For China, the End of the Beginning on Road to a Global Currency

  • `We are still relatively far' from developed world's markets
  • Policy makers mindful of historical pitfalls including Japan

Pedestrians walk through the atrium of Soho China Ltd.'s Galaxy Soho complex in Beijing, China, on Dec. 2.

Photographer: Qilai Shen/Bloomberg

After a struggle of more than half a decade, China this week overcame doubts and objections to qualify for official reserve status for its currency, the yuan. Now, the real battle begins.

Chinese officials who want a much bigger role for market forces -- including central bank Governor Zhou Xiaochuan and his deputy Yi Gang -- have used the goal as a lodestone for their ideas. In their campaign, the reformers won approval for gradually opening up the financial system to foreign participation and letting the private sector set interest rates.

With the IMF’s decision on Nov. 30 to endorse the yuan for inclusion alongside the dollar, euro, pound and yen in the International Monetary Fund’s global currency basket, known as Special Drawing Right, or SDR, the reformers in one sense realized their ambition.

While meeting the IMF’s "freely usable" requirement, Chinese policy makers are still a long way from a "freely convertible" currency. That’s the long-term objective of the reformers seeking to overturn China’s state-directed lending model. The legacy has left a $28 trillion debt pile hanging over an economy set to grow at the weakest pace since 1990.

The People’s Bank of China’s Yi Gang was quick to highlight the unfinished business.

"We are still relatively far from the world’s developed markets," Yi told reporters in Beijing hours after the IMF announcement. "Joining the SDR also means that the international community will have more expectations for China in many financial and economic aspects, so we also feel that the burden on our shoulders is heavier."

Reform Battle

The financial system is a key battleground between Zhou, Yi and their allies and the Communist Party stalwarts who advanced in the state-owned enterprise world and want to keep the old structure of a planned economy. Opponents maintain their anonymity in a system where the party is supposed to be moving forward as one.

The Communist leadership agreed in the new Five Year Plan for the economy to move toward yuan convertibility by 2020. Those next steps will be fraught with risk -- the global economy is littered with a trail of examples that illustrate what can go wrong when the sequencing of capital-account opening is fumbled. It took Japan 40 years to complete big reforms to its exchange rate, interest rates and financial sector only to see an asset bubble swell, then burst and crash the economy for two decades.

"International experience shows that financial reforms raise the risk of financial instability," said Louis Kuijs, head of Asia economics at Oxford Economics Ltd. in Hong Kong, who previously worked at the World Bank. "As long as those reforms are conducted cautiously and in the right sequence, this should in the long-term be good for China’s economy and financial system."

Yuan Shock

The lessons of others won’t be lost on China. Policy makers were jolted in August when a decision to free up the exchange rate by allowing the market a greater say in setting the yuan’s value roiled global markets and sparked record capital outflows.

Yet the status quo isn’t much of an option either, given the misallocation of capital and risk of a continued buildup of debt.

"A deep and liquid capital market that’s accessible to foreign investors is key," said Cui Li, deputy director of the International Finance Forum Institute and a former IMF senior China economist. "A flexible exchange rate helps to cushion the risks during the course of capital-account opening, and should be part of the reforms as well."

While foreign central banks have been approved to enter the domestic Chinese bond market, others still face layers of regulation or are excluded entirely. Domestic investors face limits to taking money out of the country -- yet even under the existing structure have spirited hundreds of billions of dollars away.

Moral Hazard

Meantime, China has yet to deal with the question of who will or won’t be bailed out among domestic borrowers, making bond yields and spreads a poor guide for the underlying risks of the issuer.

In the stock market, which saw a bubble burst earlier this year and wipe out $5 trillion of wealth, investors have met with surprises including sudden bans on trading certain stocks. The unexplained disappearances of CEOs -- often for corruption charges that publicly emerge only later -- point to the relative lack of transparency in China’s markets.

Those realities offset any euphoria over the hundreds of billions of dollars of yuan purchases that analysts see coming from the IMF’s SDR designation, which takes effect in October 2016.

Bond Market

"At the end of the day, reserve managers and foreign investors will decide on renminbi holdings not so much on SDR inclusion, but more on the availability, liquidity and stability of China’s bond market," said Wang Tao, chief China economist at UBS Group AG, using another term for the yuan. Also important: tools for hedging exchange-rate and interest-rate risk, and the stability of the overall economy, she said.

China is already pursuing pilot programs in its Shanghai free-trade zone that feature lighter rules on moving money in and out of the country. Further steps may be discussed at the leadership’s annual economics works conference this month.

Whatever the near-term outcome, China’s reform journey has a long way to go, said Alexander Sullivan, an associate fellow at the Center for a New American Security in Washington.

"China is at the beginning of what will become an increasingly complex story over the coming years and decades."

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