Internationalising China's Renminbi: Challenges and Opportunities for the BRI and US-PRC Competition

Authors:

Annagrazia Caricato (Junior Researcher G.E.O. Economics)

Marco Zecchillo (Head Researcher G.E.O. Economics)

Abstract

Internationalising a currency presents itself with benefits, but also with its relative costs. Namely, it is widely understood that a state cannot enjoy fully opened capital markets, a fixed exchange rate and monetary policy autonomy at the same time. It needs to make a choice between two out of these three options.

In the Chinese case, initial advancements toward currency internationalisation emerged already in the early 2000s, but it was only in the wake of the 2008-09 global financial crisis that the process of RMB internationalisation acquired momentum. Thus, the progress hitherto achieved, as well as the structural barriers that still affect cross-border RMB circulation, ought to be reframed in light of China’s complex mix of behaviours in the international monetary system. Under such circumstances, the Belt and Road Initiative represents an alternative path to RMB internationalisation, insofar as it provides partner countries with considerable economic incentives that, in turn, encourage changes in the external environment in a way that makes it conducive to further RMB circulation. While membership-related limitations and inertia in currency use may pose significant challenges to RMB internationalisation, emerging trends and ramifications thereof confirm that the process is still underway.

The paper maintains that PRC’s standing in international financial institutions may be symptomatic of the renewed power of the Yuan. According to certain views, the competition with the US projects itself onto the monetary realm, but the effects of a possible Chinese surpass are still mild. China still finds itself in front of the stability versus openness dilemma.

1. Main Elements in Currency Internationalisation

We define currency internationalisation as the progressive diffusion of a currency outside of the borders of the country in which it is issued. In basic terms, it entails that more and more transactions are denominated in that currency, with due effects on trade and financial markets. Given the magnitude of the phenomenon, whose policy determinants are challenging to grasp, the contents presented within this section deal with general macroeconomic benefits and costs arising from a deliberate and policy-determined internationalisation of a country’s currency. Further sections will redefine these broad tenets in the context of China. The effects resulting from currency internationalisation are to be defined as the outcomes of a wider diffusion of a money across international markets, with a distinction between impacts on the private (which sees financial and non-financial firms as their main actor) and the public sector (which sees the government, with its debt holdings as the primary focus). Certainly, the internationalisation of a currency is a multifaceted phenomenon, measurable from different points of view. For instance, analyses may focus on the reserve currency status, due to the ease of retrieving data on this indicator (Frankel, 2012). A global money is held by public and private actors (i.e., governments and trading or investment firms) for a variety of purposes, strongly related to the three classical functions performed by any currency. For instance, a worldwide circulating currency is employed as a store of value (via the practice of holding reserves), as a medium of exchange (by utilising the international currency as a vehicle for transactions) and as a unit of account (by denominating certain securities or commodities).

On the domestic level, having an international currency presents itself with a wide range of advantages and potential countering costs. In private terms, domestic borrowers would find themselves in a more relaxed position when dealing in their own currency rather than in foreign ones, for reasons related to the shrinking of transaction costs and the projection of the exchange rate risk onto foreign businesses. Nevertheless, the last point is subject to doubts, given that certain commodities’ prices (such as oil, which are listed in US Dollars in global markets) appear to be responsive to exchange rate risk for American nationals (i.e., a depreciation of the Dollar with respect to other currencies, for instance).

