Why Does China Have Two Currencies?

China, one of the world’s largest and most influential economies, is known for its unique and complex financial system. One of the most distinctive features of China’s financial system is its use of two currencies: the renminbi (RMB) and the yuan (CNY). While these terms are often used interchangeably, they serve different functions in China’s domestic and international financial systems. Understanding why China has two currencies requires a deep dive into the nuances of its economic policies, monetary system, and global ambitions.

In this article, we will explore the reasons behind China’s two-currency system, how these currencies function, and their roles in the broader context of China’s economic growth and international influence.

Understanding China’s Two Currencies: RMB vs. CNY

Before delving into the reasons for having two currencies, it’s important to clarify the difference between the two terms:

Renminbi (RMB): The renminbi is the official currency of China and translates to “people’s currency.” It refers to the entire monetary system of China, which includes all of the country’s legal tender, irrespective of the form it takes. The renminbi is issued by the People’s Bank of China (PBOC), China’s central bank, and is the general term for the Chinese currency.

Yuan (CNY): The yuan is the specific unit of the renminbi and is the name for the Chinese currency when used in the international financial markets. For instance, when you see the currency quoted on the foreign exchange market, it will often be referred to as CNY.

To summarize, RMB refers to the broader currency system, while the yuan is the unit of currency used in both domestic and international transactions. While these terms are often used interchangeably, they are distinct in function and usage.

The primary reason why China maintains a two-currency system is tied to the nation’s unique economic structure and the need to manage its domestic economy while engaging in international trade and investment. The existence of two currencies allows China to maintain control over its domestic monetary policy while also accommodating the demands of the global market.

Here are the key reasons why China uses two currencies:

1. Currency Control and Monetary Policy Management

China’s economic policies are heavily influenced by the country’s goal of maintaining financial stability and fostering controlled growth. The use of two currencies helps China manage its domestic economy while limiting the impact of external financial pressures.

The government uses the renminbi in domestic transactions, which allows the People’s Bank of China (PBOC) to control inflation, interest rates, and money supply. This control is crucial for maintaining domestic stability, as China’s financial system is still evolving and has a significant state-owned sector. The PBOC uses the renminbi to implement monetary policies such as adjusting interest rates and controlling liquidity in the banking system. By keeping the currency within its domestic borders, China is able to effectively influence its economic growth trajectory.

However, when it comes to international trade and investment, China faces a different set of challenges. The global economy operates in a different way than the domestic economy, and external investors and trading partners often prefer to transact in a more freely traded currency. This is where the yuan (CNY) comes into play.

2. Managing Exchange Rate Volatility

Having two separate currencies helps China maintain more control over the exchange rate of its domestic currency. The renminbi is subject to heavy regulation and can only be converted to foreign currencies in limited circumstances, such as government-approved transactions and foreign exchange reserves.

In contrast, the yuan is traded in global markets, subject to supply and demand, and can fluctuate more freely. This dual system gives China the flexibility to manage the exchange rate between its domestic currency and other global currencies, allowing the country to avoid wild fluctuations that could result in inflation or deflation.

The People’s Bank of China manages the exchange rate of the yuan through a policy of managed float. This means that while the yuan is allowed to float within a set range, the PBOC will step in if the currency moves too far in either direction, helping to stabilize the yuan against other major currencies like the U.S. dollar.

This dual approach gives China the flexibility to maintain a competitive exchange rate while avoiding the instability that comes with a completely free-floating currency.

3. Global Trade and Investment Influence

China is one of the world’s largest exporters, and its currency plays a vital role in international trade. In 2005, China began to allow the yuan to trade more freely on international markets, particularly with countries in Asia and regions like Africa and Latin America. As global trade and investment activities increased, China needed a currency system that could facilitate these exchanges.

The yuan (CNY) has become one of the world’s most widely used currencies in global trade. In fact, the yuan is the second-most traded currency in the world, behind the U.S. dollar, and is used extensively in international finance, particularly in the context of trade with China.

By allowing the yuan to be traded internationally, China can bolster its global financial influence. The introduction of the yuan into global trade markets has helped China secure its position as a central player in the world economy. This is particularly important as China seeks to expand its financial influence, particularly in emerging markets.

Additionally, the yuan has been gaining prominence in global reserves. The International Monetary Fund (IMF) recognized the yuan as one of the world’s reserve currencies by adding it to the Special Drawing Rights (SDR) basket in 2016. This move is symbolic of China’s growing economic power and marks a significant step in the yuan’s rise on the global stage.

4. Capital Controls and Preventing Capital Flight

China has strict capital controls in place to prevent large-scale capital flight and to manage the flow of money into and out of the country. By using the renminbi for domestic transactions and restricting the convertibility of this currency, the Chinese government can prevent excessive outflows of capital that could destabilize the economy.

China’s capital controls limit the amount of money that can leave the country, which protects the economy from the volatility caused by sudden shifts in foreign investment. If China allowed the renminbi to freely float without restrictions, large amounts of capital could leave the country, leading to instability and potentially triggering a currency crisis.

Using the yuan as the internationally traded currency also enables China to maintain its capital controls while participating in global trade. As a result, the yuan is more flexible and responsive to market forces, while the renminbi remains insulated from destabilizing effects.

5. Gradual Transition Towards Financial Liberalization

China’s two-currency system is also a reflection of the country’s gradual transition toward greater financial liberalization. While the country has made significant strides in opening up its markets and engaging with the global economy, it remains cautious about fully embracing free-market principles in all aspects of its financial system.

By maintaining a dual currency system, China can open up its economy to foreign investment and global trade while retaining some control over its domestic financial system. Over time, China may move towards greater liberalization, but for now, the two-currency system serves as a useful tool in balancing economic growth with stability.

Conclusion

China’s two-currency system, which distinguishes between the renminbi for domestic transactions and the yuan for international trade, reflects the country’s unique approach to managing its economy and integrating into the global financial system. The dual system offers China a way to control its domestic economy while engaging with global markets in a more flexible and responsive way. This system allows China to maintain financial stability, manage its exchange rate, influence global trade, prevent capital flight, and gradually liberalize its financial sector.

As China continues to expand its role as a global economic power, the two-currency system will likely remain a key part of its financial strategy. Understanding this system is crucial for anyone interested in the global economy and China’s growing influence in international trade and finance.

Why Does China Have Two Currencies?

Understanding China’s Two Currencies: RMB vs. CNY