Eswar Prasad on Chinese Monetary Policy – Past and Present

Eswar Prasad is the Tolani Senior Professor of Trade Policy and Professor of Economics at Cornell University and a senior fellow at the Brookings Institution. He joins the show to discuss his new book, *Gaining Currency: The Rise of the Renminbi,* which examines the rise of China’s currency, the renminbi (RMB), and its role in global finance. Prasad argues that the RMB is on the road to becoming a reserve currency, but it will not challenge the US dollar’s dominance as a safe haven currency. David and Eswar also discuss China’s interesting history as the first country with paper money and a fiat currency.

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Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Eswar, thanks for coming on the show.

Eswar Prasad: My pleasure, David. Thanks for having me on.

Beckworth: It's a real treat. I enjoyed your book and I followed your work, and it's great to read this. Also, it's a good time to be reading this book, given all the current events going on around us, the new president, who has some pretty strong views on China. Before we get into that though, I would love to hear how you got into economics, what led you down this path to become an international economist? What was your journey? In your book, you mentioned Robert Lucas, one of your teachers. Tell us about that journey.

Prasad: Well, getting into economics at one level was the path of least resistance. Because, in India, I came from a lower middle class family and education was seen as the way of leading to a better economic future. And I enjoyed economics in college, and then I got admitted to a good graduate school in the U.S., where I decided to keep going. And when I came to Chicago, I really developed a deep intellectual fascination with economics, and that's where I learned how economics can be very useful in terms of thinking about a multitude of issues beyond economics. Perhaps, we economists take it a little too far in terms of using our economic frameworks to understand and interpret real life, but I found that useful.

Prasad: After I finished with Chicago, I went to the International Monetary Fund because I wanted to do some work that was at the intersection of both academics and policy, and the IMF, at the time, was a very exciting place to work, it continues to be. The head of the research department at the time was Jacob Frankel, a very well known international economist. I went there and started working on a variety of issues. Now, when I went to the IMF, it turns out I didn't know very much about international economics, but after having spent about five to six years at the IMF, I decided I had to learn something about international economics finally. And there is no better way to learn than to try to write papers. So, that's what I ended up doing. And of course, the training I received at Chicago including through my advisors, Lucas, Robert Townsend and Michael Woodford came in very handy in thinking about these issues.

Prasad: And, over time, both my policy work and my academic work have come together in a nice way. And right now, of course, the work I do, which is in international finance, related mostly to exchange rates and capital flows, with an emphasis in emerging markets, brings together a lot of my interest in international finance, monetary economics, and basic macroeconomics. So, it's been a nice journey to where I am right now.

Beckworth: Yeah, you've been very productive. But it's interesting, you kind of cut your teeth on international econ and international macro with the IMF. It's a real world analysis, real time. I mean, that's fascinating.

Prasad: The IMF was a wonderful place to do international economics because not only where they have a very well-trained PhD economists, but there were issues all around you. So, there was no dearth of research topics, just going to the cafeteria and talking to a few people standing in line for their coffee, you'll get a ton of ideas. And most of the people at the IMF didn't have the time to work on those ideas. Being in the research department, I had the luxury of having time to work on those ideas.

Beckworth: I was briefly at the U.S. Department of Treasury and International Affairs, when John Taylor was there, and the research department at the IMF is seen as this lofty, this revered part of the IMF for lots of good research was coming out of it and stuff, and good people were working. So, I have good recollection, good memories of interacting with that department as well. Well, let's get to your book. Again, a fascinating read, and you begin by going over the history of the Chinese currency. This is about the Chinese currency and the related issues surrounding it, but I want to talk about the history, because the history itself, I think, is pretty fascinating. So, you obviously did some work looking back at this.

Chinese Monetary History

Beckworth: And I think many people know China was the first place that had paper money, and it was first linked to some commodity, it wasn't just fiat money initially, you mentioned later that Kublai Khan was the one who innovated that idea, fiat money as legal tender. But you mentioned several interesting stories and things that I did not know until I read the book, among other things, when paper money was first created during the Song Dynasty, which was 960 to 1279 A.D., one of the reasons that comes about is because the Chinese developed a movable press. And you mentioned that this occurs four centuries before the Gutenberg press. And so, most of us in the West, we think back to great innovations, we think back to the Gutenberg press, but the Chinese apparently discovered that a long time before the famous Gutenberg press.

Beckworth: Was that shocking to you too? It blew my mind when I saw that.

Prasad: This whole chapter on the issue where Chinese economic history came up because I was struggling in trying to find a way to start the book. Once one starts talking about the capital account, exchange rate issues and so on, I was in more familiar turf. But I was struggling with how to start the book and I knew this fact that China invented the first paper currency, so, I started digging into it a little bit. And then I had a couple of undergraduate students from Cornell, Chinese students, who really got into the project and helped me dig up a lot of archival material, which is how this chapter came about.

Prasad: And to be honest with you, once I started reading about Chinese monetary history, I spent about two months doing just that, and I almost derailed this project because I was considering writing a book about Chinese monetary history, which is fascinating in and of itself. For instance, as I point out in the book, many of the monetary debates that we're having in these days, had their antecedents in the Confucian Era debates, even in 150 to 200 B.C., when many Confucian and non-Confucian scholars were debating the role of the state in issuing and preserving the value of money. And as you pointed out, China did have the first paper currency in the world, which perhaps should not be too much of a surprise, because, after all, paper was invented in China.

Prasad: But what is even more interesting is the fact that China also had the first fiat currency, a paper currency that was not backed by commodity, so, precious metals. And we learn about this from the writings of Marco Polo, who talks about how the grand Khan, which is how he refers to Kublai Khan, had come up with the most wonderful form of alchemy in the world. All that Kublai Khan had to do was put his imprint on mulberry bark, which is what paper was made of at the time, and people throughout the land accepted this as money in exchange for goods and services. So, how did Kublai Khan convert his paper currency into legal tender that was just a fiat currency? He did this by basically issuing a proclamation that anybody in his domain, who did not accept this currency would be put to death.