At the public level, considerable reserves of the home currency being held by foreign intermediaries partially ensure an easier and more straightforward current account deficit financing, with a reduction of the likelihood of default in the short run. Furthermore, a seigniorage effect could potentially be produced. As the home money disseminates around the world, the country issuing the internationalised currency enjoys an effect which approximates an interest-free loan the more widespread the diffusion becomes (Kenen, 2009). Conversely, one of the costs to be potentially faced by a country wishing to internationalise its currency is that it should ensure unhinged access to its capital markets and fully socialise its economy with the world – an aspect seemingly important when evaluating potential developments in this subject for the People’s Republic of China, given the permaning access restrictions. A theoretically impossible trilemma, widely known in academia as the Mundell-Fleming Trilemma (also known as the “Unholy Trinity”, given its desirability, but impossibility to reach), certainly explains the restricted space of movement in the policy options a constituency can take in the monetary domain. Namely, one country needs to choose two out of the three following options: a stable exchange rate, free flows of capital and monetary policy autonomy. Complex reasonings demonstrate the motivations why it exists, but the Trilemma appears to be validated by empirical evidence (Aizenman, 2010). Fully-fledged financial integration, possibly a necessary step in the path towards the spread of a currency in the world economy, surely comes at a cost in the ability of a public authority to control national reserves and the exchange rate at the same time. As monetary independence is regarded as one of the most prominent symptoms of a sovereign entity, and as the policy choice to preserve it is taken, a country becomes exposed to exchange rate fluctuations.

The latter aspect could exacerbate potential crises, making the domestic environment vulnerable to possible massive sales from foreign buyers in case market expectations turn negative, which would entail a further decline in asset prices. Narrowing the analysis to the context hereby outlined within the paper, a set of remarks are deserving of attention, drawing possible inferences from available data. This evidence, which will be further detailed within the following paragraphs, appears to point in the direction of a renewed and ubiquitous RMB presence in international commodity and financial markets. Still, at the time of writing, most of world trade is invoiced in USD. However, an upward trend of worldwide CBs’ willingness to hold RMB as a reserve needs to be, nevertheless, underscored. CBs showed their desire to diversify their holdings from USD (Business Insider, 2022), by raising RMB holdings up to over 5% from current 3% level in a 10-year time span. Similarly, the Asia-Pacific area was arguably swept by a wave of cross-border transactions across the last decades, whose share in terms of total spot transactions has increased. Although the latter indicator might not perfectly correlate to an increase in the reserve holdings of a country’s currency within a trade partner’s Central Bank, it may be useful to depict an enhanced role for that particular money in international markets (Kenen, 2009). While updated data on the topic appear to be missing, it may be hypothesised that the Japanese Yen has undergone a relative decline in preeminence, both in the region and globally, vis à vis the Chinese Yuan, for a variety of simultaneous factors stemming from the archipelago’s stagnating output and declining population.

