Currency Internationalization
Presenter
Tao Wu
CTP Training Program
Macroeconomic Management and Financial Sector
Issues
Content Outline
• Definition of currency internationalization
• Objectives and benefits of currency
internationalization
• Costs of currency internationalization
• Evolution of an international currency
• RMB Internationalization
2
Definition of Currency
Internationalization
3MMF
Definition of International Currency
• A national currency is regarded “internationalized” if it
plays the role of money outside the country where it is
issued.
Medium of exchange; Unit of account; Store of value; Method of
payment.
• For an operational definition, it may be useful to identify
qualifications for an international currency.
Capital account convertibility; no restrictions on currency
trading, spot or forward;
Little or no restrictions on foreigners’ access to domestic
financial markets;
Large volume of trade and financial assets from the originating
country;
The issuer has the bargaining power to denominate trade in its
currency;
Well developed financial market with a large variety of risk-
hedging instruments; breadth and liquidity;
Stability of value: long-run price stability (low inflation) and low
exchange variability. 4
Capital Account Convertibility
• Capital account convertibility may be a
precondition, but it does not automatically lead to
currency internationalization (CI).
IMF defines the term “convertible” as “freely usable for
the settlements of international transactions”.
Unless the currency is widely used in international
transactions, it does not function as a global unit of
exchange.
The degree of a currency’s actual usage is the most
critical criterion:
Its share in the denomination of international trade and
financial assets;
Foreign holdings of the currency as international reserves.
By this standard, even Japanese yen is yet a fully fledged
international currency.
5
International Reserves (% of Total)
6Source: IMF Annual Reports
19
76
19
78
19
80
19
82
19
84
19
86
19
88
19
90
19
92
19
94
19
96
19
98
20
00
20
02
20
04
20
06
0
10
20
30
40
50
60
70
80
90
US Dollar
DM
FF
Euro
Pound
Yen
CHF
Qualifications for International Reserves
• Size of GDP
The dollar is dominant
Euro quickly became the second key currency
• Stability of value
The prospect of the economy
Euro vs. Yen
• Financial development
May not be so critical
Euro vs. British pound
7
Financial Asset Denomination (Money Market, % of Total)
8Source: BIS Quarterly Review: various issues.
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
06
20
07
%
%
%
%
%
%
%
%
%
%
US dollar
Euro
Pound sterling
Yen
Australian dollar
Swedish krona
Canadian dollar
Singapore dollar
Financial Asset Denomination
• The US dollar has lost its dominance.
• The euro has become the dominant currency.
• The pound sterling has lost its key currency
position despite London being a global
financial center.
9
Trade Denomination
United States United Kingdom Japan Germany France Australia
Export Import Export Import Export Import Export Import Export Import Export Import
1980 US $
Euro . . . . . . . . . .
Yen
Home
Other
1992 US $
Euro . . . . . . . . . .
Yen
Home 54,6
Other
2000 US $
Euro
Yen . . . .
Home
Other
2003 US $
Euro
Yen . 25 . . . .
Home 25
Other
10
Source: Bank of Korea, Kawai (2008), Kamps (2006), EURC
Determinants of Trade Invoicing
• Traded goods are more likely to be invoiced by
exporter’s currencies
Exchange rate risk is more critical for exporters.
• Producer currency pricing is more likely if traded
goods are more differentiated.
Demand uncertainty is lower for more differentiated
goods.
• More homogeneous goods such as oil and other
primary commodities are likely to be invoiced in
a very few key currencies.
11
Objectives and Benefits of Currency
Internationalization
12MMF
1. Reducing foreign exchange rate risks
• Domestic agents engaged in foreign trade may
be able to reduce foreign exchange rate risks to
the extent that their exports and imports are
invoiced in their own currencies.
• Domestic borrowers (financial institutions and
firms) could also borrow in their own currencies,
thereby avoiding currency mismatch in their
balance sheets.
The 1997 Asian financial crisis demonstrated that
macroeconomic shocks could be amplified by the
balance sheet aggravation in the banking sector.
Yet with the development of financial derivative
products, such benefits become lower. 13
2. Collecting seigniorage revenues
• Countries having major international currencies
also reap the benefits of collecting seigniorage
revenues from foreign holdings of their
currencies.
• Chinn and Frankel (2007) find that the shares
are determined by the economic size of the
country, inflation rate, exchange rate variability,
and the size of the relevant financial center.
