China isincreasingly debating whether or not the renminbi should be internationalized,possibly joining the US dollar and the euro as an international vehiclecurrency (IVC) – that is, a currency that other countries use to denominate theprices of their traded goods and international loans. Related to this is adebate about whether Shanghai can become a first-tier international financialcenter (1-IFC) like London and New York.

Financialhistory can help to answer these questions. First, a city can become a 1-IFConly if its national currency is an IVC. But, as London’s status shows, alongtime 1-IFC can retain its position in the international financial systemeven if its currency is no longer an IVC.

Second, thetransaction cost of using a foreign currency as a medium of exchange isinversely proportional to the extent to which that currency is used globally.Similar economies of scale characterize foreign investors’ use of a particularinternational financial center. As a result, there cannot be more than three orfour IVCs and 1-IFCs.

Third, acountry’s financial sector must be both open, with no capital-flow restrictions,and sophisticated, with a wide range of instruments and institutions. It mustalso be safe, with a central bank maintaining economic stability, prudentialregulators keeping fraud and speculation in check, macro-prudential authoritiesdisplaying adequate financial fire-fighting capabilities, and a legal systemthat is predictable, transparent, and fair.

Last – andmost important – successful convergence to IVC and 1-IFC status requires thenational economy to be strong relative to other economies for a substantialperiod of time. The United Kingdom occupied a position of global economicleadership for more than a century. In 1914, the US/UK GDP ratio was 2.1, butthe US dollar was not an IVC, suggesting that America’s relative economicstrength 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.

Relativeeconomic 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%of America’s at its peak in 1991, Japan never attained the critical massrequired to induce foreigners to use the yen to lower transaction costs.

Determiningthe future international status of the renminbi and Shanghai must begin with acalculation of China’s expected relative economic strength vis-à-vis theUS under two plausible scenarios.

In the firstscenario, China becomes caught in a middle-income trap, with per capitaGDP stuck at 30% of America’s – an outcome that has characterized LatinAmerica’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 belowthe necessary ratio.

In the second,more favorable scenario, China’s per capita GDP would reach 80% ofAmerica’s – higher than the 70% average rate for the five largest WesternEuropean countries since 1960 – and its economic strength relative to the USwould amount to roughly 2.8. This would make the renminbi eligible for IVCstatus and enable Shanghai to choose whether to become a 1-IFC. But China’seconomy still would not be strong enough relative to the US for natural marketforces to ensure the renminbi’s international success.

Given this,the Chinese government would have to implement decisive measures to encourageinternational traders and creditors to price their transactions in renminbi.Specifically, China would have to use its market power to promote pricing inrenminbi for relevant manufactured exports and raw-material imports, andencourage renminbi denomination of foreign financial assets that Chinapurchases (which the country’s status as a net creditor should facilitate).

But there areserious pitfalls to avoid in this process. As the Asian financial crisis of1997-1998 demonstrated, capital-account liberalization could lead to financialmeltdowns – a danger that opponents of internationalizing the renminbi oftencite. But these risks do not outweigh the potential benefits of financialopenness, and they can be minimized with effective monitoring and regulation,including requirements for large capital buffers and low leverage ratios,together with strong crisis-response mechanisms, like a resolution trustcorporation.

In fact,effective financial-monitoring and prudential-regulation systems do not have toprecede opening the capital account. On the contrary, developing and enactingfinancial regulation must be a gradual process, shaped by both existingknowledge and firsthand experience. After all, no financial market is eithercompletely open or completely closed forever; the degree of openness at a givenmoment depends on policy choices.

The recentestablishment of the Shanghai Free Trade Zone will allow for the emergence ofan offshore international financial center that offers real-world training toChina’s regulators. This will give them the tools they need to recognize thesigns of a developing crisis, defuse the threat, and efficiently handle therecapitalization and reorganization of failed financial institutions.

China’spursuit of an IVC and a 1-IFC city would serve not only its own interests.Allowing the renminbi to help meet global demand for international reserves andrisk diversification would also strengthen global financial stability.

There islittle time to waste in internationalizing the renminbi. Given the limitednumber of currencies that can serve as IVCs, the failure of the renminbi toachieve IVC status before, say, the Indian rupee, the Russian ruble, or theBrazilian real could mean that the renminbi is denied IVC status – and thatShanghai fails to achieve 1-IFC status – for generations, if not forever.