Prasad: That's a very effective way of creating a fiat currency out of a legal tender, out of paper currency. So, it turns out that one of the consequences of that was that eventually, China also had among the earliest episodes of hyperinflation, because Kublai Khan had some degree of monetary discipline, but it turned out his successors did not have that sort of discipline. So, they printed too much paper money to finance war expenditures, and so, China had hyperinflations later in the Yuan Dynasty, when there were emperor's who followed Kublai Khan. And subsequently, paper money came in and out of China, for a while it got so debased, paper money disappeared, they went back to commodity money. And then, later on, in the 17th century, once again, they went back to having paper money.

Prasad: So, it was a long and interesting saga, even of paper currency in China.

Beckworth: Yeah, you could write an entire book on this. But what you mentioned earlier also struck me is that they had many of the debates that we've had in the West. So, what you think of like David Hume is the first person coming up with a quantity theory of money, well, their discussions, they understood the quantity theory of money long before David Hume did. And some of their debates, as you mentioned between the Confucians worrying about if the state gets a hold of paper money, they'll be debased. I mean, they were discussing these issues that later the Bullionist Controversy in England or the banking and debates, and so, it's just striking to see that what we think are novel, original debates, centuries before, the Chinese were working through it themselves.

Beckworth: Also, the Kublai Khan episode that you mentioned about, became fiat legal tender by a decree, a capital punishment was the incentive. Now, there is this debate in monetary economics, how is money emerged? Is it an emergent thing? Carl Menger, you know that the most saleable asset eventually emerges. Or, is it state? Is it a state theory of money? And this is a great data point, I guess, for the state, theory of money by a decree, "You're going to use this or you're going to die." So, interesting data point, I mean, for that. There's other episodes where other forms of money emerged spontaneously, but this is definitely an interesting data point.

Prasad: Yes, and the Confucian scholars, in fact, well before Kublai Khan had the view that it will be better to have private money circulating because of private issuers would then have a strong incentive to maintain the value of the money and not let it be debased. But there was a very famous eunuch called Cai Lun, who actually became the chief eunuch in the emperor's court in 200 B.C., who was a Confucian scholar, but took the side of the non-Confucians in arguing that only the state should have the privilege of issuing money, because that was the best way to guarantee the value of money. But it was a raging debate at the time.

Beckworth: I mean, it makes me think of the kind of free banking Austrian perspective, they think the private sector banks should be the only ones making money versus the state. So, again, these are debates that have been visited well before many of the people we think were the first ones to do that. Well, let's move forward to Chiang Kai-shek and the Nationalist Party. They're coming in much more recent here, 1928, he established the Central Bank of China in Shanghai. And you mention in the book that once the Japanese occupy Manchuria, they set up their own central bank, and there's literally a currency war. We talk about currency wars today, going on because of money losing value against another, but there's literally a currency war between these two central banks. Tell us about that episode.

1920’s Currency Wars

Prasad: Yeah. China, in addition to having the privilege of having the first paper currency, the first fiat currency, there was legal tender. Among the first episodes of hyperinflations, also had the first real currency war. How it came about was that the Kuomintang government or the Chinese Nationalist, was in control of most of China by the early 1930s. But the Japanese had already started their incursion through the north and they set up a puppet government in Nanjing. And they realized that having the control of money would be a very important part of exercising broader political and economic control. So, while the Kuomintang government was trying to increase the use of its currency, the Japanese started promoting their own currency.

Prasad: Now, the Kuomintang government had a number of problems of its own in order to finance war expenditures, they'd issued too much of their own paper currency, which got debased and they had an episode of hyperinflation around mid-1930s. And then the Kuomintang government put in place a reform, well known to Chinese as the Fabi Reform. They issued a new currency called the fabi, that was, in principle, backed by U.S. dollars or British pound sterling. So, the Japanese started buying up the fabi, taking it to these banks in Shanghai. Shanghai was a very important financial center even at that time, and the Japanese started draining the Shanghai banks of their reserves of pound sterling and dollar. In fact, the U.S. and the U.K. tried to prop up the Kuomintang government at the time.

Prasad: But the Japanese also decided to undercut the fabi currency by setting up their own central bank and issuing their own notes. Now, both of these currencies were being intermediated through banks in Shanghai. And this is where the all-out war started because the Japanese puppet government in Nanjing, the Wang Jingwei government, set up a branch of its central bank in Shanghai, and the Kuomintang Central Bank also had a branch in Shanghai. And what happened was open warfare on the streets. For instance, the Japanese-backed Jingwei government, essentially started dynamiting the branches of the Kuomintang Central Bank, and the Kuomintang government, in turn, started pulling bank employees of the Japanese central bank on the streets and executing them. So, there was blood on the streets of Shanghai.

Prasad: So, if you think that these days we have currency wars, it's nothing like the currency wars that the Chinese experienced at the time with real blood on the streets.

Beckworth: Right. And I imagine the intensity, the feelings were running high because the bank out of the Japanese central bank, probably they felt that Chinese that were on their side were traitors, so, it's probably really serious, deep emotionally felt debate. Now, the Communists come in after World War II, Japan's defeated, you mentioned there was a brief truce, we have the Communist command, and that brings us into the modern currency that they now have. Before we get there, I just want to briefly go back to an episode under the Nationalist Party. Maybe this was actually during the time they had this debate or this currency war going on. But they had backed their currency up to silver for a while, is that correct?

Prasad: That's right. It was initially backed by silver, and then backed by U.S. dollars and pound sterling.