• As far as emerging economies are concerned,
since they are well behind in terms of these
determinants, this benefit is likely to be
insignificant.
14
3. Developing domestic financial institutions
• Domestic financial institutions may gain an
edge over their external competitions in
dealing in their own currency.
• Once a number of financial assets
denominated in their own currencies are
issued and freely exchanged for foreign
currencies, more opportunities in global
financial intermediation open up for domestic
financial institutions.
• Some policy makers consider currency
utilization as a way to develop the financial
institutions.
15
4. Establishing an international financial center
• Some emerging economies may find it
necessary to internationalize their currencies to
hold a regional financial center somewhere on
their soil.
For example, Korea has been pursuing
internationalization of its currency in the expectation
of hosting an international financial hub.
• However, CI does not necessarily lead to the
establishment of a financial center.
In the case of the euro, a fully developed international
financial center is located in London.
Singapore’s non-internationalization policy also
illustrates that CI is not a necessary condition for the
development of a financial center.
Restrictions of cross-border asset-side bank lending of
Singapore dollars to non-residents or to residents where
Singapore dollars were to be used outside Singapore, until
the late 1990s.
16
Summary of Objectives/Benefits
• Laying the foundation for a reserve
currency
• Avoiding “original sin”
• Improving competitiveness of exports of
financial services as regional or global
financial center countries
• Speeding up financial deepening
• Reducing foreign exchange rate risks
• Seigniorage revenues
• Holding smaller amounts of reserves
17
Benefits may not be large for emerging economies
• Demand for international currency is market
driven
Currency denomination is determined by economic
fundamentals and foreign demand
• CI is not a necessary condition for a regional
financial center.
Examples: Euro and Singapore dollar.
• Smaller reserve holdings are not necessarily
related to CI
Australia has contracted a swap with the US Fed
18
Costs of Currency
Internationalization
19MMF
I. Costs involved with capital account
liberalization and financial deregulation
• One of the necessary conditions for CI is
liberalization of capital account
transactions. Deregulation of cross
border investments would provide a level
playing field for both foreign and
domestic market participants.
Foreign investors are not subject to any
restrictions in buying and selling domestic
financial instruments in both domestic and
offshore markets
Likewise, domestic residents are accorded
the same opportunities to participate in
foreign financial markets both as lenders and
borrowers.
20
Effects of Capital Account Liberalization
Growth Benefits
• Financial liberalization leads to flows of capital from
(advanced) economies with low rates of return on
capital to (emerging and developing) economies with
higher returns, thereby complementing limited
domestic savings and lowering the cost of capital to
augment domestic investment in the latter.
• Kose et al. (2006) argue that there are certain
threshold conditions emerging economies are to meet
in order to reap growth benefits from financial market
opening such as developed financial markets, high
quality of institutions and governance, and trade
integration.
• Question: Is the country suffering from a lack of
domestic saving?
21
Effects of Capital Account Liberalization
Financial Stability
• Increasing capital account liberalization has
increased the volatility of capital flows, posing
serious impediments to financial stability.
Since the eruption of the 2008 crisis, capital flows
in many East Asian economies with fully and
partially open capital accounts have become more
unstable than before, causing a high degree of
fluctuations of stock prices and exchange rates.
To large foreign private and institutional investors
operating out of East Asia’s regional financial
markets, their investments in an individual
emerging economy often accounts for a very small
share of their total global investments, yet possibly
a large part of the local markets and can therefore
easily dictate movements of financial prices
including the exchange rate.
22
Effects of Capital Account Liberalization
International Reserve Holdings
• In theory, countries with internationalized
currencies and free floating would not need to
hold as much reserves as countries with insular
currencies, because they can use their own
currencies to substitute for dollar liquidity.
Countries with internationalized currencies . .,
Euro Area, Canada and Australia hold very small
amounts of FOREX reserves, borrowing externally to
finance their current account deficits, although there
are exceptions such as Japan.
• But a country’s capacity for external financing is
likely to be determined by its economic
fundamentals (debt sustainability), not by its
currency status.
Example: Australia
23
Effects of Capital Account Liberalization
Summary
• Little robust empirical evidence on economic
growth
• Many empirical studies show financial market
instability caused by capital account
liberalization
• Small country dilemma
• Free floating cannot fully deflect external
shocks
24
II. Increase in exchange rate volatility
• Since CI predisposes the emergence of offshore
currency markets, emerging economies may have
to endure an increase in the volatility of their
exchange rates.
