For some time a debate has been taking place between economists pointing to the dangers of rapid liberalisation of China’s capital account, such as Yu Yongding and internationally Joseph Stigliz, and those supporting it. Recent negative events affecting China’s economy clearly confirm that those opposing rapid liberalisation of the capital account were correct. But it is crucial to understand the reasons for these current trends not only from an immediate but from a fundamental economic viewpoint.
Current trends affecting RMB internationalisation
In superficial terms two apparently contradictory trends regarding RMB internationalisation recently occurred. First, in a positive development, the RMB overtook the yen to become the fourth most used currency in international payments. Second, clearly negative trends developed related to China’s position in the international economy. China’s foreign exchange reserves fell by almost $500 billion in only just over a year, from slightly under $4 trillion in June 2014 to $3.5 trillion in August 2015, international analysts point to clear evidence of exit of capital from China unconnected to fruitful investment, and the small two percent RMB devaluation in August sent shock waves through the global economy and was followed by further losses to China’s foreign exchange reserves to attempt to stabilise the currency.
But the apparent contradiction between these ‘positive’ and ‘negative’ trends is only apparent. Both reflect fundamental features of China and the international economy. If RMB internationalization is pursued as a very gradual and organic process this produces positive trends. If unnecessary forced attempts to internationalise the RMB are made, particularly if these are made in pursuit of other agendas, these can be significantly dangerous to China’s economy. Examination of the experience of other countries and of economic theory explains clearly the processes taking place.
Place of the RMB in international payments
Starting with the facts, Figure 1 shows the RMB’s place within global payments system. The dominance of the dollar and the RMB’s peripheral position is clear. The dollar accounts for 44.82% of international payments. Dollar dominance becomes even clearer if it is understood that the 27.20% figure for the Euro is very artificially boosted by its use for payments within the Eurozone – an economy which is internationally divided but only approximately the size of the US. If Euro payments within the Eurozone were excluded, as are dollar payments within the equivalent size US economy, the true global dominance of the dollar would be still greater.
The dollar’s role has also risen further in the recent period – its percentage use in international payments increasing from 38.8% in January 2014 to 44.8% in August 2015, while the Euro’s share fell from 33.5% to 27.2%.
Turning to the RMB, global payments in dollars are 16 times greater than the RMB’s 2.78%, and payments in dollars and euros combined are 25 times greater than those in RMB. Talking of the RMB being ‘in fourth place’ in international payments behind the dollar, without stating the gap between the two, may be correct but is substantially misleading because it distorts the correct sense of scale - there is no comparison between the position of the dollar and the RMB in international payments, and in these terms the RMB is a very minor currency compared to the dollar.
RMB internationalisation and trade
This gap between the dollar and the RMB becomes still clearer, and the explanation of the apparently contradictory economic trends referred to earlier becomes evident, if it is understood that the RMB is primarily used internationally in relation to China’s trade – functioning as a useful ‘hedge’ against currency fluctuations. By April 2015 31% of payments between China (including Hong Kong) and the Asia-Pacific region were in RMB – which primarily accounts for the RMB’s 2.78% of global payments. Such trade operations make limited overseas accumulation of RMBs necessary, and are a soundly based and healthy development reflecting China’s position as the world’s largest goods trading nation. They require, as has been allowed, convertibility of the RMB for current (including specifically trade) transactions.
But aside from this useful function the RMB’s role in international payments is still peripheral and for fundamental reasons analysed below cannot be substantially expanded rapidly. For example by the end of 2014 63% of all countries foreign exchange reserves were in dollars, 22% in Euros, and only 1% in RMBs.
It is sometimes argued that the RMB’s international role is certainly currently small but it is increasing and could grow rapidly, for example, if later this year the IMF during its regular review includes the RMB in the currency basket for its Special Drawing Rights (SDRs).
But this argument confuses holding reserves for the purpose of current operations (including trade) with holdings for capital transactions – including official foreign exchange reserves. The RMB certainly should be included in the SDRs basket of currencies due to China’s position as the world’s second largest economy, at current exchange rates, and the world’s largest goods trading nation. But this will not change anything fundamental in terms of international payments. SDR’s are not a currency nor a claim on IMF funds – they are only a claim on IMF member’s currencies. SDR’s can essentially only be part of countries’ foreign exchange reserves, and constitute less than 3% of their total. In practical terms SDR’s are essentially only an accounting unit, playing virtually no role in actual transactions.
Fundamental features of the monetary system
Confusion on the difference between the requirements for trade and other current transactions, compared to those for establishing the RMB as a major international capital unit, have created destabilising calls for too rapid liberalisation of China’s capital account. These can be best understood by looking at the most fundamental features of the international monetary system.
Economic theory, fully confirmed by the experience of other countries, shows that liberalisation of China’s capital account will not lead to a balanced flow of funds in and out of China, but only to large scale exit of capital from China. This would reduce China’s economic development via simultaneously decreasing funds available for investment in China and raising interest rates, and leading to further falls in China’s foreign exchange reserves if currency interventions are made to try to prevent the RMB’s exchange rate declining faced with these capital outflows.
The reason why in the absence of capital controls there will only be a net one way flow of funds out of the RMB and into the dollar is rooted in the most fundamental features of the monetary system.
All markets, including the global economy, can only operate with a single price standard which requires a single price unit. Money is fundamentally different from all goods and services. A market economy necessarily can only operate according to the ‘law of one price’ – i.e. it operates to produce a single price across a market (once transport and other transaction costs, tariffs and other legal barriers etc are taken into account). The reason for this ‘law of one price’ is that the existence of different prices for the same product entails an ability to make profit by utilising these, and therefore arbitrage operations will develop to exploit such differences - thereby eliminating this profit and ensuring the tendency for a product to be sold at a single price.
