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NARRATOR: This is a production of Cornell University Library.
MARY OCHS: I'm Mary Ochs. I'm the director of Mann Library. And I'm pleased to welcome you to our second of the semester in our Chats in the Stacks series. We have a great lineup this semester. We bring in faculty from Cals and CHE. And this semester we've got topics ranging from this talk with the renminbi to Monarch butterflies. So it's a pretty wide-spanning series of book talks.
If you'd like information about what's coming up later in the semester, these little cards are in the back table. So you can pick one of those up to see the other talks in the lineup and our exhibit programs as well.
We have Sam in the back from Buffalo Street Books. So if you'd like a copy of the book, it looks like he's got a few still back there. So he'll be here, I think, through the end of the program so you can buy your copy. But if you want to make sure you get one, you can run back there right now.
Today's talk is co-sponsored by the Emerging Markets Institute headed by Professor Lourdes Casanova, who's here with us today, and also by the Cornell Institute for China Economic Research.
So let me introduce today's speaker. Dr. Eswar Prasad is a globally acclaimed expert in international finance and trade. Dr. Prasad joined the faculty at Cornell exactly 10 years ago this month, where he serves as the Tolani Senior Professor of Trade Policy in the Dyson School. He's also a senior fellow at the Brookings Institution, where he holds the New Century Chair in International Economics, and a research associate at the National Bureau of Economic Research. He was previously the head of the China division at the International Monetary Fund.
Professor Prasad's research has focused on financial regulation, the macroeconomics of financial globalization, monetary policy frameworks, exchange rate policies, and the Chinese and Indian economies. Doctor Prasad's distinguished publication record includes the most respected academic journals in the field of economics, including American Economic Review, The Brookings Papers on Economic Activity, and The Journal of Economic Perspectives, to just name a few.
But the impact of his work extends well beyond the halls of academia. Through congressional testimony, contributions to high-level committee reports, and his role in creating the Brookings Financial Times World Index, Doctor Prasad's research has helped guide both national and international government policy in finance and financial sector reform.
Last but not least, widely cited in prominent media outlets, such as The Economist, Forbes, the Financial Times, and Newsweek, and frequently invited for appearances on BBC, CNBC, PBS, Bloomberg, Fox, and other radio and television channels, Doctor Prasad contributes regularly to public understanding and dialogue on current issues in international finance and economic development.
So our book today, Gaining Currency, The Rise of the Renminbi, is Professor Prasad's most recent book title. In line with many of his other achievements, it has been described as the definitive book on China's currency and an extraordinary helpful resource for students, investors, and policymakers alike. Without further ado, please join me in while welcoming Professor Prasad.
[APPLAUSE]
ESWAR PRASAD: Thank you, Mary, for that very kind introduction. And thank you all for coming. That was a very quick 10 years at Cornell. I wonder where it all went. Well, it's been wonderful being here. And I still count my blessings being at Cornell every day. In fact, at some level, this book could not have been written at any other place, because the wealth of knowledge that there is about Cornell and the help I got from colleagues that I was able to speak to about the concepts in this book, from many students who were involved in the research on this book. Perhaps, but for Cornell, this book might not even have existed.
The story that I tell in this book actually goes a very long way, from about 200 BC all the way to the present. So it's going to be a very long and interesting journey. It's also a book that almost didn't get written. And you will see in a little bit why, because there were many interesting distractions along the way. And I almost ended up writing a different book. But more on that later.
Why do we start back in 200 BC? It turns out that a lot of this book is about money. The renminbi is the name of the Chinese currency. And it turns out, of course, that the form in which most of us know and use money is, of course, in the form of paper currency. And it turns out that paper currency was actually invented in China.
Now, that's not so surprising if you think about the fact that paper, after all, was invented in China. It was invented in China around the time of 100 BC. But actually, while the invention of paper can be traced to about 100 BC, paper in fact, in terms of mass production, was popularized by gentleman a Sai Lun in the Han Dynasty in about 100 AD.
And Sai Lun, actually, had a very exalted title. He rose from being just a regular eunuch to being the chief eunuch. And in those days, being the chief eunuch at the palace court actually meant a lot, because you had very controlled access to the emperor. These days, apparently, you don't have to be a eunuch to have that sort of access. But it was a very important position.
But at that time, the notion of paper currency still did not exist. Currency still had the form that it had taken for a long time. It was in the form of things that had intrinsic value, either commodities or precious metals. But the reason that debates about currency go back to 200 BC was that it turned so many of the debates that we have to this very day about the nature of money, about monetary policy, about whether sovereign governments should be the only ones to issue currency or whether currency should be issued by private agents, the logic being that if private people or private financial institutions issue currency, they may have more of an incentive to make sure that the value of their currency is preserved. So economists believe competition is very good. So the idea is that competition could keep the value of those currencies more stable.
Those debates took place back in 200 BC. But again, this was with a very particular type of money. It was only in the period of the Tang Dynasty in the seventh century AD that paper currency first came into being. And this paper currency took the form of what is called fei-chien. It which was literally translated as flying money. It was called flying money, because, literally, this money could fly away in a summer breeze. But it also was very light, unlike these big, heavy, metal coins that people had to transport before that time.
But these were essentially certificates of deposit which were backed by deposits of precious commodities of metals. So they were still backed. All this was was a piece of paper saying that a particular merchant had received a deposit of a certain amount of commodities or precious metals, and that that merchant testified that this could now be used as a means of exchange.
