1. The RMB as an international currency Jeffrey Frankel Harpel Professor of Capital Formation and Growth, Harvard University Club de CEPII, Paris, 12 January, 2011

2. 2 Questions to be addressed What is an international currency? Empirical determinants of international reserve currency status. The Renminbi Why should a country care if its currency is used internationally? 5 reasons why appreciation is in China’s interests. Appendices China-U.S. currency conflict Technical addenda

3. 3 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: 1993-95 –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.

4. 4 Roles of International Currency Central bank holdings of reserves is the most easily quantified, and probably the most important, of the various measures.

5. 5 Determination of international currency status What suits a currency for international use? 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

6. 6 International reserve currency determinants from the literature on reserve currencies Determinant 1.Size 2.Depth of financial markets 3. Rate of return Empirical proxy: GDP FX turnover inflation, trend depreciation, or exchange rate variance

7. 7 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 )

8. 8 Historical illustration of the long 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 (1914-19) $ passed £ as #1 reserve currency only with a lag –by 1940-45 –though Eichengreen says 1924.

9. 9 Figure 1: Currency share vs. GDP (market rates). Is the relationship linear or “ogive”? Shares of major currencies In central bank reserve holdings Size of currency’s home economy } Tipping point Source: Chinn & Frankel (2007 )

10. 10 Explaining currency shares, logit, pre-euro (1973-98) [2][4][7] GDP2.773.691.04 [0.64][0.92][0.29] Inflation-2.64-2.86 [1.16] Depreciation -1.10 Trend [0.59] Ex rate variance-0.98-1.40-1.25 [0.57][0.64][0.34] FX turnover0.450.580.43 [0.29][0.30][0.15] GDP leader dummy -0.22 [0.16] Lag logit: 0.85 0.96 log(share t-1 / 1 - share t-1 )[0.03] [0.01] Boldface = statistically signficant: size, retruns, turnover, and lag

11. 11 How does China rank, by determinants of international currency status? 1. Size Chinese economy famously passed Japan in 2010, to attain 2 nd ranking. Some projections claim it will pass the US soon. But –What matters here is GDP (and trade) compared at market exchange rates, not PPP-adjusted. –Euroland’s GDP is still substantially bigger than China. –Chinese growth will slow down, well before it reaches per capita equality with the West.

12. 12 China’s rank, by determinants of international currency status, cont. 2. Depth of financial markets One the one hand… China is starting to use RMB in international trade Foreign central banks can hold RMB since Aug. 2010 –Malaysia’s CB went first, buying RMB bonds for its FX reserves, in Sept. RMB market is now developing in Hong Kong Since 2007, RMB 62 b RMB bonds (27 batches) issued off-shore »including by MacDonald’s. »Bank of China HK launched an index Dec. 31, 2010. In November, RMB deposits reached RMB 280 b.

13. 13 In Hong Kong banks, yuan- denominated deposits have quadrupled over the last year – but from a low base. “RMB goes viral,” Financial Times, Jan. 4, 2011

14. 14 Why should a country care? Pros & cons of having one’s currency used internationally. 4 ADVANTAGES TO A COUNTRY OF HAVING ITS CURRENCY USED INTERNATIONALLY. (1) Convenience for its residents. (2) Business for its banks & other financial institutions. (3) Seignorage –narrowly defined as willingness to hold, e.g., the $ as high-powered money (esp. fx reserves held by central banks) or –more broadly as willingness of private investors to hold $-denominated assets: America’s “exorbitant privilege.” (4) Political power and prestige.

15. 15 China’s rank, by determinants of international currency status, cont. On the other hand… RMB bonds and deposits in HK are small as a fraction. –And of course HK$ is itself still firmly tied to US$. Development of China’s financial market has just begun. It ranks far behind other major currencies.’ Still very highly regulated –Domestic system still “financially repressed.” –Cross-border capital flows still subject to heavy controls. »Foreign companies still cannot borrow in China. Liquidity, breadth, openness… still have a long way to go.

16. 16 China’s rank, by determinants of international currency status, cont. 3. Rate of return Inflation in China is again a danger currently. A financial crisis probably lurks –somewhere down the road. Nevertheless, it is quite likely that the rate of return to holding RMB over the next ten years will be high. Indeed that is the reason for the strong portfolio capital inflows since 2004. –Prasad & Wei.

17. 17 China’s rank, by determinants of international currency status, cont. Inertia suggests that China’s ascent in the currency rankings will be gradual. The rest of Asia will probably be no keener on a yuan bloc than it was on a yen bloc in the 1980s. A guess: It will take the RMB a decade to surpass the ₤ & CHF and rival the ¥. and much longer to rival the €, let alone the $. Nevertheless, that is the direction it is headed. And the $ is likely to continue losing share to all the other international reserve assets in the future.

