China internationalize only when wise(2)

But this trend is now gradually reversing as the renminbi exchange rate has now reached equilibrium with the US dollar, and as the Chinese economy slows down and its capital account surplus is reduced, there is now depreciation pressure on the renminbi and an outflow of renminbi.

Yu says that although many economists believe such renminbi outflow will affect the renminbi internationalization process, that China should further stabilize the renminbi exchange rate to encourage renminbi internationalization, this is not the correct attitude.

In the face of these challenges, Yu says, it is important to reflect why China wants to internationalize its currency in the first place, which Yu summarizes as having five key goals.

The first is to reduce currency exchange risks, the second is to help China's financial services industry grow and become internationally competitive, and the third is to reduce China's large accumulation of foreign exchange reserves.

The fourth is to reduce the costs of exchanging renminbi with other currencies, and finally there is the hope that the renminbi can become a global reserve currency.

Yu says many of these goals have been somewhat achieved by China's renminbi internationalization, such as the internationalization of China's financial services industry, but more of the objectives have not yet been well achieved.

For example, the goal of reducing renminbi exchange risks for international trade has not been achieved thoroughly because much of the international trade is not yet being transacted in renminbi. China's foreign reserves accumulation has also not been reduced, but actually increased due to speculative inflows.

The goal of helping renminbi to become a global reserve currency has experienced some milestones, as several foreign central banks have now decided to hold a small proportion of their foreign reserves in renminbi.

However, the gain from carry trade from holding the renminbi is one key motivation for such measures. This means China is paying out a large amount of interest to foreign central banks for holding its currency over the years.

"China has gained a lot from its currency's internationalization, but such progress is also made with significant costs," Yu says.

He says China should not completely open its capital account controls, as currency stability is an essential part of having a stable economy.

One major issue for China currently is its high M2 to GDP ratio, meaning much of the country's money is concentrated in the hands of a few, and opening up capital account controls too quickly could lead to capital flight, Yu says.

"Although there are no actual figures, there is a lot of anecdotal evidence that many corrupt officials are putting their money offshore, in jurisdictions like the Virgin Islands or Cayman Islands. This could generate a very large capital outflow if adequate controls are not put in place."

Although China's central bank has previously set a target to make the renminbi partly convertible by this year and fully convertible by 2020, Yu believes the mindset of having such a target is not right.

Instead, the correct method is to segment different market players' needs, encouraging foreign direct investment flows into and out of China when there is a real economic need for such flows, but restrict speculative flows.

In the long term, Yu says the renminbi needs to be fully convertible for it to be a global reserve currency, because a reserve currency is one that can be freely traded by those who hold it, so it requires high liquidity.

And in the short term, it is still important for the Chinese central bank to use exchange rate controls to stabilize economic growth in reaction to monetary policies practiced by other international major economies, and the quantitative easing about to be implemented in Europe could be an example of this.

According to European Central Bank announcements last month, at least 1.1 trillion euros will be injected into the ailing eurozone economy, and the program is expected to start next month.

"The QE in Europe could have very negative consequences for the Chinese economy, and it is our priority to guard our economic growth against such big shocks.

"We are already in a currency war. So either we have international coordination to have no intervention by governments in our financial markets, or alternatively we will need to intervene to reduce adverse effects on our economy that other countries' monetary policies are causing," Yu says.