And after that came the next dynasty, the Ching Dynasty, which, in the 10th century, introduced a similar kind of money but had more prevalent use. And these notes started being used to a somewhat greater extent. But still, this was not really money the way we know it, just issued by a central bank or by a government.
What happened in the 13th century then changed everything. And we know about what happened in the 13th century from the writings of a very famous traveler called Marco Polo. So Marco Polo visited the court of this emperor called Kublai Khan.
Kublai Khan was one of the key emperors of the Yuan Dynasty. This was just a stylized representation, of course. So when Marco Polo visited Kublai Khan's court, he was stunned by what he described in some of his work as alchemy. He said this emperor, he called him the Grand Khan, has discovered the best form of alchemy. All he does is he prints his imprint on mulberry bark, which is what paper was made of at the time, and this is accepted throughout the land as money in exchange for goods and services.
Now, in addition to money, there are two new concepts that came into being at this time. One is that of a fiat currency. A fiat currency is essentially one that is issued by government by fiat, that is it's not backed by commodities or precious metals.
And then there is the concept of legal tender. So if you or I take out a dollar bill these days, there is a law in the US that says that if I owe you some money, I can pay you this dollar, and you're obliged by law to accept it in payment for that debt. So that's what the concept of legal tender is.
So until that time, the only legal tender had been this commodity money. And there was no fiat paper currency. Kublai Khan came up with this money that was true alchemy, according to Marco Polo, because all that the emperor did was put his imprint on it, and it was accepted as legal tender throughout the land.
So this was the first time you had fiat currency, the first time you had legal tender. So how did Kublai Khan get this money of his to be legal currency and fiat money? He passed a decree saying that anybody in his domain who did not accept this currency would be put to death. It's a very effective way of creating a fiat currency and legal tender.
These days, central bankers have slightly more subtle methods of making their currency into fiat currency and legal tender. But this was the first time you had fiat currency. And the reason this was such a magical thing for Marco Polo-- and when he transmitted these tales back to his compatriots in Europe, they didn't believe him, because how could you have paper currency that was just issued by an emperor and not backed by anything. It was only four years later in the 17th century that you actually had paper currency beginning to appear in Europe.
So this is a note that appeared during the Yuan Dynasty. It's printed on these wood blocks. And it was in the form of paper printed on what is essentially a mulberry bark. And it's interesting what some of the writings on this note are. On the bottom block, for instance, it says that any counterfeiters of the note will be put to death. And more interestingly, whoever reports the counterfeiters will receive five jian of silver as a reward and in addition, all the family property of the counterfeiters. Quite an incentive to get counterfeiting out of the way.
But then paper currency came and went, because as you can imagine, the temptation to print a lot of paper currency was rampant, because all you needed to do was put the imprint of the emperor on paper, and it was supposed to be accepted as currency. So China not only had the first paper currency, the first fiat currency, the first legal tender. But they also had among the earliest hyperinflations, because you can imagine, many of these emperors were engaged in many martial adventures. They had to quell a lot of rebel provinces. All of this cost a lot of money. So they printed too much money. You had many episodes of inflation.
So paper money came and went. This was in the subsequent dynasty after the Yuan dynasty, the Ming dynasty, when paper currency again came into being. There was one measure of change, as you can see. This particular note from the Ming dynasty says something similar, that counterfeiters will be put to death. But now, in addition to the family property of the counterfeiters, the person reporting the counterfeiting now gets 250 tales of silver. So things are improving for those who report counterfeiting activity.
So paper currency came and went. But then there was a period when it essentially disappeared from the scene because of these rampant hyperinflations and the lack of discipline in terms of maintaining the value of money.
Then comes the turn of the 20th century. And in the 20th century, of course, there was a lot of dissension within China. But then the Kuomintang started taking control of a very good portion of China. And the Kuomintang government didn't quite unify all of China. But they did have political control of a very large portion of China.
So the Kuomintang again started reintroducing paper currency but faced difficulties for precisely the same reason as the earlier dynasties. They got carried away by the temptation to print too much paper currency and then had to devalue that currency. But then they put into place a reform in 1935 called a fabi reform.
So the fabi notes were essentially new currency notes issued by the Kuomintang government with one important distinction, which is that these were no longer unsupported by anything. These were backed by US dollars and British pounds sterling. So again, these were notes where the confidence in notes was to some extent backed up by other hard currencies. The British pound sterling was the dominant currency at the time. But the US dollar was beginning to come into its own. So these were backed currencies.
This is an image of Chiang Kai-Shek at the time. And then if you thought we've done with the list of firsts, it turns out there is one more first that China had in this monetary evolution. You may have heard the notion of a currency war these days. The notion of a currency war these days is that there are countries that are trying to reduce the value of their currencies or exchange rates.
Why? You might think a strong dollar or a strong currency is a good thing. But if your currency is cheaper, it makes your exports more competitive in other markets. That's the notion of a present day currency war.
But back then, it turned out there was a real currency war. So the Kuomintang government set up its own central bank, the Central Bank of China, to issue its currency notes. But the Japanese had started intruding into China and had taken over parts of Manchuria by that time. And they realized that currency control gives you a lot of economic power.
So what the Japanese did was that they set up their own central bank called the Reserve Bank of China. And they started issuing their own currency notes. Now, it turns out that even in those days, Shanghai was a very important financial center. This is what the Shanghai bund area looked like in the 1930s. Again, it's a little different these days. It was a hive of commercial activity right then. But more importantly, it was a hive of financial activity.