18. 18 Central banks’ reserve holdings The $ share has been on a downward trend since 1975 (with the exception of the 1990s). Source: Chinn & Frankel (2007 )

19. 19 The $ share of central bank holdings resumed its decline in 2001. Data: 1999-2009 from COFER, IMF. Source: http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/2009/10/01/dollar-share-in-central-banks-fx-reserves-resumes-its-decline / http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/2009/10/01/dollar-share-in-central-banks-fx-reserves-resumes-its-decline /

20. 20 The global monetary system may move from dollar-based to multiple international reserve currencies The € is still a rival for the $. The SDR is again part of the system. Gold in 2009 made a comeback as an international reserve too. The RMB will join the roster with ¥ & ₤. = a multiple international reserve asset system.

21. 21 How can international currency status translate into political power? Precedent: The Suez crisis of 1956 [i] [i] –is often recalled as the occasion on which Britain was forced under US pressure to abandon its remaining imperial designs. –But recall also the important role played by a simultaneous run on the £ and the American decision not to help the beleaguered currency. [i][i] Frankel, “ Could the Twin Deficits Jeopardize US Hegemony, ” Journal of Policy Modeling, 28, no. 6, Sept. 2006. At http://ksghome.harvard.edu/~jfrankel/SalvatoreDeficitsHegemonJan26Jul+.pdf. Also “ The Flubbed Opportunity for the US to Exercise Global Economic Leadership ” ; in The International Economy, XVIII, no. 2, Spring 2004 at http://ksghome.harvard.edu/~jfrankel/FlubJ23M2004-.pdfhttp://ksghome.harvard.edu/~jfrankel/SalvatoreDeficitsHegemonJan26Jul+.pdf

22. 22 2 DISADVANTAGES OF HAVING ONE’S CURRENCY USED AS AN INTERNATIONAL CURRENCY. The possibility of larger fluctuations in the demand for one's money. The possibility that an increase in demand for the currency would cause it to appreciate sharply, –rendering exporters uncompetitive on world markets. In the past, the German & Japanese governments were reluctant to see their currencies play larger international roles.

23. Internationalization of the RMB would likely entail appreciation: Liberalization of capital controls would allow pent-up demand to show up. International demand to hold RMB would rise. China’s fear that appreciation would lose it competitiveness vis-à-vis Asian neighbors would disappear.

24. 24 Papers by the author on which this talk draws RMB "The Renminbi Since 2005," in The US-Sino Currency Dispute: New Insights from Economics, Politics and Law, S.Evenett, ed. (CEPR: London) 2010, 51-60.The Renminbi Since 2005The US-Sino Currency Dispute: New Insights from Economics, Politics and Law "What’s 'In' and What’s 'Out' in Global Money," in Finance & Development, IMF, Sept.2009. [Translated into Chinese, for International Herald Leader, Xinhua, Beijing.]What’s 'In' and What’s 'Out' in Global Money Finance & DevelopmentTranslated into ChineseInternational Herald Leader “New Estimation of China’s Exchange Rate Regime,” i n Pacific Economic Review 14, no. 3, Aug. 2009 (Blackwell Publ.), pp.346-60.New Estimation of China’s Exchange Rate RegimePacific Economic Reviewno. 3Blackwell "Assessing China's Exchange Rate Regime," with Shang-Jin Wei, in Economic Policy 51, July 2007, pp. 575-614."Assessing China's Exchange Rate Regime," Economic Policy "On the Yuan: The Choice Between Adjustment Under a Fixed Exchange Rate and Adjustment under a Flexible Rate," in Understanding the Chinese Economy, G.Illing, ed. (Oxford Univ. Press), 2006."On the Yuan: The Choice Between Adjustment Under a Fixed Exchange Rate and Adjustment under a Flexible Rate,"Understanding the Chinese Economy,G.Illing International Currency Rankings “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), 2007. NBER WP No 11510. Chinese translation, International Finance, Central Bank of China, Taipei. “Will the Euro Eventually Surpass the Dollar as Leading International Reserve Currency?”G7 Current Account Imbalances: Sustainability and AdjustmentWP No 11510 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. (International Monetary Fund), 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, July/August 1995, 9-16"Still the Lingua Franca: The Exaggerated Death of the Dollar," Foreign Affairs, 74, no. 4, July/August 1995, 9-16 "On the Dollar," In The New Palgrave Dictionary of Money and Finance (MacMillan Press Reference Books, London), 1992."On the Dollar,"

25. 25 Addendum: Five reasons China should let RMB appreciate, in its own interest 1.Overheating of economy 2.Reserves are excessive. –It gets harder to sterilize the inflow over time. 3.Attaining internal and external balance. –To attain both, need 2 policy instruments. –In a large country like China, expenditure-switching policy should be the exchange rate. 4.Avoiding future crashes. 5.RMB undervalued, judged by Balassa-Samuelson relationship.

