Saleem Bahaj and Ricardo Reis
Only a handful of currencies are regularly used for cross-border payments: the euro, the yen, the pound, the yuan and, of course, the US dollar, which dominates almost any measure of international use. But how does a currency achieve an international status in the first place? And which government policies assist in that jump-start? Economic theory and the rise of the renminbi (RMB) in the last decade offer some clues.
In 1912, the United States was the world’s largest exporter but the dollar was not widely used internationally. US firms used financial markets in London to access credit denominated in sterling. This state of affairs started to change with the Federal Reserve Act of 1913. US banks were allowed to branch abroad and the new central bank was committed to keep the exchange rate stable. The first president of the FRBNY, Benjamin Strong, had an explicit goal of making the dollar an international currency. He succeeded, with the dollar widely used by the 1920s and becoming the dominant currency by the end of World War II. Through many policies, he helped create a liquid secondary market in New York for dollar-denominated trade acceptances, the credits used to fund international trade. Particularly important was giving banks the ability to discount these acceptances at the Federal Reserve, making the Fed a lender of last resort to international trade in US dollars (see Eichengreen, Mehl and Chitu (2017)).
Fast forward one century to China in 2009. It was about to become the largest goods exporter in the world but strict capital controls made it difficult for the RMB to be used internationally. Starting in July 2009, the Chinese authorities enacted a series of policies to internationalise the RMB that resemble the actions of the Fed almost one century earlier. A new scheme allowed for the settlement of trade claims abroad, an offshore RMB market was promoted in Hong Kong, and the People’s Bank of China (PBoC) started signing swap lines with foreign central banks thus providing a lender of last resort to RMB lending linked to trade.
Was the rise of the dollar an inevitable consequence of the increasing size of the US economy and negative shocks to the London market? Or did the policy interventions by the Fed one century ago play a key role? Can we use the Chinese experience of the past decade to answer this empirically? Did the PBoC policies succeed in making the RMB an international currency? And, more generally, can policy be used to jump-start the international use of a currency? We analyse this question in a recent paper (Bahaj and Reis (2020)).
A threshold for international currency status
Our paper starts from a theoretical perspective and considers an import-export firm operating in a small open economy that needs to choose both the currency in which to price exported products and the currency in which to obtain trade credit to pay for imported inputs. In principle, the firm can choose an incumbent dominant currency or a rising international one (as well as its own currency and that of the export market), and it could make different choices for the currency of sales and the currency of trade credit. These choices are complementary though because firms want to align prices to marginal cost, so they wish to link the choice of currency for pricing and for trade credit.
Our analysis shows that for the rising currency to be used, three thresholds must be met. First, the cost of trade credit must be predictably low. Firms that borrow in the rising currency also want to denominate revenues in that currency to hedge against currency fluctuations. But, they will only borrow in the rising currency in the first place if the credit will almost always be available at a low cost. Hence, policies that backstop the cost of trade credit, be it a trade acceptance discount facility like the Fed operated in the 1920s or a swap line like the PBoC operates today, can help push a currency towards being used internationally.
Second, the variance of the rising currency’s exchange rate cannot be too high. Volatile exchange rates increase the chances of costly misalignments in prices and input costs. Policies to stabilise exchange rates like the Fed’s commitment to a stable dollar in the 1910’s or the PBoC’s peg today encourage a currency’s use.
Third, the size of the economy that issues the rising currency and, endogenously, the role its currency plays in denominating other international trade, must also be large enough. Firms globally want to use the rising currency if a large part of the firm’s exports goes to the economy issuing it or the firm already has suppliers and/or competitors whose prices comove with the rising currency. As a result, neighbouring countries that trade with an economy that starts using more of the rising currency have an incentive to use more of the currency as well.
Most currencies in the world are not international. They are volatile, expensive to borrow in, and lack an issuer with sufficient economic clout. Policies like the ones undertaken by the Fed or the PBoC would fail to have a significant effect if they were undertaken by most other central banks. But, if the country was already close to the thresholds, the financial policies can push the economy to just cross them, leading to the emergence of an international currency.
