The renminbi challenge: the future role of the Chinese currency.

• Author: Wu, Friedrich

With the rapid economic ascent of China in the new millennium, the explosion of the global crisis in 2008-2009, and the consequent discrediting of the U.S. and European financial models, as well as recent new policy initiatives adopted by Beijing toward its own currency, there have been growing debates on the future role of the renminbi. Will the Chinese unit challenge the primacy of the U.S. dollar in the international monetary system? These unfolding developments have been further fuelled by senior officials of the People's Bank of China who have recently become increasingly vocal in world forums on the need of other economies to rely less on the dollar as a reserve currency and for trade settlement.

THREE FUNCTIONS OF AN INTERNATIONAL CURRENCY

Economists generally agree that for a currency to gain international stature, there must be strong demand by world traders, investors, and central bankers for the currency as a medium of exchange for foreign trade settlement, a unit of account for denominating international financial transactions, and a store of value for central banks" foreign exchange reserves. Hitherto, the dollar, euro, and yen--the so-called "Big Three" currencies--have been fulfilling these three tasks by virtue of the fact that the GDP size, trade volumes, and financial markets of the three note-issuing economies are the world's largest. As such, the dollar, euro, and yen in combination also account for an overwhelming 94 percent of the world's total official foreign exchange reserves.

THREE DETERMINANTS OF CURRENCY INTERNATIONALIZATION

Monetary economists agree that three key economic pillars are required to support the internationalization of a currency: the size of an economy and its trade volume; the breadth, depth, and liquidity of its capital markets; and the stability and convertibility of its currency.

The United States, the euro area, and Japan account for 28.5 percent, 22.0 percent and 11.2 percent of world GDP respectively, compared to China at 4.6 percent (see table). However, with breakneck growth rates since the beginning of the twenty-first century, China has managed to surpass the United Kingdom in 2005 and Germany in 2007 to become the world's third-largest economy after Japan and the United States. Goldman Sachs has projected that China will overtake the United States to become the world's largest economy by 2027, should China continue to grow at its current rate.

However, large GDP is not necessarily equal to a wealthy or healthy economy. Despite its number-three world ranking in absolute economic size, China remains far behind the other leading economies in average per capita income level. In the long run, even though China's GDP per capita is projected to surge exponentially to US$49,650 by 2050, up from US$2,432 in 2007, it will still lag far behind that of the United States (US$91,683) and many other developed and emerging economies, according to Goldman Sachs.

Furthermore, despite optimistic projections of China's future growth potential, its economy is still beset by numerous imbalances and risks in the medium term. These include persistent and even widening regional economic disparity and rural-urban income inequality, rising social unrest and inter-ethnic conflicts, rampant corruption, and serious environmental...