The yuan, China’s currency, is in a pickle. Its inclusion in the IMF Special Drawing Rights basket (SDR) on October 1 now makes it part of the reserve assets of central banks all around the world. It means the SDR, a unit of account used by the IMF, is now valued by a weighted average of five currencies now, previously four: the US dollar, euro, yuan, yen, and pound.
This prestigious new status also means that nations, and official financial institutions, worldwide can choose to use the yuan as a unit of account, or to settle SDR-denominated deals. That could include lending, issuing bonds, and settling their IMF quotas. For example, the World Bank sold 500 million SDR-denominated bonds (about US$700 million) on China’s interbank market on August 31, all with settlement in yuan.
But as the SDR inclusion was announced, the yuan’s official value, set by the People’s Bank of China (PBOC), the country’s central bank, kept falling to new lows against the US dollar within just ten trading days between the end of September and October 17. The yuan’s value on the offshore market also fell for eight consecutive days during this period. That strengthened the bearish belief that the yuan is set to further depreciate, causing more capital flight, which in turn could cause more depreciation and set up a painful downward spiral.
Chinese analysts don’t see an immediate boost to the yuan’s value as a likely dividend of its SDR inclusion. Instead, they’re concentrating on the long-term prospects of inclusion. The official endorsement of the yuan by the IMF as a reserve currency will attract more trading in yuan-denominated assets, while a more influential role for the yuan on the international market will give China more say in reshaping global financial governance. This is a virtuous cycle.
But that doesn’t make the present fate of the yuan unimportant, nor a happy future certain. China needs to tackle the challenges of today to make a prosperous future for the yuan possible. Those issues are far more formidable than the short-term yuan fluctuations.
In this article for NewsChina, Li Wei, an associate professor at the School of International Studies, Renmin University of China, offers a broader view of the challenges the yuan faces.
The five-currency SDR basket is like the five permanent members of the Security Council. The first represents the major global economies, and the second represents the great powers who take the lead in global governance. Joining the club of the world’s global currencies also brought China side-by-side with core players in global economic and financial governance.
But the official stamp of approval for the yuan by the leading international financial governance institution paves the way for, but does not guarantee the rise of the currency or a more prominent role for China’s financial sector in international markets. There are financial, economic and political challenges within and beyond China.
Major international currencies need the country that issues them to be open to international investors if they are to keep and expand their position. This means China’s bond and stock markets will have to give foreign investors wider access. As theory shows and experience proves, this normally puts much more competitive and regulatory pressure on domestic financial systems than opening up trade does.
This will be particularly difficult for China. The country’s State-owned commercial banks are big, but not strong. Its securities companies are undersized, and its stock market has been plagued by fraud. Fragmented bond trading floors are split between the jurisdictions of too many ministries. The PBOC’s monetary policy is often inconsistent and opaque. That’s why the opening up of the financial market has been so slow, and why there hasn’t been more market-orientated operation of monetary policy.
China relied on massive, cheap, under-educated labor to rise to become the world’s largest goods exporter. But it can’t repeat that as it strives to become an important player in the international financial markets and global financial governance. There are not nearly enough financial professionals working in China’s official regulators, investment banks, credit rating firms and sovereign wealth funds. And as the nation’s engagement in international finance increases, both international and regional financial institutions will need more Chinese professionals. Although a few Chinese citizens have taken on senior positions in such institutions in recent years, the pool of talent remains small.
The legal framework for Chinese finance also needs two crucial reforms. First of all, it needs a more independent central bank. The PBOC’s monetary policy record is respected internationally. But its independence is not explicitly protected by the law, and as a result its decisions are sometimes disturbed by political intervention. If it were more independent, its monetary policy would be recognized as more transparent and authoritative, boosting international confidence in the yuan.
But the biggest weakness, and the hardest one to fix, is the lack of robust rule-based financial and commercial dispute settlement mechanisms. Trading in international currencies often involves huge sums, and disputes are unavoidable. Investors expect fair legal solutions. Reform efforts should be combined with better protection of property and an accounting system that meets modern commercial standards. Investors’ stake in the yuan is, de facto, an endorsement of China’s political stability. China needs more efforts in these systematic reforms to convince the world of its ability to maintain stability and dynamism.
China also has to remember that there may be more competition from the other four currencies in the SDR basket. The US publicly supports the yuan’s internationalization, as it wants a more open capital market that should emerge alongside the process. But the US is warier toward the challenge from the yuan than it was toward the yen, given China’s economic weight and rising geopolitical influence.
As a result, the US has not been as positive as some Asian and European countries have been about yuan internationalization, in contrast to the strong role it played in yen internationalization in the mid-1980s. [At that time the US believed a more international yen could strengthen it against the US dollar, helping US exporters and widening Japan’s capital market to US investors. In contrast, five yuan clearing centers have been built in Europe over the last few years, but the first one in the US wasn’t established until September 20, 2016.]
The biggest challenge for the yuan in becoming a core regional currency first before expanding globally comes from China’s neighbor, Japan. At present Sino-Japanese currency cooperation is moving slowly due to their economic and geopolitical competition and territorial disputes.
The yuan has the third largest share of the SDR basket, after the US dollar and euro. That means the euro might be undermined as the yuan moves toward being a major international currency. European countries have already felt the squeeze. The increases in China’s IMF quota and the World Bank’s voting power have mostly come through a decrease in the European countries’ share. [China’s SDR share is also mainly taken from the euro and pound, with only a slight reduction for the US dollar and yen]. We can’t expect the Eurozone to play a leading role in yuan internationalization in the future.
The pound, the currency with the smallest share of the SDR basket, is quite a different story. Although the UK is never hesitant in defending the pound’s position as a major international currency, it has no ambitions to surpass the euro or the US dollar. The City of London consolidated its position as an international financial hub by acting as the offshore center for US dollar trading after WWII. The UK’s relatively unambitious goals for the pound and successful experience as an offshore currency center make it well motivated and prepared to support yuan internationalization.
China needs political support from other countries in pushing the yuan as an international currency, but this can’t be taken for granted. The US is fully aware of the geopolitical implications of financial moves, as demonstrated in its diplomatic resistance to the China-backed Asia Infrastructure Investment Bank. China needs to put in the diplomatic work to gain political support for the yuan from around the world. Asia-Pacific countries are already fearful of China’s military and geopolitical rise, and may be just as fearful about its economic and financial rise. China needs to understand and disperse this fear.