Review: The Renminbi Bloc is Here - A Subramanian, M Kessler

Here is a paper by Subramanian and Kessler on the question of transformation of the Chinese Renminbi into an international currency:

http://piie.com/publications/wp/wp12-19.pdf

The authors have defined three factors that go into the making of an international currency - store of value, medium of exchange and unit of account. While they have focused the paper on the last factor, I would like to talk about the first two briefly.

As a store of value, a currency's value must be stable, or at the very least should not decrease. This has been the primary argument against the Dollar's continuation as a global currency. In fact, the very breakdown of the Bretton Woods system was due to expansionary monetary policy in the US. The inability of the US to rein in the fiscal deficit is also expected to cause a flight from dollars sometime in the future. On this front, judging the Renminbi is difficult, since the Renminbi has been pegged to the Dollar for most of recent history. How the Renminbi would perform on this front when the pressure of internationalisation would force China to liberalise the capital account, is not known.

The usefulness of a currency as a medium of trade, while linked to the first, is also a function of the home country's trade volumes. This has been the primary force behind the internationalisation of the Renminbi. The fact that Malaysia now follows an active policy of keeping Renminbi reserves is testament to China's growing external trade. The paper also talks about this aspect when dealing with the unit of account nature of currencies, and I will reserve more discussion for that.

The paper is fairly easy to understand, using a number of regressions to test the hypotheses. What I particularly like about the structure is that the authors introduce various reasons that could affect the robustness of their results, and either disprove or acknowledge it. The theme - the rise of the Renminbi - is fairly common. Being one of the first research papers on this theme that I have read, it has been an enlightening first read.

Here are a few themes in the paper that I found very interesting:

• The least controversial result in the paper is the assertion of the existence of a 'Renminbi bloc' - a group of East Asian economics whose currencies show higher movement with the Renminbi (as reflected by high co-movement coefficients, or CMCs, in the regression) as compared to the Dollar or the Euro. Also hardly surprising is the finding that the influence of the Renminbi outside of East Asia is still less than the Dollar or the Euro. The interesting observation, however, is that while the influence of the Dollar and the Euro is decreasing, that of the Renminbi is increasing.

• The emergence of the East Asian 'Renminbi bloc' is talked about, with the introduction of an East Asian dummy in the regression. The reason for the formation of the Renminbi bloc could be two fold - (1) that East Asian countries trade most with China (2) geographical proximity to China. Separation of the two effects is hampered due to high correlation between the two - geographical proximity usually implies a higher trade share. Despite this, the introduction of an East Asian dummy keeps the significance of the CMC intact. The implication of this fact would be that as China's trade share with countries outside of East Asia increases, the Renminbi as a reference currency will only grow stronger. As an illustration, the authors cite India as one of the countries for which the Renminbi has the highest CMC.

• The last section compares today's Renminbi to the 1990s' Yen. While the CMCs with a sample of East Asian countries is much higher for the Renminbi, the international character of the currency (as reflected by the percentage of trade settled in the currency) is significantly higher for the Yen. The authors provide only indicative answers, and not definitive ones, to this apparent paradox. Their hypothesis is that East Asian countries are more competitive with today's China than the 1990s' Yen (explaining the high CMC); and that the 1990s' Japan had a more liberal capital account and more multinational firms (explaining the international character). These hypotheses, especially the one about capital account, seem fairly reasonable. Even though East Asian countries have a greater incentive to mirror the Renminbi (to avoid losing their competitiveness), they would be unable to settle their trade in the currency because of restrictions on the capital account. Hence, for the Renminbi to become more international, liberalisation of the capital account becomes more important, given that the need already exists.

• The last paragraph deals with the most controversial question - will the Renminbi replace the dollar as a global currency? The surprising answer advocated by the authors is that on the basis of growth in trade alone, the Renminbi will be the most dominant currency by 2037. They argue that with liberalisation, this date could come sooner. To me, this is a very strong assertion to make. What the authors are saying is that given the capital controls that exist in China, the Renminbi could overcome these restrictions to become the global reference currency. Agree or not, that is what the data (and a few assumptions about trade growth) implies.