Why RMB internationalization is neither easy nor urgent

Capital account liberalization and market-oriented reforms must come first, Professors Yu Yongding and Pan Yingli say.

The internationalization of the RMB and its perceived challenge to the USD's dominance have been hotly debated topics. However, two prevalent misconceptions persist. The first is an underestimation of the obstacles, and the second is an overestimation of the priority Beijing assigns to this endeavor. These misconceptions are interlinked. While Beijing is undoubtedly interested in elevating the yuan to a global reserve currency, this is not a unilateral decision—even for a powerhouse like China. Moreover, the necessary steps to internationalize the currency involve policies that are not feasible in the short term due to various constraints. Therefore, experts such as Professors Yu Yongding and Pan Liping understand that Chinese policymakers have not truly prioritized dethroning the USD.

Below is a recent interview of the two economists published by Southern Weekly, a Chinese newspaper, on the complexities and challenges of elevating the RMB's global status, reducing China's USD holdings, and challenging the USD as the world’s reserve currency.

Yu Yongding is a former director-general of the Institute of World Economics and Politics (IWEP) at the Chinese Academy of Social Sciences and former member of the Monetary Policy Committee of the People's Bank of China, the central bank. He says that RMB internationalization should be approached as a long-term objective rather than an urgent task, and China’s central bank, in his observation, agrees with that. While the "weaponization of the USD" has created a demand for a bigger role of RMB, Yu cautioned against overly aggressive efforts. "It is not that it cannot be pursued, but it is essential to understand the extent to which it can be achieved," he said, highlighting the importance of maintaining realistic expectations.

Pan Yingli, Professor at Antai College of Economics and Management, Shanghai Jiao Tong University, said that China’s market-oriented reforms are incomplete and its institutions often distort the market, making it difficult to internationalize the RMB through market forces alone. China’s issuance of RMB has long been anchored in the USD and, in its transition to issuing RMB based on Chinese government bonds, the key, according to Pan, remains domestic reforms so that the money raised from the bonds float efficiently to job-creating causes and promote consumption.

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专访余永定、潘英丽：大国博弈中，人民币国际化何以突围？

Exclusive Interview with Yu Yongding and Pan Yingli: RMB Internationalization Breakthrough in the Great Powers Game?

Capital account liberalization is the precondition

Southern Weekly: You previously highlighted the risks of holding extensive U.S. dollar assets. What were your considerations? Does the risk persist today?

Yu Yongding:

China is one of the world's largest holders of U.S. dollar assets, especially Treasury and U.S. agency bonds. This poses two problems: 1. significant risks; 2. cross-border resource misallocation.

First is the financial risk. Two key figures warrant attention. In 2006, the U.S. current account deficit to GDP ratio reached 6%, and the U.S. NIIP (net international investment position, which is a country’s foreign assets minus its foreign liabilities) was -$1.8 trillion, accounting for 12%-13% of its GDP. Around 2006, the increasing U.S. current account deficit sparked a global debate on "global imbalances." There were concerns that the excessive U.S. current account deficit might lead to a sudden halt in foreign capital inflows, causing USD depreciation and its difficulties in meeting debt obligations.

Currently, although the U.S. current account deficit to GDP ratio has improved compared to 2006, the U.S. net foreign debt (negative NIIP) to GDP ratio has surged to 70%-80%, with the net foreign debt skyrocketing from $1.8 trillion in 2006 to nearly $20 trillion. Projections suggest further deterioration of the U.S. NIIP in the future.

Since 2023, the Big Three credit rating agencies have downgraded the U.S. sovereign debt's credit rating. Although the U.S. government has never defaulted, China should remain vigilant as one of the largest holders of U.S. debt. In fact, in 2009, the U.S. agency debt—Fannie Mae and Freddie Mac bonds—almost defaulted, and China held $300 to $400 billion in these bonds.

