China-US Currency Issues Jeffrey Frankel Harpel Professor Revised from CLD Program, June 8, 2010; CHINA FUTURE LEADERS, 10 a.m., Bell Hall, January 17, 2011

2 Topics to be covered (I) Historical timeline of exchange rate diplomacy (II) What is in Chinas interest? (III) What is in the interest of the US & Rest of World? (IV) Shifting power relationships –Appendices: U.S. Treasury biannual reports on currency manipulation The current account imbalances The internationalization of the RMB Technical appendices

3 Historical timeline I have listened to both sides of this debate. Here is what I think. I think those who call for a fixed exchange rate are right in the short run. And those who call for a floating exchange rate are right in the long run. How long is the short run, you ask? You must understand. China is 8000 years old. So when I say, short run, it could be 100 years. -- Li Ruogu, Deputy Governor, Peoples Bank of China, Dalian, May 2004

4 Historical timeline of currency diplomacy 1973: End of Bretton Woods era. –Major currencies switch from fixed to floating. The rest keep their pegs. 1977: IMF members agree that each shall avoid manipulating exchange rates … in order to prevent effective balance of payments adjustment or to gain an unfair competitive advantage over other members. [Principle (A) of the 1977 Decision on Surveillance over Exchange Rate Policies, and Sect.1, Clause 3, of Article IV amended in 1978.] –In practice, the IMF almost never pressures countries to revalue their currencies upward; It just pressures deficit countries to devalue : ¥/$ Agreement. 1985: Plaza Accord. –Japan, US & others cooperate to bring down overvalued $, esp. vs. ¥ : –Louvre Agreement: $ depreciation halted. –Big bubbles in Japans equity & real estate markets, –followed by crash, & severe Japanese stagnation in 1990s.

5 Timeline, continued 1988: The Omnibus Trade & Competitiveness Act mandates the US Treasury report to Congress biannually on whether trading partners were manipulating currencies. –Section 3004 requires the Treasury to consider whether countries manipulate the rate of exchange between their currency and the US $ for purposes of preventing effective balance of payments adjustments or gaining unfair competitive advantage in international trade.'' –The US must hold talks with governments deemed to be breaking rules. –In the first Reports to Congress on International Economics & Exchange Rate Policy, Korea & Taiwan PoC were found to be guilty of manipulation, while Singapore & Hong Kong SAR got off with a warning. China was named in early 1990s.

6 Timeline, continued : Exchange rate Jan. 1994: China devalues its official rate, –unifying its dual exchange rate system : East Asia crisis. –China wins plaudits for keeping RMB (yuan) fixed while all its neighbors are devaluing : China continues to peg – for 10 years – at 8.28 RMB/$.

7 Timeline, continued : US pressure Oct. 2003: Treasury Secretary Snow begins to browbeat China to allow appreciation. –Treasury Report: RMB merits concern & talks –Speculators in financial markets start to bet appreciation. –as reflected in either capital flows (see Prasad & Wei) –or non-deliverable forward price (see appendix graph). Feb. 2005: Senators Schumer & Graham propose first of bills to impose (WTO-illegal) tariffs of 27.5 % against all Chinese goods if China does not substantially revalue its currency. –Subsequent versions, by Baucus-Grassley and others substitute the phrase currency misalignment in place of unfair manipulation to ease standard of proof.

: Rapid growth puts China into Excess Demand : Despite large balance of payments surpluses, PBoC sterilization of reserve inflows prevents excessive money growth & inflation : Sterilization finally falters: Money becomes excessive. –Inflation becomes a serious concern. –Shanghai stock market experiences a bubble. Mid-2008 – early 2009: Worst of the global recession hits. –China loses 26% of exports –Growth slows; danger of overheating disappears. Mid-2009 – 2011: China resumes very rapid growth –in response to domestic demand stimulus + renewed exports –China is now a major engine of growth in world economy. –Danger of overheating returns: esp. real estate bubble. Timeline, continued : Chinas macroeconomy

9 Timeline, continued : Exchange rate July 2005: China announces a new policy, –Immediate 2.1 % revaluation, –Followed by managed float: controlled appreciation, supposedly against an unspecified basket of currencies. –But, as often, de jure exchange rate regime de facto. Estimation of true regime reveals: –$ link did not even begin to loosen until –By 2007, implicit basket had shifted some weight onto other currencies, especially the. –RMB appreciates against the $ from 2006 to 2008, because does.

