Will Market Volatility Hobble Renminbi Internationalization?

Since the renminbi's exchange rate reform in August of last year,market expectations for the renminbi have undergone a significant change. A perception of future appreciation or relative stability has been replaced by expectations of depreciation. Not until March or April this year,did we see an easing of the downward pressure on the currency and a slowing of capital outflows.

Changes in expectations for the renminbi exchange rate also aroused domestic and global concerns over the prospects for the currency's role on global markets. Based on the experience of the Japanese yen,we can see that admission to the elite club of global reserve currencies is not enough to win international recognition. The currency needs to see a continued expansion of its global reserve status. When the Japanese yen was appreciating in past years,it showed continued gains in its use as an international reserve currency. However,its depreciation starting in the 1990s,particularly after the Asian financial crisis,led to a reversal of those gains and its role in the international arena declined. Since then,the global status of the yen has not really improved. From that we can tell that depreciation and expectations of further depreciation are usually not conducive to promoting a greater role for a currency. So,will depreciation expectations mean a declining role for the renminbi on the world stage? The answer could be "no",because the renminbi's situation is quite different from that of the yen.

Currency Volatility

Experience shows that the internationalization of a currency does not necessarily require current account convertibility,capital account convertibility or even capital account liberalization. Nor does it require the deregulation of foreign exchange management or free-floating exchange rates. When the pound and the US dollar took on their roles as global reserve currencies,they did not meet these requirements; their exchange rates were fixed. Both of these currencies were linked to gold and their respective governments promised that the currencies could be exchanged for gold at any time.

However,things changed with the disintegration of the Bretton Woods system.

For a paper currency to serve as a reserve currency these days,it must have international credibility and broad acceptance from the international community. That means it must be widely used outside the borders of its home country. For that reason,it should be convertible under the current and capital accounts. Otherwise,the international community will make use of other currencies that are convertible. During the currency internationalization process,we must allow the free float of the exchange rate and domestic interest rates. Without liberalization of exchange rates and interest rates,we will not have real markets in these key areas as international financial transactions depend on this kind of trade. This shows that,with the developments and changes of the global economy,new requirements have emerged for currency internationalization. After being admitted to the International Monetary Fund's Special Drawing Rights basket,it is necessary to realize capital account convertibility,allow cross-border capital flows and let the exchange rate of the renminbi move freely. The exchange rate reform of August 2015 was actually an effort to promote internationalization of the renminbi. Of course,the expectations for further depreciation of the exchange rate had a dampening effect on internationalization,and there will be delays in that effort as a result. Nevertheless,we should recognize the fact that the expectations for renminbi depreciation are a reflection of the inability to adjust to new circumstances. That is essentially different from the depreciation expectations in more mature markets. Therefore,we cannot simply assume the renminbi will depreciate further; we need more time to assess the situation.

Exchange Rate Fluctuations

Why has the nation's renminbi exchange rate moves led to market volatility? That is largely because of the changes we have already seen in the exchange rate mechanism.

First,it reflects the easier cross-border flows of capital. Currently,on institutional and policy levels,foreign currency and renminbi accounts can be opened abroad and payments can be made in foreign currency and renminbi. Funds can flow across our borders,and this is to ensure that there is a smooth return of at least some of the renminbi parked offshore. Renminbi and foreign currency held offshore can be used for direct investments in China,and can be used to invest in the interbank market,as well as the stock and bond markets. Regulations that restrict cross-border capital movements have been rolled back and controls on exchange rate and interest rate arbitraging have been pared back. That is to say,through cross-border capital flows,the renminbi is now convertible abroad,and is basically convertible in China. That makes exchange rate and interest rate arbitraging possible. Thus,current exchange rate depreciation expectations are a result of an institutional opening up. They are a market reaction to the initial stage of renminbi internationalization,and not necessarily an indication of a future trend.

Second,exchange rate speculation has been permitted,and it has little to do with the process of internationalization. At the time of the Asian financial crisis in 1997-1998,China committed to holding its exchange rate firm despite the big devaluations of other currencies in the region. And China's policy makers kept their word. China also maintained a stable exchange rate during the 2008 US subprime mortgage crisis.

After August 11,2015,China's exchange rate pricing mechanism was changed from a call auction ahead of the opening of trade to one that used bidding based on the previous day's closing price. The reference system for the pricing of the exchange rate was also changed. Especially after the decision to let the renminbi join the IMF's Special Drawing Rights,or basket of reserve currencies,the central bank reduced administrative management over the market,and speculative forces were gradually strengthened. The different exchange rate expectations from domestic and foreign markets inevitably were reflected in the market's behavior. In short,it was the allowance of speculative trading through cross-border capital flows that ensured the realization of market expectations. Volatility and even severe volatility were the inevitable result in the financial markets. However,speculative capital could not be allowed to run roughshod over the market. The central bank still controls and regulates trading when necessary. In the test of strength between the market and policy makers,there are risks for both sides. For now,the downside risk to the renminbi exchange rate is not severe. In the early days after the euro's creation,for example,annual exchange rate fluctuations reached 15% to 20%,but that did not affect the new currency's widespread acceptance on global markets. The annual range of fluctuation of the renminbi is relatively small,and we should not assume this movement will interrupt renminbi internationalization.

Third,it takes time to adapt to the  renminbi exchange rate mechanism. In the months after the August 2015 devaluation,the renminbi's exchange rate against the dollar continued to decline. The central parity rate weakened from 6.11 to the dollar to around 6.57. The unusually large movement (for the renminbi,at least) in the exchange rate undermined traditional expectations for a steady market rate. In fact,it could take two to three years for the market to adjust to the new situation. The emergence of speculative trades that anticipate a depreciation is therefore normal. After a period of time,the media will no longer exaggerate what is normal behavior for the currency. During the European debt crisis,there were many forces shorting the euro. But European policy makers kept a cool head and a steady hand,and the European central bank stepped back from a volatile market. We too should accept exchange rate volatility. We need to gradually accept this situation. Once the market gets used to movements,the concerns over the international