So what form did this currency war take? In 1938, the Kuomintang government set up a branch of its own central bank in Shanghai. And the Japanese, who by that time had set up a puppet government in Nanjing called Wang Jingwei Government, they set up the Reserve Bank of China, as I mentioned. And that bank set up a branch in Shanghai.
So now you had these two central banks operating in the same financial center. As you can see, trouble was to come. But it took on a very gory form. The Kuomintang-allied banks and some of the thugs associated with them, they went into the bank branches of the Wang Jingwei, that is the Japanese puppet government's, central bank, started pulling employees out onto the streets and executing them.
And what did the Japanese do in return? They went into the bank branches off the Kuomintang central bank and started dynamiting this thing. So this was a real currency war with blood on the streets of Shanghai. So if you think that these days you have currency wars, it was nothing like the currency wars in those days.
To this point, the currency that we've been talking about or that I started talking about, the renminbi, still is not in existence. These currencies have different names. But it was only in 1949 that the People's Republic of China was formed.
On December 1, 1948, about 10 months before the PRC, or the People's Republic of China, came into being, the People's Bank of China, which to this day is the country's central bank, was formed. The People's Bank of China, in late 1948 and early in 1949, started issuing this new currency called the renminbi.
There was a great deal of patriotic fervor at the time. So everything belonged to the people. There was the people's press, the people's newspapers, the people's party, and the renminbi, which literally translates to the people's money.
Now, if you go to China these days-- and some of you here were born in China-- the only notes you see, all the yuan notes that you see-- and the yuan is literally the unit of accounts, so it's sort of like the pound sterling. The pound sterling is the name of the currency. But if you walk into a pub in London, you don't get a tab in pounds sterling, you get a tab in pounds.
So the pound sterling is the name of the currency. The pound is the unit of account. Just like that, the renminbi is the name of the currency, and the yuan is the unit of account. So I'm going to use these two terms a little interchangeably as we go along.
So these days, if you go in and pick up any yuan note of any denomination, you see the picture of Mao staring out at you from the yuan note. It turns out that in 1948 when the very first yuan notes were issued, there was, of course, a clamor in the senior levels of the Communist Party of China to have Mao's image on the banknotes. But Mao apparently said, no, I am just a party functionary. This is the people's money. My image should not be on it.
So in the very first series of bank notes that was issued, Mao's image does not even appear. Then come the second and third series of bank notes. The third series was issued in 1987. Even at that time, you don't have Mao's image appearing on the bank notes. I'm sorry, the third serious was issued before 1987. But by that time, you have one feature that remains to this day.
On the front of the banknote, you have the denomination being shown in Mandarin. And on the back side, you have it in four languages, Mongolian, Uighur, Zhuang, and one other language. And all of these essentially remain to this day.
It was only when the fourth series of bank notes is issued that you start seeing a couple of features beginning to appear. This is the formation of the People's Republic of China. In the fourth series of bank notes-- and bank notes are interesting, because they sort of trace the evolution of thinking about society. So this was the idealized version of society, because it features an intellectual, a farm worker, and an industrial worker, which was seen as the ideal combination of skills in a society. And for the first time, you see Mao's image appearing with three other leaders, including Zhou Enlai and a couple of others, but still no full frontal image of Mao.
It was only in 1999, at the time of the 50th anniversary of the People's Republic of China, when the fifth series of banknotes, which continues to this day, was issued that Mao's image appears. But even then, it turns so that Mao's image appearing on the banknotes was not a slam dunk. There is archival material with, actually, Cathy Yang who did some of this work for me, uncovered, finding out that, in fact, there was a discussion among the printing bureau officials, and they decide that, because at that time, counterfeiting was a real problem, they consider various Chinese leaders, Li Bai, Li Shi Zhen, a variety of natural landscapes, a variety of leaders, and decided the only image that everybody in China, no matter what province, no matter what level of literacy will recognize is, of course, the image of Mao. So now every bank note of every denomination has the full frontal image of Mao on the banknotes.
I said that this book almost didn't get written. All of what I've described so far is in chapter one. I found this material completely fascinating, because I was wondering how to start my book. It is about the exchange rates, capital flows, and so on, boring stuff that only economists care about. But I started digging into this material. And it turned into something where I was distracted for nearly two months. And I really wanted to drop this whole project and write a book about Chinese monetary history. And someday, if I find the courage, I will.
So if you ever pick up the book, and especially if you're a non-economist, read chapter one. I guarantee that chapter one is really fun and interesting. After that, I make no such guarantees.
So let me talk about what else is in the book. But as you can see, this is the stuff that I really enjoy. So the Chinese renminbi has come a very long way since then. But it turns out that a lot of what has happened has happened in a very short period. We went all the way back to 200 BC. But the real emergence of the Chinese currency on the international scene dates back really to only the period of the last decade and a half or so.
So in the early 2000s, after the global financial crisis, China started allowing its markets, its capital account, that is the inflows and outflows of capital, to be somewhat less restricted. China's financial markets started developing. And China, of course, started becoming a major country.
So if you think about what has happened in terms of the RMB's progress to being an international currency, you may have seen a lot of discussion about this concept of the internationalization of the currency. It's a big word. And it means very different things to many different people.
So especially as a professor, I think it's very important to keep concepts in mind. The first concept that I think is worth thinking about is of an international currency. So what do I mean by an international currency? It's essentially a currency that is used in terms of trade and financial transactions between countries.
So the US trades with China, or China trades with Russia. What is the currency they use to denominate those transactions and to settle those transactions. That's the notion of an international currency.
