Internationalization of RMB: The Impacts on China and Its Trading Partner Essay

After the thirty years of great economic reforms, imposed in 1978, China has been showing an incredible results and performance. Due to the suitable economic conditions such as cheap labor force and low domestic currency’s (RMB) exchange rate, China has become the largest manufacturer of goods and receiver of foreign direct investments, the majority of which has been in manufacturing industry. And today China has totally changed from the poor agricultural country to the world’s arising economic power state. So with the rise of Chinese economy, its deep integration and significant influence in the world market and at the same time with the instability of euro area and in international monetary system in a whole, the issue of RMB internationalization and China’s exchange rate policy has become of huge importance to the world. So in this essay I will briefly analyze the characteristics of the international currencies, their benefits and costs, and then I will explain China’s interest and steps toward the RMB internationalization and will mainly focus on its impacts on China and its partners. The term of international currency has defined characteristics so that a currency can be considered international if it is used outside the issuing country for the transactions between other foreign states (Investopedia). And according to Chinn and Frankel (2008) (as cited in Lee, 2010) there are four criteria to determine â€Å"international currency status†: 1) Large enough size of country’s trade and output; 2) Liberal developed financial market; 3) Stable currency exchange rate; 4) High level of demand of the currency. Moreover, Kenen(1983) and Chinn&Frankel(2005) (as cited in Haihong Gao & Yongding Yu) stated that the international currency has several functions : 1. act as a store value(i.e. country’s international reserve); 2. act as a medium of exchange(e.g. in trade transactions ) and 3. be a unit of account. So, considering all these, let’s check the suitability of Yuan for international currency status and Chinese government’s challenges and policy steps in internationalizing RMB (Eichengreen, 2010). As their first step China stimulated the use of RMB in setting trade and trade transactions with the neighboring countries by allowing the companies to open RMB-denominated accounts in the banks in Hong Kong and make operating transactions (payments, transfers, etc.) in Yuan. Secondly, they encourage using Yuan in all kinds of financial transactions and permit private institutions to issue their RMB-denominated bonds, making Hong Kong the offshore RMB bond market center. And as the third step, China made arrangements with interested foreign central banks about adding RMB into their international reserve baskets, reaching total of China’s bilateral currency swap agreements in RMB to over RMB 800 billion (Cookson & Dyer 2010, as cited in Otero-Iglesias) and making RMB a world reserve currency. However, RMB is still far from the international status(due to highly government-controlled banking system and capital control) and its internationalization is just beginning and all these shows only China’s commitment to that policy and market’s increasing interest. But still it is obvious that the internationalization of RMB is just only a matter of time. There are several obvious benefits of RMB internationalization for China and it’s trading partners (Haihong Gao & Yongding Yu). Since there will be more RMB-denominated trade and financial transactions, the exchange risk for the trading parties (both Chinese and foreign) be will red uced and the related costs be eliminated. And this in turn will increase the cross border bilateral transactions and gains from it, especially in the East Asian region, where RMB has already become a dominant currency. Secondly, with the internationalization of RMB, China and other countries will be less dependent on USD (Haihong Gao & Yongding Yu). Since USD accounts for more than 70% of China’s exchange currency reserve, China faces a huge risk of big losses as a result of USD exchange rate fluctuations. However, with the RMB-denominated claims, China would not be so dependent on USA. Moreover, with RMB other countries will have more choice on reserve currency and will not be so dependent on USD as well. Thirdly, RMB internationalization will allow the foreign direct investments into China and also cross-border outward investments from it be in RMB. This will obviously benefit the investors, expand the circulation of RMB in both directions of investments and will expand China’s financial market, and its competitiveness and influence as well (Haihong Gao & Yongding Yu). Lastly, since the developed financial market, the currency exchange rate and currency convertibility are the criteria of the international reserve currency; China will face a need for currency and capital account liberalization reforms and further financial reforms in a whole, including unpegging RMB and RMB appreciation. Although for an export-based Chinese economy appreciation of RMB would be harmful in a short run, besides the drawbacks there are the benefits of strong RMB. Appreciation of RMB means the increase in cost of production, therefore an increase in cost for the importers from China. So the importers and the customers will switch to the cheaper substitutes produced in other countries (this statement may vary in different industries). The increasing demand for cheap substitutes will lead to developments and expansion of production in other countries, and will reduce their unemployment rates and etc. Thus, strong RMB as an international currency may benefit China’s neighbors and other developing countries. Moreover, strong RMB benefits China as well. Losing competitiveness in manufacturing industry, China will have to switch from low-efficiency and labor-intensive industries to a more efficient and developed ones and transform from an industry-based economy to a knowledge-based economy (with dominating services sector). In conclusion, with the increasing role of China in the world trade and growing demand for RMB, the internationalization of RMB is just only a matter of time. Although changing the anchor currency(USD) to RMB may cause uncertain effects, the internationalization of RMB will obviously have positive impacts on both China and the rest of the world. And in the nearest future RMB is likely to become the third international reserve currency, after euro and USD. References: Investopedia, Currency Internationalization, What Does Currency Internationalization Mean? Retrieved from http://www.investopedia.com/terms/c/currency_internationalization.asp#axzz1f5mjUVqB Lee, J-W.(2010, June) Will the Renminbi Emerge as an International Reserve Currency? Retrieved from http://aric.adb.org/grs/papers/Lee.pdf Haihong Gao & Yongding Yu. Internationalisation of the renminbi. Retrieved from http://www.bis.org/repofficepubl/arpresearch200903.05.pdf Eichengreen.B.(2010, January). The Renminbi as an International Currency Retrieved from http://elsa.berkeley.edu/~eichengr/renminbi_international_1-2011.pdf Otero-Iglesias. M. The Internationalisation of the Renminbi (RMB): A Strategy of Crossing the River by Feeling the Stones. Retrieved from http://www.igadi.org/china/2011/pdf/moi_the_internationalisation_of_the_renminbi.pdf