2. The Chinese Case

As axiomatic as a flourishing economy’s endeavour to internationalise its currency may appear, the interplay of political and economic factors underlying the Chinese experience depicts an intricate scenario that eschews unequivocal generalisations and requires adequate contextualisation instead. Whilst historical parallelisms and theoretical notions offer a key to interpreting relevant existing and emerging trends, RMB internationalisation is a moving target whose multiple ramifications are difficult to parse, particularly as internal and external transformations continuously drive oscillations in approaches to and prospects of effective currency utilisation outside national borders. When the pilot scheme for RMB cross-border trade settlement – largely considered the earliest instance of a Chinese road map for currency internationalisation – was launched in four cities of Guangdong in 2009, the issue occupied but a marginal space in the burgeoning literature on China’s international economic policy, albeit present established mechanisms that, though not necessarily intended as an effort toward RMB internationalisation, nonetheless anticipated such an objective. As evidence thereof, suffice it to consider the introduction of the Qualified Foreign Institutional Investor (QFII) programme[1], as well as offshore RMB market-related activities in Hong Kong – including, but not limited to, the first offshore RMB-denominated or “dim sum” bonds – and, finally, the reform of the exchange rate regime whereby the fixed exchange rate system pegged to the USD was substituted with “a managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies” (People’s Bank of China [PBOC], 2020; Srinivas & Cheng, 2021). These initial advancements, however, did not catalyse the attention of pundits, for it was only in the wake of the 2008-09 global financial crisis that the process of RMB internationalisation acquired momentum. The perspective of capital losses due to default – especially on the US government-sponsored enterprise (GSE) bonds – dollar devaluation, and inflation materialised in an increasingly turbulent environment, hence eliciting a response whose fulcrum were (a) diversification and (b) systemic reform (Yu, 2015). Besides the salience that the topic attained at the declaratory level, the realisation of the vulnerabilities inherent to the global monetary system profoundly affected China’s demeanour: a combination of conservatism and transformational aspiration thus shaped a complex mix of behaviours that Gregory Chin (2017) aptly conceptualised as “true revisionism,” i.e., a representation of China’s role as both a system stabiliser and reformer seeking to preserve the core elements of the existing order – as a first-order response to the global financial crisis and the Eurozone debt crisis – whilst advancing a system-reform agenda to reduce the USD dominance as a second-order response. In particular, the latter envisions (a) a medium-term goal of boosting RMB internationalisation and (b) a longer-term goal of promoting the International Monetary Fund (IMF)’s Special Drawing Rights (SDR) as a global multilateral reserve asset which, in point of fact, resonates with the call for an international reserve currency disconnected from individual nations advocated by former PBOC Governor Zhou Xiaochuan, who also articulated the need to increase SDR allocation and scope of uses as a means to reform the international monetary system (PBOC, 2009). Although an expanded role for the SDR was not attained, the decision to include the RMB in the SDR basket – announced in 2015 and effective 2016 after a period of transition – nevertheless consolidated the RMB internationalisation process and enhanced the attractiveness of the RMB as an international reserve asset, thereby conferring overall international legitimacy to the currency (IMF, 2016; Chin, 2017). Interestingly, those years also witnessed the RMB’s growing prominence in the realm of payments: in 2015, one of the SWIFT’s monthly reports on the progress of RMB internationalisation signalled a surge in its utilisation as the currency reached the fourth position worldwide at 2.79%, ahead of the JPY at 2.76%, and behind the USD, the EUR, and the GBP [2] (SWIFT, September 2015). The high set in 2015, which came on the back of a highly contested currency devaluation, remained unequalled until January 2022, when the RMB reached a 3.20% share as a global payments currency (SWIFT, February 2022). Although in the following months the RMB dropped one position to the fifth most active currency for global payments, a change in the top 15 offshore RMB economies is worth noticing: in April 2022, the Russian Federation made its entrance into said group of countries with a 0.62% share that gradually increased to 3.90% by July 2022, with only Hong Kong – unsurprisingly the first source of RMB transactions outside mainland China at 70.93% – and the United Kingdom (6.35%) ahead of it (SWIFT, May; August 2022). This shift not only substantiates the impact of external factors on RMB internationalisation but also reveals the sophisticated network of actors and arrangements that support RMB’s cross-border circulation and how adjustments in its composition can drive growth in RMB use even amidst scepticism about the currency.

Despite the accomplishments hitherto illustrated – the most recent being a slightly higher weight for the RMB in the SDR basket agreed upon at the quinquennial SDR valuation review of the IMF executive board (IMF, 2022) – RMB internationalisation still arouses contrasting views: while some may perceive the RMB’s ascendance to international-currency status almost as a natural process (Lee, 2010), others maintain that besides economic fundamentals, additional policy and institutional variables – such as openness and depth of financial markets and credibility of economic and legal systems, as suggested in Yiping Huang et al.’s model (2015) – considerably impact prospects of RMB internationalisation. Similarly, remaining capital controls, assumed unwillingness to run trade deficits, and the lack of an independent central bank are identified as widely discussed barriers to RMB internationalisation (Chin, 2017). The presence of structural impediments, however, did not necessarily inhibit the progress needed to elevate the RMB’s international standing. The policy achievements mentioned in the previous pages, indeed, proceeded alongside the setting up of a variety of avenues for cross-border clearance, simplified access to China’s onshore financial markets for foreign investors, facilitated measures for RMB trade settlement and, to cite yet another of the instruments deployed thus far, bilateral swap agreements (BSAs) that guarantee access to RMB liquidity whilst fostering enhanced financial integration. All these aspects are not to be intended in isolation but as components of a constantly evolving apparatus where they interact with other policy plans, the most illustrative case being the nexus envisaged between the Belt and Road Initiative (BRI) and RMB internationalisation, whose rationale and implications are under close scrutiny.