10 The magnitude of daily movements vs. $ increased in the spring of 2006,

11 May 2008: Chinese leaders hear exporter complaints of competitiveness difficulties. Mid-2008-April 2010: yuan re-pegs $ 6.84 RMB/$ 20% stronger, vs. $, than Timeline, continued : Exchange rate

12 The RMB rose against the $ for 2 years, but returned to peg in mid-2008 $/RMB /RMB /$

13 Oct IMF Article IV consultation finds RMB undervalued. 2007: US Treasury temporarily passes hot potato of exchange rate complaints to IMF, –which gets mandate for exchange rate surveillance. 2008: Though financial crisis originates in US, flight to quality temporarily raises demand for $. 2009: Chinese leaders, for the first time, express concerns that their vast holdings of US treasury bills may not be well-invested. –Pres. Obama & Secy. Geithner seek to reassure. Timeline, continued

: Chinese warnings –Premier Wen worries US T bills may lose value. Urges the US to keep its deficit at an appropriate size to ensure the basic stability of the $ (again on 11/10/09). –PBoC Gov. Zhou, proposes replacing $ as international currency, with the SDR (March 09).

15 Timeline, continued 2010 Winter 2010: Pressure mounts -- –International pressure on Beijing to appreciate; –Congressional pressure on US Treasury to find China guilty of currency manipulation in its biannual report due April 15. –But Chinese say they will never bow to pressure.

16 April Collision is averted: –Treasury postpones manipulation report. June 19 – PBoC announces it will increase the renminbis exchange-rate flexibility, –though subsequent appreciation is small. So both sides save face –for the moment.

17 September 27 – Brazil Finance Minister Mantega warns of Currency Wars: –Each country intervenes to push its currency down –in effort to gain trade advantage, collectively futile. November 8, G20 Summit in Seoul -- –China criticizes US Feds monetary easing (QE2) as an example of currency wars.

18 Jan. 2011: Preparations for Obama-Hu summit –Jan.14: Geithner notes that -- including higher Chinas inflation -- RMB is appreciating at 10% per year. –That suggests US lower priority on the currency issue Vs. IPR, North Korea & other issues.

19 Appreciation + inflation WSJ 1/22/11

Data sources: The Economist, BLS, CEIC, Thomson Reuters 5% nominal appreciation per annum + 5% inflation differential 10% real appreciation per annum September-December 2010 Global Macro Monitor

21 Countries should have the right to fix their exchange rate if they want to. True, the IMF Articles of Agreement and the US Omnibus Trade Act of 1988 call for action in the event that a country is unfairly manipulating its currency. But –Few countries have been forced to appreciate. –Pressure on surplus countries to appreciate will inevitably be less than pressure on deficit countries to depreciate. –I support retiring the language of manipulation. Usually, it is hard to say when a currency is undervalued. Dont cheapen the language that is appropriate to WTO rules. China should do what is in its own long-term interest. (II) From Chinas viewpoint,

22 My view: mutually-beneficial bargain, between equals –As part of G-20 process –E.g., China agrees that: its exchange rate is part of the problem, it will cooperate to lower the RMB/$ rate in a gradual manner, and of course it wont dump US treasury bills. –In exchange, US agrees that: its low national saving rate is part of the problem, it will cooperate to reduce the budget deficit, and of course it wont close off the US market to Chinese goods. But perhaps a bargain isnt even necessary; –It is in Chinas own interest to begin appreciating the RMB. What is in Chinas interest?

23 Five reasons China should let RMB appreciate, in its own interest 1.Overheating of economy 2.Reserves are excessive. –It gets harder to sterilize the inflow over time. 3.Attaining internal and external balance. –To attain both, need 2 policy instruments. –In a large country like China, expenditure-switching policy should be the exchange rate. 4.Avoiding future crashes. 5.RMB undervalued, judged by Balassa-Samuelson relationship.

