China's steady pace of RMB internationalization

By John Ross
0 CommentsPrint E-mail, May 31, 2011
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The news that China is examining policies to allow foreign investment directly in RMB in China is a further step in internationalization of its currency. Consideration of this policy was announced by Li Bo, director of the Monetary Policy Bureau at the People's Bank of China, in May. But Li didn't give a specific timetable for such a policy and it was made clear that any such step would be accompanied by strict measures to limit speculative activity.

Prominent Chinese economists have also warned against any ill designed RMB internationalization. Yu Yongding, formerly head of the Institute of the World Economy and Politics of the Chinese Academy of Social Sciences, has said internationalization of the RMB is "necessary and inevitable" but warned it should be "pursued in a cautious manner". Sun Lijian, vice dean of the School of Economics at Shanghai's Fudan University, noted the past experiences of "Japan, South Korea and several emerging Southeast Asian economies…[which] liberalized their capital markets in the hope of becoming financial hubs, only to be embroiled in disastrous meltdowns."

That such analyses are correct is confirmed not only by Chinese and Asian experience but also by that of the US. Furthermore it is a mistake to treat RMB internationalization as though it affected only China's external economic relations. How and when the RMB is internationalized will affect the whole shape of China's economy.

To take the US example, the rise of its economy to world leadership was due to the power of its productive companies. Firms such as Ford, General Motors, and DuPont dominated international mass production for a century. It was not the dollar's power that created the competitive lead of US companies, but the productive power of these firms which created the international rise of the dollar.

But in the last thirty years the great productive US companies became subordinated to its financial sector. A process traceable in the dry statistics of economists was so powerful it entered even popular consciousness via books such as Bryan Burrough and John Helyar's Barbarians at the Gate – a gripping account of how the US productive company Nabisco was torn apart by financial predators, or Michael Douglas's iconic film Wall Street.

The results have deeply damaged the US economy. Taking long term moving averages, to eliminate purely short term fluctuations, over twenty year periods the annual average US growth rate fell from 3.7 percent in 1981, to 3.2 percent in 2001, to 2.7 percent 2011. In 2008 the US financial sector then imploded, igniting the greatest economic crisis since the Great Depression – the whole US financial sector was only saved by state intervention. As vividly described by economists such as Nobel Prize winner Joseph Stiglitz, the US has created a strange type of "communism for bankers", in which tax payers pick up the losses of the insolvent financial sector while private individuals retain the profits. The result is the slowest US recovery from recession in any business cycle since World War II – average annual US GDP growth over the last 10 years has fallen further to 1.8 percent.

China's economy pursued an opposite course. China's financial sector was subordinated to the productive economy. The fact the main banks were kept in state ownership meant that China's new private sector, which emerged after the start of the economic reform in 1978, had to build private fortunes primarily in the productive sector. Alongside the state companies, China's private sector was forced to follow the pattern of the Rockefellers or Carnegies, who built the great US productive companies, not speculators such as "junk bond" king Michael Milken, or John Paulson – who made a fortune by betting on the collapse of US house prices.

It is the type of speculative capital which did such damage to the US economy that is pushing for rapid full RMB convertibility. The reason is easy to find. The RMB's exchange rate is the safest one way bet in world financial markets – it can only go up. Introduction of rapid large scale RMB convertibility in such a situation would have a predictable, disastrous, economic effect.

First, finance would rush into China to take advantage of profits to be made from the increase in the RMB exchange rate. This inflow would rapidly force up further the exchange rate – probably by the 20-40 percent some neo-con US circles countries are calling for.

The rapid exchange rate rise would bankrupt parts of China's exporting industries – leading to an economic crisis. As the crisis started, finance would then flow out – leaving China in a greatly weakened economic position. This is exactly the type of crisis that hit South East Asia in 1997 – and in a different form crippled Japan in the 1970s and 1980s, and against which Chinese economists have warned.

Undoubtedly some outside and inside China engaged in speculative operations, would make huge fortunes from such a process. But the damage to China's economy would be great. By such means the order of dominance in China's economic development would be reversed. Instead of China's finance serving its productive economy, which internationally means aiding trade and exports, China's productive economy would instead have become subordinated to finance.

None of this argues against a strategy of gradual RMB internationalization. Strategically there are great benefits to China in this. The higher the proportion of China's trade carried out in RMB the lower the exchange rate risk to which China's companies are exposed – this is the type of benefit Germany's companies have derived from the creation of the Euro zone. Over the longer term, the more the dollar is no longer the only universally acceptable means of international payment the less will be the pressure on China of irresponsible US monetary policy such as QE2. But internationalization of the RMB must be carried out from the angle of aiding China's productive economy and not starting from how to create possibilities for short term financial profits.

So far China's policy has carried out a logical step by step RMB internationalization – it is aided by Hong Kong being available as an offshore base for RMB operations.

• The percentage of China's trade conducted in RMB rose from 0.5 percent in the first quarter of 2009 to 7.0 percent, or $55.2 billion, in the first quarter of 2011.

• A growing market for international RMB bonds has been created. These are now issued so regularly they have acquired the market name "dim sum" bonds. Front rank companies such as Unilever, McDonald's and Caterpillar have issued them. By the end of April over $2.9 billion had been raised in 2011 by these means.

• The first IPO in Hong Kong in RMB, by Hui Xian, raised $1.6 billion.

• The value of RMB deposits in Hong Kong has risen to over $62 billion and is projected to reach $154 billion by the end of 2011.

• China has allowed three foreign central banks – Hong Kong, Norway, and Malaysia – to hold RMB as part of their foreign exchange reserves. A big question for China will be how it responds to the same request that has been made by South Korea.

These were step by step successful measures. Li Bo was correct to refuse to give a precise timetable for new policies and China's economists to warn against ill judged rapid moves to full RMB internationalization. Such a serious and strategic issue has to be looked at from the point of view of the overall interests of China's economy. Not from the point of view of the desire of some people to make huge fortunes by methods that have done such damage to the US economy.

The author is a columnist with For more information please visit:

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