SPEAKER: Well, thank you very much, everybody, for coming. This is a really interesting event that we have planned here. I've been in economic journalism now for about 20 years. And I can't remember a time when the rise of China hasn't been an issue that we haven't all wondered about. And it's become especially intense in the last few years, because China now has outsized weight in the global economy. And everything it does has ripples here and abroad.
I mean, I just think back to eight months ago when we wondered whether the chaos surrounding its devaluation was going to cause a recession here. So it's times like this we really benefit from the depth and historical perspective of somebody like Eswar who's been working on, has been studying, and examining, and advising on all the very complicated policy and economic issues surrounding financial and economic liberalization in China. He's been working on this for years.
He's summarized the history and the complicated dynamics behind this in a really interesting new book which we're going to talk about today. Gaining Currency, the Rise of the Renminbi.
The format of the event today is that Eswar is going to give brief opening remarks summarizing some of the theses that he has in the book. And then we're going to have a conversation among all the panelists up here on what we just heard. And then hopefully we'll have some time to hear from you and get a few questions going. So we'll start with you, Eswar.
ESWAR PRASAD: Where do I begin? It turns out one can begin a long, long time ago. What we're going to talk about today is the renminbi, which has, in fact, been China's currency only since 1949 when the People's Republic of China was formed. But, in fact, the history of paper currency goes way back. And, in fact, in chapter one of the book I talk about ancient monetary debates in China that go back to 200 BC, when many of the issues that Ben and his colleagues grapple with these days, who should issue money, and more importantly, how to preserve the value of money were being debated by Chinese scholars in the Han era back then.
China also issued the first paper currency in the 7th century and then the first Fiat currency in the 13th century. And we know about this from the writings of Marco Polo who visited the court of Kublai Khan and was stunned by this alchemy that he saw in the court of the Grand Khan as he called him. Because the Grand Khan just put his imprint on mulberry bark, which is what paper was made of at the time. And people around the land accepted it in exchange for goods and services.
So how did Kublai Khan make his currency legal tender? Very simple. He passed a decree that anybody in his domain who did not accept the currency would be put to death. I don't think that's quite the strategy that Ben and his colleagues, when they were at the Fed, were using to make the currency the dollar strong. But at the time it certainly worked.
China also soon after had among the earliest hyperinflations, because the temptation to print paper currency in an undisciplined fashion was difficult to restrain. And China also had, as it turns out, one of the first literal currency wars. The Kuomintang government in the late 1930s had issued its own currency, set up its own central bank. But the Japanese had invaded parts or occupied parts of China by that time. They set up a puppet government in Nanjing. They also set up a central bank in Shanghai.
So the Kuomintang went in and dynamited the branches of the Nanjing government's reserve bank. And in turn, the Nanjing government, which was a proxy government of the Japanese, went in, executed bank employees of the Kuomintang led government. So it was a literal currency war.
These days you don't have blood on the streets. Yes, blood in the corridors of Wall Street. But that was a real currency war.
But since 1949 the currency has come a long way. And on October 1 the IMF had officially anointed the RMB as an elite reserve currency, on par at some level with the four other big currencies, the euro, the yen, the dollar, of course, and the pound sterling that are part of the IMF's SDR basket. So how has China accomplished so much in relatively little time? Because the process and the project of making the RMB an international currency really got started only about four or five years ago.
So it's worth thinking about what has been achieved, what has not, and what the implications are for the Chinese economy itself. It's useful to distinguish among some concepts. And I am a professor. So I always start with concepts, which are very useful.
As an international currency, one that is used widely in trade and finance transactions around the world, the renminbi basically started at zero about five years ago. It didn't have a presence. Today China is about the fifth most important payments currency. It accounts for about 3% of payment transactions settled through the SWIFT network. About 30% of China's trade transactions are settled in RMB. And China accounts for about 12% of international trade. So it's not a trivial number. But again, the numbers are not very large, but the trajectory is unmistakable. Going from essentially 0% to 3% in a period of four to five years suggests that big things may eventually happen.
Then there is the concept of a reserve currency, one that is held by foreign central banks in their foreign exchange reserve portfolios. Now, in the book I lay out some notions of what it takes to be a reserve currency. You need to have an open capital account so money can flow easily in and out of the country. You need to have a market determined exchange rate. China doesn't have these. But here is the remarkable thing. The Chinese currency is already a reserve currency even before the IMF anoints it as thus.
About 20 to 30 central banks around the world, countries like Chile in Latin America, Nigeria, South Africa in Africa, Austria, the UK, and a whole host of economies in Asia all already hold or plan to hold a part of their reserve portfolio in RMB. There are 34 central banks around the world that have signed bilateral local currency swap arrangements with the People's Bank of China, giving them access to RMB credit. So de facto the RMB has already become a reserve currency.
Now, one thing that it's necessary for a currency to move from being a small to a significant reserve currency is that you need well developed and well regulated financial markets. Foreign investors need to have access to renminbi denominated instruments that they can acquire, that they can trade easily in and out of. China doesn't quite have that yet. China's moving in that direction. And, in fact, if you put together the corporate and government bond markets, that capitalization now stands at about $7 trillion. By comparison, the US is at about $35 trillion. But China already exceeds many of the other reserve currency economies by this metric.
So China seems to be moving in the right direction in terms of making its currency more flexible, in terms of opening up its capital account, in terms of developing its financial markets. But I argue in the book that there is one very important ingredient that prevents or will prevent the currency from dominating. Because there is a very persuasive narrative that without meeting the preconditions the currency is already a reserve currency. So when it meets the preconditions it's going to take over. I argue in the book that's not the case, because there is another concept which is very important.
Until the renminbi came along this was not a concept that was different from that of a reserve currency. And that concept is that of a safe haven currency, one that foreign investors can turn to because they view the country, assets denominated in that currency, as a place for safekeeping of funds during times of turmoil.
But to have status as a safe haven currency one needs foreign investors' trust. And I think what you need for that is a set of institutions. And by institutions I mean something very specific to engender the trust of foreign investors. You need an open and transparent form of government with institutionalized checks and balances. One needs trusted public institutions, including an independent central bank that will protect the value of the currency. And you need the rule of law so foreign investors know they will be treated fairly in the courts of law. China doesn't have any of this, and has signaled that it is not going to have any of this.
So my sense is that the RMB is going to erode, to some extent, but in no way rival the dollar's supremacy. But having said that, it's going to be a wild and interesting ride for the next few years to come. The currency is definitely going to make a mark in international finance, largely driven by China's size and importance in the world economy, and in the world trading and financial systems. So the RMB ultimately is going to rise if China plays its cards right with economic and financial market reforms. But will it rule? To that, my answer is no.
SPEAKER: Thank you very much, Eswar. And now just to briefly introduce the other panelists, on my far right is Jin Zhongxia who is the executive director for china at the International Monetary Fund. Formerly he was the head of the Central Bank Research Institute at the People's Bank of China.
Next to him, Ben Bernanke, who is a scholar here at the Brookings Institution. Before that he was chairman of the Federal Reserve.
And finally, Caroline Atkinson, who's head of global policy at Google. But before that she was advisor on international economic matters to President Barack Obama. But I will start the questions by asking you a question, Eswar.
And it sort of jumps off the last point that you were making about this distinction between reserve currency and safe haven currency. The big question, as your book drives us towards, is will, at some point, the RMB rival the dollar as the world's preferred reserve currency? And you raise important questions about what keeps it from achieving that status. What is standing between reserve currency and safe haven currency for the RMB?
ESWAR PRASAD: China does seem to be moving forward aggressively with economic and financial market reforms. Although, if you look at what has happened over the last year and a half one could make the case that some of these reforms have been very halfhearted, and very haphazard, which in turn has created a lot of turmoil in currency markets and equity markets. And I think there isn't a complete commitment to financial market reforms the way we might think of having a market work completely freely. And there isn't a good institutional framework to support these market oriented reforms.