24 1. Overheating of economy: Bottlenecks. Pace of economic growth is outrunning: –raw material supplies, and –labor supply in coastal provinces –Also: –physical infrastructure –environmental capacity –level of sophistication of financial system. Asset bubbles. –Shanghai stock market bubble in Inflation 6-7% in 2007 => price controls shortages & social unrest. All of the above was suspended in late 2008, –due to global recession. –But it is back again now; skyrocketing real estate prices.

25 Attempts at sterilization, to insulate domestic economy from the inflows Sterilization is defined as offsetting of international reserve inflows, so as to prevent them from showing up domestically as excessive money growth & inflation. For awhile PBoC successfully sterilized… –until –The usual limitations finally showed up: Prolongation of capital inflows <= self-equilibrating mechanism shut off. Quasi-fiscal deficit: gap between domestic interest rates & US T bill rate Failure to sterilize: money supply rising faster than income Rising inflation (admittedly due not only to rising money supply)

26 2. Foreign Exchange Reserves Excessive: –Though a useful shield against currency crises, –China has enough reserves: $2 ½ trillion by April 2010; –& US treasury securities do not pay high returns. Harder to sterilize the inflow over time.

27 New York Times Jan 12, 2011 Foreign exchange reserves held by the Peoples Bank of China are approaching $3 trillion in 2011.

28 New York Times Jan 12, 2011 The Chinese money supply has almost doubled in the last 3 years, contributing to a rapid growth aggregate demand as reflected in nominal GDP

29 Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008 The Balance of Payments rate of change of foreign exchange reserves (largely $), rose rapidly in China over past decade, due to all 3 components: trade balance, Foreign Direct Investment, and portfolio inflows

30 While reserves (NFA) rose rapidly, the growth of the monetary base was kept to the growth of the real economy – even reduced in Successful sterilization in China: Attempts to sterilize reserve inflow: were remarkably successful in High reserve growth offset by cuts in domestic credit => steady money

31 In China began to have more trouble sterilizing the reserve inflow PBoC began to pay higher interest rate domestically, & receive lower interest rate on US T bills => quasi-fiscal deficit. Inflation became a serious problem. –True, global increases in food & energy prices were much of the explanation. –But Chinas overly rapid growth itself contributed. Appreciation is a good way to put immediate downward pressure on local prices of farm & energy commodities. Price controls are inefficient and ultimately ineffective.

32 Sterilization faltered in 2007 & 2008 Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008 Monetary base accelerated Growth of Chinas monetary base, & its components

33 Chinas CPI accelerated in Inflation 2002 to 2008 Q1 Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008

34 Inflation is once again accelerating

35 3. Need a flexible exchange rate to attain internal & external balance Internal balance demand neither too low (recession) nor too high (overheating). External balance appropriate balance of payments. General principle: to attain both policy targets, a country needs to use 2 policy instruments. For a country as large as China, one of those policy instruments should be the exchange rate. To reduce BoP surplus without causing higher unemployment, China needs both – currency appreciation, and – expansion of domestic demand gradually replacing foreign demand, developing neglected sectors: health, education, environment, housing, finance, & services.

36 4. Avoiding future crashes Experience of other emerging markets suggests it is better to exit from a peg in good times, when the BoP is strong, than to wait until the currency is under attack. Introducing some flexibility now, even though not ready for free floating.

37 5. Longer-run perspective: Balassa-Samuelson relationship Prices of goods & services in China are low –compared at the nominal exchange rate. –Of course they are a fraction of those in the U.S.: < ¼. –This is to be expected, explained by the Balassa-Samuelson effect which says that low-income countries have lower price levels. As countries real income grows, their currencies experience real appreciation: approx..3% for every 1 % in income per capita. –But China is one of those countries that is cheap or undervalued even taking into account Balassa-Samuelson.