[1] Launched in 2002, the Qualified Foreign Institutional Investor (QFII) programme enabled licensed foreign institutional investors to trade RMB-denominated “A-shares” of Chinese companies on Chinese stock exchanges. In 2020, the QFII scheme was merged with the RMB Qualified Foreign Institutional Investor (RQFII) system introduced in 2011– QFII&RQFII are presently referred to as the new QFI scheme –, thereby significantly (a) easing qualification requirements imposed on QFIs, (b) simplifying the application process, and (c) expanding the investment product categories.

[2] USD (44.82%), EUR (27.20%), GBP (8.45%).

3. Link to the Belt and Road Initiative and Potential Trends

The correlation between the BRI and RMB internationalisation is, in a certain sense, based on a mechanism of mutual reinforcement: on one side, financial integration is pivotal to the development of the BRI, while on the other, the initiative itself provides an optimal platform to promote RMB adoption outside mainland China. Alessia Amighini (2021) buttresses this argument by detecting three channels where greater RMB international circulation is expected to favour the implementation of the BRI, namely as (a) a means to fund infrastructure projects, (b) a source of liquidity to finance commercial exchanges, and (c) an alternative to the deployment of a third-party currency, ultimately reducing both costs and risks related to volatility. Available data seem to confirm a dynamic of this sort, as in 2020, the value of cross-border RMB settlement between mainland China and BRI countries exceeded RMB 4.53 tr and registered a 65.9% year-on-year (yoy) increase. Moreover, settlement in goods trade and direct investment reached RMB 870.10 bn (+18.8% yoy) and RMB 434.12 bn (+72%), respectively. Still, these figures offer nothing but a glimpse into the system that factually enables the BRI-RMB internationalisation link which includes, amongst others, 22 BSAs and 8 RMB clearing arrangements along the BRI (PBOC, 2021). At the same time, it can be inferred that the promotion of trade and financial activities under the BRI framework stimulates RMB movement, as exemplified in the scheme proposed by Siqi Xia (2018).

Figure 1. Factors influencing the RMB internationalisation under the Belt and Road Initiative.

Source: Xia, S., 2018. “Path Selection of Renminbi (RMB) Internationalization under “The Belt and Road” (B&R) Initiative,” p. 676.

The BRI hence provides partner countries with considerable economic incentives that, in turn, encourage changes in the external environment in a way that makes it conducive to further RMB circulation. Eventually, these countries will have motives to settle their debts with China in RMB and preemptively increase their RMB reserves, thereby favouring its employment as a store of value. In addition, the RMB would also be increasingly used as a unit of account, as the construction contracts that fall under the BRI umbrella can be denominated entirely in RMB, partly in RMB and USD or in the local currency, a representative case thereof being the flagship China-Pakistan Economic Corridor (CPEC), where a push for RMB financing from the Pakistani side emerged even prior to the latest announcement that both parties are preparing to deal in RMB and PKR as Pakistan is faced with financial challenges (Tayyab Safdar & Zabin, 2020; Daily Times, 2022). This underlying logic of diffused interest thus impels scholars to go beyond the predominant supply-side characterisation of RMB internationalisation and ponder demand-side factors as drivers of the same phenomenon. Such an approach underpins Steven Liao and Daniel McDowell’s (2015) empirical model of BSA cooperation between the PBOC and potential partner central banks which is relevant insofar as BSAs represent one aspect of Beijing’s incremental strategy to internationalise its currency and an important component of the financial network that supports the BRI. According to the authors, higher probabilities of BSA cooperation are likely to be dependent upon (a) de facto economic interdependence and (b) de jure economic integration between China and potential partner countries which, all things considered, reminisces the reasoning proposed above[3] (Liao & McDowell, 2015).

