz (1997, 99), Eichengreen (2011), Eichengreen & Flandreau (2010), Karmin (2008).

27 Precedent (II): The Ascent of the DM after 1973 Short life of the DM: –The Bundesbank was not founded until 1957, –though Erhard had created the DM in 1948 currency reform. –The DM disappeared into the euro in In between, it was pressed into service as an alternative to the $, –after US inflation rose –& Nixon took the $ off gold in –The DM met the criterion of keeping its value better than the $. 27

28 28 Central banks’ reserve holdings The $ share has been on a down trend since 1975 (with the exception of the 1990s). Source: Chinn & Frankel (2007 )

29 But Germans were not pro-internationalization. –Leaders were averse to strutting the world stage. –The powerful manufacturing sector feared upsurges in the demand for DM => real appreciation => lost export competitiveness. Frankfurt as a financial center never developed like London. DM share in CB reserves peaked in 1989 –at ≈ 20 %. In the 1990s Germany euthanized its beloved currency. 29

30 Looking back, one might wonder what the fuss was about 30

31 Precedent (III): The Brief Ascent of the Yen after s: international use of ¥ trended up –as Japan reluctantly opened financial markets, –though domestic politics were opposed –and government policy was at best neutral. –Again, Japan feared that increased demand for its money would hurt export competitiveness. 31

32 The Brief Ascent of the Yen After 1990s: policy sought actively to promote internationalization. But it was too late: –economic fundamentals had already turned around, dominated by the shrinking economy. Today, the ¥ only ranks similarly to the £. 32

33 33 How does China rank, by determinants of international currency status ? 1. Size Chinese economy passed Japan in 2010, to attain 2 nd ranking. Some projections claim it will pass the US in But –What matters here is GDP (& trade) compared at market exchange rates, not PPP-adjusted. Euroland’s GDP is still bigger than China too.

34 34 China’s rank, by determinants of international currency status, cont. 2. Rate of return A financial crisis probably still lurks –somewhere down the road, from the shadow banking sector. Nevertheless, it is likely that the rate of return to holding RMB over the next ten years will be high. Indeed that is the reason since 2004 for the strong portfolio capital inflows. –Prasad & Wei. As of 2014, the PBoC appears to have met successfully the inflation threat that had revived in 2010.

35 35 China’s rank, by determinants of international currency status, concl. 3. Depth of financial markets One the one hand… China is starting to use RMB in international trade The IFC & ADB have issued “panda bonds ” since Foreign central banks can hold RMB since 2010 –Malaysia’s CB went first, buying RMB bonds for its FX reserves. –Swap arrangements with 13 emerging-market CBs (Yu, July 2012). RMB market developed in Hong Kong –Foreigners have been able to issue “dim sum” bonds since 2007, »Bank of China HK launched an index –Yuan deposits reached RMB 920 b in April 2014.

36 36 China’s rank, by determinants of international currency status, cont. On the other hand… Liquidity, breadth & openness still have a long way to go. China’s financial markets still rank far behind others: still highly regulated, –domestic system still “financially repressed.” –Cross-border capital flows still subject to heavy controls; –foreign companies cannot borrow in China. RMB bonds & deposits in HK are small as a fraction. –Of course HK itself, tho part of PRC, is still firmly tied to US$. The “offshore” strategy for internationalization may not be enough.

37 37 China remains far less open financially than the US or UK Higher values denote higher financial openness. Source: Chinn (2012). De jure financial openness index (Chinn-Ito KAOPEN).

38 The Chinese government’s strategy of seeking RMB internationalization offshore China first established special economic zones –in a few provinces in the 1980s –to experiment with opening to international trade. –It worked spectacularly, and the SEZ experiment was expanded to more & more regions. It is trying the same with RMB: –to experiment with international use of the currency. But segmentation of financial markets is harder, –because arbitrage is easier, than with merchandise trade.