38 Source: Arvind Subramanian, April 2010, New PPP-Based Estimates of Renminbi Undervaluation and Policy Implications, PB10-08, Peterson Institute for International Economics Undervaluation of RMB in the regression estimated above = 26%. Estimated undervaluation averaging across four such estimates = 31%. Compare to Frankel (2005) estimate for 2000 = 36%. The Balassa-Samuelson Relationship 2005

39 Solving the problem of current account imbalances, in particular, the US CA deficit & Chinas surplus.in particular, the US CA deficit & Chinas surplus. Both have widened, on long-term trends.Both have widened, on long-term trends. (III) What is in the global interest?

40 The US trade & current account balances have been on a downward path for 50 years. They improved sharply in , falling by half; but this reversal was temporary, due to US recession, Trade & current accounts, in $ billions per quarter

41 Dangers of the U.S. trade deficit Shorter-term dangers: –Protectionist legislation –A possible hard landing for the $. Long-term dangers: –Dependence on foreign investors –US net debt to RoW now $3 trillion, and rising. Will lower our childrens standard of living. –When the US cuts its deficit, that will mean the rest of the world losing its surplus The longer adjustment is postponed, the harder it will be.

42 Policies to reduce the US CA deficit Reduce the US budget deficit over time, –thus raising national saving. –After all, this is where the deficits originated. Depreciate the $ more. –Better to do it in a controlled way than in a sudden free-fall. –The $ already depreciated a lot against the & other currencies from 2002 to –Who is left? –The RMB is conspicuous as the one major currency that is still undervalued against the dollar.

43 (IV) Changing power relationships It has never worked well for the US to make a dozen different demands on China, –IPR, human rights, help on N.Korea, Iran… –when we only have one carrot / stick: keeping our markets open. As the worlds largest debtor, with China our primary creditor, our ability to make demands is diminished. There is a particular tension between hoping China will continue to buy our Treasury bills, while asking it to stop buying our Treasury bills –i.e., to stop buying $ / selling RMB, which is what keeps its currency from rising.

44 Be careful what you wish for. You might get it ! $2½

45 If China gave US politicians what they say they want... we might regret it. –if it included reserve shift out of T bills, to match switch in basket weights from $. –we could have a hard landing for the $. Skeptics argue China will not sell T bills –because, as the largest holder, it would be the biggest loser when the $ depreciated. Financial market fears that China might stop buying US T bills could send the $ down in themselves. If the $ is falling, China will not want to be the only one left holding the bag.

46 If China gave US politicians what they say they want... For US output & employment to rise, –we would first need other Asian currencies to appreciate along with RMB. Otherwise, fall in US bilateral trade deficit with China would be offset by rise in US bilateral deficit with other cheap-labor countries. –It also depends on excess capacity in US economy as … and no crowding out of domestic demand via higher interest rates.

47 Appendices Bi-Annual US Treasury reports on currency manipulation Is the US Current account sustainable? The 2003 start of RMB speculation Internal & external balance The internationalization of the RMB Technical appendices

48 Appendix 1: Analysis of the Treasury Departments biannual Report to Congress on International Economics and Exchange Rate Policy -- Frankel & Wei (2007)

49 Two hypotheses regarding determinants of US Treasury decisions whether partners are manipulating currencies: (1) Legitimate economic variables – the partners overall current account/GDP, –its reserve changes, –the real overvaluation of its currency; vs. (2) Variables suggestive of domestic American political expediency –the bilateral trade balance, –US unemployment, –an election year dummy.

50 Timeline, continued –Those countries named as manipulators, or given warnings, have always been Asian. –What political economy determines Treasury findings? Econometric analysis: Domestic political variables are as important as global manipulation criteria.

51 Findings suggest the domestic US variables affect the Treasury decision as much as the legitimate global manipulation criteria: weak role for partner reserve accumulation, very high significance of bilateral balance, significance of US unemployment, and significant (borderline) extra effect of unemployment in election years.

52 Implication If the IMF were interpreting Article IV, rather than the Treasury interpreting the 1988 US law, –the criterion of consistent uni-directional forex intervention would receive more emphasis, –and US-specific variables such as the bilateral trade balance would not appear at all.

