As Fukuyama was visualizing his ‘End of History’, a giant was stirring–awakened by a unique set of reform policies which liberalized the economics but not the politics of governance. The subsequent rise of China has oft been documented by admirers as also its critics. China is today the world’s second largest economy—a GDP of around USD 11 trillion or 15% of world GDP and 12% of world’s trade. It helped minimize the effects of the Asian Financial Crisis by refraining from competitive devaluation and, post the Global Financial Crisis of 2008, it represented, for a large swath of emerging market economies in Latin America/Africa/other Asia, the only remaining engine of global growth. While it undoubtedly still lags behind the US economy by a wide margin, its lead over the next largest, Japan, is equally wide.
An aspect of China, not often discussed is that barring the forced devaluation experienced in 1993/94 when it suffered a foreign exchange crisis, it has never devalued its currency. The former long-time critic of globalization/ liberalism/capitalism in the early post-revolution decades till the 80s,
it not only joined the WTO in 2001, but also went about far more whole-heartedly implementing not only the explicit, but also the required implicit market liberalizations to secure historically unprecedented trade and commerce growth. It consequently received a flood of Foreign Direct Investment inflows and is often called the Factory of the World. Its domestic currency, the Renminbi (RMB), was not used for trade settlement till the turn of the millennium and only accounted for 0.3% of world trade settlement till 2011 but is now around 2%, (over USD 1.3 Trillion or 30% of China trade) making it the fifth most important payment currency. It was recently recognized by the IMF as the world’s 5th reserve currency.
The resultant analyst conjectures regarding the prognosis for China have varied, oftentimes wide-eyed with excitement but more often predicting the fall. This book falls in neither camp. It evaluates the China story, post the rise, using the prism of its financial sector; depicting in the process the professionalism of its economic reform and the interconnections linking China’s growing economic strength, its expanding international influence and the rise of its currency, the (RMB) to its recent status of an international reserve currency. The nuanced approach nevertheless lands up on the shores of the politics of governance and the limitations it poses for the future trajectory of the China story.
This book is the second offering by the former head of IMF’s China division who, in the words of Ben S. Bernanke, is a ‘leading expert on International Finance’. Eswar S. Prasad, the Tolani Senior Professor of Trade Policy in the Dyson School at Cornell University, holds the New Century Chair at the Brookings Institute. The book is easy to read. The essence of the argument can well be understood in a quick skim of its short preface and equally short ‘conclusion’ chapter. However, a detour into the remaining chapters, packed as they are with information and anecdotes, often taking time to explain, in very readable language, several concepts underlying international finance, would be more rewarding, both for the lay reader and the serious academic. The takeaway would be a better understanding not only of China’s behaviour but also the dynamics and politics of the current international economic order.
The book begins with a brief history of the evolution of Chinese paper currency, the world’s first fiat currency, the internal debates it generated, the twists and turns on its way and even why RMB notes look as they currently do. The views debated some 1000 years ago, regarding the pros and cons of paper currency notes, still echo in various parts of the world. However, doubts notwithstanding, it became a ‘fiat currency’ by the time of Kublai Khan, the grandson of the legendary Genghis Khan, because none dared, ‘at the peril of his life refuse to accept it in payment’.
The second chapter, ‘Currency Concepts’, discusses how the internal and external concept of ‘value’ of a currency differ, how currencies fluctuate in value often simultaneously weakening against some but appreciating against other currencies and what it implies to the domestic economy. In the process, the reader is also taken through the intricacies of currency management, the international trading systems, ‘off shore’ and ‘onshore’ exchange rates etc., with the help of simple illustrative examples. It delineates three related but distinct aspects of RMB’s role in the international monetary system—that of capital account openness, usage as an international means of exchange or ‘internationalization’ and usage as a ‘reserve currency’ or holdings by other Central Banks as a protection against a balance of payment crisis. On the way, discussions on ‘current account’ versus ‘capital account’ convertibility and free floating exchange rates versus managed rates versus ‘pegged’ rates and IMF rules also find place.
The chapters on ‘Capital Account Opening’ and ‘The Exchange Rate Regime’ document the evolution of China’s capital account openness. The author brings out that the policy intent behind China’s ‘opening process’ was not the traditional desire to access foreign financing to spur growth. Instead, the driving force was more oriented towards introducing, indirectly, a catalyst to spur domestic reform. Illustratively, permitting entry to foreign banks creates competition for domestic banks making them conscious of the need to improve efficiency via internal reform. Another equally important driver was the embarrassment created by their own trade success. This started creating large foreign currency surpluses. However, China witnessed a paradoxical situation of having large negative ‘net’ investment income flows despite having foreign currency asset holdings substantially larger than their foreign currency liabilities (Even in 2014, the Chinese positive Asset/Liability gap was over USD 1.6 Trillion but a ‘net’ investment income negative by over USD73 Billion). USA shows a reverse behaviour. In a sense, they are losing cash. This resulted in a realization that ‘returns’ could only improve through a more efficient outward investment mechanism of the generated cash surpluses. This, in turn, implied permitting systematic corporate investment activity overseas, thus a more open capital account.
Two factors determine how open a country’s capital account is to inflows and outflows. The first, the de jure, relates to legal requirements on flows, which can range from simple registration or reporting requirements (such as the US requirements that every entrant, citizens or visitors, must declare if they are carrying more than USD 10,000 in cash) to more severe restrictions or ‘capital controls’ (such as the Indian stance regarding acquisition of domestic firms in some sectors). The second, the de facto, relates to the actual ground reality of enforcement and interpretation.
