Renminbi Rises

Myths, hypes, and realities of RMB internationalization and reforms in the post-crisis world

Book by Chi Lo

Review & Article by GlobalMacroForex

This book was written in 2013, so it was before China’s equity declines in 2014-5.  However, Chi Lo still lays down the case fairly well for the pros and cons of internationalization of the RMB as well offers some charts that give predictive information into China’s economy.   This book touches on many of the similar themes to Gaining Currency by Eswar Prasad, so I won’t be repeating the basics I laid out there.  Instead, I will be focusing this article on what knowledge Chi Lo presents that is different from other books of the same type. 

Let’s dive right in…

Positives for Renminbi

Central to Chi Lo’s bull arguments for the Renminbi is the structural decline of the rest of the world.  He argues the United States is marred in the massive household and government debt with a bad trade deficit that is unlikely to improve the outlook for the US Dollar.  The European Union is crumbling apart as each country is unable to abide by the original conditions set forth in the Maastricht Treaty.  In addition, Japan is in a downward spiral from 2 lost decades after a stock and real estate bubble.

Chi Lo (like others) points to the rise in Hong Kong RMB deposits and the huge rise in trade settled in RMB.  In addition, he points out how other Southeast Asian nations’ currencies used to be more correlated with the USD, but now they trend with the RMB.  These correlations reflect the growing influence of the RMB on the world stage.

Negatives for Renminbi

Chi Lo notes a lot of problems for China’s currency going forward.  Even though this book was written in 2013, most of these criticisms are still relevant.

The Renminbi NEER (which is the currency against its trading partners) has been declining as the RMB rose against the USD.  Therefore, Chi Lo questions the ability of the Chinese to have the RMB rise against a basket of their trading partners as it could disrupt exports to them.  However, I disagree with him and I think that it would enable a transition to domestic demand if the government doesn’t stimulate with Central bank easing.  If the government would allow this is the bigger question because the transition would not be so smooth.

As we discussed in the Gaining Currency by Eswar Prasad article, the biggest roadblock for Renminbi internationalization is the closed capital account.  Chi Lo also stresses that once the capital account is opened, there is the potential for a large amount of outflow because onshore money is already trying to get out.

While Chi Lo also stresses the over-invoicing of Chinese imports, which as we discussed previously in my article on Gaining Currency by Eswar Prasad, this is calculated by taking the value of Chinese imports reported to the Chinese authorities compared with the export prices reported to the European and American authorities.

And how RMB deposits in Hong Kong do have predictive factors for the Renminbi’s value, but it’s not been a one-way ticket up.

One of the equity market liberalizations I discussed in my article on what makes China’s equity markets unique is the QFII program, which lets foreigners invest in mainland China’s A-shares.  While in the previous book, Gaining Currency by Eswar Prasad, he thought this was positive in that it’s giving more assets for foreigners to want to invest in with the Renminbi.  Chi Lo considered it a negative because it sucks liquidity from the offshore markets back to the mainland.  While I agree with Chi Lo that it does suck liquidity back, I disagree that it’s an overall negative because in my personal opinion, having assets to invest RMB into is vitally more important to have foreigners even want RMB to begin with.

International Comparisons

Chi Lo compares the process of RMB spreading offshore with the rise of the USD and Great British Pound to internationalization.  He outlined the path the US/UK took and tells the RMB will follow as:

First) Their currencies were the most frequently used in international trade as a medium of exchange and a unit of account

Second) As importance [of the currency] becomes entrenched in the global system, it will then be taken as the anchor of exchange rate by authorities abroad

Third) Growing transaction demand for money (RMB) by the international community will create precautionary and speculative demand for the RMB.  Now it functions as a store of value.

Chi Lo questions the idea that just having trade settled in RMB is enough to have it be internationalized.  He points to the experience of the Japanese as proof you don’t even need trade settlement to rise in global reserve status.  As the Japanese yen rose to the world stage, they frequently would prefer to settle trade in USD, this is because Japan would outsource assembly to other countries in southeast Asia.  Those countries would, in turn, export to America, so by settling in USD, it avoids having any forex risk. 