Southern Weekly: There were proposals in the international community to replace the U.S. dollar with SDRs (Special Drawing Rights). Why did this fail, and how did the path to RMB internationalization emerge?

Yu Yongding:

The former governor of the People's Bank of China (PBOC), Zhou Xiaochuan, advocated for using Special Drawing Rights (SDRs) to replace the U.S. dollar as the international reserve currency, a proposal that had a significant impact.

At the time, France and Russia were the only major countries that supported this proposal. French President Nicolas Sarkozy even traveled to Nanjing for a seminar on the issue. After the financial crisis, the United Nations established the Commission of Experts on Reforms of the International Monetary and Financial System, known as the Stiglitz Commission. The Commission’s agenda was to explore using SDRs to replace the U.S. dollar. However, due to the lack of support from major countries, the committee disbanded.

The SDR scheme requires global coordination, especially U.S. support.

The RMB internationalization scheme proposed by the PBOC aims first to establish the RMB as an international currency and ultimately as an international reserve currency.

However, China faces two challenges. First, as a trade surplus country, the initial step towards internationalization is sending RMB abroad. Previously, China earned USD and then spent it. Switching to spending RMB would mean that the U.S. dollars earned would have no place to be used except to buy U.S. Treasuries again, which contradicts the original goal of de-dollarization.

The second issue is capital controls. To become an international reserve currency, capital account liberalization is a prerequisite. This process is not an all-at-once liberalization but a gradual one. Each major step towards RMB internationalization is conditioned on corresponding capital account liberalization. Thus, promoting RMB internationalization has largely become synonymous with promoting capital account liberalization.

Pan Yingli:

Most countries in Asia still primarily use the U.S. dollar, and within the global U.S. dollar system, China has effectively played the role of the third pillar. The first pillar is oil priced in dollars, the second is the support of the dollar system by the security alliance backed by U.S. military bases, and the third pillar is China's participation in the global division of labor through the dollar system, stabilizing it by using and reserving dollars.

Before 2014, the issuance of RMB was mainly through the settlement of foreign exchange, meaning China bought U.S. dollars to issue RMB, with dollars as reserves. Hong Kong has a similar system, where currency issuance is anchored to the dollar.

During the 2008 financial crisis, the dollar assets China held as reserves faced significant risks of depreciation or loss, leading to a strong desire for the country to promote RMB internationalization.

The Weaponization of the U.S. Dollar Presents Opportunities

Southern Weekly: What problems emerged during the process of RMB internationalization? Why has this term become popular again in recent years?

Yu Yongding:

After the RMB began to depreciate in 2015 [The People's Bank of China devalued the yuan by nearly 3 percent against the US dollar over two days], RMB internationalization faced significant challenges. In Hong Kong, the largest offshore market of RMB, enthusiasm for holding RMB deposits and assets diminished, leaving the RMB internationalization dormant for a considerable period.

Recently, however, the RMB has regained popularity, with cross-border RMB transactions reaching 42 trillion yuan in 2022, experiencing rapid growth. Over 57% of these transactions were conducted under capital and financial accounts. Initially, China aimed to promote the RMB through trade settlements, but cross-border RMB payments in trade have not significantly changed between 2012 and 2022. The major shift has come from capital account transactions, indicating that the recent surge in cross-border RMB transactions is primarily due to capital account liberalization.

Furthermore, the weaponization of the dollar has provided new impetus for RMB internationalization.

Reforming the international monetary system requires network effects. The credibility of the dollar is the most critical factor in its role as the international reserve currency.

Recently, there has been a global trend of de-dollarization, with countries in Southeast Asia, Europe, and the Middle East seeking alternatives to the dollar. This trend presents opportunities for promoting RMB internationalization.

Southern Weekly: With the issuance of ultra-long special treasury bonds, has the "anchor" for RMB issuance shifted from dollar reserves to government bonds? What is your interpretation?

