Download China, the US, and Currency Issues

The RMB
as an international currency
Jeffrey Frankel
Harpel Professor
of Capital Formation and Growth,
Harvard University
Club de CEPII, Paris, 12 January, 2011
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
2
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.
3
Roles of International Currency
Table B
Adapted from tables of Kenen and Cohen
Function
of
money:
Store of
value
Medium
of
exchange
Unit of
account
Governments
Private actors
International reserve
holdings
Vehicle currency for
foreign exchange
intervention
Anchor for pegging
local currency
Currency substitution
(private dollarization)
Invoicing trade and
financial transactions
Denominating trade and
financial transactions
Central bank holdings of reserves is the most easily quantified,
and probably the most important, of the various measures. 4
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
5
International reserve currency determinants
from the literature on reserve currencies
Determinant
Empirical proxy:
1. Size
GDP
2. Depth of financial
markets
FX turnover
3. Rate of return
inflation,
trend depreciation, or
exchange rate variance 6
Determinants of reserve currency standing, continued
Network externalities
=> Tipping
captured by:
1) Inertia
lags
2) Nonlinearity
in determinants
logistic functional form
or
dummy for leader GDP
Source: Chinn & Frankel (2007)
7
Historical illustration of the long lag:
£ ‘s loss of premier international currency
status in 20th 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.
8
Figure 1: Currency share vs. GDP (market rates).
Is the relationship linear or “ogive”?
SHARE vs. RATIOY
.8
.7
Shares
of major .6
currencies
In central .5
bank
.4
reserve
.3
holdings
SHARE
}
Tipping
point
.2
.1
.0
(GDP using market rates)
-.1
.0
Source: Chinn & Frankel (2007)
.1
.2
.3
.4
.5
.6
Size of currency’s home economy 9
RATIOY
Explaining currency shares, logit, pre-euro (1973-98)
GDP
Inflation
[2]
[4]
[7]
2.77
3.69
1.04
[0.64]
[0.92]
[0.29]
-2.64
-2.86
[1.16]
[1.16]
Depreciation
-1.10
Trend
Ex rate variance
FX turnover
[0.59]
-0.98
-1.40
-1.25
[0.57]
[0.64]
[0.34]
0.45
0.58
0.43
[0.29]
[0.30]
[0.15]
-0.22
GDP leader dummy
[0.16]
Lag logit:
log(share t-1 / 1 - share t-1)
0.85
0.85
0.96
[0.03]
[0.03]
[0.01]
10
Boldface = statistically signficant: size, retruns, turnover, and lag
How does China rank, by determinants of
international currency status?
1. Size
• Chinese economy famously passed Japan in 2010,
to attain 2nd 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.
11
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.
12
In Hong Kong
banks, yuandenominated
deposits have
quadrupled over
the last year – but
from a low base.
“RMB goes viral,” Financial Times, Jan. 4, 2011
13
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
$-denominated assets: America’s “exorbitant privilege.”
• (4) Political power and prestige.
14
China’s rank, by determinants of international currency status,
cont.
On the other hand…
• RMB bonds and deposits in HK are small as a fraction.
– And of course HK$ 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.
15
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.
16
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.
17
Central banks’ reserve holdings
The $ share has been on a downward trend since 1975
(with the exception of the 1990s).
80
USD share
75
USD + 0.6 Unalloc.
share (COFER)
70
65
60
55
50
Source: Chinn & Frankel (2007)
45
65
70
75
80
85
90
95
00
05
10
18
The $ share of
central bank
holdings
resumed its
decline in 2001.
Data: 1999-2009
from COFER, IMF.
19
Source: http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/2009/10/01/dollar-share-in-central-banks-fx-reserves-resumes-its-decline/
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.
20
• How can international currency status
translate into political power?
Precedent: The Suez crisis of 1956 [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] 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-.pdf
21
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.
22
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.
RMB
•
•
•
•
Papers by the author on which this talk draws
"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.
"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.]
“New Estimation of China’s Exchange Rate Regime,” in Pacific Economic
Review 14, no. 3, Aug. 2009 (Blackwell Publ.), pp.346-60.
"Assessing China's Exchange Rate Regime," with Shang-Jin Wei, in Economic
Policy 51, July 2007, pp. 575-614.
• "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.
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.
The Dollar's Demise? Future of the Dollar as the World's Principal Reserve Asset," H.W.Brock, ed., SED, 1997.
•
"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.
"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 24
Reference Books, London), 1992.
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.
25
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.
26
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
27
Rising inflation (admittedly due not only to rising money supply)
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.
28
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
Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008
29
Attempts
tosterilization
sterilize reserve
inflow:
Successful
in China:
2005-06
High reserve growth
=> steady money
offset by cuts in
domestic credit
While reserves (NFA) rose rapidly, the growth of the monetary base
was kept
to the
growth of the real
economy – even
in 2005-06.
were
remarkably
successful
inreduced
2005-06.
30
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. 31
Sterilization faltered in 2007 & 2008
Monetary base
accelerated
Growth of China’s
monetary base,
& its components
32
Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008
China’s CPI accelerated again in 2010
5.1%
in year
ended Nov.
2010
33
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.
34
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.
35
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.
36
1
.5
-1
-.5
0
The Balassa-Samuelson Relationship
2005
-3
-2
-1
0
1
Log of Real Per capita GDP (PPP)
2
coef = .23367193, (robust) se = .01978263, t = 11.81
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%.
37
Jeffrey Frankel
James W. Harpel Professor of Capital Formation & Growth
Harvard Kennedy School
http://ksghome.harvard.edu/~jfrankel/index.ht
m