China’s financial system became the first to get back on its feet, with the country’s fiscal and monetary policies normalising after combatting the impact inflicted upon by the coronavirus outbreak. Renminbi has gradually climbed back up since.
It was only a few months back that market observers were fretting over renminbi dropping below 7.2 against the US dollar, but the overall sentiment has now taken a U-turn with some floating a prediction that it will unseat the dollar as the world’s reserve currency.
We think it’s still too early to start talking about such a possibility given the data released by the International Monetary Fund (IMF) – the US dollar accounted for 61.99% of allocated global foreign exchange reserves as of the end of Q1 2020, as opposed to renminbi’s modest share of 2.02%[1].
While renminbi’s ratio in the reserves almost doubled the level when it was first included in the Special Drawing Rights (SDR) basket, it is still dwarfed by that of the dollar.
Lessons from the past suggest that the journey to gain prominence in foreign exchange reserves resembles a marathon competition.
Renminbi might have performed well this year, but it requires much more than just a momentary victory for the currency to win the race. In a marathon, physical fitness, strategy and stamina all play a key role. So for a currency to rise through the ranks, the country’s power and government policy as well as time, will be among the most essential elements.
Strength is all that matters
A country’s power is measured by its economic and political capacity. It anchors its counterparts’ confidence in using the currency.
In terms of economic capacity, the size of the economy is by no means the only consideration. The structure of a country’s economy is just as important.
For example, the currency of a mega sized agricultural economy would unlikely be considered a reserve currency despite the size of the economy. The reason being, foreign countries would have little use for it beyond purchasing agricultural products, which directly impacted its versatility.
With the second highest GDP globally, China runs a comprehensive economy. While the pandemic plunged global economies into a recession, resulting in a 32.9% YoY drop of the US’s GDP in the second quarter, China charted a 3.2% YoY growth over the same period against all odds[2], [3].
This is evident in trade statistics: China’s export growth has, in fact, beat expectations for six months consecutively, despite relentless discussions over foreign countries trying to decouple their supply chains from China amid the health crisis. The country’s export rose close to a whopping 10% YoY in August[4].
Standing in stark contrast was the US’s ever-widening trade deficit, which, excluding oil, would have been nearing a historical high[5].
According to a study entitled “The World in 2050” conducted by PwC, China will surpass the US to become the world’s biggest economy in thirty years[6].
But of course, it won’t be smooth sailing for China. The Soviet Union and Japan, for example, could serve as cautionary tales for China. While it might gain the upper hand in the future, it remains to be seen if China could eventually prevail in the marathon.
A country’s political capacity indicates the regime’s stability and predictability. Very often the currency of a country at war doesn’t lend itself to wide circulation with little political visibility.
While China’s political system is distinct from that of western countries, its stable governing environment and consistent policies with high predictability will most probably give an edge to internationalising renminbi.
Policy
The capital market of a reserve currency country must first be robust for it to amass enough financial assets to absorb capital circulating back to the economy.
China has in recent years gradually opened up its financial market, with the Shanghai-Hong Kong Stock Connect acting as a bridge for foreign capital to flow into the domestic equity and bond markets.
Following China’s move to reform the internal market, the Shanghai Stock Exchange Science and Technology Innovation (STAR) Board, ChiNext Board and the New Third Board, the country has propelled innovative technology companies to a historical center stage, deepening the domestic capital market.
Moreover, an open capital account allowing a free flow of capital is another requisite for a reserve currency country. One’s right to transfer local currency out of the country should never be undermined. The US dollar, Japanese yen and euro are among the most freely traded currencies that aren’t placed under capital control. Trading renminbi, however, is currently limited due to various factors.
Time
In the example of the US dollar taking over the British pound as a global reserve currency, we noticed that the continuity of such currency is pronounced and entrenched.
The British pound was no doubt a reserve currency from the late 19th to the early 20th century. While part of the currency’s value was backed by the gold standard, it became a globally traded currency also because the country’s economic strength and system was widely recognised at the time by foreign nations.
The US economy had already surpassed the UK’s at the end of the 19th century, but the British pound remained as the internationally traded currency before WWII. But after WWI and WWII, the UK’s economy took a heavy blow, so the pound’s reserve currency status was dethroned by the dollar as the US economy outgrew that of Europe given that it was practically untouched by the two world wars. The US dollar officially became an internationally traded and reserve currency as the country led the post-war development of a new economic order globally.
China’s economic strength is still a long way off to rival that of the US. It will be a while before renminbi can topple the dollar even if the Chinese economy immediately caught up with the US.
Renminbi’s recent rally
Renminbi may not become a reserve currency overnight, but it has indeed strengthened over the past few months. The impetus came down to a few factors: the uninterrupted widening of renminbi’s trade surplus after the pandemic, the interest rate differential between China and the US, and robust export data.
According to data released by the State Administration of Foreign Exchange of the PRC, China posted a $12.7 billion net inflow of cross-border capital in non-banking sectors in August, with net foreign investments in the domestic bond market increasing by $21 billion over the same period, higher than the historical average[7]. This is down to the Chinese economy recovering at a faster pace than the rest of the world, and the widening interest-rate premium over yields on the dollar, which has further burnished the country’s appeal to foreign companies.
It goes without saying that the unit value of a given currency drops as its supply increases. The size of a central bank’s balance sheet also generally indicates the total currency volume of its respective country. In the case of the People’s Bank of China, its balance sheet has largely remained unchanged since 2014. On the other hand, the Federal Reserve’s portfolio has ballooned from $4.2 trillion in March this year to over $7 trillion as of May’s end after rolling out an unlimited quantitative easing programme and a “whatever-it-takes” asset purchase plan2. The growth rate topped 80% in just under three months’ time2.. While such measures prevented liquidity risks from building up and turning into a financial crisis, leaving the printing press for dollar bills running would naturally make it tricky to maintain the dollar’s exchange rate.
One thing worth noting: a banknote’s existence transcends the physical world in this day and age. Central banks can buy bonds or equities, create cash on the balance sheet, and settle it through routing the transaction electronically to the sellers’ accounts.
Sellers, be they corporate or retail investors, would prefer holding less cash from a return’s point of view, so the extra cash will normally be converted to consumer spending or re-investment, which in turn stimulates the economy. The whole process may have been done digitally, without the central bank actually printing any money, but it has the same effect on the economy as if the printing machines were being put to work.
Overall speaking, the likelihood of renminbi becoming a global reserve currency in the near future is low. But if China can keep the economic development on track, and maintain relatively consistent monetary policies, renminbi’s value and degree of internationalisation will probably hold sway compared with other currencies.
[1] Source: International Monetary Fund (IMF), as of Sept 2020
[2] Source: Sina Finance, as of Sept 2020
[3] Source: Xinhua News Agency, as of Sept 2020
[4] Source: Hong Kong Economic Times (HKET), as of Sept 2020
[5] Source: Financial Times, as of Sept 2020
[6] Source: BBC, as of March 2020
[7] Source: The State Council of the People’s Republic of China, as of Sept 2020
Disclaimer
This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.
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