The exchange rate would move responding to changes
in the foreign demand for the domestic currency resulting
from foreign shocks not associated with domestic
conditions of the economy.
• The opposite could be the case: by enlarging the
foreign exchange market, CI can actually
contribute to more stabilization of the exchange
rate.
• Whether CI will lead to increased volatility of the
exchange rate or not is therefore an empirical
question.
25
III. Increased vulnerability to currency crisis
• Some emerging economies may become more
vulnerable to currency crises if foreign
investors hold widely domestic-currency
financial instruments.
If foreign investors are hit by a liquidity squeeze,
they may be forced to sell domestic-currency
assets, putting pressure on the exchange rate to
depreciate.
CI can result in providing speculators with more
instruments to be used for speculative attacks on
the currency.
After the foreign investors intentionally raise funds
by issuing financial debts or take a short position
denominated in the domestic currency, they can sell
the domestic currency in the foreign exchange
market to drive the exchange rate down.
26
IV. Complications for monetary policy management
• An additional source of money demand by
foreigners may complicate the monetary
authorities’ management of monetary policy.
If the monetary authorities change money supply
without taking into consideration external demand,
they may not able to set the level of money supply
that it intended to target in the domestic economy;
German and Japan in 70s.
• Possible counter-argument: monetary policy’s
main operating target is the interest rate, not the
money stock, if inflation targeting is the
framework of monetary policy operation.
• Indeed, the difficulty of conducting autonomous
or independent monetary policy is not due to CI
per se, but more generally due to capital
account liberalization: the Impossible Trinity
(Mundell 1963). 27
Costs of CI can be large
• Costs involved with lifting restrictions on
capital account transactions together with
deregulation of the domestic financial system.
• Increase in volatility of exchange rate
• Increase in financial vulnerability
• Complications in management of monetary
policy
• When the benefits are balanced against costs
of internationalization, strong case for CI in
emerging economies cannot be made.
28
Evolution of an International
Currency
29MMF
Evolution of an International Currency
How to transform an insular currency into
an international medium of exchange?
• De facto process : the Australian dollar
• De jure process : the Japanese yen
• Why has Japan failed to elevate the yen to
reserve currency status?
• Why has the euro been accepted as a
reserve currency from the beginning?
• Has the British pound eclipsed as a key
currency?
30
Experience of Japanese Yen
• Despite strong initiatives from the Japanese
government, the international status of yen had
changed very little in the past two decades.
Even within East Asia, Japanese Yen has not been able
to become the dominant currency in trade settlement.
. dollar is much more widely used, even in Japanese
trade with East Asia than is the yen. East Asia remains a
very strong dollar zone.
For instance, In 2002, % of Korean imports and
% of exports were invoiced in . dollar, and only
12-13% of imports and % of exports were invoiced in
Yen, although Japan is at least as important a trading
partner as the US.
• Why?
31
Experience of Japanese Yen
• The choice of invoice currency was determined by
various factors, including market power, matching of
product exports and material imports, international
price setting practice, preferences of importers and
exporters, etc.
In particular, a) raw materials constitute a large share of
Japan’s imports; b) the currencies of Asia tended to
fluctuate more with the yen than with the USD; c) there is
little need for yen loans because most trade is not
denominated in yen.
• Determinants of currency choice in financial
transactions: the level of interest rates, market
expectations about prospective exchange rate
movements, etc.
• Currency choice of reserve holdings: the most
important factor seems to be exchange rate
management practice. 32
Evolution of an International Currency
How to transform an insular currency into
an international medium of exchange?
• De facto process : the Australian dollar
• De jure process : the Japanese yen
• Why has Japan failed to elevate the yen to
reserve currency status?
• Why has the euro been accepted as a
reserve currency from the beginning?
• Has the British pound eclipsed as a key
currency?
33
CI and Financial and Monetary Cooperation
and Integration in East Asia
• Financial market integration
Liberalization of cross border investment will promote
integration of East Asia’s domestic financial markets with
one another and with global financial markets
Equally important for the integration are constructing
regional financial infrastructure including a settlement
system, and harmonizing market practices and withholding
taxes
• Competition for hosting a financial center
CI is not a necessary condition
It is a market-driven rather than a government-oriented
process.