Empirical evidence: the effect of the PBoC’s swap lines
The recent policy interventions of the PBoC offer a testing ground for these ideas, particularly on the importance of the availability and cost of trade credit. In particular, the swap lines it signed with different countries at different times provide variation that one can exploit to judge their effects. The swap lines are effectively a collateralised bilateral loan between central banks. The PBoC lends RMB to a counterparty central bank, taking a deposit in the counterparty’s currency as collateral. Operationally, this is similar to the swap lines currently employed by the Federal Reserve. However, the aim of the PBoC’s swap lines is to aid trade settlement in RMB (McDowell (2019)): the counterparty central bank uses the funds to lend on the RMB to banks based in its country to provide trade credit. So the PBoC swap lines share a similarity to the Fed’s discounting of trade acceptances a century ago. The difference is the PBoC relies on a foreign central bank to intermediate the funds it lends.
In our paper, we combine data on the timing of each of the 38 swap lines the PBoC has signed over the last decade with SWIFT data on monthly cross-border payments in RMB between country pairs. Figures 1 and 2 provide a look at the data. Figure 1 plots the share of the RMB in cross-border payments alongside the number of swap agreements signed. An upward trend is visible from 2010 onwards with RMB usage rising from near zero to a peak at around 4% of global payments in 2015. Since then the trend has levelled out and usage is running at just under 3%. Figure 2 plots RMB usage against the trade with China over 2010-2018. Three points stand out. First, there are a few countries that both trade heavily with China and make intensive use of the RMB. Second, most observations are below the 45-degree line: for most countries RMB is underused relative to China trade. Third, many countries are clustered at zero RMB usage.
Figure 1: RMB share in global payments and the PBoC swap lines
Figure 2: RMB payments per country vs trade with China
The theoretical threshold results and the presence of zeros in the data makes it interesting to consider the extensive margin: does the swap line make the country more likely to use the RMB? Figure 3 shows what happens to RMB usage for the median country in the months surrounding a swap line agreement. The typical country goes from almost zero RMB usage to the RMB making up a small share of payments. Econometric estimates suggest that introducing a swap line raises the probability that the country will make or receive an RMB payment in any given month by 13-20 percentage points.
Figure 3: RMB payment share before and after a swap line is signed
One concern with this result is that the swap line is an endogenous policy: it may have been signed in anticipation of interactions with China or a common factor may be driving both RMB usage and the policy. However, our findings still go through if we control for many possible sources of these factors, including time trends, regional use of the RMB, trade and investment to and from China, and other Chinese trade and financial policies. Moreover, the signing of swap lines agreements tended to coincide with state visits by the Chinese premier. The timing of these visits are partly random. If we use the state visits as an instrumental variable we get similar results. Finally, when a country signs one of the swap lines, presumably for reasons not driven by developments in its neighbouring countries, these countries are more likely to start using the RMB.
We also find that the effect holds excluding payments to and from China. The swap lines induce countries around the world to use the RMB more in trade between themselves, the hallmark of an international currency. The effect persists; indeed, the effect after three years exceeds that after one year of the agreement being signed.
In terms of the intensive margin, signing a swap line increases RMB usage by about 0.4 percentage points of total payments. This is not a dramatic shift but compared to the 3 percentage point rise in the RMB share of payments since 2010 it is not a small figure.
The international status of a currency depends on the financial cost of credit in that currency, and this is affected by central bank policies. This holds in theory. It also holds in the data when inspecting the impact of the PBoC’s swap lines on RMB usage. The RMB now looks to be an international currency in the sense that it used for cross-border transactions. It is still much less used than the dollar was by the 1920s. Whether the RMB will rise further is an open question.
Saleem Bahaj works in the Bank’s Research Hub and Ricardo Reis works in the Bank’s Monetary Policy Outlook Division.
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