Beckworth: Now, you're using the term Kuomintang, and that's the same thing as the Nationalist Party.

Prasad: That's the Chinese Nationalist Party.

Beckworth: All right. So, they had their currency backed by silver. And Milton Friedman, I read this somewhere, mentioned that China did not experience the Great Depression, because they were on silver. So, kind of a standard store for the Great Depression while it was at a global event, because all these countries were linked to gold, tied to gold. Can you speak to that at all? Is that true that they avoided the worst part of the Great Depression?

Prasad: That's right, they avoided the worst part of the Great Depression. Now, China wasn't that well linked into the global trading of financial system at the time. So, they were somewhat insulated. Certainly, there was a strong trade link with Britain, even at the time, but relative to the early 1900s, that link had eroded to some extent okay. But, certainly, yes, the Chinese government was less constrained than much of the rest of the world, including the U.S., because their currency was not tied to the gold standard in any way.

Beckworth: Okay. So, even if they had been on gold, you're saying that they weren't as interconnected as some of the other countries were.

Prasad: That's right.

Beckworth: Made them more susceptible. Okay. So, the currency as we know it today, the renminbi appears, you mentioned it becomes a soul currency 1949. The People's Bank of China is introduced in 1948. And you mentioned it, and there's another interesting fact that may Mao Zedong, the leader of the Communist Party, wouldn't let his image beyond the currency. Now, my vision of the currency is that he's all over it, but that's a recent phenomenon, right?

Prasad: That's correct. We're all used to seeing the iconic image of Mao's frontal image on every Yuan banknote. But in fact, that was not the case early on. The People's Bank of China or the PBOC, China's central bank, came into being in December 1948, which was about a year before the People's Republic of China, or the PRC officially came into being. That happened in October of 1949. So, the People's Bank of China started issuing the renminbi, which literally means the people's money in late 1948. All those really picked up steam in 1949. And I found some archival material about how the PBC central bank governor at the time, goes and pleads with Mao Zedong, saying, "You are the father of the country, you are the father of the party, and everybody wants your image."

Prasad: And Mao, in turn, says, "No, this is the people's money. I am just a party functionary. So, my image should not be on the currency." In fact, it turns out that the first four series of bank notes that were issued, did not have the full face image of Mao on them. The very first series of banknotes had a variety of ethnic people's images in there. And over time, the evolution of banknotes also traces the notion of what is considered the idealized version of society. For instance, in the third series of bank notes, issued in 1987, one of the bank notes has this picture of an intellectual, a farm worker, and an industrial worker altogether. This being the ideal mixture of what a well functioning society should contain.

Prasad: In the fourth series of RMB bank notes, there is one bank note which has four leaders on it and profile, including Mao, Zhou Enlai and a couple of others, but it's still not Mao's full face image. It's only the fifth series of banknotes, which is still circulating to this day, and that was issued in 1999, at the 50th anniversary of the People's Republic of China's formation, that Mao's image comes to be on every banknote. But why that happened is also interesting, and here, again, I found some archival material about these very intense discussions among the officials of the currency printing bureau. The biggest concern they had at the time was counterfeiting. So, there is a long discussion about what image would be best to put on the banknotes in order to limit counterfeiting.

Prasad: So, they considered a variety of historical figures, a variety of well known landmarks and decided that the only thing that everybody in China can recognize, whether literate or illiterate, whether in the coastal or interior provinces, is the image of Mao. So, now, every one banknote has the image of Mao on it.

Beckworth: So, the purposes of avoiding counterfeiting resorted to his image because it was the one common name. That's fascinating. Now, let's go back to the name renminbi, which you said means people's money, and we're going to use RMB interchangeably with that as an abbreviation. But renminbi's the name. Now, the other name that's commonly used is the yuan. So, can you tell us when to use one or the other because I often have confusion over this issue. I'm sure many of our listeners do as well.

Prasad: Technically, the renminbi is the name of the currency, and the yuan is the unit of account. Perhaps it's easiest to explain this by analogy to the British pound sterling. The pound sterling is the name of the currency, but when you walk into a store in London or to a pub in any British city, you're going to get quoted a price in pounds, not pound sterling. So, the pound is the unit of account, while the pound sterling is the official name of the currency. So, if you walk into a store in Beijing, typically, you're going to get quoted a price in yuan, because, again, that is the unit of account.

Prasad: In colloquial colonization, just to make things a little more complicated, there is another term called kuai, which translates into a buck or a quid. So, that's the more colloquial form. There are many publications like the Wall Street Journal, which stick with yuan, even when they're talking about the name of the currency. Certain publications like The New York Times seem to prefer the use of the renminbi. But, technically, you should be using renminbi when you are referring to the currency, and yuan, when you're talking about a specific amount of the currency as a unit of account.

Beckworth: That's good to know. We'll use RMB as an abbreviation moving forward in this conversation, and interchangeably with renminbi. Okay, that's the interesting history of China's currency, it brings us to the present. Well, let's move forward to the kind of exchange rate regime that's been going on. And then, later, we'll talk about the three aspects, three criteria to a rising currency, which shapes the outline of your book. But let's talk about the exchange rate regime because this is something that's been in the news for almost a decade or maybe more. I remember when I was working back at Treasury, it was a big deal in the early to mid 2000s. And now, with President Trump, it's reemerging as a big issue.

Beckworth: All this talk about their currency being undervalued, although, most observers today would say it's not, no longer undervalued, maybe if it's even overnight to some extent. But let's talk about what has happened to the currency. You mentioned from 1994 to 2005, it was pegged to the dollar. A pretty hard peg, or was it a soft peg? Tell us about that arrangement.