But a single price necessarily requires a single price standard – which is its monetary unit. If more than one price standard operated then arbitrage between different prices would either eliminate these differences, creating in reality if not in name a single measuring unit, or if different price standards existed fundamental instability would make it impossible for the market to function efficiently. An efficiently functioning economy therefore can only have a single universal price unit – prices cannot be set 20% by one monetary unit, 35% by another monetary unit, 45% by another unit etc. Consequently no mature country can nor does function with different currency units operating within it.
For exactly the same reason if any attempt were made to introduce different units for measuring international prices then either arbitrage would bring them into a single system, de facto creating a single international currency unit, or the market could not function – different markets with different national currency systems would then have to be prevented from meaningfully interacting. But as international division of labour is one of the most powerful forces increasing economic development any strong limits on different countries economically interacting would produce a huge regression of the productive forces – as was practically confirmed during the only modern peacetime period when such disruption of the international payments system occurred, the 1930s Great Depression.
Demand for the dollar
This necessity of a single price standard in turn determines the demand for foreign currencies, including for foreign exchange reserves. A relatively few individual companies seek to profit from relative movements in currencies, but globally this is a peripheral activity. The goal of most foreign exchange holdings is to possess the unit used to price international transactions – which is the dollar. This is the goal of central banks’ foreign exchange reserves but also the safest form of fundamental currency hedging by companies. Consequently if countries’ capital accounts are liberalised the net flow is always into dollars – as factual global experience since international capital account liberalisation began seriously in the late 1970s confirms.
The fundamental reason the US supports, and strongly presses, for liberalisation of capital accounts is precisely because of this one way net flow of funds into dollars. By the 1970s the US balance of payments passed into a sustained and large deficit which has continued to the present - reflecting a decline in US competitiveness. Attempts to restore US competitiveness by dollar devaluations in the 1970s, however, created political instability due to the reduction in the living standards of the US population this created – Nixon was forced from office in 1974 and Carter lost the election of 1980. The only way for the US to simultaneously run a balance of payments deficit, which other things being equal would lead to dollar devaluation, while preventing that devaluation occurring is to find a source of capital inflows into the US.
Pushing for liberalisation of capital accounts on a global scale was the US means to secure this solution to its combined economic and political problem. Given the fundamental structure of the international monetary system already demonstrated liberalisation of capital accounts necessarily created a one way net flow of funds into the dollar which has continued until the present.
The essential role of capital account liberalisation is therefore to ensure a net flow of funds from other countries into the dollar, thereby solving the US problem of having an internationally uncompetitive economy, shown in a balance of payments deficit, while avoiding the political unpopularity in the US that results from dollar devaluation.
History of the international monetary system
This fundamental theoretical economic principle that the international economy, like any market, must operate according to a single price standard is entirely confirmed by hundreds of years of operation of the global market. Although the world economy, the most complex market, has developed for several centuries during this prolonged historical period only two systems of international payments have existed. The first, from near the origins of the global market until 1931, punctuated by only a short interlude, was the gold standard. The second, from 1945 until the present, was the dollar standard. The only periods in which neither system functioned, the immediate post-1914 period and from 1931-1945, were marked by the most cataclysmic crises in the global economy’s history – the two World Wars.
The fact that there can only be a single price standard also necessarily determined that the transition from the gold standard to the dollar standard took place in historical terms almost instantaneously - the interregnum between the two was marked by the greatest disorder and conflicts in world history, and that the two systems did not overlap in time as it was impossible for two price standards to exist simultaneously.
The US, of course, understands that due to these fundamental economic forces liberalisation of capital accounts could also be a powerful tool for subordinating other countries policies to the US. This can be attempted even for what are in practice relatively small changes. Bloomberg, an overtly US neo-con publication, tried to argue: ‘To win the SDR prize, China will have to press on with plans to open its capital account - a reform that stands to shake up industries and the way Chinese companies do business.’ Martin Wolf , Chief Economics Commentator of the Financial Times, noted: ‘If China’s capital account were to be fully liberalised, the government would lose its grip on the most effective of all its economic levers.’
China cannot cheat on or be an exception to these fundamental economic laws. It is for this reason that as China moved to liberalise its capital account the data shows destabilising movements out of the RMB into dollars began.
China’s foreign exchange reserves should have been increased by China’s trade surplus rising sharply from $306 billion in the year to August 2014 to $540 billion in the year to August 2015. But instead of rising data shows China’s foreign exchange reserves fell at a rate much faster than was caused by productive Foreign Direct Investment (FDI) outflows. During 2015 China’s foreign exchange reserves have fallen by an average $36.5 billion a month and the rate of decline has risen sharply – August’s fall was $94 billion. This demonstrates large scale capital outflows are taking place with negative consequences for China’s economy.
The reasons for the trends noted at the beginning of this article are therefore clear, as is also why their ‘contradictory’ nature is purely apparent. The positive effects of the RMB’s use in relation to international trade has led to it organically becoming the fourth largest currency for international transactions – a healthy process which should be allowed to continue via RMB convertibility for current transactions. But failure to accurately recognise the nature of the international capital system, which can only create flow of into dollars, has led to overhasty relaxation of capital controls with negative effects for China’s economy.
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This article was originally published in Chinese by Sina Finance.