39 The RMB’s share of FX trading has risen but is still well behind SF, let alone ¥. 39 Courtesy of Menzie Chinn

40 RMB has risen… to 9 th place in FX trading 40

41 7 th place in FX transaction costs, Hong Kong $ Euro Danish krone Pound sterling Canadian $ Japanese yen Chinese yuan Australian $ Swiss franc Singapore dollar Indian rupee Malaysian ringgit Mexican peso New Zealand $ Brazilian real Swedish krona Thai baht Turkish new lira Norwegian krone Korean won0.164 Foreign Exchange Spreads between Spot Bid & Ask Quotations Against the US $ in NY (% of ask price quotation) Data for 2014 are through April 25. Average of daily closing prices. Source: Bloomberg & author's calculation s. Thanks to A.Saiki

42 In foreign exchange reserves, 42 the RMB hasn’t yet broken into the top 7. Meanwhile, the $’s share stopped falling; –it levelled off in The RMB passed the Swiss franc in Jan to become the 7th most-used currency with a market share of 1.4 %, according to SWIFT. Still far behind $ & €. In world payments,

43 43 Conclusion: China’s ascent in the currency rankings will be gradual Why? Criteria #1 & #2 are in place. But internationalization also requires: –domestic financial liberalization, –and then full currency convertibility. which China is probably not yet ready to accept.

44 My candidate to play the role of the Jekyll Island “duck hunters”: Zhou Xiao Chuan of the PBoC The internationalization of the renminbi is the will of the market rather than a government-backed move, PBoC Governor Zhou Xiaochuan was quoted as saying…. "It is the result of the growing power of the nation and its financial market boom... though there is still much to do considering the low level of development and openness," Zhou said in an interview with China Business News. According to Zhou, China needs to …further open the nation's financial market. "In general, we should do our homework, and let the market decide which currency should be used," he said. China Daily, June 5, 2012

45 One theory: officials like Zhou want to use international liberalization to force the pace of domestic liberalization. –David Pilling, FT, Sept. 6, –This is the sequence Japan & Indonesia tried. –It did not work very well. –The usual sequence is domestic liberalization before international, and for good reason. A guess: the RMB will take a decade to rival the ¥. and much longer to rival the €, let alone the $. 45

46 References by the speaker underlying this talk “China is Not Yet Number 1,” VoxEU, May 9, “Internationalization of the RMB and Historical Precedents,” 2012; Journal of Economic Integration (Seoul). “Historical precedents for the internationalization of the RMB,” 2011 workshop in Beijing of CFR & the China Development Research Foundation.Historical precedents for the internationalization of the RMB,” workshopCFR Summaries at RIETI & Vox, Oct RIETIVox International Currency Rankings “The latest on the dollar’s international currency status,” VoxEU, Dec The latest on the dollar’s international currency status “Will the Euro Eventually Surpass the Dollar as Leading International Reserve Currency?” with Menzie Chinn, in G7 Current Account Imbalances: Sustainability and Adjustment, R.Clarida, ed. (U. Chicago Press), NBER WP No “Will the Euro Eventually Surpass the Dollar as Leading International Reserve Currency?”G7 Current Account Imbalances: Sustainability and AdjustmentWP No The Dollar's Demise? Future of the Dollar as the World's Principal Reserve Asset," H.W.Brock, ed., SED, 1997.The Dollar's Demise? Future of the Dollar as the World's Principal Reserve Asset," "The SDR, Reserve Currencies, and the Future of the International Monetary System" with Barry Eichengreen, in The Future of the SDR in Light of Changes in the International Financial System, M.Mussa, J.Boughton, & P.Isard, eds. (IMF), 1996."The SDR, Reserve Currencies, and the Future of the International Monetary System"The Future of the SDR in Light of Changes in the International Financial System "Still the Lingua Franca: The Exaggerated Death of the Dollar," Foreign Affairs 74, no.4, 1995"Still the Lingua Franca: The Exaggerated Death of the Dollar," Foreign Affairs 74, no.4, 1995 "On the Dollar," The New Palgrave Dictionary of Money and Finance (MacMillan), 1992."On the Dollar,"

