CHINA'S CURRENCY VICTORY: COSTS AND BENEFITS
By Elliot Hentov
The renminbi’s inclusion in the special drawing right, approved by the International Monetary Fund board on Monday, is only a small step in China’s quest for major reserve currency status. Historically, the international monetary system has operated with multiple reserve currencies. China faces considerable challenges as the renminbi seeks gradually to attain this role. The speed with which this happens is directly linked to the pace and credibility of China’s macroeconomic reforms.
This is the first time a middle-income nation has become a candidate for reserve currency status. When West Germany and Japan were moving towards that role in the 1970s (a transition about which both countries had strong qualms), their GDP per capita, on a purchasing power parity basis, were 85% and 65% of US levels, respectively. By contrast, China’s GDP per capita is estimated at only 25% of the US equivalent.
Countries do not take on this position lightly. Reserve currencies – held in significant quantities by governments and institutions as part of their foreign exchange reserves – are generally characterised by broad and deep capital markets, floating exchange rates, scale, credible policy frameworks, voluntary private holdings of the currency, and liquidity. This list brings considerable responsibilities and potential burdens as well as benefits. It is worthwhile spelling these out.
The first important benefit is better financing through ability to borrow in a country’s own currency both domestically and internationally. China’s public and private sector can issue most of their debt in renminbi, removing an exchange rate risk that could suddenly trigger a balance of payments crisis. Second, a reserve currency country gains seignorage: income earned by issuing currency that others wish to hold. This phenomenon, frequently termed a positive ‘carry’ for governments, should not be exaggerated. For the US, the annual benefit is estimated at around 0.1% of GDP.
Third, Chinese companies and individuals, by paying for purchases in their own currency, gain from lower transaction costs. In general, lower transaction as well as borrowing costs are typically cascaded throughout the economy. Fourth, this brings enhanced policy flexibility, since – in general – reserve currency countries are subject to less financial market discipline. Fifth, reserve currency countries have less need to build large foreign exchange reserves; these are often held at a cost because the return on foreign currency holdings is lower than the interest central banks have to pay on domestic currency sterilisation bonds. Sixth, reserve currency status confers geopolitical prestige and influence, underscoring China’s global power and economic success.
Balanced against these substantial benefits are some costs. First, a higher exchange rate may depress export competitiveness; both public and private agents want to hold a reserve asset, creating demand pressure for that currency. Second, exchange rate volatility can complicate monetary policy. A reserve currency may serve as a ‘safe haven’ and at times can overshoot to the upside; conversely, depending on the policy stance, the currency can overshoot to the downside, exacerbating inflationary tendencies.
Third, China will have to shoulder greater responsibility for international monetary arrangements. As a reserve currency becomes more used internationally, domestic monetary policy decisions increasingly impact the rest of the world. A modest loss of monetary policy autonomy may ensue. Fourth, less fiscal discipline, over time, can lead to excessive levels of debt. No political system is immune from moral hazard arising from favourable funding conditions, potentially exacerbating fiscal problems.
China has evidently calculated that reserve currency benefits outweigh the costs. The renminbi accounts for roughly 1% of global foreign exchange reserves, while foreigners own only 3% of its government bond market. In the case of the US, the figure is around 60% in each category. Unless Beijing makes major policy mistakes, in coming years the Chinese percentages will rise. The pace of this development depends on the reforms China undertakes and financial market perceptions of their soundness and viability – in short, on the overall direction of China’s macroeconomic and political choices.
Elliot Hentov is Head of Policy and Research, Official Institutions Group, and George Hoguet is Global Investment Strategist, Investment Solutions Group, at State Street Global Advisors. This is an abbreviated version of a longer SSGA paper available here.