But again, even though China is moving forward with these reforms in a very haphazard way, I think the RMB could end up rivaling some of the reserve currencies, such as the Japanese yen, the pound sterling, and perhaps even take a bite out of the euro. But the dollar has a lot going for it. Its size of financial markets, plus a lot of institutions that work well. And one thing that China has made very clear. The president on downward have made it very clear that while they are committed to economic and financial market reforms, broader political, legal, and institutional reforms are off the table.
But, again, reading the press you might not quite get a hint of this, because there is a lot of discussion about the rule of law. But it's important to recognize that what China means by having the rule of law operate is not what some of us in this room might think of as the rule of law. What they mean is having property rights, contractual rights being enforced in an efficient manner. And you need that for a market oriented system to work well. What is unlikely to happen is that the rule of law will not mean that the courts or the court system takes precedence over the Communist Party of China. And that's what we might think of as the rule of law.
So I think on these dimensions it's very unlikely we'll see progress from China. And that's why I think that China could become, if it plays its cards right-- and I keep adding the qualifier. It's important-- that it could become a significant reserve currency. But is it going to become a safe haven currency? Ain't going to happen.
SPEAKER: But if you could name just a few of the things that they have to do to sort of get in towards that direction. You've talked about the rule of law, for example. What does a foreign investor or a foreign central bank that wants to hold RMB as reserve, what do they need to see in terms of judicial or legal stability to give them that comfort level?
ESWAR PRASAD: The key question that a foreign investor is interested in, are the rules of the game going to be changed for political reasons? There aren't that many countries in the world. We are in one where we are in the craziness of the political season. But there are institutionalized checks and balances in the system. And most importantly, you or I or a foreign investor could take the US government to court if we feel that a law is not being followed properly by the US government. And very often the US government does lose.
So if you think about a foreign investor wanting to be treated fairly, this becomes important. Why is it that we had a flood of money coming into US Treasury securities after the financial crisis when the financial crisis started here? It's because foreign investors knew that they could move easily in and out of these instruments. And more importantly, the US government couldn't turn around and say, you, the foreign investors, hold a lot more of our securities than our own investors. So we're going to put the torch to you, because legally they can't discriminate among different classes of investors. And that creates trust.
So there are these elements, having an independent central bank, having a better legal system, that I think are crucial for that word, trust, to be there. And I don't think China is going to get there.
SPEAKER: Ben I'd actually-- yeah.
BEN BERNANKE: I just want to make an observation. I agree with Eswar's prognosis that RMB is going to be a player, but not a big player in international reserves, for example. But I think we ought to say something about why is this important. I mean, the presumption here is this is a really big deal. I think actually that having a reserve currency is a mixed blessing.
And, for example, the United States doesn't pay lower interest rates because the dollar is the international currency. To the contrary, in times of great stress money flows into the US, and the dollar strengthens, which is actually bad for US exports, for example.
So it isn't evident that China would have tremendous benefit from having the same role as the dollar as a currency. Rather it's very much symbolic. And as Eswar's suggesting, if the RMB does become an international currency, it will indicate that China has met certain benchmarks of international role, of institutions in light, which will say China has made great progress. But the fact whether or not the RMB becomes a global currency I don't think is critical to China's development in any really fundamental way.
SPEAKER: I would actually like to ask you to assess how far China has come to having institutions that are what we associate with a credible financial system? And if I may, I'd like to recall something I heard you say when you were testifying on the Hill about a decade ago. You were being asked I think about the merits of investing into the Social Security trust fund in equities.
And you pointed out the elementary economic fact that the risk adjusted return of equities is not higher than that of bonds. And you said that if you had bought Russian stocks in 1917 you'd still be waiting for your risk adjusted return to reassert itself. So given that, given your historical perspective, how far has China come in the direction of being the sort of economy with the kind of institutions that we can associate with a trustworthy currency.
BEN BERNANKE: Well, certainly it's come a long way in terms of its size and importance. And a huge part of global growth is coming out of China. China is a big player in trade, the biggest player in trade and commodity flows, et cetera. But I agree I think essentially with Eswar.
First that there's a lot needs to be done in terms of market liquidity and depth. The size, depth, liquidity, and efficiency of China's financial markets is not yet in the same category. And understandably, because it still is an emerging market economy. So in terms of being able to buy and sell easily, the US market, the European market, UK market are still much more liquid.
And then beyond that, the safe haven aspects that Eswar's talking about. So I think progress has clearly been made, but until there is a more open, more market dominated financial system, there are some important barriers.
SPEAKER: Thank you.
BEN BERNANKE: Yep.
SPEAKER: Jin Zhongxia, Ben just talked about why having a reserve currency is not the same as that being a desirable thing. And yet, China clearly wants the RMB to be an internationally recognized reserve currency. Can you give us some historical perspective of monetary affairs in China? Why is it so important to China that the RMB be in the SDR? And give us a historical perspective of why China is moving in that direction.
JIN ZHONGXIA: Well, I think, based on my own experience in participating in the internationalization process of the renminbi what I can see is that this internationalization process has been entirely a market driven, demand driven, and market pushed process. It is because of the need for the market participants to minimize the currency mismatch that they want to use the renminbi in the foreign trade.
And it is the desire that the authority need to recycle the currency circulated in the offshore market that has pushed, at least as a partial reason that has pushed the authority to open up its capital market to absorb the inflow of the renminbi denominated money. So I think, in my view, this is a market driven and demand driven process.
SPEAKER: Just to follow up on that, do you see the inclusion of RMB in the SDR as an accelerator or an impetus to push forward on other liberalization moves in the Chinese economy?
JIN ZHONGXIA: I think so. Yeah. If you look at the history, you can get some hint for the future. And in the process that led to the inclusion of renminbi into the SDR basket, China has adopted a series of major reform steps, including liberalizing the interest rate, and improving this macroeconomic statistical framework by joining the SDDS of the fund, which is a higher standard macroeconomic statistical system.
And also by drawing in the COFER, which is a survey of the members' currency composition of these foreign exchange reserves, which was previously regarded as a national secret. But now we've become very transparent. And also, China in this process opened its financial market, including the foreign exchange market and bond market.
Although this opening up is still partial, but it has been a major step that we allow the entry of foreign central bank like institutions, international financial institutions, the sovereign wealth management fund, and also, increasingly, commercial financial institutions to participate in our foreign exchange market. And also our [? internal ?] bank bond market.
So all this, I think, has been done in a determined way. So in future I think China will continue to reform and open up in this direction.
SPEAKER: Caroline, I want to ask you about the process by which the RMB was brought into the SDR. And I believe the two main technical criteria was the size of the economy and freely usable. And I think there were a lot of questions about whether the RMB met that second criteria, freely usable. And Eswar, in his book, talks about how for the IMF it wasn't just strictly technical criteria at work. There was also a political desire to accommodate what China wanted. Can you talk to me a little bit from your perspective, having been at the White House, interacting with the IMF and your counterparts around the world about that process. Was the inclusion of the RMB in the SDR a strictly technical exercise, or was it more than that?
CAROLINE ATKINSON: Well, I think having been a policy maker for a long time that there are very few decisions that are strictly technical. But there are decisions that have a technical basis. And I think this one had a technical basis, for sure.
What was important I know to the United States at that time when I was working there was that the second criterion, the freely usable, should be an important one. I think it's also important, and it was important for the IMF as a policymaking body, and as a body that is representing the strength of the system, the economic and financial system in the world, it's important to have major economies represented in a proper way. And it was clear that this was something that was of great importance for China. And I think also for the other countries involved, including the United States, others-- I can't speak for them anymore-- to see-- and I like what Ben said about joining the SDR being an important symbolic move-- it's important to see China accepting and wanting to be a part of the obligations, responsibilities of the international financial system.
So I don't think it was a controversial decision. I agree that the steps towards it in terms of opening up financial flows, opening up exchange rate transactions, and, importantly, although it might not seem obvious, importantly becoming more transparent with China's commitment to join the SDDS and so on. Those were all important elements for those that were wondering how to strike the technical balance.