Contemporary Chinese Exchange Rate Regime

Prasad: So, until the years just before 1994, China had a dual exchange rate, that it was an official exchange rate relative to the dollar and other currencies, and there was a market exchange rate. Because the official exchange rate often diverged from supply and demand conditions in the foreign exchange markets, you had a different currency. So, in 1994, they unified those two and pegged the currencies' value to the dollar. So, if you look at a chart of the renminbi's value against the dollar, it's a flat line, all the way till June of 2005. What China was basically doing, was making sure that they were influencing demand and supply in the foreign exchange markets, to make sure that that exchange rate stayed flat.

Beckworth: So, it was very rigid, very robust fixed exchange rate. Now, with that said, the question arises, well, in what sense were they undervaluing it during the early to mid 2000s? And you mention in your book, they were having a rapid productivity growth in manufacturing. And when you have rapid growth like that, typically, it creates upward pressure on the currency. The currency wants to naturally appreciate it, but by pegging it, they were avoiding that. Is that correct?

Prasad: That's right. Now, we economists don't understand very much about day-to-day or month-to-month movements in exchange rates, but what we do know is that over a relatively long horizons of a few years or longer, how much productivity an economy is able to generate, relative to the productivity growth in its trading partner countries, tends to drive exchange rates. So, if a country has higher productivity growth than trading partner countries, its exchange rate adjusted for inflation tends to increase in value, or appreciate. The problem with currency appreciation, of course, is that it makes exports more expensive to importers abroad. So, your exports become less competitive.

Prasad: And China wanted to have more exports. So, what China did was to prevent the value of its currency from rising. And how were they doing that? Essentially, by selling their own currency and buying up foreign currencies, especially the U.S. dollar. Now, China was exporting a lot, a lot more than it was importing. And because China was a fast growing economy and continues to be, there was a lot of financial capital pouring into China. So, when you have money coming into an economy because it's exporting a lot more than it imports, or because investors want to invest in that country, usually, the value of that country's currency tends to appreciate. China didn't want that. So, it was instead taking all those dollars, euros, yen and other currencies it was receiving, and recycling them by buying more dollars, euros or yen.

Prasad: A lot of it was buying dollars. So, that way, they were preventing the currency from appreciating as fast as market forces wanted it to appreciate. So, this allowed them to keep their exports somewhat more competitive, and this was underlying the notion of China undervaluing its exchange rate. That is, China, by intervening in the foreign exchange market, what's keeping its currency from attaining a higher level that markets wanted to push it towards. That pattern persisted until about 2014, when things shifted.

Beckworth: Okay, here's a question I've often had, we can agree that China by keeping its peg very rigid, very fixed, was avoiding this appreciation. But even if it had allowed the appreciation, it was an emerging rapidly growing economy, there still would have been many of the dislocations that politicians here complain about. So many of our labor-intense jobs would have gone in any event. So, how much of the loss of jobs, the exports, when overseas, how much of that can we attribute just to China being a large economy that's opening up, developing, versus the manipulation of its currency?

Prasad: Now, here's the interesting, there is a notion that China has had the economic boom, it has largely because of exports. It turns out, that's not quite the case. In fact, if one looks at the early period of the 2000s, say, from 2000 to 2005, the contribution of net exports, that is exports minus imports, to China's overall growth was relatively modest. China had only a relatively modest trade surplus during that period. During 2005 to 2007, that surplus did increase. So, here's the secret about China, China has actually been growing much more because of investment, rather than because of exports. Exports certainly play an important role, but it's not that the Chinese economy has depended mostly or largely on exports in order to drive its growth.

Prasad: The other interesting thing is an aspect of trade data that often gets forgotten. It turns out that if you look over the period, say, 2002 to 2005, when the U.S. trade deficit with China rose very substantially, a lot of it was because China entered the World Trade Organization in 2001, and that allowed it to get easier access to markets in the U.S., Europe, and so on. So, many manufacturers in Asia started using China as part of their supply chain. So, you would get many goods where the components were coming from other countries in Asia. They would then be processed in China, and then sent abroad, but now with the, "Made in China," label.

Prasad: In fact, there was an interesting analysis done by The Wall Street Journal about three or four years ago, where they pointed out that if you take the list price of an iPhone, at the time, the list price of the iPhone was about $500. And if the iPhone was, "Manufactured in China and sent to the U.S.," that entire $500 would count as a U.S. trade deficit relative to China. But if in fact, if you looked at how much of the value was added in China, it was very modest, it was only about $50 to $60 worth. Why is that? Because the iPhone components were coming from manufacturers in Korea, Thailand, Taiwan, Singapore in some cases. And about 30% of the iPhone's lowest price, of course, is Apple's profit margin, and Apple still is largely a U.S. company.

Prasad: So, the amount of value added in China was about one-tenth the value of that export, but the entire $500 to $600 gets counted as a U.S. trade deficit relative to China. This doesn't explain all of the U.S. trade deficit with China, but the trade figures do tend to get somewhat distorted. So, going back to the question you started out with, even if China had allowed its currency to appreciate, given the relatively cheap labor one could get in China, given the fact that they were getting good productivity growth, you would still have had a lot of exports from China. And essentially, since China was just acting as a processing base, so many of these exports, the U.S. may have ended up running similar trade deficits with other low wage manufacturers.

Prasad: So, the notion that all of what we're seeing, in terms of, say, the decline in U.S. manufacturing, can be laid at the foot of trade or especially trade with China, I think is somewhat misleading.

Beckworth: Yeah, and I think that's the hard part of economics is doing the right counterfactual. What would have happened in the absence of that policy manipulation of currency. And I agree. What I read suggests that there still would have been very similar trade patterns. And it's also, I understand your point about the supply chain, the global supply chain, which I think many politicians miss, and that is, you can't just look at one country because there's so much more going into that. The value added can be much smaller than that, the price of the actual trade deficit. Very interesting. All right, 2014, things change in terms of the value of the currency being underappreciated. Tell us about that development.