And here, it turns out China's currency, the renminbi, has made very significant progress. One measure of how much a currency is used in international trade and finance is how much of international trade transactions are settled using that currency. In 2003, '04, '05, that number for the renminbi was basically zero. If you look at the trajectory since then, it goes from zero, virtually nothing, to a much bigger number.
That much bigger number turns out to be still small in absolute terms. It's about 2 and 1/2 to 3% of all international transactions. But again, we're starting from zero. And it turns out that in international finance, the dollar and the euro are still dominant. So even though it accounts for only about 2% to 3% of trade settlement, China's currency is already somewhere in the fifth to seventh spot in terms of international currencies.
And then if you look at other indicators, like the amount of renminbi-denominated bonds that are issued offshore, the amount of renminbi-denominated bank deposits that are held outside the mainland, all of those, again, show a trajectory very much like this, starting from zero, a very impressive rise, although in the last two years, it's sort of leveled off.
All of this suggests a currency that is beginning to gain traction as an international currency. And people have argued, wow, if the progress of this currency is so dramatic, it's going to start becoming much more important in international finance. And here it's worth thinking about a second concept that often tends to get conflated with the concept of an international currency. This is the concept of a reserve currency that is held by foreign central banks in their foreign exchange reserve portfolios.
Now, there are currencies like the dollar, the euro, the pound sterling, the Swiss franc, and so on that are reserve currencies. What does it take to be a reserve currency? It turns out that there are some attributes. There is nothing an economic theory tells us that you need to have these attributes to be a reserve currency. But typically, for a currency to be a reserve currency, foreign investors need to be able to easily move into and out of that currency and be able to liquidate those currencies if they want, be able to hold financial assets denominated in that currency.
So what it means is you need to have a relatively open capital account, which means foreign investors can invest in that country, and domestic investors and foreign investors who want to take money out of the country can do it relatively easily. We economists call this having a relatively open capital account for capital account transactions.
You need to have an exchange rate, the value of the currency in international markets, that is determined by markets rather than by the government. You also need a few other things. Economic size certainly helps. And China certainly has that. It's now the second largest economy in the world, one of the biggest trading economies in the world. Since the financial crisis, it's contributed even more to global GDP growth than even the US economy. Certainly, it has size.
China's financial markets are not that well-developed, but it's going in the right direction. So in all of these dimensions, China's making progress. But it doesn't have an open capital account. It doesn't have a market exchange rate, because the government still controls the value of the currency. So it should not have a reserve currency.
And here is the remarkable thing about the Chinese renminbi. It does not meet these prerequisites. But it has already become a reserve currency. There are a large number of central banks around the world, countries like Chile in Latin America, Nigeria and South Africa in Africa, a few European economies like Austria, Great Britain, and a whole host of Asian economies, Australia, Malaysia, Korea, Japan, all of which have indicated they already hold or plan to hold a part of their reserve portfolio in RMB. There are 35 countries around the world whose central banks have written agreements with the People's Bank of China, the central bank of China that gives them access to RMB liquidity if they need it.
On October 1, 2016, something even more dramatic happened. The International Monetary Fund, the IMF-- I used to work there, nice place. Not as nice as Cornell, but a nice place. The IMF has this artificial currency unit which it uses to denominate a lot of its transactions. So you can't really use this currency called the SDR, or special drawing rights, in your local grocery store. It exists only in the books of the IMF.
It's composed of four currencies, or used to be composed of four currencies, the US dollar, the euro, the British pound sterling, and the yen. October 1, 2016, the RMB entered that basket. The IMF decided that it was an important enough currency to become part of that basket. So de facto, it has become a reserve currency, even though it does not meet the prerequisites.
So one might say, China is a massive country. If it continues growing as fast as it has, even if Mr. Trump manages to make the US grow much faster than it has been over the last few years, eventually China could catch up to the US in size. China's doing some things in terms of economics reforms. Maybe the renminbi will take over from the dollar. This is where there's been a lot of hyperbole. And in my book, I take a very different point of view.
So let's go back to these concepts. This is an international currency. Have no doubt that the renminbi has already made progress. As a reserve currency, it is making progress somewhat sooner than you might have expected based on traditional economic criteria. But then there is the concept of a safe haven currency.
A safe haven currency is not just a plain vanilla reserve currency. It is a currency that investors turn to for safety at times of financial market turmoil. They go to instruments denominated in that currency just to keep their money in a safe place till all the storms blow over.
If you think about the major reserve currencies these days, the dollar, the euro, the pound sterling, the Swiss franc, all of these are seen as safe haven currencies. Certainly, Brexit had an effect on the pound sterling. Certainly, the eurozone debt crisis has affected what is happening to the euro. So the dollar, which was the subject of my previous book, remains the ultimate safe haven. But even a small economy like Switzerland still has its currency seen as a safe haven.
So what are the attributes necessary for a currency to be seen not just as a reserve currency but as a safe haven currency? For that, you need not just economic dominance or financial dominance, but you also need trust, trust of foreign investors.
And what does it take to have trust? What you need is-- or this is my argument, although again, it's not a theorem. You need an open and transparent form of democratic government with institutionalized checks and balances. You need the rule of law, so that foreign investors, domestic investors, all investors know they're going to be treated fairly according to whatever laws there are on the books. And you also need trusted independent public institutions like central banks like the Federal Reserve that can be trusted to preserve the value of money.
