China is increasingly debating whether or not the yuan should be internationalized, possibly joining the US dollar and the euro as an international vehicle currency (IVC) — that is, a currency that other countries use to denominate the prices of their traded goods and international loans. Related to this is a debate about whether Shanghai can become a first-tier international financial center (1-IFC) like London and New York.
Financial history can help to answer these questions. First, a city can become a 1-IFC only if its national currency is an IVC. However, as London’s status shows, a longtime 1-IFC can retain its position in the international financial system even if its currency is no longer an IVC.
Second, the transaction cost of using a foreign currency as a medium of exchange is inversely proportional to the extent to which that currency is used globally. Similar economies of scale characterize foreign investors’ use of a particular international financial center. As a result, there cannot be more than three or four IVCs and 1-IFCs.
Third, a country’s financial sector must be both open, with no capital-flow restrictions, and sophisticated, with a wide range of instruments and institutions. It must also be safe, with a central bank maintaining economic stability, prudential regulators keeping fraud and speculation in check, macro-prudential authorities displaying adequate financial fire-fighting capabilities, and a legal system that is predictable, transparent and fair.
Lastly — and most importantly — successful convergence to IVC and 1-IFC status requires the national economy to be strong relative to other economies for a substantial period of time. The UK occupied a position of global economic leadership for more than a century. In 1914, the US/UK GDP ratio was 2-1, but the US dollar was not an IVC, suggesting that the US’ relative economic strength was inadequate. A decade later, in 1924, the ratio was 3-2 and rising — and the US dollar had eclipsed the British pound as the most important IVC.
Relative economic strength explains why the Japanese yen failed to develop into an IVC, and why Tokyo — whose financial markets satisfied the relevant requirements — failed to become a 1-IFC. With its GDP reaching only about 60 percent of the US’ at its peak in 1991, Japan never attained the critical mass required to induce foreigners to use the yen to lower transaction costs.
Determining the future international status of the renminbi and Shanghai must begin with a calculation of China’s expected relative economic strength vis-a-vis the US under two plausible scenarios.
In the first scenario, China becomes caught in a middle-income trap, with per capita GDP stuck at 30 percent of the US’ — an outcome that has characterized Latin America’s five largest economies since at least 1960 and Malaysia since 1994. This would put China’s economic strength relative to the US at 1-1 — well below the necessary ratio.
In the second, more favorable scenario, China’s per capita GDP would reach 80 percent of the US’ — higher than the 70 percent average rate for the five largest Western European countries since 1960 — and its economic strength relative to the US would amount to roughly 2-8. This would make the renminbi eligible for IVC status and enable Shanghai to choose whether to become a 1-IFC. However, China’s economy still would not be strong enough relative to the US for natural market forces to ensure the yuan’s international success.