Is the renminbi the greenback of tomorrow? Its use is increasing, and its global influence is growing in line with China's rise. China and a rising number of partner countries are interested in expanding its international use.

But before the renminbi becomes a major global settlement and reserve currency, it will transition through a few key waypoints.

Shifting Monetary System Opens Door To Renminbi

An increasingly diversified global monetary system has renewed interest in the internationalization of the renminbi. China's rising influence has led to greater global use of its currency--through the sheer size of its economy and its place in international trade.

The global financial crisis in 2008 and 2009 and quantitative easing by the U.S. Federal Reserve drew attention to the potential downsides of the concentrated exposure of the world's reserves and payments systems to the U.S. and its economic policies.

In Europe, the 2010-2011 debt crisis hemmed in the euro's role in global settlements, while the U.K.'s exit from Europe in 2016 constrained use of the pound.

What's In It For China And Other Economies?

We examine two perspectives for greater global renminbi use. The first perspective is that of China: why are policymakers encouraging global use of the currency? What is the benefit? The second perspective is that of other economies: why would they prefer greater renminbi use in their international economic engagements?

China would have less need for holding forex reserves as more cross-border settlement happens in domestic currency.  This lowers debasement risk or volatility in the value of reserves. Lower reserve holdings reduce exposure to foreign economic policies that can affect the foreign currency and hence the value of reserves.

These risks became apparent for the U.S. dollar in 2009 when the Fed conducted quantitative easing--a new policy tool with unclear implications. Then People's Bank of China (PBOC) governor Zhou Xiaochuan stressed the possible systematic risks of the global reliance on the US dollar as a reserve currency and called for an international reserve currency with "stable value."

Renminbi use for cross-border transactions reduces the requirement for domestic agents to hold foreign currency.  Firms engaging in international trade can price their products in local currency and avoid exchange rate fluctuations. Transaction costs are lower without the need to convert transactions into third-party currencies. Additionally, firms have lower foreign currency funding needs.

China has geopolitical incentives to internationalize its currency.  Greater global acceptance of the renminbi means China can reduce its vulnerability to external geopolitical developments. China can continue to make international settlements for trade and other transactions through the renminbi and does not have to rely on the international payments system.

For other economies

Holding fewer U.S. dollar assets and currency reduces exposure to U.S. economic policies.  This perspective holds for other economies as it does for China, so economies can be less exposed to U.S. policies such as quantitative easing or inflation. For other economies, the effect is countered by greater exposure to China's policies as holdings of renminbi assets increase. Still, the value of reserves is at least more diversified for other economies if the weightage of renminbi and non-U.S. dollar currencies increases.

Trading in renminbi can lower transaction costs, particularly for economies that count China as a major trading partner.  Conducting trade in a trading-partner currency lowers foreign exchange transaction needs. Trade finance becomes easier. Lower U.S. dollar requirements mean lower exposure to U.S.-dollar funding conditions.

The group of countries for which China is the largest trading partner is now bigger than the group for which the US is the key trading nation. China's share of global trade has now surpassed the U.S.--in 2022 China's share of global trade was 13.7% compared with the U.S.' share of 11.2%. However, most trade is denominated in U.S. dollars, which is a third-party currency and hence subject to greater transaction costs.

There is now wider interest in alternative trade and reserve currencies to avoid either direct or inadvertent exposure to sanctions.  For example, countries can use renminbi for cross-border settlements where U.S. dollar transactions may not be possible.

Some economies may benefit from a reduced need for U.S. dollars.  This may be the case where funding or access to U.S. dollars is limited but access to renminbi is better, perhaps due to availability of currency swaps or favorable bilateral trade. For countries with structural balance of payments shortfalls, however, changing the currency for overseas payment obligations will not bypass foreign currency shortfalls.

The Two Avenues To Renminbi Internationalization

The PBOC is using two key avenues to promote internationalization. The first avenue is to enable and encourage use of renminbi for bilateral international trade settlement. Most international trade is settled in U.S. dollars, but renminbi clearing and settlement infrastructure facilitates greater acceptance of renminbi for international payment.

The second avenue is to promote and develop the offshore renminbi market. This enables international economic agents, including central banks, financial institutions, and firms to hold and trade offshore renminbi assets. This approach aims to make it easier to access and invest in renminbi assets and to increase liquidity for those assets.

Conducting trade in renminbi

Along this avenue, China and a trading partner country promote the use of renminbi for trade settlement. This approach is attractive for economies that have China as a major trading partner. Settlement in one of the trading partners' currencies reduces transaction costs and eases trade finance access. China's share of the trade in global goods has risen over the past 20 years (see chart 1). This increases the scope for renminbi settlement.