Now, certainly, one might argue that this is a very difficult juncture for the US with this proposition that I have laid out about all of these institutions. The institutionalized checks and balances are being tested in real time. As a human being, I'm horrified. But as an academic, it's fascinating to watch, because my thesis is being tested in real time.
But here's a funny thing. We have in the White House someone who has indicated that he may substantially increase the amount of US deficits and public debt, even suggested, at least on the campaign trail, that the US could walk away from part of its debt. But the US dollar has not fallen in value. You don't have investors fleeing from the US, because there is a sense that these institutionalized checks and balances will hold together.
So does China have that? I argue in the book that China does not. What the Chinese government under President Xi Jinping has committed to do, at least in word if not fully in action, is to undertake significant financial market reforms, economic reforms. They are proceeding on this in a very slow, haphazard way. But at least they are moving.
But Xi Jinping and his leadership have made it abundantly clear that political, legal, and institutional reforms of the sort I'm talking about are off the table. So my prognostication is that the renminbi, if China plays its cards right with financial market and economic reforms, it's going to become an important reserve currency, is well on its way to becoming an international currency. But chances of it becoming a safe haven currency are pretty small.
But having said that, the RMB and its increasing role in international finance is already playing a very big role in China's broader attempts to increase its strategic influence around the world. And China has become much more savvy about its approach to international engagement.
So as I describe in chapter nine of the book-- this is the problem with somebody who's written a book. Every time you say something, they'll say, it's all in chapter eight or chapter nine.
So in chapter nine, I talk about how China has become much more savvy about its approach to international engagement. It started increasing its influence in the existing international institutions like the IMF and the World Bank. It started setting up its own institutions like the Asian Infrastructure Investment Bank. And it is partnering with countries that have at least some common interests, like the emerging market economies called the BRICS economies, Brazil, Russia, India, China, South Africa. It's created along with them something called the New Development Bank, which is seen as a potential challenger to the World Bank, and also a reserve pooling arrangement where these countries pool at least a part of their foreign exchange reserves so they can jointly protect each other from currency or balance of payments crises.
So China has started doing this in a much more savvy way than it used to in the past, where it would go into a country, provide loans that were often seen as somewhat exploitative, because it was largely to suck up the natural resources from that country. That is all beginning to change. And the renminbi and its increasing influence is becoming a part of that, because when China starts putting in place certain projects through the Asian Infrastructure Investment Bank or through what is called, somewhat un-facetiously, as its Belt and Road Initiative, you can use the RMB much more in those transactions. So this has become a very important part of China's proceeding.
But before I wrap up, I want to address one question that comes up in many of these discussions and that may have come up in your minds as well. Why is this a priority for China to make its currency a big international currency? At some level, you might say that this is a matter of prestige. After all, China is a big, powerful economy. It should have a big, powerful currency.
But there are countries in the past, Japan is one instance, Germany is another. When their currencies were beginning to start playing a bigger role in international finance and were becoming reserve currencies, these countries actually resisted. They resisted for two reasons.
Number one, they felt that if their currencies became reserve currencies, then they would start loosing a little bit of monetary control, because a lot of the currency would be held outside the country. Whether or not that's the correct proposition is a different matter. But they had that fear.
The additional fear that many of these countries had was that if their currencies became reserve currencies, then the demand for the currency would increase. And currencies are just like other things. When the demand for something goes up, the price goes up. In this case, the price is the exchange rate. And if the exchange rate goes up, or appreciates, it makes your exports less competitive.
So Germany's Bundesbank, in fact, tried very hard to prevent the German currency at the time-- this was well before the euro of course-- from becoming a reserve currency. So they did not want the deutschmark to become a currency. Likewise, the Japanese resisted this from happening.
And China seems to be doing this even before it has met some of the conditions. Why are they doing this? Because after all, it does pose certain risks. China's financial system is not in great shape. They don't have a market-determined currency. And one thing we've learned from economic theory but also from various crises is that the right order is, you get your financial markets in good shape, you let your currency float freely so it can act as a sort of shock absorber, then you allow free flows of capital, which may lead to a currency playing a bigger role. China's going about it exactly the opposite way.
So I argue that this may look very, very foolhardy. But there is a logic to it. It may not be the ideal logic, but there is a logic.
What this did for China was very, very important, not from the perspective of making China's currency an important international currency but what it did for China itself, because what I think-- and I call this in the book a Trojan horse strategy. What Chinese economic reformers realized about two or three years ago was that this provided a very useful framework for doing what China needed for itself.
Any reform in any country has a lot of opposition to it. China is no exception. When I started working on China, and this was about a decade and a half ago, I thought, you know, communist economy. Whatever Beijing says is followed and picked up by the rest of the country. Not really.
The central government proposes. The provincial governments have minds of their own. Even within the central government, there are many who don't want any change, because the system as it is looks perfectly for them. So they resist reforms.
But what this Trojan horse strategy was about is as following. Let's take this notion of the RMB entering the IMF's SDR basket which was a big deal for China. The economic reformers managed to convince the leadership that this was very important. And the whole country sort of bought into it. Who could complain? The idea of having a currency that projects China's power onto the world stage was very important.
But then it forced China to think about what was necessary to make that happen. And what did you need to make that happen? You needed better financial markets. You needed a better regulatory structure. You needed the banks freed up from state control. You needed a more open capital account. All of this is very good for China, independent of what happens with the currency. But it worked very, very effectively as a strategy to get around all the opposition to those reforms.