Pan Yingli:

To achieve decoupling between RMB and USD, or advance RMB internationalization, several core steps are essential.

The first concerns the issuance of RMB, or the currency issuance mechanism and the cost of issuance. China needs to transition from a dollar-based reserve system to a Chinese government bond-based issuance mechanism, thereby lowering the cost of issuance through national credit support.

Since 2014, the PBOC has used tools such as the Medium-term Lending Facility (MLF) and the Standing Lending Facility (SLF), along with other pledged financial assets, to support currency supply. However, this approach has limited the effective expansion of the PBOC's balance sheet since 2014. Therefore, reforming the currency issuance system requires the central government to issue bonds and the central bank to purchase them, establishing a routine operation mechanism. The issuance of ultra-long special treasury bonds alone does not signify a change in the PBOC's monetary mechanism.

While the current trend of issuing ultra-long special treasury bonds does not indicate any immediate issues, two aspects need attention: first, strengthening the market foundation for issuing and trading government bonds within an improved currency issuance framework and regulation; and second, enhancing the efficiency of fiscal expenditure to promote a virtuous cycle between supply and demand.

The focus should be on how supply creates demand. First, the government must provide essential services such as pensions and education. Second, investments should create employment opportunities.

Data from China’s publicly traded companies show that the wage share in revenues is 2%-5% for heavy industries, 20%-30% for high-tech industries, and around 40% for consumer services. If investments do not create jobs, only 2% to 3% of the investments translate to wages/labor income, which is insufficient to stimulate consumption and hinders internal circulation. Government fiscal expenditure essentially consumes the purchasing power generated by citizens' current and future taxes and must, therefore, be directed toward projects that create jobs and meet public demand.

When China issues RMB based on government bonds, the core issue is how these bonds are used to promote China’s internal economic circulation.

Southern Weekly: How can RMB internationalization be achieved while ensuring the pricing power of RMB?

Pan Yingli: The pricing power of the RMB involves establishing international pricing authority for Chinese industries and finance.

Despite the U.S. being heavily indebted to the world, the dollar continues to appreciate because the most valuable international goods and assets are valued in dollars. To purchase them, one must first obtain USD. Therefore, a key aspect of RMB internationalization is ensuring that basic global goods and high-quality assets can be valued in RMB. China needs to expand the market for overseas goods and assets priced in RMB, allowing the RMB to gain support from more global high-quality resources and prominent enterprises.

In 2014, the UK government issued a RMB 3 billion bond as a gesture of goodwill to the Chinese government. This also suggests the strategic significance of the international pricing function of a currency. Unfortunately, China later focused on the technical cooperation between publicly listed companies in China and the UK, losing the opportunity to promote the internationalization of the RMB.

To leverage the RMB's pricing function, it is currently feasible to explore the establishment of an RMB-denominated segment in the Hong Kong stock market and introduce foreign oil and rare metal or mineral enterprises, and high-tech enterprises to list on the main board of Hong Kong or the mainland. Additionally, promoting the Chinese stock market to cultivate excellent enterprises and orderly increasing the efforts of opening up is essential.

The RMB cannot be internationalized for the sake of internationalization. Simply pursuing the indicators of RMB internationalization may lead the effort away from the ultimate goal. China's economic system has not yet completed market-oriented reform, and its institutions tend to distort the market. It is almost impossible to promote the internationalization of the RMB by market forces alone. In a government-led economy, it is essential to first straighten out domestic institutions through government-led reforms and eliminate distorting factors to allow the market to function effectively.

Good things come to those who adopt the pace of nature

Southern Weekly: Can RMB internationalization start with regionalization? For example, relying on ASEAN to realize RMB internationalization first in the Asian region, or relying on the BRICS system to realize RMB internationalization among member countries?

Yu Yongding:

Asian regional currency cooperation was first proposed by Japan in 1997 but later stalled. Subsequently, many East Asian countries signed the Chiang Mai Initiative for multilateral currency swaps, which made some progress but had little practical use during critical times.