In the de jure sense, based on an IMF measurement index, China’s scorecard reads like India’s. But, the reader thereafter is taken on a guided tour of the changes witnessed in the currency, equity and bond markets and in their trading rules through which China has been systematically but selectively and cautiously allowing capital to flow more freely, even if not fully. A methodology best likened to ‘learning by doing’. The combined impact of the rapid economic growth and ‘opening up’ of capital flows resulted in a 6-fold increase, post 2005, in the value of China’s foreign currency balance sheet to USD 11 trillion. Also, an inversion occurred in the relative shares of ‘official reserves’ and ‘other overseas investment’.
The next two chapters, ‘Promoting International Use of the Currency’ and ‘Reserve Currency’ discuss the mechanics and politics of international payment and settlement systems (the Russian plight after Master Card/Visa blocked even their domestic card settlements post US sanctions in response to Crimea also finds a place) while detailing the process by which RMB became the world’s fifth reserve currency with a 10.9 % weight in the basket used to determine the value of SDRs issued by the IMF. It is brought out that even prior to the IMF decision, RMB had started being used as a reserve currency by several of its trading partners. The China National Advanced Payment Systems (CNAPS) and China International Payment Systems (CIPS), Dim Sum and Panda bonds and Offshore RMB clearing systems and direct bilateral clearing arrangements, are all discussed along with the various aspects that determine a reserve currency, the associated dilemmas, internal reform measures, bilateral SWAP arrangements.
In the 1980s China had an ‘official ‘exchange rate and a separate rate in the official swap centres where demand/supply was permitted to determine the currency value. The official rate became overvalued resulting in a near complete depletion of hard currency reserves by 1994. This forced a devaluation. Concurrently, the two rates were unified and pegged to the US dollar till 2005. In 2005, China dropped the peg and began implementing a managed floating exchange rate mechanism with the currency value determined by market demand and supply and against a ‘basket’ of currencies, not just the US Dollar. In this, on a daily opening trading rate with a permitted intra-day volatility of 0.3% was announced by the central bank. In 2007 the band was widened to 0.5% and then to 1% in 2012. In 2013, full capital account convertibility was first permitted in the ‘Shanghai FTZ’—a small zone within Pudong but outside its financial district. While completely liberalized operations for financial institutions located in the zone is permitted for all FTZ activities and with the rest of the world, they cannot deal with other parts of China, even within that very same city. In 2014, the currency trading band was widened to 2%. In 2015, the FTZ was expanded to include the Pudong Financial District but not to other parts of Shanghai. However, simultaneously three more such FTZs were started in Guangdong, Tianjin and Fujian but again, in small earmarked sections of these cities. In terms of actual values, the RMB had remained constant at 8.27 to a dollar till 2007 where after steady appreciation in rates occurred. In aggregate, by 2014, RMB appreciated by 25% against the US dollar in monetary terms and by 30% in terms of trade weighted exchange rates. In August 2015, the currency was permitted to be fully market determined, thereby complying with a long-standing IMF requirement. Concurrently, China witnessed a stock market crash and a currency depreciation/devaluation igniting fears across the world of a Chinese ‘hard landing’ being witnessed.
The final three chapters, ‘The Mirage of Safety’, ‘Could China Stumble?’ and ‘Rising Global Influence’ explore the above issues but also what makes currencies acceptable in the absence of a ‘fiat’. In the process the reader is taken through an entertaining tour of the world of perceptions, and the importance of perceptions in economics and politics to evaluate the future possibilities for RMB as a settlement and reserve currency. The realm of shadow banking and wealth management products but also the challenges of economic slowdown, the NPA problem as also the growing mountain of public Debt, BRICS Bank and the Asian Infrastructure Investment Bank, the ‘Belt and the Road’ initiative and the implications of China’s political legacies and the personality traits of President Xi Jinping are all visited, with copious information, documentation, data and anecdotes. In the process, the book dispels notions regarding both the ‘collapse’ and ‘world dominance’ visions of the Chinese future. The NPA/Banking health/public debt problem, though large and troubling, are all shown to be within manageable range. The management of the various Chinese regulatory institutions are shown, with illustrations, to be professionally competent.
At the same time, exigencies created by politics and political legacies exist. The perceptions of independence, transparency and predictability are important aspects which govern levels of trust and thus, via generated confidence, dependence. In a global setting, this places limitations to the extent to which RMB could currently find acceptability in international holdings and usage. Then again, as the size of an economic system increases so does its complexity. The challenge of ‘managing’ or ‘influencing’ the increased heterogeneity of ambitions and desires of individual economic agents also rises in complexity. This in turn brings about an ever-increasing need for institutional independence and the ‘rule of law’ to ensure perceptibly impartial predictability and safety. The sheer increase in scale due to past successes also exposes the system to experiencing increased turbulence created by externally generated events and ‘interpretations’ of what ‘was managed’ becomes ever increasingly more important. What was thus once the mainstay of a ‘strong government’ now inexplicably, but surely, moves into the province of a ‘constitutional democracy’ and the earlier ‘strengths’ thus get converted into brittleness. Herein lies China’s challenge.
T.C.A. Ranganathan, an alumni of the Delhi School of Economics and a former CMD of Exim Bank, is currently a freelance writer.