RMB Internationalization

Implications for U.S. Economic Hegemony

Policy Analysis Exercise, Harvard Kennedy School

Executive Summary

China has recently emerged as the second largest economy after the U.S., marking a remarkable turnaround from the undeveloped, largely agrarian society of only 40 years ago. With its growing size has come a desire to translate economic potential into global prestige and influence. A major part of this effort is the initiative to internationalize China’s currency, the renminbi (RMB), also known as the yuan.

While China’s economy has become a major force on the global stage, its financial system remains underdeveloped, and the RMB is a minor player in global transactions. Despite its economic prowess, China plays a minor role in existing international financial institutions relative to the West, spurring frustration with the current system. Perhaps more importantly, China has seen the danger of allowing the U.S. to own the global financial system and potentially weaponize it against China.

Beginning after 9/11, the U.S. has built an impressive toolkit for leveraging the centrality of the U.S. economy and dollar-denominated transactions to foreign banks, corporations, and nations in order to achieve political objectives. This has taken the form of sanctions and threats of sanctions against individuals, entities, and even whole nations, along with actions such as freezing accounts and expelling undesirable actors from ostensibly commercial institutions like SWIFT, the global payment messaging network. The U.S. has demonstrated a willingness to sanction not only rogue states like North Korea and Iran but also great powers like Russia. More worryingly for the Chinese, the U.S. has threatened to target their financial institutions directly unless they cooperate with its North Korean policy.

As a result, Chinese policymakers have called for an end to U.S. dominance and a new global currency controlled by the IMF, while simultaneously working to internationalize their own. To make the RMB more widely used as both a reserve currency and a means of transaction, China has relaxed onerous restrictions on its financial system, reduced government management of the exchange rate, and launched a number of new economic and financial institutions. These include the BRI, which aims to connect Eurasia through infrastructure investment, the AIIB, which is designed to challenge the Japanese-led ADB, and CIPS, which is designed to eventually replace SWIFT.

These measures have generated notable successes, including the recognition of the RMB as an official reserve currency by the IMF (meaning central banks stockpile it in their holdings). However, while the comparative gains have been great, in absolute terms, the RMB remains a minor player compared to the dollar, euro, yen, and pound sterling. The biggest hurdle to faster internationalization has been the inability of Chinese elites to manage the tension between executing the reforms necessary to internationalize the currency and maintaining the Party’s control of the economy so as to ensure stability. Although the Chinese government has bought into the idea of internationalization, powerful domestic factions remain opposed, keeping the most significant reforms out of reach. Furthermore, a recent tightening of capital controls after a period of reform has caused the RMB’s progress up the currency ladder to temporarily come to a halt.

Although China is likely decades behind replacing the dollar as the global reserve currency, internationalization is possible much faster given sufficient political will. Assuming a viable alternative is possible, there is pent up demand for a non-western dominated global currency, both from states politically at odds with the West and from the many recipients of China’s economic and development assistance. Should China succeed in internationalizing the RMB, it would be able to (most likely partially) shield itself and its trading partners from the stranglehold of the U.S. dollar system. If it successfully goes even further and replaces the dollar, it would enjoy many of the same perks the U.S. does today, including the ability to dictate global financial norms and shape global financial institutions, the ability to coerce other nations, and advantages for its banks and corporations.

To halt the ascendancy of the RMB, the U.S. could either take steps to undermine China or solidify the position of the dollar by taking steps to improve confidence in its economy, currency, and political decision-making. Attempting to undermine China through sanctions, trade restrictions, and exclusion from international institutions is a dangerous path with unpredictable consequences for both countries. Accordingly, the preferred path is to work on making the U.S. model more attractive by (1) Scaling back economic warfare (2) Passing predictable budgets and reducing deficit spending (3) Making international institutions more inclusive. Global reserve currencies, once at the top, have tremendous inertia keeping them in place. With wise policymaking, the U.S. can continue to occupy its dominant position for a long time to come.