Currently, some Arab countries have proposed pricing oil in RMB, and Russia has suggested settling trade in RMB. These proposals are also possible steps, but any moves must not go beyond China’s responsibilities. The internationalization of the RMB is a long-term goal, not an urgent task. It is not that it cannot be pursued, but it is essential to understand the extent to which it can be achieved. The internationalization of the RMB cannot solve the problem of the safety of China's overseas assets, and excessive efforts may backfire. For instance, previous attempts to settle imports in RMB inadvertently strengthened the dollar's hegemony instead of weakening it.

Yi Gang, former PBOC Governor, emphasized that the issue of promoting RMB internationalization and enhancing the influence of the RMB should be 心平气和approached with calmness. He said that the internationalization of the RMB is a market-driven process that will succeed at "the pace of nature," and that 人民银行没有特别急切地推进 "the PBOC is not particularly eager to promote it." I very much agree with his perspective.

Southern Weekly: In recent years, the foreign exchange market has fluctuated significantly. Is it necessary for the Chinese government to intervene?

Yu Yongding:

I have always advocated for minimal intervention in the foreign exchange market. Historically, the RMB faced appreciation pressure, but since 2014, it has been under pressure to depreciate. In 2015, the Chinese government intervened in the market. At that time, my team at the Institute of World Economics and Politics of the Chinese Academy of Social Sciences recommended widening the RMB exchange rate's floating range and devaluing the currency. Devaluation can slow foreign exchange outflows, as a higher cost of converting RMB to dollars reduces the incentive for exchange, thereby mitigating depreciation. Exchange rate fluctuations themselves serve as an automatic stabilizer.

Unless under very special circumstances, such as combating international speculators systematically shorting the RMB, the government should generally refrain from intervening and instead allow the exchange rate market to function as an automatic adjustment mechanism.

I believe the current exchange rate policy of the PBOC is appropriate, adhering to the principle of "benign neglect" while remaining open to intervention if necessary.

Pan Yingli:

Currently, the RMB has not depreciated against a basket of currencies. Compared to a few years ago, the RMB has appreciated against the euro and yen but has depreciated against the dollar. Suppose the RMB exchange rate is set at 6.9 yuan as the mid-range, with fluctuations between 6.55 and 7.25, this should be considered normal without requiring special intervention. Additionally, considering the signs of a potential economic recession in the United States and the Federal Reserve's lowering of interest rates, there is a possibility that the RMB may appreciate in the second half of this year.

From a policy perspective, the effects of RMB depreciation and the export rebate policy on exports have been exhausted. Appreciation would be more beneficial for attracting capital inflows, and assisting Chinese enterprises in overseas investments, and overseas resources at a lower cost. Therefore, a strong RMB could be a viable policy option for the PBOC in the future.

Southern Weekend: Why does the U.S. stock market continue to rise despite consistently high Federal Reserve interest rates?

Pan Yingli:

This can be attributed to a certain bubble in the market. The U.S. stock market is buoyed by a few high-tech companies that leverage industry monopolies to achieve rapid profit growth. The ongoing U.S. technological competition with China aims to create favorable conditions for American companies to dominate international markets, such as by establishing import barriers in the new energy sector.

First Solar, a listed company in the U.S., is currently the world's largest photovoltaic company by market value, and its shipments rank 10th globally. However, its photoelectric conversion efficiency is less than 20%, compared to an average efficiency of 25% among Chinese counterparts. The rapid growth of First Solar's profits can be attributed to U.S. restrictions on the new energy market, enabling it to achieve a domestic market monopoly.

The development of AI technology has significantly increased computing power consumption, providing green energy companies with opportunities to drastically increase profits and share prices. Meanwhile, China's photovoltaic manufacturing industry is experiencing widespread negative net income, a situation that warrants reflection.

