Conference—China's Financial Stability and Monetary Policy Outlook

Brookings, China Finance 40 Forum, Euro50 Group, Beijing 29 August 2015

Renminbi internationalisation: Need for a new gentlemen’s agreement?*

Ousmène Jacques Mandeng

The impact of renminbi internationalisation on the global financial system will likely depend in large part on whether the renminbi will add or subtract stability to central banks’ reserve allocation patterns. This will naturally be contingent on renminbi conversion pressure, that is, whether adoption of the renminbi as a reserve currency will be sustained. The threat of large-scale reserve currency conversions has been a concern for a long time and a cornerstone for managing international liquidity has remained tied to some understanding about limited reserve currency convertibility. During the 1960s, U.S. Treasury Under-Secretary Robert Roosa famously resorted to different mechanisms to hold central banks to restrain from dollar conversions.1 Similarly, sterling was subject to extensive informal and formal agreements to allow for an orderly unwinding of unwanted sterling balances during the 1960-70s.2 In 2009, U.S. Secretary of State Hillary Clinton notably urged China not to sell its dollar reserves.3 Milton Friedman called it "the gentlemen's agreement among central banks not to press for conversion […]."4

The international monetary system’s credit-based nature relies to a very large extent on central bank foreign lending behaviour. In 1964, Robert Triffin warned of “the haphazard accumulation—or liquidation—of reserves […; and] the key currency countries’ surpluses or deficits, the waves of confidence or diffidence in such currencies […].”5 He described the “curious breed of international monetary cooperation” arguing that the system “has become dependent on the political willingness of foreign countries to finance, through their own monetary issues, the deficits of the countries whose national currency is accepted by them in international reserves […] and to finance debtor countries’ policies in which their own governments have no voice, and with which they may profoundly disagree [for example] “to help finance [U.S.] military assistance to Chiang Kai-shek, the escalation of the war in Vietnam, [the] ill-fated intervention in the Dominican Republic, etc.”6

The high level and concentration of foreign exchange reserves has heightened the risks from abrupt changes in central banks’ lending patterns. Foreign exchange reserves have reached US$12,000 billion in June 2014 (15 percent of world GDP), up from US$2,000 billion (6 percent of world GDP) in 2000, and have receded for the first time during the 2000s through March 2015 to US$11,430 billion (15 percent of world GDP). Central banks’ foreign exchange reserves are allocated predominantly in government securities of the reserve currency issuing countries. The relatively homogenous central bank reserve allocation behaviour in the main currencies and sharp directional buying has made central banks a major force in international capital markets.

The impact of central bank lending in capital and exchange markets has been particularly manifest in the Euro Area. Central banks have undertaken significant changes in allocations of euro-denominated reserve assets and to Euro Area peripheral countries. Prima facie evidence suggests that the share of euro-denominated central bank foreign exchange reserves and the eurodollar exchange rate shows a close correlation supporting the notion that large changes in reserve holdings can cause important exchange rate adjustments (Chart 1). The sharp movement of yield spreads between Euro Area peripheral countries and France and Germany during 2009-11 has been accompanied by an important decline of central banks’ holdings of Euro Area peripheral government notes relative to total holdings of Euro Area government notes. Central banks’ changes in lending behaviour may therefore have significantly contributed to the divergence of Euro Area government note yields (Chart 2). Similarly, the reserve accumulation by the Swiss National Bank, increasing its euro-denominated reserves tenfold from US$24 billion in 2008 to US$225 billion in 2012, represented in 2012 more than 65 percent of the combined general government deficits of France and Germany possibly exerting significant downward pressure on government note yields (Chart 3).7

