A Middle Ground

• Author: Eswar Prasad

A Middle Ground Finance & Development, March 2017, Vol. 54, No. 1

Eswar Prasad

The renminbi is rising, but will not rule

In November 2015, the IMF made an announcement that was symbolically momentous in the annals of international finance. It decided to anoint the Chinese renminbi an elite global reserve currency. The renminbi was to join the select basket of currencies (previously comprising the US dollar, euro, Japanese yen, and British pound sterling) that constitute the IMF’s artificial currency unit, the special drawing right (SDR). The renminbi appeared to be on its way to taking the world by storm and reshaping global finance.

Since then, much has changed. The renminbi has lost value relative to the dollar, and China is dealing with a spate of capital outflows, partly reflecting loss of confidence in the economy and the currency. The renminbi’s inclusion in the SDR basket, which took effect in October 2016, has not stanched this erosion of confidence.

The earlier hype predicting the renminbi’s inevitable rise to dominance, perhaps even rivaling the dollar, has proved overblown. But the same is likely to be true for doomsday scenarios now predicting a plunge in the renminbi’s value and prominence as financial capital surges out of China. Reality likely lies somewhere between these two extremes.

In the long run, what the renminbi’s ascendance means for the global financial system depends, to a large extent, on how China’s economy itself changes in the process of elevating its currency. Transforming the domestic economy may in fact have been a hidden agenda behind China’s aggressive promotion of its currency.

Size counts but not for allChina’s economy is now the second largest in the world (based on market exchange rates). In 2016, its annual GDP was $11 trillion, accounting for 15 percent of world GDP, second only to the United States, whose annual GDP is $19 trillion. China is also an important player in international trade, accounting for 13 percent of global trade in goods. China’s impact on the world economy is even greater when measured along other dimensions. The country holds about 30 percent of global foreign exchange reserves and accounts for a third of global GDP growth since the financial crisis.

Despite China’s economic might, the international stature of its currency, the renminbi, does not quite match that of its economy. Among the currencies of the world’s six largest economies, the renminbi is only now beginning to emerge as a factor in the global economy. The others—the dollar, euro (used by two of the six largest economies—Germany and France), yen, and British pound—all have, to different degrees, well-established roles in global finance.

Unique playbookIn recent years, the Chinese government has taken a number of steps to elevate the renminbi to this group of elite currencies by increasing its international use. The renminbi’s adoption in global markets is constrained, however, since the Chinese government seems unwilling to condone a fully market-determined exchange rate and an open capital account that allows for free cross-border capital flows. This may reflect a conservative approach to giving market forces freer rein as well as prudence dictated by the risks of rapid economic liberalization.

China has therefore adopted a unique playbook for promoting the renminbi while trying only gradually to free up capital flows and the exchange rate. Given China’s sheer size and its rising shares of global GDP and trade, the government’s steps quickly gained traction.

In the mid-2000s, the government started removing restrictions on capital inflows and outflows, but in a controlled and gradual manner. This...