On June 13, the European Central Bank (ECB) said it converted 500 million euros of foreign reserves to RMB during the first half of 2017, adding the Chinese currency to its reserves for the first time.

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On June 13, the European Central Bank (ECB) said it converted 500 million euros of foreign reserves to RMB during the first half of 2017, adding the Chinese currency to its reserves for the first time.

The RMB is gradually becoming more recognized as an international currency as its role in the international monetary system grows. More and more public and private institutions are considering purchasing RMB as a long-term rather than short-term investment, demonstrating that the RMB has achieved a steady stage of internationalization.    

 

ECB supports RMB
Headquartered in Frankfurt, Germany, the ECB is the second-largest central bank in the world. It is responsible for making monetary policies for all nations in the euro zone. In addition, the ECB also conducts foreign exchange operations and manages the euro area’s foreign currency reserves. The foreign reserve assets held by the ECB now include the US dollar, the British pound, the Japanese yen, gold and Special Drawing Rights (SDR). The ECB added the RMB to its foreign reserves for the first time on June 13 this year.

Despite the fact that only a small portion of the ECB’s foreign reserves were shifted to the yuan this time, it is an important beginning. It means that one of the world’s most important and influential central banks has faith in the RMB as an international currency. Serving as a reserve currency is the highest function of an international currency, and becoming a reserve currency of the ECB marks another milestone for RMB internationalization after its inclusion into the IMF’s currency basket of SDR.

Before this, foreign reserve systems of the central banks and currency-management agencies in emerging countries accounted for the majority of holders of the RMB as a reserve currency. The ECB’s decision will push the governments and private sectors in other nations to use the RMB on the international level, strengthening the RMB’s status as a reserve currency and solidifying the ECB’s partnership with the RMB.

European nations’ support for the establishment of the Asian Infrastructure Investment Bank (AIIB) as well as the ECB’s strategic support for the internationalization of the RMB all, to a great extent, can be attributed to the healthy development of China-Europe relations in recent years. China has been the second-largest partner of the European Union for years while the European Union has been China’s largest trading partner as well as its largest provider of technology.

China has supported Europe in European integration and the European debt crisis. The European Union also supported the inclusion of the RMB in the IMF’s SDR currency basket. The anti-globalization attitudes of Donald Trump’s administration have further strengthened the willingness of major European nations to promote global governance by uniting with China.

Before the ECB announced its decision, many nations in the world, including developed nations like Australia, had already included the RMB among their reserve currencies. China’s central bank also signed currency-swap agreements with most large nations in the world, confirming the reserve currency status of the RMB in a practical way.

The elevation of the international status of the RMB is a general trend that can be attributed to the increasing influence of the Chinese economy. China has become the second-largest economy in the world and gradually widened its lead over the third-largest economy. In fact, China has replaced the United States as the largest trader of commodities. Financially, China’s stock market is second only to the United States in terms of scale. Shanghai and Shenzhen are establishing themselves as major global financial centers. In addition, the AIIB and the “Belt and Road” initiative proposed by China have also greatly improved China’s economic soft power, presenting new opportunities for the rise of the RMB.

According to data released by the IMF, as of the first quarter of 2017, central banks around the world hold a total of $84.5 billion worth of RMB as their reserve assets, accounting for about 1 percent of the total foreign reserves of the world’s central banks. The proportion is expected to rise to 5 percent as other central banks will follow the breaking movement of the ECB.   

 

Challenges
The current international monetary structure is a hierarchical pyramid. The US dollar holds an overwhelmingly advantageous position over other currencies. The US dollar was barely affected by the US financial crisis and the rise of the RMB. It is still a dominating currency.

The euro is the second-most commonly held currency in the international monetary structure. However, the use of the euro cannot compare with the US dollar in terms of both functional domain and geographical spaces. The functions of the euro are limited to the euro zone and peripheral regions that are economically and politically connected with the euro zone. Although the international status of the euro has continued to rise since 2001, the European debt crisis in 2009 marked a turning point that cut the euro’s share of the worldwide currency reserve basket.
 

 

The British pound and the Japanese yen are at the third tier of the international monetary structure. The currencies at the fourth tier include the Swiss franc, the Canadian dollar, the Australian dollar and the Hong Kong dollar. However, due to the limited economic scale and political influence of the nations or regions that issue them, these currencies are unlikely to become major international currencies.    

The current international monetary system is still a highly hierarchical structure with the hegemony of the US dollar . This is the external monetary environment for the rise of the RMB, which is basically different from the pluralistic monetary structure in the post-World War I era, when the US dollar rose to the status of an international currency. The Chinese government hopes the RMB will one day surpass the Japanese yen and the British pound to match the status of the euro and be second only to the US dollar. Compared with its earlier growth of trade, China faces greater risks and challenges in its efforts to internationalize the RMB.

China faces the challenge of opening up. Elevating the RMB to a major international currency requires the Chinese financial market to open to global investors, which is far more risky than opening its commodity market. The bond market and stock market should allow larger-scale international investment, presenting challenges to China’s ability to manage open financial markets and maintain financial security. In the meantime, China should also grant transnational financial institutions easier access to its financial markets, which means fiercer competition.

Furthermore, the rise of China’s finance sector requires a large number of financial and technological professionals. However, the shortage of professionals is a common problem for both financial administrative departments of the Chinese government and private financial institutions. In addition, as China increasingly participates in international financial diplomacy, various global and regional financial organizations require more financial professionals from China, which the nation currently lacks.

Also, the rise of RMB requires a better decision-making system for monetary policies. China will be expected to be more responsible when making monetary policies should the RMB rise to the status of an international currency. Having established a good reputation for its management of the RMB and preliminarily won the trust of the international market, the People’s Bank of China (PBOC), China’s central bank, has a long way to go before it can establish itself as a global central bank, like the US Federal Reserve. The PBOC should increase transparency and the authoritativeness of its policies. China’s current legal system is insufficient to support the RMB as a major international currency.

The RMB also faces competition from other currencies. The RMB, as an emerging currency on the international stage, will no doubt impact the international monetary system, which is currently dominated by the US dollar, euro, British pound and Japanese yen. The issuing nations of these currencies will inevitably take actions to defend the share of their currencies in the worldwide currency reserve basket.

Considering the tremendous scale of China’s economy and increasing geopolitical influence, the rise of the RMB will have more influence than the rise of Japanese yen decades ago, possibly presenting a more comprehensive threat to the hegemony of the US dollar. As a neighboring nation of China, Japan is also worried about the expansion of the RMB’s influence in the Asia-Pacific region.

Last of all, the geographical challenges are worthy of attention. The rise of the RMB is both an economic and political phenomenon. Countries in East Asia commonly have an ingrained fear about a perceived Chinese threat in the military, political, financial and economic domains. Theoretically, an international currency can be employed as an instrument of national power in pursuing other interests and targets. Therefore, China should pay great attention to the possible geopolitical consequences of the rise of the RMB. In addition, how to win more political support for the rise of the RMB by conducting positive and enterprising monetary diplomatic activities is also a major geopolitical challenge faced by China.   

 
Li Wei is from the School of International Studies at Renmin University of China.