2014 Chinese Currency Underappreciation

Prasad: In 2014, some concerns start building up about the Chinese economy, because it looked like growth was slowing down. And in addition, what the Chinese government has been doing, related to a subject that I'm sure we'll turn to, which is trying to make the currency somewhat more prominent in international finance, they had started making it easier to take money into and out of the country. What we economists would call as reducing restrictions in capital flows or reducing capital controls on both inflows of money into China, and more importantly, outflows. China saves a lot. About half of Chinese output each year is saved by Chinese households, Chinese corporations, and to some extent, the Chinese government.

Prasad: So, there's a lot of savings, private savings in particular, locked within China. And what China decided to do was to give its investors, including households, corporations, institutional investors, the opportunity to diversify their portfolios by investing abroad. This is something they wanted to do for a while. But they were opening the capital account outflows at the same time that concerns were building up about the Chinese economy. And then, in 2015, one had the big stock market run up, and the crash in the middle of 2015. So, all of these concerns led to capital beginning to flow out of China at much greater rates. And this led to substantial downward pressure on the currency.

Prasad: So, China, which until then, until mid 2014, had been trying to prevent the currency from appreciating, and buying up dollars in order to prevent the currency from appreciating, suddenly found that things had shifted, that it had begun to act in order to prevent its currency from depreciating, and was selling dollars. Now, one might ask, why was China trying to prevent its currency from depreciating? If that's what the market wanted, maybe it wasn't such a bad thing for China. Because, after all, a weaker currency would mean that China's exports were more competitive, which could actually help the economy at a time of regrowth. But the concern that the Chinese government had, is that, too much capital flowing out of the country too quickly, could destabilize the financial system.

Prasad: If people started pulling deposits out of the banking system, it could undercut the stability of the banking system. And the one thing the Chinese government dislikes is volatility. They prefer stability and control. So, even if the renminbi was going to depreciate relative to the dollar, they preferred that it happened gradually. Now, the problem is that, in financial markets, if people think that a currency is going to go in one direction, there is no easy way to do it gradually, because people expect the currency to depreciate, so they start pushing the value down, and then it becomes very difficult for the central bank or the government to control that. But that's the difficult spot the Chinese central bank has been in since mid-2014.

Beckworth: Now, you mentioned they wanted to have a controlled flow of capital. They didn't want the big panics, one reason they avoided the depreciation. I'm wondering, to what extent were they also worried about dollar-denominated debt, like the corporations had and stuff? Because if the dollar quickly devalued, lost value, it would increase real debt burden of these firms. Is that a real issue that China's concerned about, too?

Prasad: No, Chinese corporations do have a lot of debt, but the interesting thing is that most of that debt is domestic and denominated in RMB. If you look at the total amount of corporate debt that Chinese corporations had issued in foreign currencies such as the dollar, euros, and so on, around early 2015, that number was about $1.6 trillion. Seems like a lot of money, but remember, this is an $11 trillion economy, plus, China, at the time, in early 2015, still had about 3.6, $3.7 trillion worth of foreign exchange reserves. So, China was not a typical emerging market economy where a fall in the value of the currency would make the value of the foreign currency denominated higher, and make it very difficult to pay off.

Prasad: But certainly, this added to the downward pressures in the currency. Because, when the renminbi started depreciating against the dollar, and the value of that foreign currency debt in domestic, that is renminbi term, started rising, corporations naturally just wanted to start paying off that debt. So, that also led to a flow of capital out of the country, at a time when other forms of capital outflows were also kicking in. So, this is what made things very complicated. A lot of capital flowing out for different reasons, all at the same time. Now, a lot of this foreign currency debt has been paid off, they're still estimated to be about 600 to $700 billion left. Again, seems like a large amount in absolute terms, but relative to the size of the economy, it's not a major concern, either for individual corporations or for the economy as a whole.

Beckworth: Because it's a big economy and they have a large stock of reserves which can pay that off.

Prasad: That's right.

Beckworth: You often hear the Bank for International Settlements, the BIS, talk about this $10 trillion figure of dollar-denominated debt outside the U.S. And as the dollar gets stronger, it makes that debt burden heavier. But in the case of China, what you're saying is, it's really a drop in the bucket for them. Maybe the other emerging countries, it's a problem, but not so much for China.

Prasad: That's right. China has always had a very low level of external debt, relative to the size of its economy or relative to the size of its reserve. So, that's really not a huge concern for China. For certain corporations that have gone haywire in terms of issuing dollar-denominated debt, maybe it could be a problem, but, systemically, this is not going to be a problem.

Beckworth: That kind of answers my next question, and that is, starting in 2005, they started following a weighted basket of currencies. And the dollars, you mention in your book, was the most important one. And they've changed the way as time has gone along. And something that's given us the case, that the RMB is still tracking the dot, not as tightly as it was before 2005, but still tracking it. Then, beginning in mid-2014, the dollar begins its biggest ascent. And so, as the Fed begins talking of rate hikes, we see the dollar going up, it plateaus in 2016, and lately, it's gone back up. So, I wonder to what extent did Fed policy in the stronger U.S. dollar, weigh into any of the considerations of the Chinese in 2014/2015?

Prasad: It was a very important factor. In 2005, when the People's Bank of China took the RMB off the dollar peg, they said that in principle, they will be managing the currency's value against a basket of other currencies rather than just the U.S. dollar. But in practice, what they were doing was managing the currency's value against the dollar rather than a basket. And this has created complications for them at a variety of context. And starting in 2014, those complications came to head, because, as you've pointed out, from 2014 to the middle of 2015, the dollar did start rising against many of the other major currencies like the Japanese yen and the euro. And because the RMB was still managed against the dollar, it went up along with the dollar. And it made very little sense from a Chinese domestic perspective because their growth was slowing down, while the currency was appreciating.

