To RMB or not to RMB? Lessons from Currency History

China is the world’s largest trader and (on a purchasing power parity basis) is about to surpass the United States as the world’s largest economy (see chart). China already accounts for about 10% of global trade in goods and services, and over 15% of global economic activity.

China and the United States: PPP-adjusted Real GDP (2011 International U.S. Dollars in Trillions)

Source: World Bank. Data through 2013. Authors' simulation from 2014 assumes annual growth rate of 6.5% for China and 2.3% for the United States.

So, as China takes its place as the biggest economy on the globe, will its currency, the renminbi (RMB), become the most widely used international currency as well? Will the RMB supplant the U.S. dollar as the leading reserve currency held by central bankers and others, or as the safe-haven currency in financial crises?

This issue is not an immediate one because the RMB is not freely convertible into other currencies. Moreover, without specific government authorization, residents and nonresidents cannot move large quantities of RMB across the border. Even foreign central banks face an application and approval process before they can make onshore deposits in China, and after they complete the process, these official-sector investors are subject to quotas.

Nevertheless, there are good reasons to look ahead. Promoted by the Chinese government, international use of the RMB has picked up rapidly in recent years. It is now the second most important currency (with an 8.7% share) in trade finance – ahead of the euro, but still far behind the U.S. dollar (with an 81.1% share). Its presence in foreign exchange markets has grown commensurately, rising in rank from #17 in 2010 (with a 0.9% share) to #9 in 2013 (with a 2.2% share). Again, the U.S. dollar is still by far the most traded currency, with an 87% share. And, the RMB now ranks #7 as a settlement currency (accounting in mid-2014 for about 1.6% of all transactions through SWIFT), up from rank #35 less than four years ago (see chart). Assuming, as China’s leadership seems to intend, that RMB convertibility is on the horizon within a decade, how far will this internationalization go and how fast?

RMB Ranking and Share in International Payments

Source SWIFT RMB tracker press releases, various issues. 

In this post, we ask what history can tell us about currencies that lead in international use and about the transitions between them. In the future, we’ll look at specific issues affecting international use of the RMB, including cross-border controls on capital flows, financial development and stability, and the exchange rate mechanism.

Turning to history, since the industrial revolution, there have been only two currencies that have led in international use: the U.K. pound and the U.S. dollar.

Until recently, historians focused on World War II as the turning point, with the pound prevailing before the war and the dollar thereafter. But a flurry of new research concludes that the transition occurred significantly earlier. While the pound was in the lead until 1914, the dollar rose rapidly in importance thereafter, with the two currencies sharing the principal role during the inter-war period. One study suggests that the U.S. dollar surpassed sterling as the leading reserve currency in the 1920s. As of 1929, the two currencies accounted for virtually all global foreign exchange reserves at central banks, with the dollar somewhat ahead. Similarly, almost all sovereign bonds denominated in foreign currency were issued in either sterling or dollars; with somewhat more in sterling, but the dollar ahead among non-British-Commonwealth issuers. 

We draw four lessons from this history. First, over the past 200 years, the two currencies that served as the leading international means of exchange each benefited from a reliable legal system, backed by a stable political system with an independent judiciary that efficiently enforced property rights.

Second, an economy’s size alone does not make its currency an international leader. By 1880, the U.S. economy was larger than the U.K.’s (see chart), but the dollar was barely used abroad for the next 30 years. By 1914, when the dollar began its ascendancy, the U.S. was the leader in world trade and its economy was more than double the size of the U.K.’s.

U.K. and U.S.: PPP-adjusted Real GDP (Billions of GK 1990 International Dollars), 1870-1950

Source: Maddison website.

Third, the rise of a new international currency requires effective financial markets and institutions, in addition to a supportive external environment. Between 1914 and 1929, a number of things happened. Two stand out. There was the creation of the Federal Reserve, which began operating in late 1914. The Fed promoted the rapid expansion of U.S. financial markets, including short-term instruments (bankers’ acceptances) where foreign investors could park their holdings of U.S. dollars and foreign borrowers could raise funds. At virtually the same time, World War I forced the European combatants, including the United Kingdom, off the gold standard for a decade. By contrast, the United States was able to maintain this commitment, giving the dollar a leg up on the competition.

And fourth, two currencies (or more?) can share a leading role for some time, as the pound and dollar did in the 1920s and 1930s. Portfolio diversification favors such multiple currency regimes. What we don’t know is how stable such a regime is. Scale economies lower transaction costs and concentrate liquidity. The greater the scale economies, the more likely it is that one leader will emerge from the competition. While the recent historical research suggests these economies are small, the issue is far from settled.

What does all this mean for the international use of the RMB? The main thing is that China’s economic size per se is far from decisive. Financial markets must be accessible and attractive to make investors and borrowers use a currency in international finance (as opposed to trade settlement). For China to approach the depth and breadth of markets of other international currencies today, vast – politically sensitive – reforms remain necessary. 

Ultimately, what investors of all stripes – public and private – care about is that they can get their funds back when they want them. Given the chance, they will flock to RMB markets and use the RMB in financial transactions if they see China’s enforcement mechanisms to secure property rights as credible and efficient. That is the challenge.