These arguments thus seem to validate the thesis that the BRI could serve as an unconventional exit strategy to the Mundell-Fleming Trilemma through which China would be able to promote RMB international circulation in a system of controlled convertibility (Amighini, 2021), that is without having to fully open its financial markets or find a costly trade-off between its independent monetary policy and a fixed exchange rate. Although recent data display considerable advancements in this direction, however, the feasibility of this alternative path remains under discussion, not least because the very concept of RMB internationalisation through the BRI is accessible only to countries actively involved in it which, as numerous as a group they may form, do not represent the totality of China’s external relations. Furthermore, the weight of inertia, though potentially ameliorated through the BRI, constitutes an important limiting factor: an expensive process of financial adaptation, as well as the high uncertainty associated with switching to alternative moneys (Cohen, 2000), substantially ensure the USD international status, thus reducing the economic attractiveness of other currencies. Maha Kamel and Hongying Wang (2019) include this condition among the challenges that the RMB may grapple with as an alternative currency in the international oil trade. Interestingly, however, in light of the dramatic transformations presently underway in the international order, Chris Leung (2022) defines an anchoring system of the RMB comprising (a) a Petro-RMB system involving major oil producers, (b) a Renewable Energy-RMB system with Latin America, and (c) a RCEP-RMB system in Asia. As difficult as it is to forecast the actualisation of this scheme, it nonetheless elucidates some trends that deserve greater consideration. For instance, China already enjoys a prominent place in the renewable energy sector in Argentina, and the latter’s adhesion to the BRI fuels prospects of further engagement (Lewkowicz, 2022). In addition, as the South American country manifested an interest in the BRICS (Bruschtein, 2022), perspectives of RMB internationalisation may evolve, particularly as a new reserve currency recently came to the fore as a topic of discussion within the group. Finally, although digitalisation is not expected to close the divide between China’s share of the global economy and its share of international payments (Kärnfelt, 2020), the digital RMB or Digital Currency Electronic Payment (DCEP) remains a variable to investigate in the process of RMB internationalisation.

[3] Broadly speaking, in the proposed model de facto economic interdependence refers to bilateral trade and direct investment flows, whereas de jure economic integration relates to the existence of formal international agreements, e.g., preferential trade agreements and bilateral investment treaties (Liao, 2015).

4. US-China Competition, International Determinants and Policy Dilemmas

By matching economic policies of a country and its stake amongst other powers, the phenomenon treated within the analysis could be evaluated in the context of direct economic-power benefit link. This aspect often appears as the basic ground for International Political Economy scholarships. In this regard, the diffusion of the RMB could be associated with a relative increase in China’s standing in general international relations and trade. As an example, the concept of Monetary Hegemony was drafted, embodied by the post-World War II American experience and by the earlier British case of the pre-World War I period. A typical power-oriented approach to international political economy would match closely the diffusion of a country’s currency with its prestige and actual capabilities (as highlighted by Norrlof’s work Dollar Hegemony). Thus, a similar power-based logic could be the link relating two parallel trends: the relative rise of China and the global diffusion of the Renminbi. A Realist view would interpret the worldwide spread of the Yuan as a deliberate Politburo-led move, while other approaches, such as the Liberal one, would remain more nuanced, and plug in a multiplicity of other actors in the model. Certainly, international politics do not occur in a vacuum, in which a state’s discretion (China, in this case) explains the whole of its external agenda.

