By Zhang Yimin

China has enjoyed a surplus in international trade for many years. At the same time, it has experienced a surplus of capital projects for many years. Such dual surpluses have left China with huge foreign exchange reserves which, in turn, have led to a fundamental problem of whether it’s better to have more foreign exchange reserves. The answer is no.

Currency issuance is the most important in monetary policy. Does the People’s Bank of China (PBoC) over-issue currency? No. The value of collaterals is equivalent to that of currency, so there is more currency when there are more collaterals. The PBoC is not over-issuing, there are just more collaterals. But, where do these collaterals come from? Obviously, the biggest part comes from foreign exchange reserves.

Under the previous monetary policy, RMB issuance was mainly based on foreign exchange reserves. The PBoC’s power to print money was largely dependent on the inflow and outflow of US dollars. In this sense, RMB was not an independent currency, but a “sub-currency” attached to the US dollar – a situation which was adverse to the internationalisation of the RMB. As such, the first step in the reform of China’s currency issuance mechanism was to get rid of its dependence on foreign exchange.

Since 2015, China has relied on a new mechanism, namely, the mortgage of commercial banks’ credit assets. The PBoC allows commercial banks to refinance with credit assets, which gives financial institutions more active claims, and this part will become bigger and more important in the future.

An independent exchange rate formation mechanism

If you ask people what the RMB exchange rate is, the first thing that comes to their minds is likely to be whether the current exchange rate is 6.8 or 6.9 RMB per dollar. This is the exchange rate of RMB against the US dollar, and not what we call the “RMB exchange rate.” This misunderstanding stems from a habit we developed over a long period – namely, the dependence on the US dollar. If you continue to ask what the exchange rate of US dollar is? The answer is that the exchange rate of US dollar is what is called the “US dollar index.” It is the index of US dollar against a basket of six world currencies – not including the RMB – and that is why the RMB and the US dollar are not on the same footing.

The RMB index, which was 100 at the end of 2014, is about 95 or 96 now. From this, we can see that although there are a lot of changes in the exchange rate between the RMB and the US dollar, the RMB index is very stable and has actually experienced a slight decrease. This is because the RMB has a basket of currencies as reference for it. While the US dollar appreciates and strengthens, its related basket of currencies experience different degrees of depreciation against it, but, in general, the index has pointed relatively downward.

The reform of the PBoC’s exchange rate policy meant that we changed from anchoring the RMB to the US dollar to anchoring it to a basket of currencies. Moreover, since it was previously a fixed exchange rate, it was no wonder that when people mentioned the RMB exchange rate, they referred to its exchange rate against US dollar. Today, however, it is different. The current RMB exchange rate against US dollar just happens to be one exchange rate between two currencies with no particularity. It is a floating exchange rate like the stock market. Volatility in the stock market is normal, so is RMB fluctuation.

An independent global circulation channel

What do we mean when we say that RMB is going to be internationalised? What does an international currency look like? As a global currency, what kind of global circulation channel does the US dollar have?

When it comes to trade, the US trade deficit is the outflow channel of the US dollar. When it comes to investment, the US Treasury bond market is the world’s largest financial market to attract overseas funds and there are both inflows and outflows. Including the international trade, transportation and settlement of oil and commodities, the US dollar has realised overseas precipitation and circulation. This is the global circulation channel of US dollar.

The RMB, however, has not achieved such circulation. First, China is country with a trade surplus and, hence, with an outflow of goods and a net inflow of RMB from overseas. China also has an investment surplus with more RMB flowing in than going out. Global circulation, therefore, cannot be achieved. Moreover, a very important factor in RMB “going out” is global circulation and China’s task is to figure out how the RMB can go out through capital projects.

Over the past four decades, China has developed from a labour-intensive economy to a capital-intensive one. From the theoretical perspective of international comparative advantages, China may begin to export capital. China’s capital intensity was 1 unit in 2001, compared to 18 units in 2016, which means its capital expanded 18 times. With the overcapacity, overstock and surplus of capital, what China should do is to go out under capital projects and achieve the outflow of RMB through overseas investment and capital output, to realize the inflow of RMB through industrial output under trade projects and, in this way, ultimately achieve the global circulation of the RMB.

Zhang Yimin is a Professor of Finance at CEIBS. For more details about his research and teaching interests, please visit his CEIBS faculty profile here.