Author: Paola Subacchi, Chatham House
At times of big turmoil, currencies take the hit, but economic transformation can also create Currency winners. Nowhere is this more apparent than when we compare the prospects of British sterling and China’s Renminbi.
Between February 2016 — when the referendum on the UK’s membership of the European Union (EU) was announced — and the end of January 2017, the sterling fell by 14 per cent against the US dollar. Then, at the beginning of October, when the UK government appeared to signal a preference for a clear break with the EU — a ‘hard Brexit’ — the sterling dropped again by 6 per cent.
As the British government is serving notice on the membership of the EU, it is not yet clear what the future relationship will look like. Will Britain remain a member of Europe’s single market? Or will it embrace a totally independent trade policy to maintain control at its borders?
Currencies not only reflect geopolitical dynamics, but also patterns of trade and debt. A weak currency is not much help for an economy that imports more than it exports. The UK has a significant deficit in its current account — roughly, it consumes more than it produces — at almost 6 per cent of GDP. Of course, a weak currency would lower the prices of exports, but only if these goods are produced with limited inputs from imports.
In a world of global supply chains this is questionable. Even assuming that a weak sterling would help shift the UK model of growth from domestic demand to exports, this adjustment will take time and is unlikely to cushion the adverse impact of Brexit on real GDP growth in the next few years.
The ‘hard Brexit’ option, by reducing market openness, will affect investors’ confidence, have an adverse impact on capital inflows and undermine growth. If the UK becomes less attractive as an investment destination, and stricter immigration policies cause the labour force to shrink, then Britain may find it difficult to attract the quantity of foreign capital and labour necessary to sustain a domestic demand-driven economy.
The sterling remains in the IMF’s Special Drawing Rights (SDR) basket of international reserve currencies. To some extent the sterling has been a proxy of British global influence: on the way down, but still ‘punching above its weight’. But the sterling’s protracted weakness coupled with the inclusion of the Chinese renminbi in the SDR basket — in effect from the beginning of October 2017 — may result in downgrading the pound when the composition of the basket is reassessed in 2020.
If currencies are an expression of national sovereignty, they also epitomise the limits of such sovereignty in an open economy. Exchange rate dynamics tend to reflect divergences between domestic politics and global markets. Thinking that domestic policymaking can be insulated from the rest of the world, so that no coordination or cooperation is needed, is deeply fallacious. The sterling’s troubles are a reminder that foreign investors have an indirect say — and interest — in how a country is managed.
The inclusion of the renminbi among the currencies that compose the SDRs — the US dollar, the euro, the yen and the sterling — is a ‘milestone’ for China, as International Monetary Fund Managing Director Christine Lagarde said when she presented the IMF executive board’s decision on 30 November 2016.
The renminbi’s inclusion recognises the work that China’s monetary authorities have done in the last five years to push the renminbi’s transformation into an international currency — a currency that can be used to invoice and settle international trade and that is traded in international capital markets. The outcome of this process has been remarkable: approximately 25 per cent of China’s trade is now settled in renminbi — it was less than 1 per cent in 2009.
In addition, the inclusion somehow addresses the contradiction that China has faced for years: being the world’s second largest economy and the largest exporter without a currency that reflects that role. For years the dollar has been the currency used in China’s trade and investments, and this is still largely the case. This has suited China well throughout its transformation from a poor and isolated nation into an industrial powerhouse that is well integrated in regional and international supply chains.
But China’s dollar dependence no longer reflects Beijing’s ambitions for playing a more engaging and assertive role in international economic and financial affairs and governance. If ‘great nations have great currencies’, to paraphrase Nobel laureate Robert Mundell, then it is understandable that the Chinese leadership would push to turn the renminbi into a ‘great currency’.
Finally, and even more critically, being part of the SDR basket implicitly recognises the role that the renminbi, going forward, can play in the international monetary system. The hype that has surrounded the IMF decision — the SDR made headlines beyond the financial press, perhaps for the first time since its creation in 1969 — should not obscure the fact that the development of the renminbi is not a linear process, even if it is heavily policy-driven, and there is no guarantee that progress will continue at the same remarkable pace. The renminbi remains a currency with limited international circulation because of obstacles that are still in place to constrain capital flows into and from China’s domestic market.
This is not the case for trade transactions, where the renminbi has been fully convertible since 2001 when China joined the World Trade Organisation. But what is the incentive for foreign businesses to hold renminbi if liquidity is constrained and therefore so are investment opportunities?
To make the renminbi into an international currency that foreigners want to hold as a store of value the Chinese leadership needs to continue the pace of reforms. Top of the list is the exchange rate and the abandonment of the system where the central bank intervenes every time the value of the renminbi moves outside a pre-determined range. Until foreign investors believe that the renminbi is liquid and trustworthy, any suggestion that the renminbi may one day rival the dollar and seriously threaten the greenback’s dominance within the international monetary system remains wishful thinking. The renminbi is moving in the right direction, but much more needs to be done to make it into a pillar of this multi-currency system.
Paola Subacchi is Director of Economic Research at Chatham House, London, and the author of The People’s Money: How China Is Building a Global Currency (Columbia University Press, 2017).
This article appeared in the most recent edition of the East Asia Forum Quarterly, ‘Towards Asian integration’.