And I also would pick up on what Ben says about-- and I think there was a little bit of a disagreement there. Was this just a purely market led development? Or was this something that was important symbolically? And I would certainly say that from the outside it seemed as if this was something that was important symbolically, something that's easy for a political audience, a president and other policymakers to understand that you're becoming a currency of the kind that is recognized.
And I certainly know that in my experience people that I spoke to in the political sphere who might not have been able to tell you what a freely usable currency was or why one currency was and another was not could get the idea of are you a reserve currency, and are you included in this basket?
And I think that it has been used in a good way actually by the IMF, by the People's Bank of China, and by others to promote the kinds of reforms that will make China's financial system stronger.
SPEAKER: Eswar, what's your view on this? How closely do you think the IMF did adhere to the spirit and the letter of the requisite requirements of including RMB?
ESWAR PRASAD: On the technical requirements one could quibble. And I spend two or three pages in the book quibbling. But the broader points that I think Ben, Caroline, and Jin have brought up is important. Ultimately, I think this decision is very good for China, and for the IMF and the international financial system that it represents.
Why is that in China it's very difficult to undertake reforms, given that the system as it is presently structured works very well for the large state owned enterprises, the large state owned banks, the provincial governments. But the notion of having a very specific objective that the leadership of the country and the people of the country could sign on to, the notion of a big important country having a big important currency I think served the PBOC very well in terms of being able to dislodge opposition to the reforms. If one thinks about what was accomplished on the reform front in China over the last year and a half-- and Jin Zhongxia listed many of these-- liberalizing the deposit rates, therefore, freeing up the entire rate structure of banks, making the exchange rate ostensibly more flexible, putting in place an explicit deposit insurance system. All of these are about the financial system or the capital markets. And most of these come off the checklist that the IMF set out for China.
So it was very good for the internal reform process. And I think it's going to be good for the Chinese economy over the long run. It's also good for China to feel that it has more of a stake, more ownership at the IMF. And so from the IMF, although perhaps it's not really an existential issue, it was still very important in terms of bringing on board the emerging markets, which have felt somewhat slighted over the years in the sense they have that there is a somewhat unfair, unbalanced treatment between the emerging markets and advanced economies. Whether or not that is fair, that impression exists. And I think it was important also to see that having a big economy recognized as taking its place among the economic elite was very important.
But ultimately, again, going back to what both Jin Zhongxia and Ben have said, this is going to be a market determined process. The IMF can bless the renminbi, can elevate it onto a pedestal. But ultimately, it's what happens in the Chinese economy. It's what happens with the Chinese financial markets that is going to determine the RMB's status as a reserve currency. And perhaps this will catalyze the process and push it along, but it's not going to be enough.
CAROLINE ATKINSON: Can I just comment that I remember rather similar, or some similar debates around the time of the introduction of the euro, some debates in the United States about is the euro going to rival the dollar? Is it going to take over? And before that with the Japanese yen, when the Japanese economy was the second largest in the world and there was a question about, well, maybe the yen is going to be the currency, leaving aside as Ben rates the question, do you even want to be in the country that has the reserve currency? I think that what we saw with and what we've seen with the euro and the yen, and in a way also with the pound sterling, which has remained strong, even though the economy is much smaller in relative terms, is that the nature of the financial markets, as well the economy and the rule of law, all of those things, but including the more technical elements of are assets available and so on really matters to whether a currency sort of takes off and becomes-- we can see there are two tiers clearly at the moment between the dollar and then the other currencies. So it's not, in a sense, a new phenomenon to be thinking about maybe this currency is about to go somewhere different.
SPEAKER: But actually, you brought up the yen and the euro. And that actually brings me back to one of the early points that Eswar raised, which is the importance of institutions. Right? So one thing we can say about Japan and the European Union was that they did have rule of law, judicial independence, a democratically accountable system of government and so forth. But Eswar, as you point out, the Communist Party has made it clear that those are not the end game. So how significant is that distinction in terms of whether the RMB follows the path of the European or Japanese currencies on the way to reserve status?
ESWAR PRASAD: My sense is it's going to be a key determinant. Again, given China's sheer economic size the RMB is going to become a reserve currency. But the question is, how far does it go and where does it plateau?
Given China's importance in international trade and finance, I think, again, that you could have the RMB becoming a significant international currency, perhaps accounting for as much as 10% of global foreign exchange reserves. But, again, will it go beyond that to becoming a safe haven currency and rivaling the dollar? I don't quite see that happening.
SPEAKER: Thanks. We also talked about market forces. And Jin Zhongxia, you talked about how this is a market driven process. But one of the things we associate with a market driven process is a market driven exchange rate. And last August the Chinese authorities, August of last year, said that's what they were going to do. And so there was a surprise announcement that the RMB would be allowed to have its value reflect market forces.
Then it dropped, and it became a very chaotic process as most of us remember. And to all intents and purposes, it looks like it's no longer market determined. It's back to being fixed. So Ben, I'd like to ask you, is that a problem? I mean, the fact that China even now still closely manages the value of the exchange rate in a way no other major economy really does. Is that a problem for China? And how long can it stick with that regime?
BEN BERNANKE: Well, I think the flexibility will increase over time. I think that given the stage of development of China and its institutions, I think that its current system is not unreasonable. I think it is a reasonable strategy.
In contrast, before 2005 the renminbi appeared to be deliberately undervalued to give Chinese exports a global advantage. And associated with that was rapid acquisition of US treasuries and other financial assets, and a large outflow of net saving from China, which also was, I think, disruptive in some ways. So that was a set of arrangements that other countries objected to. And frequently in my role I was sometimes in the so-called strategic and economic dialogue. And we would argue with China that they should be letting their exchange rate be more flexible. And they should have less dependence on exports as a source of demand. They should be more balanced and use more domestic consumption and investment as a source of growth. And they've moved in that direction.
So currently their current account surplus is much smaller than it was. They're more reliant on domestic demand. The devalue of the renminbi is much closer to what most people would think of as something in the range of equilibrium. Although, of course, precisely where that is is hard to tell. They're no longer accumulating significant reserves. In fact, they've lost some reserves over the last year.
While the exchange rate is not fully flexible, it is market sensitive. And I think over time they have guided it in the direction that market forces have been pushing it. So where I think that over time that a still more flexible, more liquid foreign exchange market would be the right direction for them to go, I think currently the system they have is a reasonable one.
The more important imbalances remain internal ones, consumption versus investment spending, services versus manufacturing, SOEs versus private sector, and so on. But on the exchange rate I think they've made a lot of progress.
SPEAKER: Jin Zhongxia, did you want to comment on that?
JIN ZHONGXIA: Yeah. I think in the past decade or two that the Chinese government has always been trying to strike a balance between exchange rate flexibility and exchange rate stability. So as Ben touched upon the issue of 2005 reform, actually at that time the renminbi, we remember, it has a strong appreciation pressure. But people may have forgotten that during several years ago, just not very long ago, before that, during the Asian financial crisis the RMB suffered a very severe depreciation pressure. At that time Premier [INAUDIBLE] announced where we would keep the renminbi stable.
So you can see that as the market condition changes, sometimes the currency faces a depreciation pressure. And for the same level of exchange rate, nominal rate, the market condition will change into an appreciation pressure. And this change may be quite dramatic.
So my observation is that the Chinese authorities, they have very sincere intention to try to keep and maintain a stable macroeconomic environment by trying to keep the exchange rate more or less stable. But at the same time, they also want to respect the market development.
So what they have done is just to iron out the short term fluctuation. But if you look at the level of exchange rate from the medium and long term, it is still quite flexible.
ESWAR PRASAD: You have to hand it to China, though. It's interesting that for years, the US administration, the IMF, random economists like myself are telling China, you should make your exchange rate more flexible. And they picked the perfect time to do it when it was in their interests and in the interests of nobody else. So the world then turned around and said, thank you for doing what we've been asking you to do, but please don't do it quite now.
