Is the RMB the Next World Currency?

The U.S. dollar has faltered as the world’s stable currency during the recent financial crisis. Will China’s renminbi (meaning the people’s currency) step up to the plate? According to Geng Xiao, director of the Brooking-Tsinghau Center for Public Policy, we should not dump the dollar just yet. He asserts that China needs to take its currency through various structural reforms before it will be ready to carry the weight of the global economy. While the U.S. wants a quick adjustment to correct trade imbalances, it will take time to correct the internal subsidies and inefficiencies that have floated the yuan, distorting its value against the dollar.

There is no question that both powers want to improve imbalance between China’s surplus and the U.S. deficit. But rather than short-term exchange rate adjustments, the Chinese focus is on medium and long-term structural and institutional changes, which will not quickly correct the trade imbalance. China’s central bank needs to reform its pricing structure so that it is comparable to global pricing and compatible with productivity. For example, changing the exchange rate would not change inefficiencies in energy use, because people would still waste energy. But adjusting the pricing is a market based monetary mechanism that consumers and producers will both react to.

Although China hopes to create a stable, enduring currency in the future, the current exchange rate uncertainty has negative consequences now. Foreign investors look to invest in the RMB because they expect the RMB to appreciate, generating “hot money.” These capital flows also create bubbles in the property market and stock market. To correct distortions that attract unhealthy investment levels, China is taking on land reform, energy reform, state-owned-enterprise reform and social welfare to make its non-tradable sectors more comparable to the global pricing structure. Because China is still a developing country and still has low productivity compared to the U.S, so the two countries price structures will take time to converge.

In a recent interview with McKinsey & Co., Dr. Xiao argued that structural and institutional reforms, rather than exchange rate changes, are in America’s interest as well. During the recession, U.S. consumers were not consuming, even though the U.S. manufacturing sector largely targets the domestic market. So even if you change China’s exchange rate, the impact on the U.S. trade deficit will be minimal because the U.S. will buy from elsewhere. Going forward, he recommends that the U.S. produces for consumers in emerging markets – not just Chinese consumers in China – but also Chinese consumers who will go out and spend abroad.

So will the dominance of the dollar come to an end? If the Chinese economy and population continues to grow at a steady pace, it will easily become the largest world market. And if China can implement its reforms and create a modern market economy, the RMB will certainly secure its place as one of the important reserve currencies along with the dollar.

Photo Credit: David Dennis