Prasad: So, this was another disconnect between what was happening to their currency and what was happening in their economy. And I think markets also saw through it and this is one reason I think we may have had pressure building up on the RMB to depreciate because people saw that there was this inconsistency that could only be resolved by having the PBOC let the currency value drift down against the dollar. Now, in the past few months, the Chinese central bank is again trying to get the message out to markets, that now, seriously, it is managing the currency's value against a basket. But the reality is that most people in China, and most financial market participants outside China, still have a laser focus on the RMB dollar rate, not the other bilateral rate.

Prasad: That's partly because most of the trading on the Shanghai foreign exchange markets in China, and also offshore markets like the ones in Hong Kong, most of the trading is still the RMB/dollar bilateral pair. And the reality is that is the biggest traded market. So, most of the betting about the RMB's value does take place, in terms of that currency. So, once again, China's facing this odd situation, where their growth has stabilized, but now there is the prospect that although Mr. Trump is trying to talk the dollar down, all his policies are likely to lead to the dollar strengthening if you have an expanding fiscal deficit, if you have stimulative policies that goose up the U.S. economy, while at the same time, the European Central Bank and Bank of Japan want to maintain monetary policy.

Prasad: So, the dollar could strengthen further against the Japanese yen, against the euro, which means that again, the PBOC would be in this difficult position of letting their currency's value depreciate against the dollar, which could once again, raise concerns, and in this case, concerns not just among financial market participants, but it could bring a strident reaction from the new administration that China's trying to, "Cheapen the value of its currency." And the irony in all of this is that, for years, the U.S. Treasury, the IMF, where I used to work, were all telling China that it should not manage the value of its currency, it should let the value of its currency be determined by market forces. And now, the entire world, including Trump, are telling China, "Don't let market forces determine the value of your currency." Because then, the currency would depreciate against the dollar.

Beckworth: It is a rich irony. You finally let the market do its magic and you get the results you don't want and you change your story. And it's challenging, it's frustrating to see Trump's still holding the view or claim that the dollar is stronger because China's manipulating its currency as opposed to what you just mentioned, the expected path of interest rates in the U.S. is going up, in Europe and Japan's going down, that divergence, it's really driving the dollar, not what's going on in China so much. But another interesting, I guess, observation from that is this tension between what the Fed was doing in 2014, they're talking up rates, what's going on in China, it speaks to the influence that Fed has on global monetary conditions, right?

Beckworth: The Fed has a domestic mandate, but its influence is felt around the world and it's a tough job, if your focus is domestic, but you can create these global spillovers that can come back and effect the domestic economy. Well, let's move on into the rest of your book, and you mention three criteria for a rising currency, for a currency that wants to become important currency. And that's named, it's the subtitle of your book, The Rise of the Renminbi. And you mention, how open is the capital account, the internationalization of the currency, and whether it becomes a reserve currency. So, let's talk about the opening of the capital account. First, what is the capital account, for our listeners? And what has China done to make it more open over time?

Prasad: Opening the capital account is basically the notion that financial flows that are not related to underlying trade transactions, can be done in a relatively unrestricted fashion. For instance, if a U.S. investor wants to invest in the Shanghai stock market, or, if a Chinese household wants to invest in the New York Stock Exchange, say, in a mutual fund, that becomes easier to do. Or, for a Chinese corporation to invest either in stocks or some hard assets in the U.S. So, basically, freeing up restrictions in capital inflows and outflows is what opening the capital account is. And for a currency to become a reserve currency, one that is held by foreign central banks in particular, but also investors more broadly, one of the key criteria is that foreign investors need to be able to acquire and easily trade financial assets denominated in that currency.

Prasad: So, it's hard to imagine that renminbi could become a viable reserve currency in the medium to long run, by which I mean the next three to 10 years, unless China makes it easier for investors to bring money into, and take money out of the country.

Beckworth: Now, they had been pushing reforms, you mention many of them in your book. But recently, they've also been tightening down a little bit, haven't they?

Prasad: That's right. China has made a lot of progress in terms of opening up its capital account, until about five or six years ago. Foreign investors could directly invest in China in the form of what is called foreign direct investment. That is, they could set up new firms or buy large shares in existing firms, but they could not easily invest in the stock market or bond markets. China has now opened up its capital account to inflows more broadly, and also to outflows. Now, one of the reasons they were able to push through many of these reforms was because China wanted one very important price, which was to get the International Monetary Fund to include the Chinese renminbi in its artificial currency unit called the special drawing rights, which until last year, had just four of the elite currencies in it, the U.S. dollar, the euro, the British pound sterling, and the Japanese yen.

Prasad: China is now the second largest economy in the world, and the Chinese want their currency to have big international stature. So, what the IMF had told China was, "We can consider this, but in order for your currency to become part of this SDR basket of currencies, you need to have more free flows of capital across your borders, you need to have a more market-determined exchange rate, you need to have more freely market-determined interest rates in your banking system." So, that prize that China really wanted, turned out to be a very important spur to many reforms, including opening the capital account. China did get that prize, it became effective in October of 2016, although the decision was made in November of 2015, that the RMB would become part of the SDR basket.

Prasad: That was a very important spur for many of the reforms. But since then, because of the capital outflows and because of the volatility that it has created in currency markets, China has slowed down on capital account opening, and in some respects, has even made it harder to take capital into or out of the country, especially out of the country.

Beckworth: I was just reading an article, where individuals can take up to $50,000, but the government now is requiring further documentations, more red tape, more barriers to get that money out, because of the capital outflow. Now, you mention in your book as well, the net errors and omission, part of the balance of payments. There's a part of measuring this flow of capital that's not being recorded because people find ways around the capital controls, around the restrictions. And you show that it's actually been, that that measurement problem's been getting bigger over the past few years, even before the capital flows heightened. Is that correct?