26. 26 1. Overheating of economy : Bottlenecks. Pace of economic growth is outrunning: –raw material supplies, and –labor supply in coastal provinces –Also: –physical infrastructure –environmental capacity –level of sophistication of financial system. Asset bubbles. –Shanghai stock market bubble in 2007. –Real estate prices now. Inflation back up to 5.1% last year (to Nov. 2010). –Starting to look like 2007 => price controls  shortages & social unrest. All of the above was suspended in late 2008, –due to global recession. –But it came back again in 2010.

27. 27 Attempts at “sterilization,” to insulate domestic economy from the inflows Sterilization is defined as offsetting of international reserve inflows, so as to prevent them from showing up domestically as excessive money growth & inflation. For awhile PBoC successfully sterilized… –until 2007-08. –The usual limitations finally showed up: Prolongation of capital inflows <= self-equilibrating mechanism shut off. Quasi-fiscal deficit: gap between domestic interest rates & US T bill rate Failure to sterilize: money supply rising faster than income Rising inflation (admittedly due not only to rising money supply)

28. 28 2. Foreign Exchange Reserves Excessive: –Though a useful shield against currency crises, –China has enough reserves: $2 ½ trillion by 2010; –& US treasury securities do not pay high returns. Harder to sterilize the inflow over time.

29. 29 Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008 The Balance of Payments ≡ rate of change of foreign exchange reserves (largely $), rose rapidly in China over past decade, due to all 3 components: trade balance, Foreign Direct Investment, and portfolio inflows

30. 30 While reserves (NFA) rose rapidly, the growth of the monetary base was kept to the growth of the real economy – even reduced in 2005-06. Successful sterilization in China: 2005-06 Attempts to sterilize reserve inflow: were remarkably successful in 2005-06. High reserve growth offset by cuts in domestic credit => steady money

31. 31 In 2007-08 China had more trouble sterilizing the reserve inflow PBoC began to pay higher interest rate domestically, & receive lower interest rate on US T bills => quasi-fiscal deficit. Inflation became a serious problem. –True, global increases in food & energy prices were much of the explanation. –But China’s overly rapid growth itself contributed. Appreciation is a good way to put immediate downward pressure on local prices of farm & energy commodities. Price controls are inefficient and ultimately ineffective.

32. 32 Sterilization faltered in 2007 & 2008 Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008 Monetary base accelerated Growth of China’s monetary base, & its components

33. 33 China’s CPI accelerated again in 2010 5.1% in year ended Nov. 2010

34. 34 3. Need a flexible exchange rate to attain internal & external balance Internal balance ≡ demand neither too low (recession) nor too high (overheating). External balance ≡ appropriate balance of payments. General principle: to attain both policy targets, a country needs to use 2 policy instruments. For a country as large as China, one of those policy instruments should be the exchange rate. To reduce BoP surplus without causing higher unemployment, China needs both – currency appreciation, and – expansion of domestic demand gradually replacing foreign demand, developing neglected sectors: health, education, environment, housing, finance, & services.

35. 35 4. Avoiding future crashes Experience of other emerging markets suggests it is better to exit from a peg in good times, when the BoP is strong, than to wait until the currency is under attack. Introducing some flexibility now, even though not ready for free floating.

36. 36 5. Longer-run perspective: Balassa-Samuelson relationship Prices of goods & services in China are low –compared at the nominal exchange rate. –Of course they are a fraction of those in the U.S.: < ¼. –This is to be expected, explained by the Balassa-Samuelson effect which says that low-income countries have lower price levels. As countries’ real income grows, their currencies experience real appreciation: approx..3% for every 1 % in income per capita. –But China is one of those countries that is cheap or undervalued even taking into account Balassa-Samuelson.

37. 37 Source: Arvind Subramanian, April 2010, “ New PPP-Based Estimates of Renminbi Undervaluation and Policy Implications,” PB10-08, Peterson Institute for International Economics Undervaluation of RMB in the regression estimated above = 26%. Estimated undervaluation averaging across four such estimates = 31%. Compare to Frankel (2005) estimate for 2000 = 36%. The Balassa-Samuelson Relationship 2005

38. Jeffrey Frankel James W. Harpel Professor of Capital Formation & Growth Harvard Kennedy School http://ksghome.harvard.edu/~jfrankel/index.ht m Blog: http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/ http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/