But I think one point that Jin Zhongxia and Ben have touched upon is very important, the intentions. There was a notion that what was done in August 11, 2015 was a sort of desperate move to prop up the economy by depreciating the currency. I think there were much more honorable intentions at play. This is what the PBOC has, for a long time, wanted because the whole point of having a flexible exchange rate is that it gives you much more room on domestic monetary policy. It gets around a lot of the complications in financial and macro sector policies that the PBOC has had to contend with.
So I think the intentions were very good. But unfortunately, it was not implemented or communicated in quite the right fashion. And communication, of course, is a challenge that virtually every central bank is facing these days. But I suspect that from the Chinese government's point of view and the PBOC's point of view in particular, a more market determined exchange rate is a lot more sensible for China's economy.
CAROLINE ATKINSON: But Eswar, you said both that they picked exactly the moment that helped them. I would actually challenge that a little bit, because I don't think what happened was very helpful for China. But also that the intentions were honorable. I'm quite sure the intentions were honorable, but I also think there were real pressures at that point about what was happening with growth.
And I think we can get into, or it's important to bear in mind what Jin Zhongxia said about the goal should be a balanced macroeconomic growth. And I think that, as Ben pointed out, there was a period of time when it was not really balanced in China. And, in fact, there was a lot of dependence on exports to promote growth. Also, there were a lot of imports. And China was, in general, growing very rapidly and helping to pull the world along.
Right now we're in a slightly different phase of the global economy. And there are others, maybe in Europe, where current account surpluses are extremely large, and not China. But I think there's still an issue about how does China move its overall economy to a more balanced position? And what role does the exchange rate or the financial system, the exchange rate system play in that move?
SPEAKER: And, in fact, Eswar, there's a point you make in your book, which I think is a very good one. I would recommend everybody to check this part out especially, which is that China has always had this character of wanting it both ways. They want stability and they want market determination. But those of us with a sort of Schumpeterian sort of tradition do not really believe those things are compatible, that markets tend to be unpredictable, wild, and volatile. That's kind of the beauty of the mechanism. It is not fundamentally compatible with stability. And you get the sort of sense that China's desire for market determination and stability is reaching a very sort of tense and perhaps not sustainable coexistence. Don't you agree? Or how much longer can this last? Forever?
ESWAR PRASAD: This is a grand experiment in the making that as an academic it's fascinating for me to watch. As a policymaker, it must be harrowing. What China is trying to do is essentially try to meld two fundamentally contradictory impulses, which is to let the markets work freely, but at the same time maintain stability and control. Jin Zhongxia referred to this. And there is a line by a policymaker that I refer to in this thing, where he speaks about how it's important to follow the market, to fear the market, to trust the market, and respect the market. But then he says, sometimes the markets behave like a herd of sheep, and then you have to step in to control the market. And that's a fundamentally contradictory impulse. Because if you say we need to let markets work, but once they start getting out of hand you're going to control the markets, that creates a lot of unpredictability. And especially with this weak institutional environment that I spoke about, you get what we saw last year, a lot of volatility in currency markets, a lot of volatility in equity markets. Because markets don't quite know how to read the policy signals.
So I think, again, although my sense is still that the intentions in many of these dimensions, at least on the financial sector, are honorable, we are going to see a lot of stumbles and missteps along the way because the government wants the market to work well as a pricing mechanism, as a resource allocation mechanism. But it's still a little concerned and wants to maintain control.
SPEAKER: Ben, did you want to add something to that?
BEN BERNANKE: Well, I wanted to say that the August 2015 episode also illustrated the importance of clarity of communication and transparency. The reason that was such a disruptive event was because people didn't understand what did it mean? Did it mean there was a weakening economy that was not evident in the statistics, for example? And the Chinese have done better. In particular, earlier this year at the G20 and so on they began to clarify their regime. And that has been very helpful, reduced a lot of the uncertainty about the course of the exchange rate.
I think they could go further still. I mean, I think there's still a lot of ambiguity about exactly how the market is affecting the exchange rate, what is the role of the basket, what is the role of the dollar peg, and so on. So I think there's more they could do. You asked me initially about the exchange rate regime. I think that's one direction that could improve.
The idea about the question of market versus non markets are a little bit misleading, because the exchange rate, of course, is the obverse of the monetary policy regime. To the extent the exchange rate is stabilized, it has implications for and puts restraints on monetary policy. In that respect, there is, in fact, some scope to be consistent with market forces and still have some control over the exchange rate if you're willing to constrain monetary policy appropriately.
SPEAKER: And do you think at this point those particular constraints are helping or hurting China? Or put another way, if they were to let the currency go and not intervene, where would it go? And would that be a good thing or a bad thing?
CAROLINE ATKINSON: Well, what Ben's saying, it depends what they do with monetary policy.
ESWAR PRASAD: Right.
BEN BERNANKE: Yeah. Well, this is putting a constraint on their ability to use monetary policy freely in an entirely expansionary way. And I've recommended, as you know, in a blog post, Brookings blog post, that one way to deal with that problem is to have more emphasis on fiscal policy, which doesn't have quite the same implications for the exchange rate, or the same direction implications.
So I think actually that, again, given their state of development, the combination of their exchange rate regime and their monetary policy, at least it's coherent I think at this point.
SPEAKER: And Jin Zhongxia, can you tell us, is it too soon to talk about what the final end game is for the evolution of the RMB? Will it ultimately be a currency as freely used and so completely free of capital controls as the US dollar is, or the British pound sterling? Or will it be somewhere between where it is now and that end point?
JIN ZHONGXIA: I think in the long run China will eventually liberalize the capital account to a larger degree. And also, the exchange rate will become much more flexible. But I think that will not happen in one step. So it will go through a gradual or evolutionary process.
ESWAR PRASAD: Actually, one thing that may be of interest to the people here, I argued that the PBOC has nothing but honorable intentions. And Caroline was a bit skeptical about that, I sense.
CAROLINE ATKINSON: No. No. I was just suggesting that there was an internal contradiction in what you said.
SPEAKER: Doesn't it partly depend on your definition of honorable intentions?
ESWAR PRASAD: Well, all right. But there is some question about what the PBOC's regime actually is. Because in August 11, 2015 there was the ostensible de-pegging from the dollar. And then in December we heard that the currency's value was being managed against a basket, or with reference to a basket, as Mr. [? Egan ?] told us here on this very stage some time ago. But then the currency has continued to depreciate against the basket. So what is China's currency policy now?
JIN ZHONGXIA: I think the principle is that the exchange rate should be fundamentally determined by the market. And in this process, the principle we can see that it is based on the market supply and demand. And also take a reference to a basket of currencies.
So we are saying that, take a reference to a basket of currencies. But we are not saying that we are pegged to this basket. Because ultimately, it is determined by the market supply and demand. And in a period in which the major currencies and their exchange rates are relatively stable, it will be easier for China to keep a stable exchange rate against a basket of currencies. But if the exchange rates between the other major currencies becomes very volatile, that will make the Chinese currency its exchange rate against this basket stable very difficult. So ultimately, I think this is not the exchange rate of Chinese currency against any single currency. Or the basket currency depends not only on China itself, but it also depends on how the other economy, how the monetary policy of the other central banks act.
SPEAKER: There's another aspect going on here, which is the role of capital coming in and out of China. And when the IMF and the United States was trying to make evaluations of whether the exchange rate was fairly valued fundamentally, they were primarily looking at real factors, GDP per capita, in terms of trade, et cetera. But, as we know, for most currencies, the big drivers from month to month are capital flows. And since the somewhat confused devaluation of August 2015 China's experienced very large capital flows. And as you've described very well in the book, Eswar, many of these don't even show up in our normal definitions of capital flows.
Maybe you could talk a little bit about that, and how worried should we be? And does the volatility of capital flows fundamentally challenge the ability of the Chinese authorities to ever establish a market determined exchange rate?
ESWAR PRASAD: So it's a risky proposition. What China has done flips the traditional order of reforms on its head. Logically it would be best to fix the financial system to have a more flexible exchange rate, and then move towards opening the capital account. That would be safer. That would lead to a lot less risks in terms of volatile capital flows. But I think there is an interesting logic to what the Chinese did. Although, it's created a lot of volatility.