Chart 1

Bilateral local currency trade settlement arrangements are likely to gravitate to the currency that has wider global acceptability and greater attractiveness as a reserve currency. A wide network of economies that settle trade with China in renminbi can facilitate greater use of the currency to settle cross-border payments.

Data from the PBOC show increased usage of the renminbi in cross-border settlement of goods trade (see chart 2).

Chart 2

Cross-border settlement in renminbi increased until 2015, when the currency depreciated against the U.S. dollar by just over 4% in August of that year, followed by further 2.5% depreciation over November and December. The exchange rate volatility lowered demand for renminbi settlement, and this has recovered over the past few years.

Renminbi cross-border settlement has soared since early 2022. At the start of 2022, about 2.1% of global trade was settled in renminbi. As of May 2023 this number had increased to slightly more than 3.2%. This increase in cross border settlement came even as China's share of global trade remained roughly the same. This is because the proportion of China's bilateral trade settled in renminbi jumped from about 15.0% at the end of 2021 to about 24% as of May 2023.

Data from the Bank for International Settlements show the share of renminbi in over-the-counter foreign exchange transactions rose to 3.5% in 2022 from 2.2% in 2019. Part of the reason is geopolitical as Russia increased payments in renminbi.

Some economies have sought to diversify cross-border settlement options. The PBOC and other regulators have set up infrastructure that can smooth bilateral trade settlement in renminbi with trading partners.

A key part of such trade settlement infrastructure is renminbi clearing facilities in trading partner countries. Such clearing infrastructure smooths cross-border settlement in renminbi. Hong Kong has had renminbi clearing facilities since 2003. Since 2012, the PBOC has expanded renminbi clearing arrangements to 26 other countries (see table 1). Exporters and importers can conduct bilateral trade with China in renminbi more easily through renminbi clearing accounts.

Table 1

Hong Kong remains the top clearing center: about 72% of all offshore renminbi clearing is processed there, according to SWIFT data. The next largest centers in terms of total value are London (6%), Singapore (4%), and New York (3%).

Developing the offshore renminbi market

The offshore renminbi market is a central support for the currency's internationalization. Policymakers have set up a network of renminbi swap lines with several global central banks (see chart 3). This ensures availability of renminbi, which is a key requirement for enabling international payment and financing in the currency. Without the availability of a swap line there can be scarcity of payment currency for cross-border transactions, particularly when there are capital controls on the payment currency.

Chart 3

An element of wider renminbi use is greater depth in the offshore RMB bond market. As global use of the currency increases, there will be demand for quality renminbi assets, and a deep offshore bond market can help meet those requirements.

Offshore bond issuance was RMB353 billion in 2021, compared with about RMB397 billion in 2019, pre-pandemic. The 2021 offshore issuance was just 1.6% of onshore issuance. The offshore market structure remains incomplete. A complete yield curve is not available, and the group of issuers is limited.

Foreign investors' access to onshore bond markets in China is gradually increasing. Platforms for accessing onshore bond markets include the China Interbank Bond Market (CIBM), Qualified Foreign Institutional Investor (QFII) scheme, RMB Qualified Institutional Investor Scheme (RQFII), and Bond Connect.

At the end of 2021, foreign investors held RMB4.1 trillion of onshore bonds compared with RMB1.2 trillion at the end of 2017. That period coincided with greater policy reform, and a push to open the financial market to foreign investors.

Outlook For Renminbi Internationalization

We identify four key checkpoints for further global adoption of renminbi as a payments and reserve currency.

(1) Wider use of renminbi in foreign exchange markets

There are five main avenues for cross-border renminbi flows:

• Trade settlement;
• Direct investment;
• Financing, such as renminbi trade finance, loan disbursements and bond issuances;
• Financial markets including portfolio flows; and
• Foreign exchange markets, where domestic and international holders buy and sell renminbi.

Trade and direct investment settlements have so far been the cornerstone of renminbi internationalization. Since the gradual opening of China's domestic financial market to overseas investors, the financial markets avenue has also been a key part of cross-border flows denominated in renminbi.

However, the role of the RMB in financial/capital flows and foreign exchange cross-border flows remains very small. This matters because, globally, capital account transactions tend to dwarf trade transactions. As a result, global shares of renminbi in foreign exchange turnover and for use as foreign exchange reserves remains small relative to the size of the Chinese economy.