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48 Some papers by others on RMB internationalization Yu, Yongding, “Revisiting the Internationalization of the Yuan,” ADBI Working Paper Series No. 366, July 2012.Revisiting the Internationalization of the Yuan Zhang, C “The Development of the Offshore RMB Business,” presentation, ADBI, Tokyo. Feb. Eswar Prasad & Le (Sandy) Ye, 2012, The Renminbi’s Role in the Global Monetary System (Brookings).The Renminbi’s Role in the Global Monetary System Subramanian, Arvind. 2011a. “Renminbi Rules: The Conditional Imminence of the Reserve Currency Transition.” WP s No (Peterson Institute for International Economics, September). Subramanian, Arvind. 2011b. Eclipse: Living in the Shadow of China’s Economic Dominance (PIIE). Marcel Fratzscher & Arnaud Mehl, “China’s Dominance Hypothesis and the Emergence of a Tri-polar Global Currency System.” CEPR Discussion Paper No (London), Nov Chen, Hong Yi, Wenshen Peng & Chang Shu “The Potential of Renminbi as an International Currency,” in Currency Internationalisation: Lessons from the Global Financial Crisis and Prospects for the Future in Asia and the Pacific, BIS Papers No. 61, Dec Gao, Haihong, & Yongdin Yu, 2011, “Internationalisation of the Renminbi,” BIS Papers No. 61. Chen, Hong Yi, Wenshen Peng & Chang Shu “The Potential of Renminbi as an International Currency,” in BIS Papers No. 61, December, pp Chen, Xiaoli, &Yin-Wong Cheung, “Renminbi Going Global,” HKIMR Working Paper No. 08/2011. Robert McCauley, “The Internationalisation of the Renminbi.” HKIMR. Masahiro Kawai & Shinji Takagi, “The RMB as a key International Currency: Lessons from the Japanese Experience,” AEEF conference, Paris, January Agnès Bénassy-Quéré & Jean Pisani-Ferry, “What international monetary system for a fast-changing world economy,” AEEF, January Yung Chul Park & Chi-Young Song, “RMB Internationalization: Prospects and Implications for Economic Integration in East Asia,” 2010, Asian Economic Papers. Jong-Wha Lee, “Will the RMB Emerge as an International Currency?” workshop, ADB & CCER, Wu, Friederich, Rongfang Pan, & Di Wang, 2010, “Renminbi’s Potential to Become a Global Currency,” China and the World Economy 18(1): Takatoshi Ito, “China as Number One: How About the RMB?”Asian Economic Policy Review, 2010, 5. Chen Yulu, Wang Fang & Yang Ming “Currency Internationalization as a National Competitive Strategy: US Dollar's Empirical Evidence—And a Study on the Issue of Renminbi,” Ec.Res.J., 2005.

49 References on yuan exchange rate by the speaker " The Renminbi Since 2005," in The US-Sino Currency Dispute: New Insights from Economics, Politics and Law, edited by S.Evenett (CEPR: London) The Renminbi Since 2005The US-Sino Currency Dispute: New Insights from Economics, Politics and Law “ New Estimation of China’s Exchange Rate Regime,” in Pacific Economic Review 14, no.3, August NBER WP no New Estimation of China’s Exchange Rate RegimePacific Economic Reviewno.3WP no “Comment on ‘China’s Current Account and Exchange Rate,’ by Yin-Wong Cheung, Menzie Chinn & Eiji Fuji,” in China’s Growing Role in World Trade, NBER, edited by Feenstra & Wei (University of Chicago Press, 2010).CommentChina’s Growing Role in World TradeNBER,University of Chicago Press “Comments on Cline and Williamson’s ‘Estimates of the Equilibrium Exchange Rate of the Renminbi?’,” in Debating China's Exchange Rate Policy, M.Goldstein & N.Lardy, eds. (Peterson Institute for International Economics), “Comments on Cline and Williamson’s ‘Estimates of the Equilibrium Exchange Rate of the Renminbi?’,”Debating China's Exchange Rate PolicyPeterson Institute for International Economics " Assessing China's Exchange Rate Regime," with Shang-Jin Wei, Economic Policy 51, July Video interview. Vox summary. NBER WP " Assessing China's Exchange Rate Regime,"Economic PolicyVideo interviewsummaryNBERWP " On the Yuan : The Choice Between Adjustment Under a Fixed Exchange Rate and Adjustment under a Flexible Rate," in Understanding the Chinese Economy, edited by G. Illing (Oxford U. Press), NBER WP " On the Yuan : The Choice Between Adjustment Under a Fixed Exchange Rate and Adjustment under a Flexible Rate,"Understanding the Chinese Economy,G. IllingNBERWP “ On the Renminbi,” CESifo Forum, 6, no.3, Autumn 2005 (Ifo Institute for Economic Research, Munich).“ On the Renminbi,”CESifo


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