But this is not without its risks, because again, ideally, China should have gotten its financial markets in shape, should have improved its regulatory structure before it did all of this. So there is a big risk. And we've seen some of those risks beginning to play out right now.
China is experiencing a lot of capital outflows. There are some downward pressures on the currency. So we might go back five years from now and ask, was this a risk worth taking. But I think, rather than thinking about this as the way the Western media often paints it, as policymakers who don't quite know what they're doing, and they're stumbling along, I think there is actually a very interesting, but certainly very risky, logic to this.
So the bottom line is that the Chinese currency is well on its way to becoming a much more prominent international currency. It is already a reserve currency, even though it doesn't meet the prerequisites. But none of us should get swept up by this hyperbole that the Chinese currency is taking over.
I think it's going to become, again, if China plays its economic cards right, a very important reserve currency. But the chances that it will become a major reserve currency, especially one that in any way challenges the dollar, I think, is completely off the cards. But having said that, I think in the years to come, it's going to be very interesting not just to see how China approaches this but whether in fact the RMB's increasing role in international finance goes along with China's own financial market and economic development as I've laid out.
And in any case, the one thing I can guarantee is that it's going to be a wild and interesting ride in the years to come. So buckle up, hold on. And thank you.
[APPLAUSE]
Thank you. So as I said, I stopped putting up slides here, because the rest of the thing is less enchanting than the history stuff. But if you have any questions, I'd be delighted to help clarify anything I may not have been clear enough about.
GENE REILLY: Gene Reilly here. I tend to ask the first question, because I don't really know what I'm-- very interesting talk. And obviously, it reflects what we're reading in the paper. I guess my question would go to the extent to which it's important that China get its state industries and state banks that lend too much money in the context of perhaps the value of their currency under control. How much of a factor is that in leading them towards a more acceptable currency for the world?
ESWAR PRASAD: Two words, chapter eight.
AUDIENCE: [CHUCKLES]
There is a complicated set of issues that China has to manage right now. One is the state control of its economy and state control specifically of its financial system, because the Chinese financial system still remains bank-dominated. And most of the banks are still owned by the state. And those banks, to a very large extent, are lending money largely to the state-owned enterprise sector, not to the more dynamic parts of the economy.
And this has created a lot of risks in the system. And again, one hears, if you read the financial press, prognostications about China coming apart at the seams, especially in terms of its financial markets. And there is a risk that this could happen.
In fact, I've been working on China for about 15 years. And every year, you could tell basically a similar kind of story, that this year, somehow they manage. But if they don't deal with the problems this year, by God, next year, they're going down. We could say this every year. And the problems have grown. And we've continued saying this.
And this is not to say that this may not be the year that it actually happens, that the system comes apart. But what is interesting is that they have actually built a lot of safety buffers into the system.
So if you look at the financial press again, one number that is stated a lot is the overall amount of debt in the economy. It's about 300% of GDP, three times the size of the economy. It sounds like a lot. It's similar, actually, to that of the US, Japan, and so on. So by itself, that number is not scary. In the US, a lot of it tends to be government debt.
In China, what is scary is that about 160% of GDP worth of corporate debt outstanding in this economy. This seems massive and crazy, because again, It's 160% of GDP worth of credit intermediated through a banking system that's not functioning very well. This has got to end badly.
But again, the good thing about China is that the big borrowers, the big lenders are all owned by the state. So some of the stuff nets out on the central bank balance sheet. And if you think about how leverage or debt brought down the US economy, part of it was a liquidity problem, that there were firms that were sort of marginally solvent. But when the banks started facing pressures, they started calling in their loans. They didn't make new loans. And this sort of set off a cascading effect.
You don't have this liquidity problem in China, because the government owns all of the stuff. They'll make sure that whoever needs the liquidity, which is money in the short run, has it.
The right way to think about China is how expensive is it going to be to fix this. So my baseline pre-assumption is not that that there is going to be a financial crisis. But there is a big financial hole to be filled, because a lot of this money that has been lent out to the state-owned enterprises is not going to be paid back. Somebody is going to have to pay back. And who's that? Ultimately, it's going to be the Chinese taxpayer, the Chinese household.
So a better way of framing this discussion is how big is the price tag going to be. And estimates by the IMF, some work I've done myself, I'll suggest it could be large. It could be somewhere in the range of 10% to 20% of GDP, which sounds like a big number, especially if you think about it in dollar terms, because the Chinese economy is now an $11.5 trillion economy. So you say 10% of GDP, oh, my god, $1.1 trillion worth of bad loans. It's a big number, but it's 10% of GDP.
So if you think about this cost being born over a three-year period, that's 3% of GDP per year. Big cost but not unmanageable. But it is certainly true that if they don't fix the financial system and get things going in the right direction, it has implications for China's growth, which in turn may have implications for China's currency.
And it's all the volatility that we've seen in China's financial markets that has sort of led to the leveling off of all of these indicators of international use of the currency over the last two years. I said the trajectory initially was like this. This is from about 2005, 2006 to about 2014. Starting in the middle of 2014, everything levels off.
Yes?
SPEAKER 5: [INAUDIBLE].
ESWAR PRASAD: So the question is, is this China trying to make its currency backed by gold. No. I think most countries have recognized that backing by gold can actually be a severe constraint, especially in a complex financial system.
So if you think about what happened during the Great Depression, there was a constraint on the ability of the Federal Reserve to print money at will. The financial crisis was very bad. It would have been much worse if you didn't have a central bank like the Fed or other central banks like the ECB with the ability to effectively supply money elastically, meaning at will.