There was an opportunity last year to undertake a series of reforms. Some of these are mandated by the IMF. Some the PBOC pushed. But I think the objective of all of these was to push forward with capital account opening in a manner that would impel certain reforms that are important domestically. I've referred to this in the book as a sort of Trojan horse strategy. Once you move forward on capital account opening, it's going to create a lot of risks if we don't fix the financial system. And in particular, it creates competition for the banking system, which until then, until now has had a captive source of deposits which it could rely on. So there was no impetus for reforms. Having foreign investors come in to the corporate bond markets and the equity markets brings more liquidity and depth, but it also brings in better governance practices.
So I think the PBOC is towing a very fine line here, because this could end up badly. And what we saw last year I think suggests what could happen.
But going back to the internal contradiction that Caroline pointed out too, I think the problem, what set of all this turmoil was essentially the fact that they started off with not just allowing the currency to become more flexible, which I think people would have understood. And the currency would have depreciated. But starting with the 2% depreciation was what set off the panic.
Now, again, there is perhaps not the right logic, but there is an internal logic to what they did. At the time the forward markets and what was happening to the currency within the band was signaling about a 2% depreciation expectation by the market. So I think the PBOC's view was, let's give the market what it wants. Then we can let the currency fluctuate around that central parity.
The problem was that a 2% depreciation was anticipated by the market based on the assumption the PBOC wouldn't do anything. So when the PBOC did 2%, suddenly expectations flipped around. There was no communication at the press conference explaining the move [INAUDIBLE] 36 hours, which is a lifetime in financial markets after the policy's announcement. And that has unfortunately created this negative currency depreciation capital outflow dynamic, because it came at a very sensitive time when there were concerns about the Chinese economy.
So I think getting intentions right is not good enough. Getting the implementation and the communication right, as we've seen from this episode, is crucial. So the capital account opening process I think has generated some of its own risks. And it's a very risky strategy. But I think it's the one thing that may, in fact, shake loose what is necessary for reforms in China.
CAROLINE ATKINSON: But can I just ask if that process, which I think is similar in a way to the process of China joining the WTO, and then gradually, inexorably, some openness and changes were forced domestically, but it only goes so far, because it's also, again, possible to have other interferences with the free movement of goods, do you think that these financial reforms-- suppose the strategy succeeds in promoting financial reforms, even if it begins with the exchange rate, with the regime first-- can feed into deeper reforms domestically? Or is that where there's a conflict with the government's goals?
ESWAR PRASAD: The answer to your well framed question is no. And let me be clear what I mean by that. I think what this process has been very good for is financial and capital account reforms. But the big concern I have about China is not that there are no reforms, but every reform that Jin Zhongxia mentioned, that I can point to, is about the financial system. It's about capital account opening. We have seen very little reforms on the real side of the economy, especially state enterprise reform. We've seen very little in terms of institutional reform, not just the things I spoke about earlier.
But if you say you want the stock market to work well, first of all, there is the question of how much room you are willing to give it. But in addition, you need some elements, like you need a good corporate governance structure. You need good auditing and accounting standards. You need corporate transparency. If you don't have those, the market becomes a casino. And I think that's the fundamental problem right now, that this process has been very good for a very limited set of reforms. But for the other reforms that are crucial concomitants of financial sector reform, you don't have a framework. You don't have an effective advocate. And you don't have a sense of urgency. So this big imbalance building up in the economy I think is going to lead to a lot of turmoil in the years ahead.
SPEAKER: Jin Zhongxia, could you respond?
JIN ZHONGXIA: Yeah. Yeah. Right away. I think that the process of the SDR review has been actually, in my observation, a very prudent, cautious process. For example, the IMF raised several operational requirements, including saying that China should have some risk management instrument in place. For example, the foreign exchange future market and the interest rate swap product that can be available in China's capital market, financial market.
So for these, China managed to install all these instruments, make it ready before the inclusion of the RMB. So I think this process is a very healthy process in which we can see that the IMF didn't push blindly that China just open the market without considering the risk management.
And China also takes that very seriously. And it established the necessary risk management arrangement or tools. So this is a very prudent process.
SPEAKER: I would actually like to pick up something you talked about, Eswar. You said, we've been talking all along about reforms on the financial side of the economy. But what bothers you is the absence of reform on the real side of the economy. For example, state owned enterprises. And one place this shows up, I think, is in the debt statistics. We've seen an astonishing growth in China of non central government debt. You see it in the private enterprise side, the local government side. And it's starting to show all the symptoms of a classic credit bubble, which in the experience of Western countries always ends badly.
My question to you, Ben, is you've seen that story before in other countries your academic work and as a policymaker. When you see China and these statistics, does that worry you? Where is China headed? Are they headed for some kind of destructive--
BEN BERNANKE: Well, It's an important issue. The amount of credit, debt outstanding in China in corporate, government, and so on is very large and growing quickly. And the returns are diminishing. In other words, the amount of output being created by additional credit is declining. So that is a concern.
But you have to understand, think about why it's a concern. So we're not looking at, it seems to me, sort of a classic emerging market financial crisis situation for a couple of reasons. One is that the debt, a great majority of the debt is, in fact, in local currency, in RMB. It's not like we have foreign lenders lending in dollars to the Chinese economy.
What you see primarily is domestic Chinese bank depositors who are lending in RMB, and deposits are a sticky form. And, again, it's in the local currency. So you wouldn't expect this to collapse in a financial crisis. What it is, instead, is that the large amount of debt outstanding is, in some sense, the financial or paper analog to what's happening on the real side. On the real side what we have is a lot of excess capacity in heavy industry, and in construction, real estate, and so on, with excess capacity meaning low returns, inadequate transition to services and the consumer oriented production. And so there's losses there. There's real economic losses. There they're embodied in all of this paper.
Which reflects, again, basically the fact that the government's fiscal policy and its development strategy has, in many cases, been implemented via the banking system, or via the debt markets. So ultimately, the right way to think about much of the Chinese debt is that it is ultimately, in some sense, the obligation of the government, one way or the other. Either as the backstops to the banks, backstops to the SOEs. And so they're going to have to work carefully to manage that and to allocate the losses according to banks, to SOEs, and to the government.
The good news is that it's not going to be an immediate collapse type of situation. It's something they can work on over time as part of the process of real side reform. And the other good piece of news is that the fiscal authorities have a lot of space. That is, the official central government debt relative to GDP is only like 40%, which is not particularly high by international standards.
But what they do need to do is, as part of the reform process, they need to convert or otherwise rationalize this credit structure and allocate losses that correspond to the excess capacity in the lower return industries. But as part of the reform process, they should be able to manage that.
But it's going to be tricky. They're going to have to continue to be closely attentive to it. But it doesn't look to me like it's an imminent time bomb.
SPEAKER: Jin Zhongxia, what are your thoughts? I mean, you must get this question a lot. Does China have the means to avoid a debt crisis?
JIN ZHONGXIA: No. Of course. Of course.
I think China [INAUDIBLE].
SPEAKER: Any other answer would have been a headline I guess.
JIN ZHONGXIA: We discussed this issue extensively with the IMF staff when they drafted the Global Financial Stability Report, in which they made a whole chapter discussing this issue. I think it is quite manageable. We discuss this issue in many details, including the potential credit risk, and what's the criteria when you classify the credit which is under risk.
And also, we calculate the possible losses, which may be, even if it is larger than the official declared [? NPAR, ?] even if it is larger than that, we can see that the provisioning of the commercial banking sector and also the current profitability, the profit level of the commercial banking sector as a whole actually can quite easily, quite comfortably absorb the potential losses.
And by this, we haven't mentioned the possible backup by the government. And if you look at the government, as mentioned by Ben, the total government debt over GDP ratio, even if you include the local government contingent liability, it is still low, lower than 60%.
And it is lower than any major country in the G7. For example, Germany is the best on this indicator. It is over 70%. So I think China really has a very comfortable room to deal with this issue.
BEN BERNANKE: But if I could just add that it is important going forward that they should stop using-- if they want the banking system to allocate credit in a market determined way, it needs to stop being the channel of fiscal policy. And the government should more directly allocate fiscal funds.