Countries with internationalized currencies have a
competitive edge
34
CI and Financial and Monetary Cooperation
and Integration in East Asia
• CI and monetary integration – privileges of
reserve currency countries
Except for the yen, currencies of other Asian
countries are poor substitutes for the US dollar and
euro in creating global liquidity
Even the yen has a limited capacity of complementing
the US dollar in supplying global liquidity
Unlike those in the US and Euro area, Asian
institutions are exposed to insolvency risks when
global liquidity vanishes
Asian countries could join either a US dollar or euro
bloc (Unrealistic option)
Alternatively they could construct a monetary union
among themselves. According to Shirono(2009), the
RMB could play the role of an anchor currency in
such a union.
35
Summary
• It is important to articulate the objective of CI
• It is important to determine the readiness,
efficiency of the institutions required, and order
of capital account liberalization before
embarking on CI
A de jure process may require a big bang style capital
account liberalization
A de facto process may be consistent with a gradual
approach
Creating offshore markets where non-residents can
issue and trade financial instruments denominated in
the domestic currency is the last stage of CI.
36
RMB Internationalization
37MMF
Motivations
• Long-run goal: for RMB to ultimately attain an
international status that is commensurate with
China’s economic weight and trade scale.
• Background:
High current account surpluses and rising capital
inflows have contributed to the rapid accumulation of
reserve assets, primarily denominated in the .
dollar.
Substantial increases in intra-emerging markets trade
and capital flows, for instance, within the Asian region.
Chinese capital “going out”: increased needs for
outward direct and portfolio investment by Chinese
firms and individuals.
Chinese economy and RMB became more attractive
amidst the most recent financial crisis in the . and
Europe.
38
Monetary Considerations
• RMB internationalization may also help
overcome the so–called “conflicted virtue”
problem (the inability of a creditor country to
lend in its own currency):
If international trade in particular exports can be
invoiced in RMB, then CA surpluses will not lead to
accumulation of dollar-denominated assets on the
PBC’s balance sheet.
Capital outflows can also help alleviate domestic
liquidity pressure ; if outflows can be denominated in
RMB, better ER risk sharing will encourage more
outward direct and portfolio investment.
39
A Gradualist Approach
• A three-step strategy for RMB
internationalization has been planned:
In terms of targeted regions:
Surrounding countries Asian region
worldwide
In terms of the functions of RMB abroad:
Invoice currency Investment vehicle
Reserve currency
40
Progress since Mid-2009
• Since mid-2009, the PBC has launched a
number of initiatives to speed up the
process, including:
Promoting RMB settlement of trade transactions;
Easing restrictions in RMB cross-border
remittance for trade settlement;
Allowing the issuance of RMB-denominated
bonds in Hong Kong and by foreigners in
Mainland;
Permitting selected banks to offer offshore RMB
deposit accounts;
Setting up local currency bilateral swap lines with
other central banks.
41
• The amount of RMB trade settlement rose from
billion in 2010 to trillion RMB in Jan-
Sep 2013 (at an annual rate of more than 4 trillion
RMB), accounting for about 16% of total trade
volumes.
42
Progress: RMB as Trade Settlement Currency
• The imbalance between import settlement and
export settlement has improved in the last two
years:
2010-2011, RMB settlement primarily concentrated in
imports (85% - 90%) instead of exports;
2013:Q3: import settlement accounts for 60%, still
substantially higher than export settlement.
• Possibly reflecting:
Market’s expectations of RMB appreciation;
Hidden “carry trade” transactions between Mainland
companies and their oversea subsidiaries;
Lack of market power in exports.
43
Progress: RMB as Trade Settlement Currency
• In October 2013, RMB’s market share in trade
finance, or Letters of Credit and Collection, rose
to %, overtook euro to rank the second after
. dollar (%).
The sharp rise in RMB-denominated trade financing
partly reflects interest rate arbitrage activities and the
evasion of capital account barriers.
• The RMB remained the 12th payments currency
of the world, with a slightly decreased share of
%, compared with % in September 2013.
• Clearly the RMB’s market share will increase
sharply with further liberalization of currency and
capital controls.
44
Progress: RMB as Trade Settlement Currency
• Triffin (1960): When a national currency becomes
an international reserve currency, there could be
conflicts between short-term domestic and long-
term international objectives:
The country needs to run CA deficits to meet foreigners’
reserve demand for the currency;
However, continued CA deficits weaken investors’
confidence on the currency.
