Berkeley Economics and Political Science Prof. Barry Eichengreen : The Renminbi’s Grand Tour

Both announcements were greeted with great acclaim. British Chancellor George Osborne hailed the creation of a London clearing bank as “hugely important” for the financial future of the City. Joachim Nagel of the German Bundesbank lauded the Bank of China announcement as a “milestone on the road toward creating a renminbi trading center in Frankfurt.”

We should expect these kinds of enthusiastic pronouncements from European officials, who are desperate for good news, whatever its source. But should the rest of us care? After all, banks, firms, and even individuals already can buy renminbi for their pounds and euros. A range of financial institutions, both locally and in Hong Kong, have long stood ready to provide this service.

The only difference is that the two big Chinese banks, when doing business in London and Frankfurt, will be permitted to purchase renminbi in China itself when their foreign customers demand it. The People’s Bank of China (PBOC) will give them a quota for this purpose. Other banks, when seeking to provide renminbi to their clients, are limited to bidding for the fixed supplies that circulate offshore. This raises their costs and limits demand for their services.

Thus, by permitting two clearing banks to access renminbi onshore, Chinese officials are effectively subsidizing their London and Frankfurt operations and encouraging direct sterling and euro trades.

But London and Frankfurt would be reckless to bank on rapid growth in their renminbi transactions. In its most recent survey of foreign-exchange markets, in April 2013, the Bank for International Settlements found that renminbi-dollar trades averaged $113 billion a day, whereas direct renminbi-euro trades totaled a mere $1 billion, while direct renminbi-sterling trades amounted to even less.

In practice, when Europeans want China’s currency, they use their euros and pounds to buy dollars, and then use those dollars to buy renminbi. This reflects the fact that the market in dollar-denominated assets is exceptionally deep and liquid, which limits transaction costs. In other words, European practice reflects the dollar’s “exorbitant privilege” as the only true global currency, freely accepted by currency traders and investors in China and around the world.

Chinese officials presumably believe that this situation will change over time. Once banks offer new assets denominated in renminbi, more customers will be drawn into the market, thereby adding liquidity and reducing transaction costs for purchases of renminbi in European currencies. The dollar’s asymmetric role will be superseded. At that point, the renminbi, the euro, and sterling will all play consequential international roles.

Thus, the decision to designate renminbi clearing banks in London and Frankfurt is, in effect, one more step by China to foster the emergence of an international monetary system with several global currencies, not just one. It is a step toward creating a better match between our multipolar global economy and its monetary and financial system – and thus a step toward ending the world economy’s dependence on the dollar, which European and Chinese policymakers have complained about since the global financial crisis erupted in 2008.

But it is only a step. Deep and liquid markets are not built in a day. In June 2013, when the PBOC unexpectedly tightened monetary policy, domestic interbank interest rates shot up to 25%. Thus, even a quota that permits an offshore clearing bank to tap funding in China does not guarantee that it can obtain that funding at a reasonable price.

Moreover, if China develops financial problems, capital outflows may accelerate. The Chinese authorities may then be forced to tighten the quotas made available to the clearing banks. Market liquidity would be a casualty.

One can also question how much appetite European investors will display for renminbi-denominated financial assets. In the past, demand for such assets has been fed by the expectation that the renminbi will continue to appreciate. If Chinese growth slows, such expectations might well dissolve.

There is no doubt that, with time, the renminbi will acquire a more consequential international role. Twenty-first-century financial technology will facilitate direct trading in a variety of different currencies, eliminating the need and custom of routing virtually all international transactions through the dollar. Ultimately this will spell the end of America’s “exorbitant privilege.” Just not yet. And not anytime soon.