CAROLINE ATKINSON: And, of course, that would be complicated to choose which industries, but it would be cleaner.
BEN BERNANKE: Yes.
CAROLINE ATKINSON: It might also spur reform if individuals-- if the government were to cut, for example, payroll taxes, or other taxes to stimulate the economy through fiscal policy, rather than stimulate it through credit policy.
SPEAKER: And I'm reminded of the analog to Japan, for example, which also had a current account surplus at the point that it entered a very long crisis. It never had kind of a Lehman moment until well into the deflation of its bubble. What it did have was an enormous amount of malinvestment, a lot of real estate and construction that'd be financed by very large debts in the banking system. And that malinvestment was a symptom and a cause of the slowdown in Japan's growth rate.
Is China facing a similar risk? Has China suffered through a long period of malinvestment because of the government directed nature of economic growth? Is that the real problem? And how do you correct that?
BEN BERNANKE: Well, it's not-- yes. To some extent. Obviously it's reflected in the excess capacity and the heavy imbalance between consumption and investment, for example. But it's not because of a bubble dynamic in Japan, which is basically a market economy. It's because of the political influences and the development decisions that have been made by the central government. And allowing markets to work, in this case, would probably give you a better allocation.
SPEAKER: Did you want to add anything to that, Eswar?
ESWAR PRASAD: When somebody has just written a book, they become very boring. No matter what question you ask them, they say it's in the book. It's in the book.
But let me summarize my answer to this. I think in terms of the broader question about the crisis, I think both Ben and Jin Zhongxia are right. It's unlikely that we'll see a financial meltdown, because there is enough room to absorb losses in the system. There is enough of a buffer. There isn't much external debt.
I think there are two key questions. One is, how expensive is it going to be to fix the problem? And it is going to be expensive. And as Jin Zhongxia pointed out, the IMF estimates that if things are really bad in the banking system in terms of the NPLs that the SOEs cannot pay back, that's going to lead to a fiscal cost of 5% to 7% of GDP. I think it could be somewhat higher, but that's a cost that can be managed.
The big question is whether, before that hit is taken, the government gets the economy moving in the right direction and gets the financial system allocating resources in the right fashion. Because if the financial system is not fixed, then two things happen. Number one, you have the problem growing even worse. So the cost is going to be greater. And second, you have a misallocation leading to either lower growth or the wrong kind of growth.
So I think the big question right now and the challenge the government faces is whether, given that they have a little bit of breathing room since some of the indicators are not terribly bad, whether they will use this room to start fixing the financial system.
And this is where things become very complicated, because, again, you can do things in the financial system. But if you don't reform the other parts of the economy, then the problems don't really go away. The deeper problems remain.
SPEAKER: I think we'd like to start broadening the conversation now. So if you have a question, please raise your hand. We'll get a microphone to you. Please state your name and your affiliation. We'll take a few questions down. Then we'll go to the panelists. Starting with you, sir.
AUDIENCE: Good afternoon. My name is [INAUDIBLE]. I'm a research assistant of professor Prasad's at Cornell University.
ESWAR PRASAD: I hope I've trained you well, [INAUDIBLE]. We will see now. OK?
SPEAKER: Going to be a brutal one, Eswar.
AUDIENCE: Definitely have. My question was both to the professor and Mr. Bernanke, because it has to do with the Fed. While working on this book and as all of you have been mentioning, we're seeing some remarkable and important events and trends with respect to China. I was wondering what your opinion is on to what extent these developments abroad, as the Fed is calling them, should affect the Fed's decisions and discussions here at home, especially at this point in time?
SPEAKER: Next question. This gentleman here on the aisle.
AUDIENCE: Hi. [INAUDIBLE] I mean, does it make sense to you that the two presidential candidates still blame China for currency manipulation, especially manipulation to keep it artificially low while the pressure in China is really downward pressure? I mean, you have Chinese premier going everywhere saying there is no basis for further devaluation.
I also want to ask Bernanke and Caroline-- you were both in the government. It seemed that the US White House until not long ago still believed, I mean, the RMB is grossly undervalued. Why is that wrong? It seems a lot of-- [? some ?] pointed out, the White House actually got it very wrong. Thank you.
SPEAKER: And another question right here.
AUDIENCE: This is [INAUDIBLE] from China [? Inner ?] Institute. Deeper reforms, including SOE reforms, might mean large scale unemployment, hence social chaos. Is this too big a price to pay?
SPEAKER: OK. Great. We'll start with these ones. Let's start with the last question, which I think is a very good one, Eswar. What is your view? I mean, everybody says China needs reforms. And this happened I think in the '80s and the '90s in the first round of reforms. You get a lot of unemployed people. Where is the balance? Is that a price worth paying?
ESWAR PRASAD: I think the right question is what are the reforms necessary to get the economy growing in a more sustainable fashion without creating too many imbalances. And unfortunately, the answer to that cannot be unitary. If one wants to fix the state owned enterprises, yes, there is a lot of excess employment there. And you need to do something about that potential unemployment problem.
But as Ben pointed out, there is a lot of room in terms of fiscal space. And what China could be using a lot more effectively right now, rather than credit or monetary policy, which in China are roughly the same thing, is to use fiscal policy more aggressively. This will be good in terms of short term demand management, and in terms of longer term growth rebalancing, if one could use some of that money to strengthen the social safety net and start investing in some expenditures, or using it for certain expenditures that could provide a buffer for this transition from a state managed economy to a private sector led economy, which is going to involve some turmoil.
So if you have fiscal space, one could use that a lot more effectively to buffer this. But it's not going to be an easy process. Nobody expects reform to happen overnight. And in a system which is so clogged up, any of these reforms can set off unexpected forces or outcomes. But I think there is no alternative to going forward on multiple fronts.
SPEAKER: Jin Zhongxia, could you also give us your input on that. I mean, to what extent is the possible social repercussions of reform a factor in the thinking of the Chinese authorities?
JIN ZHONGXIA: I think the state owned SOE reform is very important in the Chinese economy. The reform may take various different forms. Maybe one extreme case is let them go into bankruptcy. Another may be we can arrange some merger and acquisition. And some other way is to just do some restructuring.
So the net result of these SOEs under reform that have been affected by the overall restructuring I think can be managed. And the government also takes effort, allocate resources to control the potential risks, and the potential disruption in the real economy.
For example, the government has identified the two sectors with excess capacity, like steel and iron industry, and also the coal mining industry. The government allocated 100 billion yuan as a fund to solve the unemployment issue that may be possible because of the restructuring of these state owned enterprises in these sectors. So the central government may contribute some resources. And the local government will also contribute. The corporations, the companies themselves will also bear the cost. So I think if that process can be managed property, the risk could be under control.
SPEAKER: The first and the second question, I'm going to sort of meld them together, cause they're sort of related. And it has to do with the effect of China's policies on the rest of the world. The first fundamental question is, is the Chinese currency still undervalued as so many of China's political critics say? And what effect, irrespective of that valuation question, are Chinese policies having on the United States and its other trading partners? Ben, do you want to give that one a try?
BEN BERNANKE: Well, it's always hard to know exactly what the equilibrium exchange rate is. But we're not seeing large capital surpluses. We're not seeing large accumulation of reserves. So I think the IMF and others who look at this think that the RMB is much closer to equilibrium certainly than it was 10 years ago.
On the effects on the US obviously, there's a lot more impact now than there would have been 20 years ago when China was a much smaller economy. I remember when I first joined the Federal Reserve Board, I remember a staff presentation-- this was in the early 2000s-- about what would be the impact on the US of a slowdown in China. And the staff said, well, on the one hand, we don't export that much to China. On the other hand, if China slows down, maybe oil prices'll go down and that'd be good. So the net effect was, well, if China slows down, we don't care.
But now, of course, that is no longer true. Now, we do care, for many reasons. And, in particular, because the world financial markets are so integrated now that China's slowdown, even if it's most direct effects are on, say, other emerging markets, it's going to affect risk taking and risk preferences in financial markets, and cause swings potentially in equity, for example, as we saw in August of 2015. That would have implications for the United States.