After these premises, interpreting the Chinese currency’s relative rise (in terms of heightened RMB incidence in the invoices of cross-country trade and its increasing presence in the denomination of financial instruments) could be ascribed to the present tense relationship with the United States. However, this interpretation is an excessively simplistic depiction of the real world. China is part of its neighbourhood and considers itself as an “in-development” project (Yiping, 2014), making it much different from past experiences. Contextual, regional and international determinants are at play simultaneously, which may constrain a country’s will. The factors establishing a fertile ground for the phenomenon to occur (i.e., enhancing a currency to the so-called “International Status”, in Jeffrey Frankel’s take) relate to the size of the country and whether other states in the region employ that currency in cross-national trade and finance. Furthermore, financial openness is pivotal. However, as it is prescribed by the Trilemma, this may become costly in terms of exchange rate stability. For an international currency, confidence in the expectation that its value will be preserved (in order to be used as a unit of account) is equally fundamental. But this effect would be curbed and would fail to materialise, given the policy choice to maintain free flows and monetary independence. China, undoubtedly, sits at the core of the financial and trade flows of the region, making its investment position and participation in regional or multilateral financial institutions a factor to be noted. In the trade domain, influence within the ASEAN group shall be kept under scrutiny, also in the context of the United States’ stakes in the area.

At the regional level, China’s noticeable standing in the ADB (Asian Development Bank) is deserving of attention, even though the institution is not new in the global financial environment (given its establishment in 1967). At the institution, Beijing possesses the third largest participation stake in terms of subscribed capital and voting rights (ADB, 2022). A more recent experience is certainly embodied by the NDB (New Development Bank), with its establishment in 2015. In this very subject, debates have risen whether the BRICS grouping’s initiatives will produce a scenario of “de-dollarisation” (Papa, 2022). This claim, however, could be disputed, given that some of those countries have “under-performed” in GDP or overall welfare achievements, if compared to early 2000’s expectations (particularly for the Russian and Brazilian cases). Clearly, the focus is to be directed at China, given its de facto prominent position in the grouping, even if subscribed capital to the bank is the same for all the 5 parties of the BRICS. Nevertheless, the Bank has not been shy in issuing Yuan-denominated securities, in the form of bonds, mainly (NDB, 2019), a factor that seems to point in the direction of a substantial Chinese primacy in leading the group.

A recent development that was seen across the grouping is the cross-listing of benchmark equity index derivatives, with a likely outcome of increasing liquidity and a potential effect of lessening dollar preeminence (Papa, 2022). In China, the gain of relevance of the Shanghai International Energy Exchange could pave the foundations for an advent of yuan-denominated oil futures. Current effects in the sector are already visible. Amongst them, a higher incidence of RMB over Pound in the sector is present, but with still little contract demand with respect to the London or New York markets. However, there is an undeniable tendency to view the RMB as a risk-hedging currency, vis à vis the US Dollar (Papa, 2022). As it is reasonable, China sets itself individually in financial activities rather than in a regional pattern. Even if strongly participative in initiatives, further integration of the latter, such as ASEAN-China FTA (i.e., into becoming a customs union), are unlikely, leaving Beijing as an individual actor in this realm. This does not equate to state that the country’s operations within these initiatives will not be functional and propaedeutic to the diffusion of its currency.

Additionally, the future development of Yuan internationalisation is conditional on the ease for foreign firms in issuing RMB-denominated securities and on the credit-worthiness of borrowers. Given the inherent exposure to fluctuations coming with financial opening, a country willing to climb the ladder of currency internationalisation is expected to weigh the benefits of dynamic and open markets with the resulting potential costs for domestic stability (i.e., in money supply and interest rate targeting, with potential effects also on inflation and exchange rate as a reflection). The Chinese state system, therefore, may need to thoroughly devise the beneficial effects of undertaking the policies determining a currency’s successful internationalisation against the related downsides.

In this area of international economics, the blanket appears to be too short for the mattress. Future developments need to be taken into account, to observe the way China manages to unravel this conundrum, which possesses strong implications for its international position in areas other than finance and trade.

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