China has been acquiring more gold. And you've probably heard about this. So China has been trying to manage the value of its currency. So a lot of dollars have been coming into China, because investors have been putting money into China. China has run a trade surplus. All of that brings in foreign currencies.
But all of that would have led to the currency's value appreciating, because all of those currencies had to be converted into RMB for use in China. So instead, China has been recycling those and buying up dollars in the form of US Treasury securities, euro government bonds, and so on. But they already hold more than a trillion of US Treasury securities and so on. And they would like to diversify.
So they've started increasing their holdings of gold. And again, concerns about the US dollar have been transmitted to concerns that maybe China is no longer buying US Treasury securities, they're buying gold. We don't know how much gold China holds.
They say they hold about 1,000 tons of gold. They held 1,000 tons of gold two years ago. There are some indications that they may have doubled that holding to about 2,000 tons. That's still, at present market value, would amount to about $100 billion. Their foreign exchange reserve holdings are $3 trillion. And the amount of money in circulation in China is about twice the size of GDP. So it's about $23 trillion. They could not back it by gold, even if they wanted to. Yes?
SPEAKER 6: Most of the major economic crises in emerging markets happened in a moment in which the debt in dollars becomes unbearable. There are tremendous devaluations in the local currency. And all of this with devastating effects. Let's say Latin America did not recover the GDP per capita in 25 years.
So China has no debt, on the contrary. So is it real, the possibility for tremendous devaluation of the renminbi? And isn't China doing all this to avoid that, to avoid the emerging markets curse that has happened before?
ESWAR PRASAD: So what this is referring to is the experience of many emerging markets where they borrowed in foreign currencies like dollars. And then the problem is if people stop financing you, the value of your currency falls.
So let's say you're a Korean company earning Korean won as revenues. And you have your debt in dollars. And the Korean won falls sharply in value. The value of the dollar debt, because it's denominated in dollars, shoots up in won. So even if you're a good company and took reasonable amounts of debt, the won value of that debt may have changed, because the dollar appreciated or the won fell in value relative to the dollar. And that has caused a lot of crises.
In China's case, as you pointed out, the amount of external debt is very small. It's about $1.3 trillion worth. And only about 60% of that, about $800 billion is foreign currency-denominated. So $800 billion sounds like a scary amount of money. But $800 billion for an 11 and 1/2 trillion dollar economy, especially one where they have $3 trillion worth of hard currencies, is not really a problem.
What they're concerned about right now is that until about mid-2014, the Chinese were trying to prevent their currency from rising too fast. And this is why the US, the IMF, and so on were complaining China's manipulating. Now we hear the complaint that China is manipulating its currency. But what China is actually doing is a big favor to the US, because now the value of the currency is falling relative to the dollar. So China's trying to prevent the value of its currency from falling too fast.
So if China were to do what the US and the world have been asking it to do for the longest time, what would happen? The renminbi would fall even faster relative to the dollar, making Chinese exports cheaper to the US. So we would import more, which would make things worse. So this should rank along the list of categories of be careful what you wish for. But in Washington, we're continuing to wish for what we should not be wishing for. But that's Washington's. It's good here in Ithaca, a little more reason here.
But what they've been dealing with is the fact that, because the RMB is falling in value, people in China, both domestic investors and foreign investors, have invested their concern. What if the RMB continues falling in value? So they've started taking money out.
So what China is trying to prevent is too much money flowing out too quickly. So they're trying to prevent the RMB from depreciating too fast. And this is a big change since 2014.
Until the middle of 2014, the RMB was rising in value relative to the dollar, and they were trying to stop it from rising too fast. Since the middle of 2014, the story is exactly the opposite.
Yes? OK, I don't want to keep you too long. So we're going to take two or three questions. And I'll answer them all together.
SPEAKER 7: The Chinese military seems to be an enterprise unto itself. How did they do that?
ESWAR PRASAD: OK. I'm going to take two or three questions and answer them all together.
SPEAKER 8: What's your take on the demographic transition and its effect on the value of Chinese currency?
SPEAKER 9: Do you think the RMB will play a very significant role in China's grand stratagem of One Belt, One Road, though the TPP has been slowly falling apart?
ESWAR PRASAD: OK.
SPEAKER 10: Just wondering in terms of capital controls and export-led growth in the beginning and how it's changed now to an emphasis on domestic-led growth and a different type of capital controls. So I was wondering how that plays into how they've treated currency and growth prospects in the future.
ESWAR PRASAD: OK, so four questions, seemingly very different, but all, in fact, quite related. So what China has been trying to do is increase its geopolitical influence. It's a very big term, but it encompasses what they're trying to do with the military and also with initiatives like this One Belt, One Road.
So this One Belt, One Road is this initiative that tries to expand the old maritime silk routes through the northern and interior portions of China and through parts of Asia, like Mongolia, there's areas around Pakistan and so on, and onward all the way through Europe. And part of the reason is to increase international defense but also to do what they've been trying to do, which is to develop the interior provinces, because China's economic development has been quite unbalanced.
There's been a lot of development in the coastal provinces, especially the eastern coastal provinces. The interior provinces haven't had as much development. So this is a way of trying to stimulate economic activity there but at the same time increase strategic influence.
So I don't have any special insights into the Chinese military. But what I can see is, again, a very concerted move to increase influence through a variety of different means. Now, there are more and more countries around the world that are coming closer into China's economic and geopolitical ambit, because it's very hard to ignore a country like China that is at the margin, adding more and more to world GDP than even the US economy.