Chi Lo points out how Japan managed to secure a prominent role as the third most liquidly traded currency and third largest in most Central bank reserves.  All of that without significant trade settlement, as this chart from in 2010 shows,

On the other hand, China (without having an open capital account and lacking in political reforms) wants to push through to the internationalization of the RMB primarily through trade settlement.  Chi Lo questions if that’s possible.

One point I strongly disagree with Chi Lo on is he argues the Renminbi’s internationalization would benefit if China had a trade deficit.  His argument is that by having more RMB flow out of the country from a trade, it would give foreigners liquidity and access to RMB.  He points to China’s trade deficit with the rest of Asia, and the rise of Hong Kong and Singapore as offshore RMB trading centers as proof that this liquidity is the key factor.

Diagram: Chi Lo points to China running a persistent trade deficit with other southeast Asian economies, this is providing them with RMB liquidity:

While China runs a trade surplus against America and Europe:

I disagree with Chi Lo on this issue of the trade deficit being good for the RMB liquidity.  To do offshore trading, you actually don’t need to physically have RMB.  In a free market, you can just have offshore banks assets as claims to a mainland RMB demand deposits.  To understand how this works, check out my article on how the Eurodollar market works and you’ll see that Eurodollars don’t come from US trade deficits but from fractional reserve banking on claims to demand deposits with US-based banks.

The real problem is China’s closed capital account would not allow for a system like the Eurodollar, so instead Chi Lo shifts the blame to China’s trade surplus saying it isn’t “providing liquidity”.

Chi Lo points to Wenzhou as proof that China isn’t ready to rapidly liberalize the financial account.  Wenzhou is a city in southeastern China where microcredit lending had been liberalized in an experiment by Chinese authorities.

According to Chi Lo, this produced rampant underground finance, which threatens the ability of the government to loosen the system.  I disagree, I think these microcredit firms overextended themselves because the region is so starved for credit and the government mandated interest rate margins are artificially distorting the environment.

Unfortunately, due to loan quota restrictions currently in place, mainland banks can only lend a certain amount and state-run enterprises take the lion’s share of those loans, leaving smaller firms to rely on riskier things like Wenzhou microcredit shadow banking.  I think the answer is to open the capital account so foreigners can lend if the state banks are unwilling.  What Chi Lo is advocating is not exactly clear, because he complains about Wenzhou liberalization but a few pages later he complains that nonstate companies are starved of credit, which is a result of the current intervention.

Chi Lo points out how when interest rates were liberalized it squeezed bank margins,

Having state-mandated interest rate margins as cushions for bank profits increases systemic risk by creating an artificial (non-market) loan allocation which exposes it to larger malinvestment risk.  Malinvestment combined with the artificial stimulus is the real cause of bubbles in a fractional reserve banking system.  As we’ve seen with the Japanese bubble, all governments do a bad job at allocating resources, especially bank credit. 

Chi Lo presents the “impossible trinity” that the Chinese authorities are now presented with.  Under this scenario, the government has to choose between 2 of the 3 options: monetary autonomy, fixed exchange rate, and an open capital account.

I agree with Chi Lo that it’s impossible for the government to do all 3 of these separate things.  Monetary autonomy meaning the Central bank can stimulate the economy and act independently of any political process.  Fixed exchange rate meaning a rate that’s stable to the USD or other trading partners.  And an open capital account meaning unrestricted flows across China’s borders.  The reason this combination is impossible is that by having an active Central bank (if there are unrestricted flows) then the exchange rate will move with market forces.  So China’s leaders have to pick what their priorities are and so far the capital account remaining closed has been their choice.

Chi Lo points out how the CNY/CNH bond market segmentation decreases liquidity of market by having different regulatory needs.  I covered this in my article on the difference between Panda and Dim Sum bond markets.  Chi Lo says the reason for the differences in the CNY/USD and the CNH/USD rates is because the CNY/CNH can’t be arbitraged directly.


Chi Lo does an excellent job at presenting the pros and cons of renminbi internationalization.  In this article, I focused more on the negatives because those stood out as different than the previous information I covered on the same topic.  However ultimately, Chi Lo thinks it will be easier for China to displace Japan and the UK as the third largest reserve currency then it will be for it to displace the USD or Euro.  He argues the USD has too much momentum working in its favor now and the hardest reforms for China are still ahead.  He says the RMB could go to the #3 spot with relatively little reform, but major reform would be needed to make progress beyond that.