Broader cross-border settlement in renminbi has remained modest at between 2% and 2.5% of the total (see chart 4). Use of the renminbi as a reserve currency remains small as well (see chart 5).

The renminbi share in global reserves rose from about 2% pre-pandemic to about 2.7% at the end of 2022. This partly reflects the strength of the renminbi against the other reserves over this period. The currency appreciated from about 7RMB per U.S. dollar at the end of 2019 to 6.4RMB per dollar in mid-2022. This happened even as other reserve currencies such as the euro and yen were depreciating against the dollar. Since then the renminbi exchange rate has depreciated, and this will likely affect reserve valuation.

Smoother operation and greater depth for the renminbi foreign exchange markets, financing availability, and offshore markets form a notable checkpoint.

Chart 4

Chart 5

(2) Greater third-party renminbi use

Significant use of the renminbi for cross-border settlement is currently based on bilateral trade whereby China and a trading partner use one of their domestic currencies for settlement. One checkpoint for internationalization is when third-party economies conduct their trade in renminbi.

For example, China has in place renminbi clearing facilities across various countries. If these third-party economies then settle their bilateral trade in renminbi instead of U.S. dollars, this provides a much stronger framework for renminbi acceptance. These are network effects whereby wider acceptance of a currency further increases that currency's international acceptability. Third-party renminbi settlement may be efficient particularly among economies where China is a key trading partner.

Stronger network effects through a wide set of renminbi settlement facilities between China and trading partners can accelerate this process. This can enable trading partners with large trade links with China to consider settling their independent trade in renminbi to lower foreign exchange transaction costs and diversify their cross-border settlement currencies.

(3) Greater capital account flexibility

Investors want flexible convertibility--the ability to move funds in and out of the currency as required. This is not possible with capital controls in place; and funds may become stuck or inaccessible. Renminbi can also become scarce, making it difficult to convert into the currency to make cross-border settlements.

The policy choice regarding a free or closed (controlled) capital account involves a so-called impossible trinity. An economy can have two out of the following three policy choices: independent monetary policy; managed exchange rates; and free capital flows.

China is keen to have monetary policy independence. And, while there has been little forex intervention in recent years, policymakers do not yet want a completely flexible exchange rate. That requires managed capital flows.

China can increase the attractiveness of the renminbi for international investors by freeing up capital flows. But that would require full exchange rate flexibility. As PBOC Governor Yi Gang notes, policymakers are reluctant to do that for now.

Debate surrounds the question of whether capital account flexibility is mandatory for greater renminbi internationalization. It is difficult for foreign investors to hold a currency under capital controls. However, the offshore renminbi market offers a way to alleviate some of the pressure. If investors can easily withdraw and deposit offshore renminbi, then China can retain onshore capital controls.

But a jump in global use of renminbi would lead to a large foreign holding of offshore renminbi. This could result in wide divergence between exchange rates and interest rates in the offshore and onshore rates. This would strain cross-border settlements.

For instance, exporters would have to decide whether to price products in offshore currency or onshore currency; such a choice would have differing implications for importers.

The onshore and offshore currencies currently trade close together, with an average spread of 0.17% against the U.S. dollar over the past 12 months. These differences have been larger at times. Over the past five years, the spread has been wider than 0.6% on about 1.4% of trading days.

Most academics and market participants see greater capital account flexibility as a prerequisite for wider internationalization of the renminbi. The reluctance of policymakers to entirely move in that direction will remain an obstacle to internationalization.

(4) The Chinese economy would require a sustained current account deficit

A fourth checkpoint is the Chinese economy's current account position. Wide renminbi internationalization would tend to lead to pressure on the current account balance (in 2022 China ran a current account surplus of about 2.2% of GDP).

More internationalization means greater foreign demand for holding renminbi. That implies inflows into the country's capital account. The increased RMB demand would cause the currency to appreciate. Exports become expensive and imports become cheaper, and eventually the economy must run structural current account deficits to offset the inflow pressures.

Policymakers can offset these capital inflow pressures by increasing holdings of foreign currencies and gold. However, the increased foreign reserves would reduce the benefit of internationalization for China. This means a current account deficit is a likely checkpoint on the road to greater renminbi internationalization.

Gradual Internationalization Likely

The renminbi will continue to internationalize as China's economic and trade influence rises. China's financial markets remain attractive for global investors.

However, China's policymakers appear in no hurry to remove capital account restrictions and thereby increase the flexibility of the exchange rate. The renminbi's path to internationalization remains gradual.

Editor: Lex Hall

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