And the US right now looks like a less and less reliable partner. So you referred to the Trans-Pacific Partnership falling apart. The Trans-Pacific Partnership was to be a deal that included 11 other countries other than the US. And what is important about the TPP, which included many Asian economies-- so it was seen as a way of forestalling the expanding Chinese influence in the Asian region, even if that was not something that could be done in any permanent way. But that has now been taken off the table.
So if you think about economies in Asia, there is this massive economy right at their door which has very strong military power and is an economy that they cannot afford to disentangle themselves from. So everybody wants to be friends with China. And you see this with the ramping up of trade deals, with the even military deals, even though many countries in Asia would like to have an offsetting influence. But again, the US doesn't seem like that reliable a partner.
So I think the ability to use initiatives like this One Belt, One road have to be seen in this broader context. But a lot is happening within China itself, because the key economic challenge there in China-- you spoke about demographics.
So China already has, depending on how exactly you define it, either a workforce that is already shrinking or that will start shrinking in about three to four years. So the sort of growth that China needs cannot come from the way it used to generate growth in the past. And the way China was generating growth in the past, although there is notion of China being an export-led economy, it turns out that in fact investment was a key driver of growth.
So over the last decade and a half, about half of China's real GDP growth has come from investment growth. On average over this period, the amount of contribution from net exports, that is exports minus imports, which is what matters for GDP, has been relatively small. China is trying to shift away from investment. Why is this? For an economy that is relatively capital-poor, a developing economy like China, more investment is good, especially when your demographics are not working in your favor. But a lot of this is investment undertaken by big state-owned enterprises financed by big state-owned banks. And it's not necessarily a good investment.
So what they're trying to do is shift towards an economy that is driven more by consumption rather than investment. It's not like consumption is a great thing. But China saves a little too much of its income, especially because you're not getting good returns on those savings. Plus they're trying to get the financial system to allocate capital to the more productive parts of the economy, the services sector, small and medium enterprises, which can not only generate better productivity growth if all goes well but can perhaps do better at generating employment growth as well.
So these are enormously difficult challenges. And so my frames of reference are Washington, to some extent New Delhi, and then Beijing. In Beijing, when I talk to policy makers, I sense at least an understanding that there are big challenges that they face. And they're trying to come to terms with them. And there are many promising signs.
So until about three years ago, all of these indicators like the amount of growth coming from investment, the employment growth, the share of the services sector in GDP, all of those were not looking good. In the last three years, things have started looking better. You have to tilt your head a little bit to make things look really good. So they're not good. But at least things are flattening out and in some cases getting better.
The services sector now accounts for a little over 50% of GDP. Consumption growth, public and private together, account for more than 50% of GDP. The saving rates in the economy, especially households, are beginning to decline, which it turns out is a good thing, because Chinese households save way too much. So everything is going in the right direction but very slowly.
And I'll finish up with one last concern that I have about China. I spoke about how there had been these reforms in the reals in the financial sector. They've actually done some things in the last two years, largely on account of this Trojan horse approach, because in the guise of making the RMB an international currency, they've actually managed to push through some financial market reforms. But the big challenge is trying to get the state-owned enterprise sector to work better, trying to fix the regulatory system, trying to improve the institutional framework.
It's all very well to say let the stock market work. But then if you don't have good corporate governance standards, if you don't have good auditing and accounting standards, who knows what's on the books of these companies, if you don't have good corporate transparency or government transparency, this doesn't work. So the real side reforms, the institutional reforms are all not moving very fast.
So we have a situation where it's not that China's not reforming. But it's becoming a very unbalanced set of reforms, with financial market reforms, capital account opening getting ahead of everything else.
So China's going to continue to be a very interesting economy to watch. I'm somewhat optimistic that they're proceeding in the right direction. But again, there are going to be lots of stumbles, missteps, and risks that arise in this process. So for an academic like myself, there is going to be much to look at.
And I hope that all of you will keep looking at China. But again, whenever you look at it, look at it with some degree of balance. A lot of the reporting that you see suggests either that China is taking over or that it is falling apart. Neither of the two. It's stumbling along. And that's the way it will remain. Thank you.
[APPLAUSE]
NARRATOR: This has been a production of Cornell University Library.
China’s growing global prominence is taking the world by storm and reshaping global finance. With the recent rise in the renminbi, China's currency since 1949, China’s international influence has expanded, and its currency could someday rival the euro and the Japanese yen. In a Chats in the Stacks book talk given at Mann Library in February 2017, Eswar Prasad, one of the world's leading experts on international finance and the Chinese economy, presents his new book, Gaining Currency: The Rise of the Renminbi, examining the rise of the renminbi and its implications for global finance today.
Starting with a brief look at the deep history of currency development in China, Prasad examines the important role that China’s expanding prosperity and targeted government policy have secured for the renminbi in the world’s global economy. However, as Prasad convincingly argues, the lagging alignment between China’s economic reforms of the past decades and the country’s political and legal institutions signifies an important truth: While the renminbi’s position in the world economy is likely to continue growing in coming years, it does not pose a serious challenge to the U.S. dollar’s dominance.
Eswar Prasad is the Tolani Senior Professor of Trade Policy in the Charles H. Dyson School of Applied Economics and Management, part of the College of Agriculture and Life Sciences CALS and the Cornell SC Johnson College of Business. He holds the New Century Chair in International Economics at the Brookings Institution and is research associate at the National Bureau of Economic Research.
