In 2016, the IMF included the Chinese renminbi (RMB) in the Special Drawing Rights (SDR) basket with a weight of 10.9%. Prior to its inclusion, this basket of international currencies consisted of the US dollar, euro, Japanese yen and British pound. The IMF’s rationale was ‘China’s expanding role in global trade and the substantial increase in the international use and trading of the renminbi’. The move came seven years after the Chinese government enacted a series of policies to internationalize the RMB. This begs the questions: how can a currency achieve this status, and which policies assist that jumpstart? A new BoE staff working paper aims to answer just that.
The problem of ‘Original Sin’ is a familiar one. It provides an example of the advantages to having an internationally regarded currency. Yet not every country is able to achieve such an accolade, and the paper’s authors want to know why. They draw comparisons between the US dollar’s rise in the 1920s with the renminbi’s introduction into the SDR basket a century later. They conclude that, for countries with (i) a stable exchange rate, (ii) a large enough international trade presence, and (iii) relatively inexpensive and liquid credit in their own currencies, central bank policies can jumpstart the use of their currency outside the country’s borders.
Specifically, the authors use data analysis on 38 swap lines created by the People’s Bank of China (PBoC) between 2009-2018 to establish three empirical findings. Firstly, swap lines increase the probability that a country uses RMB in payments to and from that country by between 13-58%. Secondly, an adjacent country was 5-10% more likely to use the RMB as an international currency in the months following a neighbour signing a swap line. Thirdly, the larger the correlation between a country’s producer price index with the RMB exchange rate, the stronger the predicted impact of the swap line on using the RMB in that country.
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In 2016, the IMF included the Chinese renminbi (RMB) in the Special Drawing Rights (SDR) basket with a weight of 10.9%. Prior to its inclusion, this basket of international currencies consisted of the US dollar, euro, Japanese yen and British pound. The IMF’s rationale was ‘China’s expanding role in global trade and the substantial increase in the international use and trading of the renminbi’. The move came seven years after the Chinese government enacted a series of policies to internationalize the RMB. This begs the questions: how can a currency achieve this status, and which policies assist that jumpstart? A new BoE staff working paper aims to answer just that.
The problem of ‘Original Sin’ is a familiar one. It provides an example of the advantages to having an internationally regarded currency. Yet not every country is able to achieve such an accolade, and the paper’s authors want to know why. They draw comparisons between the US dollar’s rise in the 1920s with the renminbi’s introduction into the SDR basket a century later. They conclude that, for countries with (i) a stable exchange rate, (ii) a large enough international trade presence, and (iii) relatively inexpensive and liquid credit in their own currencies, central bank policies can jumpstart the use of their currency outside the country’s borders.
Specifically, the authors use data analysis on 38 swap lines created by the People’s Bank of China (PBoC) between 2009-2018 to establish three empirical findings. Firstly, swap lines increase the probability that a country uses RMB in payments to and from that country by between 13-58%. Secondly, an adjacent country was 5-10% more likely to use the RMB as an international currency in the months following a neighbour signing a swap line. Thirdly, the larger the correlation between a country’s producer price index with the RMB exchange rate, the stronger the predicted impact of the swap line on using the RMB in that country.
Swap Lines
What are RMB swap lines? They are fixed duration (usually a two- or three-year) contracts between the PBoC and a foreign central bank that enables RMB to be borrowed for a maturity that potentially goes from overnight to up to two years. When approved, the foreign central bank must give the PBoC a deposit in its own currency as collateral which, at the end of the swap, is then cancelled. Since no currency gets exchanged in the spot market, and the interest rate is fixed, the swap line has only credit risk.
Why are they used? Like other central bank lending programs, swap lines put a ceiling on interest rates. For a rising currency country like China, where a credit market already existed but was still illiquid, they can ex-ante significantly affect a firms’ inclination to borrow from banks in RMB. Less credit uncertainty, alongside a reduction in exchange rate volatility and deregulation of private activity, makes borrowing in a rising currency more appealing (especially for less developed countries that are reliant on foreign currency credit for trade financing).
How does China operationalize swap lines? Given capital controls in China, the RMB is exchanged through an RMB settlement bank either locally in the borrowing country, in Hong Kong, or potentially in another offshore RMB centre. The foreign central bank will have an account with the settlement bank, which itself has an account at the PBoC backing it. These settlement banks serve as intermediary correspondent banks, since foreign central banks cannot have deposits at the PBoC.
The Data
The authors collect data on each swap line agreement signed or renewed by the PBoC starting from 2009. The information was compiled from the PBoC’s official news releases and then cross-checked with the foreign central bank’s official communications. The data shows the number of outstanding swap lines and the sum of their notional amount increased from nearly zero on both accounts in 2009 to 38 and RMB 2.8 trillion respectively, ten years later (Chart 1).
