The staggering economic rise of China in the last three decades leads to the question of the potential internationalisation of its currency, the renminbi (RMB). Internationalisation has different dimensions. An international currency is widely used in financial and trade transactions, and crucially it is used as a store of value. Some, like Eichengreen (2011) and Frankel (2011) see a potential global role for the RMB, provided important ancillary reforms to the domestic financial system and to the financial account first take place. In Eclipse, one of us projected that such a shift might happen in less than two decades (Subramanian 2011).
But there is a third dimension to an international currency: it serves as a unit of account or as a reference point for other currencies. We define a reference currency as one which exhibits a high degree of co-movement with other currencies. This co-movement could reflect either pegging choices by the government or be driven by market forces. In a new paper (Subramanian and Kessler 2012), we measure the co-movements of the US dollar, the euro, the RMB and the Japanese yen for a sample of 52 emerging market economies. We do that by following a methodology first applied by Frankel and Wei (1994): running a regression of each emerging market currency exchange rate (against the Swiss franc – which plays the role of a neutral numeraire) on this basket of four currencies (also against the Swiss franc). The coefficients on each of the major currencies are called “comovement coefficients” (CMCs), and measure the extent to which exchange rates movements are correlated with the four benchmark currencies.
The RMB as a dominant regional actor and a significant global player
The RMB became more flexible from July 2005 to July 2008, appreciating by about 22% when the People’s Bank of China decided to tighten the peg against the dollar to weather the crisis, and then gained flexibility again after July 2010 until August 2012 (the end of our sample). We use those two periods, which provide variation between the dollar and the RMB, to estimate the CMCs.1
We first turn to East Asia, China’s potential “backyard”. Table 1a shows the striking reversal from a dollar to a RMB-dominated region. In the period July 2005-July 2008, six out of ten East Asian currencies co-moved more with the dollar than the RMB. However, after July 2010, the positions have been reversed and now the currencies of seven out of ten countries – Indonesia, Korea, Malaysia, the Philippines, Taiwan, Singapore and Thailand – co-move more with the RMB. This is the sense in which we describe East Asia as effectively a RMB bloc.
The magnitudes are also striking (Table 1b). In the first period, the average CMC was 0.61 for the dollar and 0.26 for the RMB; now it is 0.53 for the RMB and 0.38 for the dollar.
In the rest of the world, the US dollar is still the dominant reference currency, but the new phenomenon is that the RMB is starting to matter. To show that, we compare the CMCs beyond the “natural backyard” of each country – Latin America for the US, emerging Europe and MENA for the euro, East Asia for the yen and the RMB.
The RMB is still dominated by the USD as a global reference currency (Table 2a), but this is changing. The RMB is the dominant reference currency in four cases in the most recent period, compared to one previously; and it is a dominant reference currency in more cases than the euro. For example, the RMB moves more closely with national currencies of India, Chile and South Africa than any other in the latest period, and comes second in Israel and Turkey. These results of the rising role of the RMB are robust to a number of changes to the baseline specification: choice of numeraire currency; controlling for common financial factors such as emerging market financial risk; and to cases of both RMB appreciation and depreciation.
Trade and reference currencies
What accounts for this rise of the RMB as a reference currency? Will its orbit expand beyond East Asia? Noticing the importance of the RMB both inside and outside East Asia, we can start looking for the relevant linkages. Trade is an obvious candidate; countries that trade a lot with China might wish to stabilise their currency against the RMB to limit the exchange rate risk for their companies. Common real or financial shocks could also play a role, as well as competition in third markets (Mattoo et al. 2012).
Figure 1 is indicative, and shows that there seems to be a link between trade and CMCs. It is restricted to those countries with a significant and positive CMC – but this relationship holds when extended to the whole sample, as shown in Table 3, column 1.
Table 3 Correlates of CMCs
The clear conclusion is that trade has a robust relationship with the size of the CMCs, even accounting for a specific East Asia effect. Financial shocks also matter, but the effect disappears when one adds an East Asia dummy. There are some hints that competition with China may have a role in explaining the rise of the RMB as a reference currency but the evidence is not definitive. This association with trade is robust to a number of changes in the basic specification. Interestingly, it is not only trade integration with China which is associated with high CMCs with the renminbi. Symmetrically, trade integration with the United States is associated with high dollar CMCs.
This phenomenon of the rise of the RMB is different from the historical experience of Japan. Even at the height of its economic boom in the early 1990s, Japan never came even close to become a reference currency and the dollar remained the dominant reference currency even in East Asia. Further, trade of countries with China will undoubtedly expand in the next couple of decades. With simple gravity-based projections, and even accounting for a slower growth for China in the future, the correlation that we uncover points towards a crossover of the RMB as a dominant reference currency in about 25 years. Complementary reforms of the financial and external sector in China could considerably speed up the process.
Frankel, Jeffrey (2011), “The rise of the renminbi as international currency: Historical precedents”, VoxEU.org, 10 October
Frankel, Jeffrey, and Shang-Jin Wei (1994), “Yen Bloc or Dollar Bloc? Exchange Rate Policies of the East Asian Economies”, in Takatoshi Ito and Anne O Krueger (eds.), Macroeconomic Linkages: Savings, Exchange Rates and Capital Flows, University of Chicago Press.
Marcel Fratzscher, Arnaud Mehl (2011), “China’s dominance hypothesis and the emergence of a tripolar global currency system”, VoxEU.org, 15 December.
Eichengreen, Barry (2011), “The Dollar: Dominant no more?”, VoxEU.org, 10 January.
Mattoo, Aaditya, Prachi Mishra, and Arvind Subramanian (2012), “Spillover Effects of Exchange Rates: A Study of the Renminbi”, IMF Working Paper 12/88.
Subramanian, Arvind (2011), Eclipse: Living in the Shadow of China's Economic Dominance, Peterson Institute for International Economics.
Subramanian, Arvind and Martin Kessler (2012), “The Renminbi Bloc is here: Asia Down, Rest of the World to go?”, Peterson Institute for International Economics Working Paper 12-19.
1 Several authors, notably Fratzscher and Mehl (2011) on this website, prefer to remove first the dollar component from the RMB. The drawback of this method is that it prevents comparisons of the different coefficients. Although RMB and US Dollar movements are still close, the standard errors do not seem to show important disruptions due to too high collinearity. We thus run a simple and clear horse race between currencies to measure the CMCs.