And we saw in August 2015 that the Fed was looking very carefully at the impact of even the potential slowdown in China on financial markets, and therefore, on the outlook for the US economy. So clearly China's growth rate, its imports of commodities, its exchange rate, all those things are of global significance now, certainly.
SPEAKER: And Caroline, this was obviously a question that came to you all the time when you were in the White House. Were or are China's policies hurting the United States?
CAROLINE ATKINSON: I want to flip that around just to say that I believe, and I think it's consistent with what others here have said and with the research and analysis, that policies that drive faster, stronger growth and more jobs in China will also be good for the United States and for the global economy, provided that they are promoting a balanced growth. Obviously policies anywhere that are just looking at promoting domestic demand-- I beg your pardon-- promoting export demand, and not domestic demand are, in a sense, taking away from the rest of the world. But policies that, and including Ben's suggestion of fiscal policies, that support transition, that support the economy as it becomes more domestic demand and consumption lead, are also good for the United States. So I think that that's the key. And the concerns about the exchange rate that were often expressed by the United States were really most acute before the exchange rate, the renminbi had appreciated. And one could see that over time the exchange rate did appreciate so that the current account surpluses shrank.
I think there's still a lot more that could be done domestically in China. But, of course, as they were suggesting, it needs to be done in a way that supports jobs and employment. But there's a lot more that could be done to make China's growth more balanced, which would be supporting social safety nets. I like the idea of there being tax cuts for maybe employment. And obviously that needs to be paired with a careful reform.
SPEAKER: More questions? You had a question over here, please. And anybody else, please raise your hand and we'll get this microphone to you.
Sorry about that. We'll get you.
AUDIENCE: Yes. Jim Bowden with the Center for International Governance Innovation. I wondered if you'd say a little bit about the systemic implications of these developments. We have an international financial system that's based on a small number of currencies that are widely traded, freely usable, managed in a transparent manner, and so on. And last year I think the IMF took a huge leap, if I may put it that way, in saying even if China isn't all the way there yet, we think it's made so much progress that it's likely to be there in a very short period of time. But just as a thought experiment, suppose that all this new openness were to destabilize the Chinese economy. And then you saw a pull back from the progress that's been made. So all of a sudden the renminbi is not freely usable. It's not widely held by reserves anymore, and so on.
Now, we have a risk, it seems to me, to the international financial system. And I haven't read anything or heard anything where people seem to be addressing that risk. So maybe I'm overstating the case, but I wonder if I could get your reactions.
SPEAKER: OK. There's another question right near you I think I saw. Yes. And then we'll have this woman over here.
AUDIENCE: Thank you. My name is Matilda. I'm a research intern here at Brookings. And my question is more domestically focused. Given the increased global recognition of the renminbi, do you think the United States will or should acquire a sizable portion of the RMB as part of its foreign currency reserves, or is that not advisable at the current moment? Thank you.
SPEAKER: And you still have a question? Yeah. Can you bring the microphone up here, please, to this woman on the aisle?
AUDIENCE: [INAUDIBLE]. For Mr. [? Zhongxia. ?] You mentioned that the [INAUDIBLE] liabilities of the local governments [INAUDIBLE] [? potential ?] future [? debt. ?] Do these contingencies include the excess capacity [INAUDIBLE] But if so [INAUDIBLE] What would the be an appropriate response to it? [INAUDIBLE]
SPEAKER: So if I could rephrase, just interpret the question, essentially if there is a severe slowdown in China and real estate values fall a lot, the government may be faced with much more contingent liabilities than it now thinks if it has to bail out the banks. Has the government of China thought about that? Is it worried about that? Does it have the capacity to bail out local governments and banks if there is severe distress in the real estate or other sectors of the economy now facing excess capacity?
JIN ZHONGXIA: Well, I think in China even the state owned enterprises, they are an independent market player. So there is no legal obligation, nominally, for the government to bail out entirely.
But, of course, government in this process, they are considering to implement the restructuring, and at the same time maintaining social stability. So that's why the government tried to establish or strengthen the social security network in order to prevent over destructive process of this restructuring.
SPEAKER: Eswar, do you have any thoughts on that? This is obviously something that you have come across a lot.
ESWAR PRASAD: Actually I prefer to deal with the other question that Jim raised, if I might. It's a broader, interesting one. Jim is the fund historian. So he's thought deeply about these matters.
Let's be very clear about what's happening on October 1, 2016, which is just a few days away. The IMF will officially sort of knight the RMB by putting the shoulder on probably Zhongxia's shoulder. But it's not going to be a game changer. It's not like there are portfolios around the world that are benchmarked to SDR. So you're going to have a flood of money going into SDRs.
As John just correctly pointed out, ultimately, this is going to be a market determined outcome. The IMF, one could argue on technical grounds, perhaps, did play a little fast and loose. Although, again, with all the right intentions and motives. And I think it's going to be good for China. The MSCI, by contrast, did not include the A shares into its MSCI index in its review in June. Why? Because they had a similar checklist, and they felt that China had met many of the elements of the checklist, but not all.
But moreover, the investors and abroad that the MSCI talks to were not convinced that China meant it. So they said, let's see how this works, not just in principle, but in practice. So there isn't going to be a flood of money going into SDRs. Right now only the IMF and the BIS, as far as I know, maintain their balance sheets in SDR terms.
So you will have a little more portfolio reallocation of central banks towards RMB. But ultimately, the question is whether China will have the right kind of growth and stability, whether China will have the right sort of financial regulatory architecture, well developed financial markets. That will determine how much traction the RMB gets.
So I think all of these reforms that have been impelled by the inclusion in the SDR basket have been good for China. I hope they'll be good for the world economy as well if China gets things right. But I don't think it's going to be hugely disruptive to the international financial system, for this reason.
Of course, if China starts experiencing trouble for other reasons, as Ben, Caroline have pointed out, that's going to hurt all of us at some level, because China is so important right now. But this SDR inclusion, by itself, is not going to be the reason we should panic.
JIN ZHONGXIA: Yeah. Let me add two more points. I think the inclusion of renminbi into SDR is a milestone, as said by the managing director of the fund, a milestone for the RMB. But this is not the whole picture.
In my view, based on my experience, I can see that this is also an achievement of the so-called new multilateralism of the International Monetary Fund, which aims at integrating, in an orderly way, the emerging market economies into the international financial and the monetary system. So this case shows clearly that the existing multilateral framework can be adaptive to the changing world economy. So this is the first point.
The second point is that, based on my experience, I think the constructive communication and cooperation during the process of the SDR review has contributed positively to all the parties involved to accumulate mutual trust and mutual confidence. And that will be very positive, very helpful for maintaining the global financial stability, and also for the entire international society in the long term.
CAROLINE ATKINSON: Yeah. I would like to just agree that what's really important is to see-- and I think this has been a process going on for a long time. If I think back to the creation of the G22 and then the establishment of the G20, the process of making sure that major economies that may not be fully advanced or industrialized yet, but are really important are a part of the governance of the international system. And I think that's certainly in the interests of those economies, and also in the interests of the system itself. Because we all have a shared stake in that.
SPEAKER: There's an element to that question that also, I think, poses itself, which is, are these reforms reversible? As China having opened up, if it decides it doesn't like what it sees, is it going to pull back? Or more to the point, will it play the part that we expect of a large global player?
I'm reminded of what Charles Kindleberger said about the breakdown of the international financial system in the '30s. Great Britain could no longer be the stabilizer, and the United States would not. The global financial system works because there is a hegemon that basically takes upon itself the role as importer of last resort, as guarantor of the international financial system. Can China or will China play that role? Eswar?
ESWAR PRASAD: I think we should turn to the representatives of that hegemon.
BEN BERNANKE: Well, the US played the role in the crisis.
CAROLINE ATKINSON: Yeah.