Prasad: That's right. And it's flipped, actually, because when there was pressure on the RMB to appreciate, everybody wanted to buy more RMB because the value of the RMB was going up. In fact, at the time this measure called net errors and omissions, which basically is a way of reflecting all the capital account transactions that don't go through official channels, that number was positive, meaning that people were bringing money into China, through unofficial means. But over the last three, four years, it's turned negative, meaning that money is flowing out of the economy through unofficial channels. One of the proximate reasons it may be going out through unofficial channels is that President Xi Jinping intensifying an anti-corruption drive over the last two or three years, and there is a belief that there is a lot of money that corrupt officials now want to take offshore, because they are concerned about expropriation.

Prasad: And of course, they don't want it to go through the traditional banking channels because that would expose all of that ill gotten wealth. So, they're finding other ways to take it out of the country. It cannot be clearly measured in the official accounts, it gets measured as a residual, which is what this net errors and omissions is.

Beckworth: Yeah. As I read that, it reminded me one of the critiques of capital controls is that corruption will emerge and as an economy as big as China, it's hard to imagine a really, truly secure fence that can be put all around that economy. And secondly, as you mention in your book, they don't have the institutions and the levels of courts and rule law and all those things that can truly enforce those barriers to keep capital from flowing out. Let's move on to the next thing, so, we've got capital account opening, and the next element is the internationalization or how widely used the currency in China is becoming. And you mention a number of examples. It's not quite yet what we call a vehicle currency, where other countries, we use it as transaction purposes between two other currencies. But tell us, how is it progressing in general? Is it going in the right direction?

Internationalization of Chinese Currency

Prasad: It certainly made a lot of progress given that it was starting from basically zero in a variety of criteria related to internationalization. If you look at the amount of international trade transactions that are being denominated and settled using RMB, rather than a vehicle currency like dollar, that went from virtually nothing, to nearly one-third of China's overall trade, a couple of years ago. That number has since fallen back because of all the concerns about the RMB to about 23%, 24%. But still, from a start of zero, basically four or five years ago, that is not a trivial amount. The RMB now accounts for about 2% of global payments. That may seem like a very small number, but that puts China now among the top five or six currencies in terms of global payments.

Prasad: The dollar, of course, dominates, the euro comes well behind. But most of the currencies account for a very, very trivial fraction of global payments. So, the RMB is making progress. If you look at the amount of RMB-denominated deposits offshore, the amount of RMB-denominated bonds being issued by corporations in the Hong Kong market, those numbers rose very impressively in the first four or five years, after China started making a push for its currency to become an international currency. All of these measures have leveled off in the last couple of years, and some of, in fact, receded a little bit. But I think if China plays its cards right, by continuing to open its capital account, trying to reform its financial system and its economy more broadly, it will continue its progress as an important international currency.

Beckworth: Two very interesting observations you make in the book on this point. Number one, China has built its own cross-border international payment system. So, it's like CHIPS in the U.S., and that it's not a big deal now, but it has the potential to be an alternative way to transfer funds across borders. And you also mention, it is interesting that it could one day replace SWIFT, which is how they transfer information about financial transactions. So, that was an interesting, very sobering assessment, especially from the U.S. perspective.

Prasad: Yeah, that is an important geopolitical angle to that as well. During the Crimea crisis, when the West imposed many sanctions on Russia, the effective way to do sanctions worked, was because Russia lost access to many of the payment systems that are controlled by the West. I think China has taken some very important lessons from that episode and knows that control of international payment systems, not only reduces the costs of financial transactions for Chinese, but in addition, allows it to not be vulnerable to the Western powers that could use that as a choke point, if there were to be a geopolitical conflict.

Prasad: So, China has taken very aggressive moves to develop its own cross-border payment system, which allows its financial system to get better connected to the international financial system, but as you noted, also has the potential to eventually supersede something like SWIFT, which right now is the only major interbank messaging system that is used for transactions among domestic or international banks.

Beckworth: That was very interesting. You also mention in the book, that central bank in China has established swap lines or currency swap lines, where central banks will exchange each other's currency. And they have this understanding with 36 other central banks, including Bank of England and the ECB. Now, the Fed's not a part of this yet, is that correct?

Prasad: That's correct. Now, this is another interesting part of the Chinese currency's journey to international prominence. It has made some progress in terms of being an international currency. In the book I draw a distinction between that and another concept, which is that of a reserve currency, held by foreign central banks as protection against balance of payments crises, or by foreign investors for some degree of safety. And typically, the prerequisite said were thought to be important for a currency to become a reserve currency. But not only that the economy had to be large and have a well developed financial system, but also that it needed to have a market-determined exchange rate, and an open capital account.

Prasad: China does not have these two yet, and yet, its currency has already become a reserve currency as evidenced by this fact that you pointed out, that there are 36 central banks around the world, that have signed bilateral local currency swap arrangements with the People's Bank of China, which gives them access to renminbi liquidity, if crunch time were to arrive. Now, why would so many central banks care about having access to RMB rather than dollars? In the book, I argue, this does not mean that the RMB has arrived, but really, it's a sign of how very many major powers including Japan, Europe, the U.K., Canada, all want to be seen as friends of China, because it is a rising and very important economic power. And in addition, it shows that all of these countries are making what I think is a very low cost, best bet that the RMB is one day going to become prominent.

Prasad: So, they're lining up and placing a very cheap bet on that prospect right now. These are the things that I think will allow China to translate its economic might to increasing international stature of its currency.