The . experience during the 1950s to 1970s.
Today, Triffin’s dilemma may no longer hold in the strict
sense, but it does in a broad sense.
• China faces a similar dilemma:
Long-run objective: need to maintain an expectation of
RMB appreciation to promote RMB oversea;
Short-run concern: continued appreciation may lead to
declines in CA surpluses and weaken economic growth.
45
Triffin’s Dilemma
• Off-shore RMB deposits:
730 billion RMB at HK in Sep. 2013, 10% of total
deposit balances at HK; Singapore (5%); Taipei
(155 billion or 4%), London (%).
RMB loan balances at HK: 30 billion in 2011, 79
billion in 2012, expects to exceed 100 billion in
2013.
• RMB-denominated FDI:
Outward DI in RMB: billion RMB ($ billion)
during 2013:H1, compared to a total ODI flow of
$ billion during the same period (about %);
Inward FDI in RMB: controls relaxed in September
2011; billion RMB ($44 billion) during
2013:Q1-Q3, compared to a total FDI flow of $
billion during the same period (about 27%, rose
from 7% in 2011:Q4). 46
Progress: RMB as Investment Vehicle
• Financial portfolio flows in RMB
Outward: RMB-denominated bond issuance at HK,
Singapore, and London
2012: billion RMB ($ billion);
The popularity of dim sum bonds seems to have
correlated with RMB appreciation expectation; Lacks
an active secondary market;
Inward through a pilot RQFII program.
Dec. 16, 2011: A total of 20 billion RMB, at least
80% of which need to be invested on fixed-income
securities.
By Sep. 2013, 42 foreign firms had obtained a total
quota of 134 billion RMB.
Oct. 2013: London-based quota expanded to 80
billion RMB (stock, bond, and money market);
Singapore-based: 50 billion RMB.
47
Progress: RMB as Investment Vehicle
• Increased demand for RMB as reserve
currency; Swap agreements with foreign
central banks.
Since 2009: HK, Japan, Korea, Australia, Malaysia,
the ., etc.
October 9, 2013: currency swap with the ECB --
350 billion RMB/45 billion euro.
Total amount: trillion RMB.
RMB included in the SDR basket? Needs to be
convertible or at least “freely usable” at first;
possible in the near future.
48
Progress: RMB as Reserve Currency
A Checklist of CI Readiness
49
Necessary Conditions of
CI
China’s Current Scores
Economic size 10% of world GDP; Outperform other major
economies in recent years.
Economic and trade
importance
9% of global trade; However, market power
on world market is quite limited.
Capital account openness:
no restrictions on capital
flows; currency fully
convertible
Gradually and selectively easing inflows and
outflows in recent years; Extensive capital
controls remain.
Flexible Exchange Rate:
ER market-determined
RMB ER still tightly managed.
Broad, deep, and liquid
domestic financial markets
So far, still relatively shallow and under-
developed government and corporate bond
market.
Faith on economic policies:
Low and stable inflation,
sustainable public and
external debt, long-run
growth prospect
Recent performance has been satisfactory:
moderate inflation, low public debt, strong
growth.
Central bank independence?
Main Challenges Going Forward
• How to sequence RMB Internationalization with
1) financial market development: government and
corporate bond markets; equity markets; RMB spot and
derivative markets; strengthening market supervision and
regulation, etc;
2) monetary and exchange policy reforms: improving ER
flexibility; interest rate liberalization; reform monetary
policy framework such as a transition to indirect policy
instruments; how to handle “the impossible trinity” during
transition, etc;
3) capital account openness: remove restrictions on
capital flows, both inward and outward;
4) strengthening banking sector: remove restrictions on
foreign bank operations on RMB transactions; improve
domestic banks’ balance sheets; improve bank
supervision and regulation framework
5) enhancing international competitiveness of domestic
firms. 50
Main Challenges Going Forward
• How to conduct monetary and exchange policies
with an internationalized RMB:
Operational: for instance, how to predict and manage
liquidity demand from domestic and oversea?
How to conduct policies in a market-based
framework? How to choose nominal anchor?
Transmission mechanism?
How to communicate with financial market and guide
market expectations --- rule-based monetary policy
approach? Inflation targeting?
With large sum of offshore RMB, how to prevent
currency attacks?
Policy goals and preference: Griffin’s dilemma.
51
