December 16th, 2015

Yuan’s slow rise could mean trouble for Western economies

by Enrico Colombatto At the end of November, the International Monetary […]

Team AEC

At the end of November, the International Monetary Fund (IMF) announced that from October 2016 the Chinese yuan will be part of the basket of currencies that defines the Special Drawing Right (SDR), the accounting unit the organisation uses to carry out financial operations. The immediate practical effects will be minor. Being part of a unit of account means all but nothing in terms of monetary policy. Yet, the symbolic significance of this decision is considerable and could lead to consequences that will change the very foundations of global finance – if China decides to take advantage of the opportunity.

Powerful symbol

The IMF’s SDR will now include the dollar, the euro, the yuan, the Japanese yen and the British pound, in decreasing order of importance. The inclusion of the yuan (officially known as the renminbi) means that China has de facto been recognised as the world’s third economic power, behind the United States and the European Union. The EU ends up as the big loser from the move, since the yuan’s share (11 per cent) within the SDR corresponds almost exactly to the combined reduction in the weight of the euro (from 37 per cent to 31 per cent) and the pound (from 11 per cent to 8 per cent). The share of the US dollar will remain constant at 42 per cent.

The recognition of China as the third global economic power will be particularly relevant at the IMF, one of the very few supposedly neutral institutions where global politics is discussed and informal agreements are reached. Moreover, a stronger image on the international scene also enhances the prestige of Chinese leaders at home. This comes at the right moment for the authorities in Beijing, given that the recent unease over the country’s economic situation has tarnished their reputation. The Chinese banking system is fragile, inflation is likely much higher than the official figures show and the economy is slowing down.

Finally, this recognition means that the Western economies acknowledge the role that China has recently come to play in the developing world. From now on, China will no longer simply be a developing country that is larger and more powerful than the others. Instead, it will be a political actor playing on an equal footing with the US. It will be more authoritative than Western European governments and more influential than other major players such as Russia.

Two conditions

The international community will develop a keener interest in the renminbi, both as a means of payment and as a store of wealth. According to the Society for Worldwide Interbank Financial Telecommunication (SWIFT), at the end of 2014 the yuan’s share in payments worldwide was a modest 2.2 per cent. However, during the past few months its role has increased, and it will probably come close to 3 per cent by the end of 2015.

Much will depend on what Beijing does next. In order for the yuan to acquire the operational status typical of a truly international currency, two conditions must be met. First, the currency must be fully convertible, so that traders do not risk holding a unit of payment that others could reject. Second, the currency must be stable.

Until now, the Chinese authorities have maintained some restrictions on capital movements, and have shown a marked propensity to intervene in order to nudge the renminbi’s exchange rate towards desired levels. That means they value exchange rate stability and are more than willing to operate accordingly. They are also inclined to intervene and regulate whenever they believe it necessary, something that usually does not please market participants.

Weak spots

While the yuan’s international role is certain to grow rapidly, it will not become a major player – which for our purposes can be defined as accounting for at least 10 per cent of transactions on the global currency market – until it passes three further tests. First, the Chinese authorities must decide to lift all capital controls. Second, the renminbi must remain stable in the absence of such controls. Third, traders around the world must be confident that China will not backtrack on such reforms.

Meeting these requirements will take years, not months. This suggests that global demand for the Chinese currency will rise relatively slowly in absolute terms, even if the rate of growth is high. In particular, within the context of capital markets, the use of renminbi will probably concentrate on short-term assets. These are less vulnerable to the risk of a sudden reversal in official policies, and also to the political risk associated with a potential implosion of the whole Chinese economy – whose weak spots still have not been addressed.

A different and far more challenging scenario for the US and Europe would present itself if China took advantage of its new position by transforming the yuan into a unique, prestigious currency. This would be possible if it created a ‘golden renminbi’ – that is, if it declared a gold parity for the currency and backed it with Chinese reserves. All golden renminbis in circulation – but not the ‘ordinary’ ones – would be redeemable on demand. Such a move would put China at least partially back on the gold standard, breaking new ground in the history of the international monetary system.

Golden rule

This project would run up against a number of difficulties. The People’s Bank of China has declared gold reserves of about 1,700 tonnes – much less than what it would need to back a new golden renminbi on a large scale. China does have copious amounts of gold registered under an account managed by a special agency outside the central bank, so that these reserves do not appear in the official statistics. This creates an uncomfortable lack of transparency, since potential investors could fear that their golden renminbis might be left without collateral if the Chinese authorities decide to shift gold from one account to another. A gold standard involves trust, and the Chinese authorities still need to show that they are reliable counterparties.

Nevertheless, the introduction of a gold backed Chinese currency is feasible, especially if the new monetary unit circulates on a relatively small scale, alongside the ordinary renminbis. The presence of a golden yuan would certainly send ripples throughout the international monetary system. It would easily acquire the status of reserve currency, since many traders would welcome another way to denominate their transactions.

It would be interesting to observe how the other major currency players react. A Chinese switch to a partial gold standard would persuade many central bankers throughout the world to alter the composition of their foreign currency reserves: more golden yuan, more ordinary renminbis, fewer dollar- and euro-denominated assets. Central banks would start selling Treasury bills issued by the US and countries in the euro area, or buy them in smaller quantities than before. If that happens, the fiscal authorities in rich nations will need to fix their parlous finances in a hurry, since there would be fewer buyers for their bonds and interest rates would begin to rise.

Ready or not

It is obvious that the IMF did not reward the yuan with international status because China deserves it. At present, the renminbi is not a fully convertible currency, China is not a free market economy, and its statistics are dubious at best. Rather, the yuan’s upgrade acknowledges the role Beijing plays in global politics and the weakness of the EU.

The Chinese will not spend much time resting on their laurels. Rather, they will hasten to make good in the opportunities granted by a prestigious currency. One hopes that the world’s rich economies are ready for the challenges that may soon arise in consequence.

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