The composition of central banks’ foreign exchange reserves has been subject to important changes by currency.8 Key developments include the sizeable increase of the share of dollar-denominated reserves and reduction of sterling-denominated reserves during the 1950s-1970s, the expansion into European currencies in particular the mark during the 1970s and to a lesser extent into the yen during the 1970s-80s with a peak in reserve diversification in the 1990s. With the introduction of the euro renewed reserve currency concentration occurred (Chart 4). At the same time, adoption of new reserve currencies at a meaningful level outside the dollar, euro, sterling and yen remains modest. The expansion into other currencies, including notably the Australian dollar and Canadian dollar has progressed somewhat since 2008 but receded from a high in the first half of 2014. Allocations to renminbi have remained marginal though growing representing 1 percent of foreign reserves in 2014.9

The adoption of new reserve currencies during the 1970s and 2000s occurred amid rapid reserve growth. Foreign exchange reserves increased ninefold between 1970 and 1980 and fivefold between 2000 and 2010. Today, the seeming end of massive foreign exchange reserve accumulations may mark a new phase in the demand for and issuance and distribution of reserve currencies. The large accumulation of reserves can be attributed largely to China and emerging markets through 2011. Since 2011, advanced economies, notably Switzerland, represented an increasing proportion of total reserve accumulation. The share of China and emerging markets in total foreign exchange holdings increased from 40 percent in 2002 to 68 percent in 2011 and declined to 66 percent in 2015. The accumulation of reserves has remained highly asymmetric in nominal terms with China holding one third of total foreign exchange reserves and China, Japan, Saudi Arabia and Switzerland representing more than half.

Renminbi internationalisation will not only depend on China. The history of reserve currencies seems to indicate that central bank lending behaviour is critical for orderly renminbi internationalisation. The significant amount of reserves and central banks' market power suggests that adoption by central banks of renminbi-denominated assets as reserves could have ceteris paribus a major impact on the exchange rate and underlying asset markets. However, the stagnation of reserve accumulation may reduce incentives for reserve diversification and increase the risk of reversals in reserve allocations. Renminbi internationalisation will be successful if it leads towards an orderly diversification of reserves. This will require mitigating adverse shocks to central banks' lending confidence. A new gentlemen's agreement to ensure moderate reserve conversion and gradual adoption would therefore likely constitute an essential element for allowing sustainable renminbi internationalisation.

Euro reserves and euro exchange rate

Reserve allocation to peripheral Euro Area

Swiss National Bank reserves and Euro Area government debt

Foreign exchange reserve composition

*Draft 24 August, 2015, as background for discussion in Session IV—Impact of renminbi internationalisation on the global financial system.

1See e.g. Michael Bordo, Owen Humpage and Anna Schwartz, U.S. intervention during the Bretton Woods era: 1962-1973, Federal Reserve Bank of Cleveland Working Paper, April 2011.

2 See e.g. Catherine Schenk, The retirement of sterling as a reserve currency after 1945: Lessons for the U.S. dollar? mimeo, 2009.

3 See e.g. The Guardian, China ‘worried’ about safety of US assets, 14 March 2009.

4 Milton Friedman, Real and pseudo gold standard, Journal of Law and Economics, 1961, pp. 66-79. Reference to the gentlemen’s agreement was also attributed to Roy Harrod as “institutionalising the inconvertibility of the reserve currencies”, see e.g. Robert Triffin, Updating the Triffin Plan, in Maxwell Stamp (ed.), Moorgate and Wall Street: A review, Summer 1965.

5Robert Triffin, The end of the dollar glut? The Banker, London, June 1964, pp. 351-354.

6 Robert Triffin, 1965 idem.

7 The general government of Germany was running a surplus of EUR2.6 billion in 2012.

8 Reserves have also been subject to important diversification by instrument with the relative decline of gold in reserve holdings, a decline in bank deposits and the increasing allocation to government treasury securities.

9 IMF Survey on the holdings of currencies in official foreign currency assets 2015 with total renminbi assets representing US$75 billion. The survey numbers refer to December 2014 and differ from the IMF CPIS survey (Table 9) where the renminbi represented US$13 billion with a share of only 0.3 percent in total reserves in June 2014.