03 Apr 2013, David Carbon , DBS Bank , Asia Risk
Everyone knows China’s economy has grown really quickly for a really long time. Most wouldn’t be too surprised to learn this growth equates to 10% per year since 1978, when Deng Xiaoping began replacing central planning with the market. One might be a little more surprised to learn that, at that rate, gross domestic product (GDP) (or anything) doubles in size every seven years. But one would probably be very surprised to learn the equivalent fact: China’s economy is 28 times bigger today than it was back in 1978.
Twenty-eight times. No fooling, no magic. Except perhaps the magic of compound growth, 35 years of which has made China the world’s second-largest economy and the largest trader. Last year, China’s total trade came to $3,867 billion, surpassing the US by a billion dollars.
Real economy versus financial economy
Ironically, these tectonic shifts in the world’s real economy have not been accompanied by similar changes on the financial side. China now trades more than any other country but, even today, almost nobody uses its currency, the renminbi (RMB), to do the deals. In mid-2011, less than 1% of the world’s trade was conducted in RMB terms. Some 46% of the world’s trade was still conducted in US dollars (USD) with the next 35% conducted in euros, yen, sterling and Australian dollars.
A global RMB
Over the past two to three years, China has embarked on a path to change this lopsided situation – to make the RMB an ‘internationalised’ global currency, one as important to the world’s financial markets as China’s production, demand and trade have become to the world’s real economy.
To anyone who worked or lived through Asia’s financial crisis of 1996–1998, a huge question naturally arises: why would China want to do this? A globalised currency, practically by definition, must be supported by an open capital account. And open capital accounts have wreaked all kinds of havoc on all kinds of countries for years. China has experienced 35 years of 10% GDP growth. It’s 28 times bigger today than it was in 1978. Why risk this kind of success for a globalised RMB and an open capital account?
The answer is, in the main, not because China wants to, but because it needs to.
The whys and why nots
There are a lot of reasons for globalising the RMB that, in DBS’s view, are either trivial or nonsense, or both. Lower foreign exchange transactions costs; lower hedging costs; lower borrowing costs; the advantage of seigniorage and the wish to protect foreign assets from a hypothetical drop in the value of, say, the dollar all fall into these categories, and we refer readers to our full report for a more complete discussion. The real reasons for globalising the RMB, of which there are three, are discussed below.
Avoiding a credit crunch
The collapse of Lehman Brothers in September 2008 triggered the biggest global recession in 80 years, which many countries are still recovering from today. Asia, of course, recovered quickly – way back in mid-2009. But the downturn here was still sharp and deep – and much of it could have been avoided had an alternative to the US dollar existed for financing Asia’s trade.
To see this, one must understand that Asia’s downturn wasn’t ‘imported’ from the US or Europe in the normal textbook manner. In the textbooks, an economy falters and stops importing from its neighbours. A couple of months later, the neighbours stop importing from theirs, and so on. It’s a daisy chain, real economy transmission mechanism.
When the global economy went down in Q4 2008, it didn’t happen in a daisy-chained fashion over the course of several months and quarters. When Lehman Brothers collapsed in September 2008, the whole world dropped at once – instantly and simultaneously. Asia fell just as quickly, if not quicker than, the US. This was not from a lack of real economy demand, but from a credit crunch – the freeze in dollar funding that is so absolutely crucial to Asia’s international trade. No credit, no trade, no activity – end of story.
Of course, weak real demand from the West didn’t help Asia. But neither was it a big problem. Between mid-2008 and mid-2012 (the four years that book end the crisis), Asia grew by 32 percentage points – an almost average pace – while G3 growth was a net zero. Asia’s central banks raised interest rates 50 times to slow growth and cool inflation.
The Federal Reserve gave us quantitative easing 1, 2 and 3. The message was clear: weak demand from the West didn’t help Asia but it was never the key problem. Asia’s downturn was caused mainly by a credit crunch in the financial sector – a lack of US dollars to fund regional and international trade.
Avoiding a recurrence of this situation is the first thing China hopes to gain by internationalising the RMB.
Rising trade volumes
China is 28 times bigger today than it was in 1978. It is the world’s second-largest economy and the world’s largest trader. One of the stated goals of the new leadership is to double GDP growth from 2010 levels by 2020.
What does this expansion path imply for imports going forward? We calculate China’s imports will grow to $3.8 trillion by 2020 in today’s prices and exchange rates2. That would be an increase of nearly $2 trillion over 2012 levels. If exports move roughly in line with imports, then China’s total two-way trade would grow by some $4 trillion by 2020.
Four trillion dollars is a lot money. It could buy all of Germany’s GDP with change to spare. It is $2 trillion more than the amount the Fed’s balance sheet has expanded by in recent years.
And it’s almost as many dollars as the $4.5 trillion that the Bank for International Settlements estimates comprise the entire offshore dollar market today. That’s right, the eurodollar market – born in the 1960s, fed by US current account deficits, the market that grew and grew and that many feared would balloon to infinity because it was beyond the Fed’s jurisdiction to mandate a required reserve ratio; the market that finances anything and everything but most of all international trade – could barely cover just the growth in China’s trade between now and 2020.
Now it becomes clearer still why China wants to internationalise the RMB. The structure of the global economy has changed dramatically since 1978; the world’s financial architecture has hardly changed at all. The entire eurodollar market would barely cover just the growth in China’s trade over the coming seven years.
The bottom line? A globalised RMB doesn’t exist, and it has become necessary to invent one.
Prestige and politics
Economics is key, but prestige and politics play a third role in the push to internationalise the RMB. How could they not? China is already the world’s largest trader. By 2020 the gap will have widened dramatically.
Against this backdrop, it would be surreal if China was still denominating its trade in US dollars in 2020. It would be like having the biggest house on the street – a mansion – and calling a taxi for a ride to the ball. Mansion owners don’t take taxis to the ball. It doesn’t just look funny, what if there are no taxis available? What if, one day, China calls its foreign bank to arrange for some dollar trade credit and the bank says “sorry, you recently took control of a disputed offshore territory and we’re no longer at liberty to facilitate this transaction” – what then?
If China wishes to assume the role in Asia, and in the world, that it seems destined for, a globalised currency is necessary and desirable for both economic and political reasons.
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