The market is also skeptical of U.S. government statistics. For instance, the positive U.S. nonfarm payroll employment figures are partly due to an increase in the number of people taking second jobs to cope with inflation. However, there has been a sharp decline in medium and long-term job opportunities.

Yu Yongding:

From the second half of 2023 to the present, the U.S. federal funds rate has remained unchanged, and the inflation rate has also been stable. Theoretically, the federal funds rate and the inflation rate should be negatively correlated, meaning that as the federal funds rate rises, the inflation rate should decrease, and vice versa. However, the U.S. stock market has experienced a significant surge. This recent rally can only be explained by other factors, such as continued technological breakthroughs by a few high-tech companies or speculation. Let's wait and see.

Southern Weekly: Why has the dollar been so strong in recent years? How will the dollar fare in the future?

Pan Yingli:

The main reason for the relative strength of the U.S. dollar since 2017 is that the global economy has entered an era where each economy is performing worse than the next.

As far as the world's major economies are concerned, Japan's performance is unimpressive. Europe recovered from the European debt crisis in 2010, but fell into an economic downturn due to the outbreak of COVID-19 and Russia-Ukraine conflicts, driving massive safe-haven assets into the United States. Meanwhile, China's economy is also facing numerous challenges.

While the United States talks down China, it is also short-selling China. Additionally, high inflation in the United States led the Federal Reserve to raise interest rates, attracting massive capital inflows for arbitrage and promoting a soaring stock market. The profits made in the U.S. market encouraged further capital inflows, all of which have boosted the strength of the dollar.

However, the dollar may be a spent force as the U.S. real economy faces a recession and can no longer support high interest rates and a strong currency. Federal government debt is growing rapidly, with the U.S. national debt climbing from $20 trillion to $35 trillion during the Trump and Biden administrations, and it may continue to grow at a rate of $2 trillion per year. Under high interest rates, the cost of interest payments will rise sharply as the U.S. secures new debts to repay old ones.

If Donald Trump wins the U.S. presidential election this year, there is a high probability that the dollar will depreciate. Trump's economic policy focuses on rebuilding manufacturing and expanding employment, and a strong dollar is not conducive to exports and the real economy. His main economic policies include raising tariffs on products from China, accelerating decoupling from the Chinese economy, devaluing the dollar, and requiring allies to implement export restrictions to cede a portion of their market share to the United States.

Therefore, the dollar will remain relatively strong and volatile in the short term but is expected to decline in the medium and long run. A more favorable scenario for China would be a gradual decline in the dollar rather than an uncontrolled one. Given the economic interdependence between the U.S. and China, China does not want to witness an uncontrollable depreciation of the dollar.

Southern Weekly: Is now a good time for China to reduce dollar holdings?

Yu Yongding:

As early as 2013, British economist Martin Wolf warned that in the event of a conflict between China and the United States, the U.S. could confiscate a significant portion of China's overseas assets. The freezing of over $300 billion of Russia's dollar reserves by Western countries during the Russia-Ukraine conflict served as a warning to China that national credit sometimes yields to political considerations. From an economic standpoint, in addition to risks related to resource allocation, China now faces significant geopolitical risks.

Currently, many countries are consciously reducing their holdings in dollars. In the past, when everyone was buying, reducing holdings wasn't a major problem, as asset prices didn't incur losses. However, if everyone starts selling now, losses will occur. Reducing holdings of assets such as U.S. Treasuries is a step in the right direction, but the optimal time has passed. A better approach might be to increase imports, including purchasing more American products, to spend dollars.

There are other options, such as not purchasing new U.S. Treasuries upon maturity, adjusting the maturity and type mix of the U.S. Treasuries held, allocating more dollars to multilateral organizations, and decentralizing U.S. Treasuries custodians. However, these involve numerous highly technical issues that make it difficult for outsiders to make decisions. Whether and at what pace to reduce dollar holdings has now become more of a geopolitical question.