Harpel Professor
Revised from CLD Program, June 8, 2010; CHINA FUTURE LEADERS,
10 a.m., Bell Hall, January 17, 2011

(I) Historical timeline of exchange rate diplomacy
(II) What is in China’s 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
2

“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,
People’s Bank of China, Dalian, May 2004
3

• 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.
• 1983-84: ¥/$ Agreement. 1985: Plaza Accord.
– Japan, US & others cooperate to bring down overvalued $, esp. vs. ¥
• 1987-89:
– Louvre Agreement: $ depreciation halted.
– Big bubbles in Japan’s equity & real estate markets,
– followed by crash, & severe Japanese stagnation in 1990s.
4

Timeline, continued
1988:
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.
5

Timeline, continued : Exchange rate
• Jan. 1994: China devalues its official rate,
– unifying its dual exchange rate system.
• 1997-98: East Asia crisis.
– China wins plaudits for keeping RMB (“yuan”’) fixed
• while all its neighbors are devaluing.
• 1995-2005: China continues to peg
– for 10 years
– at 8.28 RMB/$.
6

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

Timeline, continued
: China’s macroeconomy
• 2004-07:
Rapid growth puts China into Excess Demand.
• 2005-06:
Despite large balance of payments surpluses, PBoC sterilization of reserve inflows prevents excessive money growth & inflation.
• 2007-08:
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.
8

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 2006.
– By 2007, implicit basket had shifted some weight onto other currencies, especially the €.
– RMB appreciates against the $ from 2006 to 2008,
• because € does.
9

Changes in CNY per USD over Time: 07/22/05-1/8/2007
01 Jul 05 01 Jan 06 date
01 Jul 06 01 Jan 07
10

Timeline
continued
: Exchange rate
• May 2008: Chinese leaders hear exporter complaints of competitiveness difficulties.
• Mid-2008-April 2010: yuan repegs ≈ $ 6.84 RMB/$
• ≈ 20% stronger, vs. $, than 2005.
11

Exchange rates, Jan. 2005 - March 2010
0.18
0.16
0.14
0.12
0.1
0.08
0.06
0.04
$/RMB
€/RMB
€/$
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M ar-
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M ay
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Date
$/RMB ($/2+euro/2)/RMB euro/RMB Euro/$ (RHS)
2
1.8
1.6
1.4
1.2
1
0.8
0.6
0.4
0.2
0
12

Timeline, continued
• Oct. 2006 -- 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.
13

– 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).
14

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.
15

• April 2010 -- Collision is averted:
– Treasury postpones manipulation report.
• June 19 – PBoC announces it will
“increase the renminbi’s exchange-rate flexibility,”
– though subsequent appreciation is small.
• So both sides save face
– for the moment.
16

• 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
Fed’s monetary easing
(“QE2”) as an example of currency wars.
17

– Jan.14: Geithner notes that
-including higher China’s inflation
--
RMB is appreciating at 10% per year .
– That suggests US lower priority on the currency issue
• Vs. IPR, North Korea & other issues.
18

WSJ 1/22/11
19

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

• 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.
• Don’t cheapen the language that is appropriate to WTO rules.

• 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 won’t 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 won’t close off the US market to Chinese goods.
• But perhaps a bargain isn’t even necessary;

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.
23

• 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 2007.
• 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.
24

• 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 2007-08.
– 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) 25

• 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.
26

27
New York Times Jan 12, 2011

28
New York Times Jan 12, 2011

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
Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008
29

High reserve growth
=> steady money offset by cuts in domestic credit
While reserves (NFA) rose rapidly, the growth of the monetary base
30

In 2007-08 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
• China’s 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.
31

Monetary base accelerated
Growth of China’s monetary base,
& its components
32
Source: HKMA, Half-Yearly Monetary and Financial Stability Report, June 2008

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

34

• 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.
35

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.
36

• 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.
37

The Balassa-Samuelson Relationship
2005
-3 -2 -1 0
Log of Real Per capita GDP (PPP)
1 coef = .23367193, (robust) se = .01978263, t = 11.81
2
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%.
38

Solving the problem of current account imbalances,
• in particular, the US CA deficit & China’s surplus.
• Both have widened, on long-term trends.
39
39

The US trade & current account balances have been on a downward path for 50 years.
They “improved” sharply in 2008-09, falling by half; but this reversal was temporary, due to US recession,
Trade & current accounts, in $ billions per quarter
40

• 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 children’s 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.
41

• 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 2007.
– Who is left?
– The RMB is conspicuous as the one major currency that is still undervalued against the dollar.
42

• 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 world’s 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.
43

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

• 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.” 45

• 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 2008-2011…
• and no crowding out of domestic demand via higher interest rates.
46

• 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
47

-- Frankel & Wei (2007)
48

Two hypotheses regarding determinants of
US Treasury decisions whether partners are manipulating currencies:
• (1) Legitimate economic variables
– the partner’s 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 .
49

Timeline, continued
or
• Econometric analysis:
• Domestic political variables are as important as global manipulation criteria.
50

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.
51

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.
52

• 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.
53

• 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)
54

Time plots of cumulative US Treasury and Non-Treasury Complaints
01 Jul 05 01 Jan 06 cumulative non-treasury report date
01 Jul 06 01 Jan 07 cumulative treasury report
55

(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 RMB’s weight on the US dollar.
56