53 Some sympathy for the Treasury It walks a fine line. An additional finding: Treasury is eager not to single out one country for unique opprobrium. –No single country is left exposed on its own. the top-ranked country is less likely to be named than if it had some other country to hide behind, while the 2nd- & 3rd-ranked countries are more likely to be moved up, to give the leader company.

54 Has US pressure pushed the pace of increased flexibility? We searched an electronic database of news reports (FACTIVA/NewsPlus), recording the number of US news reports of US officials asking China to speed up RMB flexibility/revaluation. Two separate time series on the cumulative numbers of complaints –from US Treasury and –from officials of other government agencies (e.g. the White House, Congress and Fed)

55 Complaints: Treasury & other US

56 We added # complaints as a regressor (Table 19) No evidence that U.S. official complaints are associated with RMB appreciation relative to the currency basket. There is evidence that cumulative complaints are associated with a reduction in the RMBs weight on the US dollar.

57 Appendix 2: CA Imbalances: Economists were split between Ken Rogoff *Ken Rogoff * Maury ObstfeldMaury Obstfeld Larry SummersLarry Summers Martin FeldsteinMartin Feldstein Nouriel RoubiniNouriel Roubini Menzie ChinnMenzie Chinn MeMe Lots moreLots more Ben BernankeBen Bernanke Ricardo Caballero *Ricardo Caballero * Richard CooperRichard Cooper Michael DooleyMichael Dooley Pierre-Olivier GourinchasPierre-Olivier Gourinchas Alan GreenspanAlan Greenspan Ricardo HausmannRicardo Hausmann Lots moreLots more those who saw the US deficit as unsustainable, requiring a $ fall, and those who saw no problem. * Some claim that the crisis of fits their theories.

58 The events of struck major blows against both interpretations of CA. Most of us in the unsustainability camp would have predicted that something like the US sub-prime mortgage crisis would cause a big fall in the $. –Instead, the $ strengthened. Most of those in the sustainability camp had been arguing that the US has uniquely superior assets (corporate governance, securities markets, bank regulation…) –Instead, the crisis showed the US system to suffer serious flaws of crony capitalism like other countries (Simon Johnson, Ragu Rajan) or – worse – excessive deregulation (Joe Stiglitz) The answer, for the moment: The $ and US Treasury bills still play unique roles in the world monetary system.

59 Critics of the twin deficits view say that the US current account deficit is sustainable. 1.Global savings glut (Bernanke) 2.Its a big world (R. Cooper; Al Greenspan..) 3.Valuation effects will pay for it (Gourinchas) 4.US as the Worlds Banker (Kindleberger…) 5.The US offers superior-quality assets (Caballero, Forbes, Quadrini & Rios-Rull, Wei & Wu …) 6.Dark Matter (Hausmann & Sturzenegger) 7.Bretton Woods II (Dooley, Folkerts-Landau & Garber)

60 Exorbitant Privilege of $ Among those who argue that the US current account deficit is sustainable are some who believe that the US will continue to enjoy the unique privilege of being able to borrow virtually unlimited amounts in its own currency.

61 When does the privilege become exorbitant? if it accrues solely because of size & history, without the US having done anything to earn the benefit by virtuous policies such as budget discipline, price stability & a stable exchange rate. Since 1973, the US has racked up $10 trillion in debt and the $ has experienced a 30% loss in value compared to other major currencies. It seems unlikely that macroeconomic policy discipline is what has earned the US its privilege !

62 The Bretton Woods II hypothesis Dooley, Folkerts-Landau, & Garber (2003) : –todays system is a new Bretton Woods, with Asia playing the role that Europe played in the 1960sbuying up $ to prevent their own currencies from appreciating. –More provocatively: China is piling up dollars not because of myopic mercantilism, but as part of an export-led development strategy that is rational given Chinas need to import workable systems of finance & corporate governance.

63 There is no reason to expect better today: 1)Capital mobility is much higher now than in the 1960s. 2)The US can no longer necessarily rely on support of foreign central banks: neither on economic grounds (they are not now, as they were then, organized into a cooperative framework where each agrees explicitly to hold $ if the others do), nor on political grounds (China & OPEC are not the staunch allies the US had in the 1960s)..