Chart 1: PBoC Swap Lines Have Increased Sharply in the Past Decade
Source: Page 23 of “Jumpstarting an international currency“
Their data source for cross-border payments is the Society for Worldwide Interbank Financial Telecommunication (SWIFT). It provides information on payment orders that are settled via correspondent accounts that banks hold with each other. They assume, as is standard in the literature, that the currency used for invoicing and for settlement payments are the same. Spanning 97 months between 2010 and 2018 there is a clear upward trend in the use of the RMB since the PBoC started using swap lines (although this has levelled off in recent years).
How a Currency Rises to Dominance
In the early 1900s, global trade credit was largely denominated in British pounds. By World War II, however, the US dollar had become the dominant global currency. Its rise is attributable to the Federal Reserve Act of 1913, alongside the Fed’s lender of last resort status to firms trading in US dollars. One-hundred years on, China – the largest exporter and creditor in the world – designs comparable policies to similar success.
How did both the USD and RMB transition from ‘rising currencies’ to the internationally regarded ‘dominant’ ones we see today? Well, according to the authors, the success of this evolution hinged on the decisions of firms to adopt the currencies in their rising phase. Indeed, any rising currency that has a stable exchange rate and large international presence can also become dominant if it is cost effective for profit-maximizing firms to denominate their debt and prices in them. The authors build a framework to show how.
Let’s paraphrase their model into a thought experiment. Imagine a firm that produces a good. In this world, the firm can sell that good in any country in a currency of its choosing – call this its price-denomination choice. The four currency options are: (i) the currency of the domestic market in which the firm operates (PCP), (ii) the currency of the export market in which it sells (LCP), (iii) the currency of the export market in which it sells which is also the rising currency country (RCP), and (iv) the currency of the export market in which it sells which is also the dominant currency country (DCP).
The second currency decision a firm must make is its debt-denomination choice. To make the good, the firm requires inputs obtained locally and abroad. Those imported from abroad (working capital), are paid for with credit denominated either in a dominant or rising currency. This choice is important because the interest paid on the credit will depend on which currency is chosen. The problem, however, is that the firm does not know which currency has the lower interest because there is uncertainty in the credit market of the rising currency country.
The tradeoffs from denominating debt in either a dominant or rising currency are clear. Dominant currencies offer less volatility, greater liquidity and more certainty so that interest rates in this currency are lower than what a simple UIP condition would suggest. Without policies, no firm would reasonably choose a rising currency. However, the authors of this paper use swap lines to reduce credit risk (policies that reduce default or exchange rate risk can also work), levelling the playing field.
As with any tradeoff, there exists a threshold that, in this case, rising currencies must clear. They do so if: (i) central bank policies reduce enough the uncertainty in the cost of credit, (ii) the volatility of rising currency country exchange rates are lower than other export markets, (iii) the export market of the rising currency country is larger than other export markets, and (iv) the costs of locally sourced inputs to the firm move closely with the exchange rates of the rising currency.
The first condition is key. The effect of swap lines lowers the expected costs of rising currency credit, switching some firms from dominant currency credit. For those that switch, if the exchange rate of the rising currency country is stable (ii) and the country is large (iii), firms will price their goods in the rising currency if (iv) holds. This complementarity in financing working capital and invoicing sales reinforces the adoption of the rising currency in a self-perpetuating cycle, helping a currency rise to dominance.
Bottom Line
The results from the paper are fascinating. Empirically, we should expect an increase in the usage of the rising currency in payments to and from a country that has signed swap lines. This is not just with respect to the rising currency country, but also with countries it trades with. Indeed, the authors show that swap lines have increased the RMB share of payments by 0.4 percentage points (Chart 2).
Chart 2: RMB Payments Jump Following Swaps Lines Being Signed
Source: Page 27 of “Jumpstarting an international currency“
Theoretically, the research also provides conditions under which some countries can use effective government and central bank policies to jumpstart their currencies on the international stage. The policies are not limited to swap lines. The results can also be achieved through a direct government subsidy to banks that give overseas credit for trade in the rising currency (although this is much more costly).
It is worth noting, however, that the vast majority of currencies cannot be international. Exchange rate stability is the most important pre-condition. Also, the Fed and PBoC had (a) sound monetary policy, (b) large capital markets and (c) large weights in international trade to start with. Nevertheless, this does not dilute the main take-away: the PBoC’s policy of signing swap lines with foreign central banks has significantly increased the usage of the Chinese renminbi over the last 10 years. By the end of 2019, the RMB accounted for 2.0% of foreign currency reserves starting from virtually zero in 2009.
To view the full paper, please click here.
Sam van de Schootbrugge is a macro research economist taking a one year industrial break from his Ph.D. in Economics. He has 2 years of experience working in government and has an MPhil degree in Economic Research from the University of Cambridge. His research expertise are in international finance, macroeconomics and fiscal policy.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)