BEN BERNANKE: And notably, if I may say so, the Federal Reserve acted as a lender of last resort in dollars to 14 other economies. Not including China, but including some four emerging market economies. So acting as lender of last resort, acting as a source of reserves, the US, at least in the crisis, did fulfill that role. Now, whether it will indefinitely in the future, of course, is a great question.
I think just on this previous question, I mean, everything that was said about the SDR inclusion and its importance is true. Nevertheless, it was still symbolic. Nothing real changed. But nevertheless, it did indicate the willingness to work together. And it is very important that China be included in international institutions and the like.
So in that respect, symbolism is a real thing, but it was still symbolic. And there was a question about US reserves. The US doesn't have reserves. Don't need them with the dollar.
CAROLINE ATKINSON: We've got the dollar.
SPEAKER: Well, the US does have some reserves.
BEN BERNANKE: A small amount of reserves.
SPEAKER: Should the US add some RMB to those reserves?
BEN BERNANKE: It's irrelevant.
It's symbolic, again.
JIN ZHONGXIA: Also, maybe one more point. I think the inclusion of renminbi into SDR, there is no room for complacency for China, as you know. Because we are fully aware that our modernization drive and our market oriented reform efforts are still is a work in process. So there is still quite a lot of work to do before China can become a highly developed country.
So this a new starting point, if I can see that, for China's reform and development in future, rather than the end of China's reform minded development.
CAROLINE ATKINSON: Yeah. And obviously at a time when openness and globalization is under a lot of threat and pressure because many people in many societies feel that they haven't benefited from it, I think that part of what one would want to see going forward is that there is a greater sense of sharing of the benefits of globalization, technology, and so on, and that openness. I think how China plays that role going forward will be important, because, as you were saying before, that balance between stability and flexibility is going to be important. If you keep things stable for too long in too fixed a way, that stability becomes a source of instability.
SPEAKER: There's a question back there.
AUDIENCE: Ian Talley, Wall Street Journal. Far be it for me to disagree with the chairman, but it seems to me that US's dollar hegemony has leveraged a great deal of power through sanctions on Russia, Iran, or even some of the lender of last resort credit lines that it's applied sometimes, particularly through time. But my question is about whether--
BEN BERNANKE: No. That was a question.
No. The sanctions goes through the financial system. It has nothing to do with the dollar. It has to do with the fact that the United States financial institutions are so critical and the US market is so critical. But we could be trading in Turkish lira or whatever. It would still be the same ability to sanction.
The ability to serve as lender of last resort was a service provided, not a benefit.
AUDIENCE: I shall not argue with you for reasons that you've just shown. But perhaps we can take it up afterwards.
But it seems to me, I wonder how much the IMF risks being co-opted by lending its legitimacy to China in this way, in the same way that perhaps the US, it could be argued, lended China legitimacy by backing its accession to the WTO. Caroline, you mentioned about balanced access, whereas China has been able to take advantage of that accession, and perhaps it hasn't been reciprocated in the same way that the US expected. Therefore, the US is not willing to call China a market economy right now. Is there a risk that China is able to take advantage of this legitimacy and not move forward on the reforms it's supposed to encourage?
SPEAKER: Caroline, you want to tackle that?
CAROLINE ATKINSON: Well, I'd rather sort of turn it around about and think about what is the real value for China, and for the rest of the world what is the outcome of this move to join the renminbi? I think that we all ended up agreeing it was probably not very good for a panel that the demonstration of China being willing to take on obligation, responsibilities, roles, and being part of the system is a good thing.
The next steps will be, well, how does China proceed with further reforms, as was said. It's not over yet. And those reforms will be important in terms of China's broader role in the economy. [? They've ?] typically gone cautiously, but in a certain direction. I think part of the question that people are asking is, is that direction still assured now towards greater openness?
SPEAKER: I'll let everybody actually just take a minute or two if they want to share some final thoughts on that.
JIN ZHONGXIA: Yeah. I think you're very right. I think that the reform, the market oriented reform, actually it is in the interest of the Chinese people themselves. This is a conclusion based on China's experience in the past 30 years, in the past 60 years, and in the past 100 years.
And if you look even further, go to the deep history of China, you can see that this is also consistent with many beliefs, many thoughts that has a deep root in Chinese history. As I said, actually, Prasad, he has a very good chapter in his book talking about Chinese economic or monetary policy history.
I think I just want to add two more things. One is that actually Chinese currency was international currency in history. Several years ago when I visited a museum of a foreign central bank in Asia, I discovered in surprise that in the 12th to 13th century, the Chinese currency was widely accepted and circulated in that Asian country actually. And another point is that in the 6th century before Christ, a famous Chinese economist and also a philosopher whose name is [? Ghanzu ?] who argued that in the period of economic recession, the government or the king should increase the budget expenditure, fiscal expenditure to implement some seemingly wasteful projects with the purpose to increase the employment. So this is quite consistent with the modern Keynesian theory.
And also, about the same era in Chinese history there is another famous philosopher whose name is [? Lao ?] [? Tzu, ?] who advised the government that they should rule by no intervention. Actually, this is a modern version of the-- this is an ancient version of the modern laissez faire or invisible hand. So if you look at the basic thought, the system of thought in China, there is a lot of similarity or common ground between Chinese people and the people in the rest part of the world. And if you look at history, it is very useful. By reading the history, it's like qualitative regression.
So like the time series analysis, the longer the time series, the better. So if you read the history, and not only the most recent several decades, but also there is-- several centuries ago, 2,000 years ago, and you draw a line, you will see what will happen in the future more accurately.
CAROLINE ATKINSON: Maybe not here.
SPEAKER: I'll leave the--
SPEAKER: Eswar, we [? want to have ?] a couple minutes left. I'll leave the final word to you. Especially, will the world end up being happy that it accommodated China's entry into these institutions?
ESWAR PRASAD: I think ultimately it's going to be good for China and the world. It's going to be a rocky and very interesting ride ahead for the RMB. I have no doubt that there will be periods when the world will think to itself, what have we done bringing the RMB into the international financial system in such a way. But ultimately, it's going to be a reality as China becomes more important economically. And, as the other panelists have pointed out, bringing China to the table as a responsible member of the international community. And China has been taking on a more constructive role, not just on economics, but in climate change issues and so on. I think that's a good outcome.
So it's going to be an interesting ride. But again, I think it's important for us not to get caught up in the hype. Because there is a lot happening with the RMB. It seems to have gone a fairly long way in a very short period. It is now going to become technically an elite reserve currency. But one should not read too much into these things, because a lot still remains to be done in China.
I'm also very grateful to the panelists and you, Greg, for having come and help talk about the themes in my book. I also want to say one other thing. Many people have said nice things about my book, including Jin Zhongxia, including Ben who had an endorsement. But one very important person whose standards are far higher, my dear wife, actually read the book. She's not an economist. And she gave me the best endorsement that I could. She read it carefully and said, you know, it's not bad.
To me, that meant a lot more. It turns out I also found one's loved ones are always the harshest. I found that despite all the care I put into the book, I had many people proofread it, there is still one typo that comes early in the book. So I was sitting at home last week, because one of my interns actually just pointed this out. And my elder daughter, my 14-year-old was very reassuring. She said, don't worry, dad. Nobody will get that far in the book.
So I hope that some of you get that far. But thank you very much.
SPEAKER: OK. I would like to say that I finished the book. Before I read the book I knew that China had invented paper. When I'd finished the book I'd realized they invented paper money. And now because of this panel, I discovered they also invented helicopter money 2,600 years ago.
So thank you, all of you, for a very insightful panel. And thank you for coming.
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The Global Economy and Development program at the Brookings Institution hosts the launch of "Gaining Currency: The Rise of the Renminbi," featuring the book's author, Brookings senior fellow and Dyson School professor Eswar Prasad.
Distinguished panelists joining him include: Ben Bernanke, distinguished fellow at Brookings; Jin Zhongxia, executive director for China at the IMF; and Caroline Atkinson, head of global public policy at Google with a long career in international monetary and diplomatic affairs. Greg Ip, chief economics commentator at The Wall Street Journal, moderates.