64 My own view on Bretton Woods II: The 1960s analogy is indeed apt, but we are closer to 1971 than to 1944 or Why did the BW system collapse in 1971? The Triffin dilemma could have taken decades to work itself out. But the Johnson & Nixon administrations accelerated the process by fiscal & monetary expansion (driven by the Vietnam War & Arthur Burns, respectively). These policies produced: declining external balances, $ devaluation, & the end of Bretton Woods.

65 Appendix 3: Internal and external balance Between 2002 and 2007, China crossed from the deflationary side of internal balance (ES: excess supply, recession, unemployment), to the inflationary side (ED: excess demand side, overheating). And again in –=>Moved upward in the Swan Diagram –=> appreciation called for under current conditions. –Together with expansion of domestic demand gradually replacing foreign demand, developing neglected sectors: health, education, environment, housing, finance, services General principle: to attain 2 policy targets (internal & external balance), a country needs to use 2 policy instruments (real exchange rate & spending).

66 China is now in the overheating + surplus quadrant of the Swan Diagram Excgange rate E in RMB/$ YY: Internal balance Y = Potential ED & TD ES & TD ES & TB>0 China 2011 BB: External balance CA=0 China 2002 ED & TB>0 Spending A

67 The US is not alone in its path of rising debt. Other major industrialized economies have the same problem. A remarkable role-reversal: Debt/GDP of the top 20 rich countries ( 80%) is already twice that of the top 20 emerging markets; and rising rapidly. By 2014 (at 120%), it could be triple.

68 Appendix 4: The RMB as an international currency Based on presentation to Club de CEPII, Paris, 12 Jan., 2011 What is an international currency? Empirical determinants of international reserve currency status. The Renminbi Why should a country care if its currency is used internationally?

69 What is an international currency? Definition: An international currency is used by non-residents. The prospects for a countrys status as an international currency is not the same as its exchange rate prospects. Example: –The dollar depreciated strongly, reaching an all-time low against the yen, among much hand-wringing. –And yet its international currency use rose during that period.

70 Roles of International Currency Central bank holdings of reserves is the most easily quantified, and probably the most important, of the various measures.

71 Determination of international currency status What suits a currency for international use? People use a given currency –when everyone else is using it, –not just because of its intrinsic characteristics. English became the international lingua franca –not because of its beauty (French), –nor its simplicity (Esperanto), –nor even the number of native speakers (Chinese). => Network externalities

72 International reserve currency determinants from the literature on reserve currencies Determinant 1.Size 2.Depth of financial markets 3. Rate of return Empirical proxy: GDP FX turnover inflation, trend depreciation, or exchange rate variance

73 Determinants of reserve currency standing, continued Network externalities => Tipping captured by: 1)Inertialags 2)Nonlinearitylogistic functional form in determinantsor dummy for leader GDP Source: Chinn & Frankel (2007 )

74 Historical illustration of the long lag: £ s loss of premier international currency status in 20 th century By 1919, US had passed UK in 1.output (1872) 2.trade (1914) 3.net international creditor position ( ) $ passed £ as #1 reserve currency only with a lag –by –though Eichengreen says 1924.

75 Figure 1: Currency share vs. GDP (market rates). Is the relationship linear or ogive? Shares of major currencies In central bank reserve holdings Size of currencys home economy } Tipping point Source: Chinn & Frankel (2007 )

76 Explaining currency shares, logit, pre-euro ( ) [2][4][7] GDP [0.64][0.92][0.29] Inflation [1.16] Depreciation Trend [0.59] Ex rate variance [0.57][0.64][0.34] FX turnover [0.29][0.30][0.15] GDP leader dummy [0.16] Lag logit: log(share t-1 / 1 - share t-1 )[0.03] [0.01] Boldface = statistically signficant: size, retruns, turnover, and lag

77 How does China rank, by determinants of international currency status? 1. Size Chinese economy famously passed Japan in 2010, to attain 2 nd ranking. Some projections claim it will pass the US soon. But –What matters here is GDP (and trade) compared at market exchange rates, not PPP-adjusted. –Eurolands GDP is still substantially bigger than China. –Chinese growth will slow down, well before it reaches per capita equality with the West.