Beckworth: And so, this third criteria, which you've touched on is becoming a reserve currency and China again is making progress was a long ways to go. And I wanted to ask you, because you bring up this idea of the Triffin dilemma in the book, which is a very fascinating idea, that, I think the way I think about it is the main reserve currency of the world. The rest of the world depends upon it to provide money, safe assets that they can use, but that requires it to run current account in deficits. It requires it to send these assets abroad, and the way they do that is by running current account in deficits. And it was my impression that it's inevitable, you're going to have to run a current account in deficit.

Beckworth: You're not convinced of that, though. You're not convinced that it necessarily requires like the... I mean, I'm being very abstract here, the U.S. is the main reserve currency of the world but running current account in deficits, and you're not convinced, at least, in the book, that that has to be the case.

Prasad: That's right. If you look at the reserve currency economies right now, they don't run current account deficits, and it hasn't affected their ability to remain reserve currencies. So, the Swiss, the Japanese, the Europeans as a whole, the eurozone as a whole, they have not run very large current account deficit, so, it's not affected their ability to have reserve currency status. Someone might argue perhaps that not every reserve currency does, but the anchor or the dominant reserve currency, still has to provide liquidity to the rest of the world. Now, the Triffin dilemma made a lot of sense when Triffin talked about this dilemma, which is when the gold standard was in operation. So, at the time, the U.S. needed to be willing to provide gold in exchange for dollars, upon demand.

Prasad: These days, things have changed. Take the U.S. right now, the U.S. could in principle supply all the liquidity the world needs, while at the same time, its own investors could be investing in the rest of the world. So, the U.S. could in fact run a balanced current account, even while it was providing all the liquidity the world needs. So, in a world where you don't have a gold standard and where you have free flow of capital, the Triffin proposition does not hold. Now, China has a very long way away from becoming a dominant global reserve currency. So, on the path to becoming a significant reserve currency, there is certainly no requirement, as evidenced by what is happening with the euro, the yen, and so on, that they need to run a current account deficit.

Prasad: And the point I make in the book is that even if one day they were to challenge the U.S. dollar, as the dominant global reserve currency, this is not given that they need to run current account deficits. But of course, in the book, I argue there is little prospect that the renminbi will, in fact, become a dominant reserve currency that could rival the dollar.

Beckworth: Well, let's talk about that in time we have left. You have a chapter called the House of Cards, basically, going forward, what are the big problems? Some people look at, there's a natural growth slowdown as China transforms more into a service economy. There're some people who argue that there's a debt overhang, that the gross debt levels in China have increased dramatically from about 2008 to the present. You're much more optimistic in terms of growth prospects, but you do worry about the institutions in China, and that may prevent it from becoming a safe haven. So, talk about that.

Problems in the Chinese Economy Going Forward

Prasad: The Chinese economy has a huge amount of risk, especially in terms of debt in the corporate sector. As I argue in the book, these are going to be very costly to resolve, but I don't think they will bring the Chinese economy down. But how well China manages these problems it has created for itself because of its growth model, it is going to be interesting to watch as an academic, but I'm not in the camp that sees disaster around the corner. But even if China does not face an economic disaster, is the RMB going to continue its unmitigated rise, and perhaps, one day rival dollar? Here in the book, I argue that there is a different concept renminbi has to add to the mix, not just an international currency or a reserve currency, but a safe haven currency.

Prasad: A safe haven currency is not just a plain vanilla reserve currency, but one that foreign investors have trust in. And what is essential for this trust, I argue in this book, is that you need a combination of institutions. What I mean by institutions are an open and transparent democratic form of government, with institutionalized checks and balances, so that economic policy does not go haywire, because there is an inherent correcting mechanism. Second, you need the rule of law. That is, foreign investors must have the trust that they will be treated on par with domestic investors. And third, you need independent public institutions like the U.S. Federal Reserve, for instance, that foreign investors can trust will preserve the value of money.

Prasad: China has ostensibly made a commitment to market-oriented reforms to its economy, and to its financial system. But President Xi Jinping's government has at the same time, repudiated decisively both in word and in deed, any political, legal or institutional reforms. So, I argue in the book that while China's economy might continue to prosper, and if China plays its cards right with economic and financial market reforms that stabilize growth at a decent level, then, the China's economy could continue growing decently, and the currency might become a viable reserve currency, perhaps one day, by which I mean in the next decade or so, even challenging currencies like the pound sterling or the Japanese yen. But is it going to become a safe haven currency that could one day rival the dollar? I think not.

Beckworth: One last question related to this idea of a reserve currency, is there a natural tendency in the global economy to gravitate toward just one main reserve currency? So, if it wasn't the dollar, would it be something else? In other words, are there economies of scale, network effects that would naturally push us towards one currency with some other ones in the margin playing a role?

Prasad: I think most of us economists would say that if we were starting with a blank slate, we would not design the international monetary system that we have today, where there is one currency that is so dominant, and where the country that owns that currency, in fact, has no incentive to run disciplined macroeconomic policies. Because we are in this very strange equilibrium, where if the U.S. creates a financial crisis, or if the U.S. runs bad policies, people have nowhere but the U.S. dollar, to run for safety. If you had competing reserve currencies, perhaps we would have a more stable equilibrium. But given where we are right now, with a lot of deficiencies and defects in individual countries' policies, and in the structures of the international financial system, perhaps it makes sense to have one anchor currency that everybody can rely on and trust at a time of crisis.

Prasad: So, I don't think it's the best equilibrium we've arrived at, but given all the defects that I spoke about, perhaps it's not bad to have one currency that everybody can trust. But it's certainly not an ideal system by any means.

Beckworth: All right, but given the world we have, it's where we are, and maybe the suboptimal equilibrium we're stuck with for now. Our guest today has been Eswar Prasad, the author of Gaining Currency: The Rise of the Renminbi. Eswar, thank you for coming on the show.

Prasad: It's been my pleasure, David. Thank you for that conversation.

About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.