Before it steps up, China also needs to bear in mind that international reserve money status requires formidable preconditions. The GDP of a currency area must be comparable to that of the Dollar and Euro areas. Financial markets must be liquid and transparent. Supervision and regulation must be adequate. Banks, along with the rest of the financial industry, must be commercialized and opened up to domestic private as well as international investors. Monetary and fiscal policies must be sound, stable and responsible. The currency must be fully convertible. Domestic and foreign investors must have full freedom to trade assets across national boundaries. Foreign exchange markets must be well developed for investors to hedge exchange risks, yet currency rates must be stable enough to prevent speculative capital flows from becoming uncontrollable.

So the Chinese people will have to overcome many hurdles in order for the Renminbi to become a fully-fledged international reserve currency. By the end of 2009, China’s GDP accounted for only about 8 percent of the world’s GDP, against 25 percent for the US and 22 percent for the euro area. The Renminbi is only partly convertible, reflecting restrictions on capital flows. China’s financial markets are extremely underdeveloped, and its financial sector is almost fully controlled by state-owned enterprises. In other words, it’s protected by prohibitive barriers to entry for both foreign banks and domestic private entrepreneurs seeking to participate in financial innovation.

At the root of the challenge is modifying China’s growth model and development strategy, which relies strongly on the state-controlled financial sector and on fiscal measures to maintain an extremely high ratio of investment to GDP. This model is unsustainable and inconsistent with the aim of Renminbi internationalization. Chinese leaders have accordingly decided to speed up transformation by shifting the emphasis of growth strategy from exports to domestic demand; from labor, energy and resources to technological innovation and human capital; and from secondary industries to the tertiary sectors led by services.

Boatman in Guangxi's Dongxing City will surely unload more imports from Vietnam when the China-ASEAN Free Trade Zone makes it the first ti witness RMB internationalization. (Source: China Foto Press)

The key to achieving these objectives and promoting competition and innovation is financial deregulation. Without consumer finance, it will be impossible to build up a long-term mechanism to stimulate domestic demand. Without venture capital, private equity and a range of other financing measures, the road toward independent technology innovation and entrepreneurship will remain sealed. Without a liquid securities market, particularly for bonds, local governments will continue to rely on tax revenue and land sales to finance their infrastructure investments and other expenditures.

Financial deregulation will above all involve measures to open up the financial sector to domestic private investors. Domestic entrepreneurs must be allowed to operate banking, securities businesses, insurance, trust and other financial services. Domestic companies and local governments must have the freedom to issue bonds which domestic and foreign investors can trade freely. Interest rates must be liberalized to create an equal playing field for all banks, and a legal framework must be set to encourage innovative financial services such as venture capital and private equity.