78 Chinas rank, by determinants of international currency status, cont. 2. Depth of financial markets One the one hand… China is starting to use RMB in international trade Foreign central banks can hold RMB since Aug –Malaysias CB went first, buying RMB bonds for its FX reserves, in Sept. RMB market is now developing in Hong Kong Since 2007, RMB 62 b RMB bonds (27 batches) issued off-shore »including by MacDonalds. »Bank of China HK launched an index Dec. 31, In November, RMB deposits reached RMB 280 b.

79 In Hong Kong banks, yuan- denominated deposits have quadrupled over the last year – but from a low base. RMB goes viral, Financial Times, Jan. 4, 2011

80 Why should a country care? Pros & cons of having ones currency used internationally. 4 ADVANTAGES TO A COUNTRY OF HAVING ITS CURRENCY USED INTERNATIONALLY. (1) Convenience for its residents. (2) Business for its banks & other financial institutions. (3) Seignorage –narrowly defined as willingness to hold, e.g., the $ as high-powered money (esp. fx reserves held by central banks) or –more broadly as willingness of private investors to hold $-denominated assets: Americas exorbitant privilege. (4) Political power and prestige.

81 Chinas rank, by determinants of international currency status, cont. On the other hand… RMB bonds and deposits in HK are small as a fraction. –And of course HK$ is itself still firmly tied to US$. Development of Chinas financial market has just begun. It ranks far behind other major currencies. Still very highly regulated –Domestic system still financially repressed. –Cross-border capital flows still subject to heavy controls. »Foreign companies still cannot borrow in China. Liquidity, breadth, openness… still have a long way to go.

82 Chinas rank, by determinants of international currency status, cont. 3. Rate of return Inflation in China is again a danger currently. A financial crisis probably lurks –somewhere down the road. Nevertheless, it is quite likely that the rate of return to holding RMB over the next ten years will be high. Indeed that is the reason for the strong portfolio capital inflows since –Prasad & Wei.

83 Chinas rank, by determinants of international currency status, cont. Inertia suggests that Chinas ascent in the currency rankings will be gradual. The rest of Asia will probably be no keener on a yuan bloc than it was on a yen bloc in the 1980s. A guess: It will take the RMB a decade to surpass the & CHF and rival the ¥. and much longer to rival the, let alone the $. Nevertheless, that is the direction it is headed. And the $ is likely to continue losing share to all the other international reserve assets in the future.

84 Central banks reserve holdings The $ share has been on a downward trend since 1975 (with the exception of the 1990s). Source: Chinn & Frankel (2007 )

85 The $ share of central bank holdings resumed its decline in Data: from COFER, IMF. Source: / /

86 The global monetary system may move from dollar-based to multiple international reserve currencies The is still a rival for the $. The SDR is again part of the system. Gold in 2009 made a comeback as an international reserve too. The RMB will join the roster with ¥ &. = a multiple international reserve asset system.

87 Technical appendices

88 Prices on Non-Deliverable Forwards showing post-2003 speculation on RMB appreciation

89 Explaining findings of Treasury Department biannual Report to Congress on Int.Ec. & Exchange Rate Policy All countries 15 Asian economies Excluding oil exporters US bilateral TB -0.92*** -0.99*** Partners 0.014*** 0.028** CA/GDP Partners Real -0.18*** -0.23** Exchange Rate Change in reserves/GDP US unem ** 0.08** ployment *** statistically significant at 99% level

90 Estimating the weights in RMB basket A problem made-to-order for OLS regression. Regress % changes in value of RMB against % changes in values of candidate currencies. Δ log RMB t = c + α Δlog $ t + β 1 Δlog t + β 2 Δlog ¥ t + … The coefficients are the basket weights. Can impose α + Σ β j = 1. F& Wei (2007), Frankel (2009)

91 Does the Balassa-Samuelson relationship have predictive power? Typically across countries, gaps are corrected halfway, on average, over subsequent decade. => 3-4 % real appreciation on average per year, including effect of further growth differential. Correction could take the form of either inflation or nominal appreciation, but appreciation is preferable.

92