Appendix 2:
CA Imbalances: Economists were split between those who saw the US deficit as unsustainable, requiring a $ fall , and those who saw no problem .
• Ken Rogoff
*
• Ben Bernanke
• Maury Obstfeld
• Ricardo Caballero
*
• Larry Summers
• Richard Cooper
• Martin Feldstein
• Michael Dooley
• Nouriel Roubini
• Pierre-Olivier
Gourinchas
• Menzie Chinn
• Alan Greenspan
• Me
• Ricardo Hausmann
• Lots more
• Lots more
* Some claim that the crisis of 2007-09 fits their theories
.
57
57

both
• 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.
58

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

• 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.
60

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 !
61

• Dooley, Folkerts-Landau, & Garber
(2003) :
– today’s system is a new Bretton Woods,
• with Asia playing the role that Europe played in the 1960s —buying 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 China’s need to import workable systems of finance & corporate governance.
62

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). .
63

My own view on “Bretton Woods II”:
• The 1960s analogy is indeed apt,
• but we are closer to 1971 than to 1944 or 1958.
• 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.
64

• 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 2009.
– =>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).
65

+
ED & TB>0
China
2011
BB:
External balance
CA =0
ED & TD
China
2002 ES & TB>0
ES & TD
Spending A
YY:
Internal balance
Y = Potential
66

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.
67

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?
68

• Definition:
An international currency is used by non-residents.
• The prospects for a country’s status as an international currency is not the same as its exchange rate prospects.
• Example: 1993-95
– 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.

Table B
Adapted from tables of Kenen and Cohen
Function of money:
Governments
Store of
value
International reserve holdings
Medium of
Vehicle currency for foreign exchange exchange intervention
Unit of
account
Private actors
Currency substitution
(private dollarization)
Invoicing trade and financial transactions
Anchor for pegging Denominating trade and local currency financial transactions
Central bank holdings of reserves is the most easily quantified, and probably the most important, of the various measures.

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

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

Determinants of reserve currency standing, continued
Network externalities
=> Tipping
1) Inertia
2) Nonlinearity in determinants
Source: Chinn & Frankel (2007
) captured by: lags logistic functional form or dummy for leader GDP

th
•
By 1919, US had passed UK in
1.
output (1872)
2.
trade (1914)
3.
net international creditor position (1914-19)
• $ passed £ as #1 reserve currency only with a lag
– by 1940-45
– though Eichengreen says 1924.

Figure 1: Currency share vs. GDP
(market rates).
Is the relationship linear or “ogive”?
SHARE vs. RATIOY
.8
Shares
.7
of major
.6
currencies
.5
In central bank reserve
.4
.3
holdings
.2
.1
.0
-.1
.0
Source: Chinn & Frankel (2007
)
.1
}
Tipping point
(GDP using market rates)
.2
.3
.4
.5
.6

Explaining currency shares, logit, pre-euro (1973-98)
GDP
[2]
2.77
[4]
3.69
[7]
1.04
Inflation
[0.64]
-2.64
[1.16]
[0.92]
-2.86
[1.16]
[0.29]
Depreciation
Trend
Ex rate variance -0.98
-1.40
-1.10
[0.59]
-1.25
FX turnover
[0.57]
0.45
[0.29]
[0.64]
0.58
[0.30]
-0.22
[0.34]
0.43
[0.15]
GDP leader dummy
[0.16]
Lag logit: log(share t-1
/ 1 - share t-1
)
0.85
[0.03]
0.85
[0.03]
0.96
[0.01]
Boldface = statistically signficant: size, retruns, turnover, and lag

• 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.
– Euroland’s GDP is still substantially bigger than China.
– Chinese growth will slow down,
• well before it reaches per capita equality with the West .

China’s rank, by determinants of international currency status, cont.
One the one hand…
• China is starting to use RMB in international trade
• Foreign central banks can hold RMB since Aug. 2010
– Malaysia’s 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 MacDonald’s.
» Bank of China HK launched an index Dec. 31, 2010.
• In November, RMB deposits reached
RMB 280 b.

“RMB goes viral,” Financial Times , Jan. 4, 2011
In Hong Kong banks, yuandenominated deposits have quadrupled over the last year – but from a low base .

Pros & cons of having one’s 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: America’s “exorbitant privilege.”
• (4)
Political power and prestige.

China’s 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 China’s 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.

China’s rank, by determinants of international currency status, cont.
• 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 2004.
– Prasad & Wei.

China’s rank, by determinants of international currency status, cont.
• 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.

The $ share has been on a downward trend since 1975
(with the exception of the 1990s).
80
75
70
65
60
55
50
45
65 70 75
USD share
80 85 90
USD + 0.6 Unalloc.
share (COFER)
95
Source: Chinn & Frankel (2007
)
00 05 10

The $ share of central bank holdings resumed its decline in 2001.
Data: 1999-2009 from COFER, IMF.
Source: http://content.ksg.harvard.edu/blog/jeff_frankels_weblog/2009/10/01/dollar-share-in-central-banks-fx-reserves-resumes-its-decline
/

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

showing post-2003 speculation on RMB appreciation
Spot and Forward Rates of USD/RMB
04/07/03 10/15/03 12/31/04 07/22/05 date spot
3-month
1-month
12-month
01/08/07
88

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***
0.0655
-0.99***
0.1548
Partner’s
CA/GDP
0.014*** 0.028**
0.002
Partner’s Real -0.18***
Exchange Rate
0.0291
0.007
-0.23**
0.1115
Change in 0.003 reserves/GDP
0.003
-0.012
0.009
US unemployment
0.022** 0.08**
0.010
0.037
*** statistically significant at 99% level
89

• 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 Δ log $ t
+ β
1
Δ log € t
+ β
2
Δ log
¥ t
+ …
• The coefficients are the basket weights
.
• Can impose α + Σ β j
= 1.
F& Wei (2007), Frankel (2009)
90


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.
91

http://ksghome.harvard.edu/~jfrankel/index.htm
92