China's Yuan Faces a Rocky Road to Becoming a Truly Global Currencyby
Globally used yuan could boost Chinese consumers, investment
China first seen needing to implement a long list of reforms
Great powers have great currencies.
From Roman times to the U.S. today, empires and superpowers have minted currencies that dominated trade and projected their influence. Now, China wants its turn.
The yuan on Oct. 1 will enter the International Monetary Fund’s reserve currency basket alongside the dollar, euro, yen and pound, paving the way for increased global use.
But decades of isolation from the world economy under Mao Zedong and rigid capital controls in place since China’s opening began in the late 1970’s mean China begins its push for a globalized currency from square one. The yuan is estimated at less than Canada’s dollar in central bank reserves, and under 2 percent of global payments are settled in the unit.
"Countries can’t simply snap their fingers and create a reserve currency," said Jennifer Harris, a senior fellow at the Council on Foreign Relations in New York who previously advised on economics and markets in the U.S. government. "Where countries have ignored history’s advice and attempted to develop a reserve currency, their motivation is often more geopolitical than economic," she said, pointing to the euro area’s strains.
In China’s case, the geopolitical goal is clear: increased global influence. Soaring demand for dollars in the depths of the 2008 financial crisis saw officials the world over seeking a U.S. currency lifeline from the Federal Reserve. As for economics, a yuan that’s universally usable would lock in Chinese financial reforms, lifting the purchasing power of the nation’s consumers.
For the world economy, reduced reliance on the dollar would mean less exposure to cycles in U.S. economic policy, and diminished risk of sudden surges in demand for liquidity in a single, dominant reserve currency. China’s trading partners could benefit from the strengthened buying power of the country’s households, and a new influx of investment.
While such shifts appear distant given the yuan’s starting point at the back of the pack, China has proved a quick study in recent economic history.
The nation’s gross domestic product has swelled to about $11 trillion from about $150 billion at the start of the reform process, turning it from economic outcast to a driver of global growth. Entry into the World Trade Organization in 2001 accelerated global trade and Beijing’s stimulus after the 2008 crisis helped put a floor under the world economy.
Ding Shuang, the head of Greater China economic research at Standard Chartered Plc in Hong Kong, forecasts the yuan’s share of global reserves will swell to match the pound and yen within five years. It’ll join the IMF’s special drawing rights (SDR) unit of account with the third-biggest allocation.
Lessons from history show that it could be a long march before the dollar’s primacy is threatened. The U.S. became the world’s biggest economy in 1872; it wasn’t until the middle of the next century that the greenback’s dominance was complete. The dollar has held the top spot since, seeing off threats from the yen and euro along the way.
Communist Party leaders must also stomach a long list of potentially painful economic, legal and political reforms needed for the yuan to meet its potential. Domestic financial markets remain shallow and illiquid, and strict curbs remain on moving money into and out of the country. The nation’s nascent debt markets must keep developing in a way that will ensure there’s enough securities that reserve managers want to purchase.
Policy missteps last year might have hampered that cause. Widespread intervention including curbs on large shareholders selling their holdings shook confidence in the wake of an epic $5 trillion stock market rout, while a shock yuan devaluation further rattled investors.
"China might have rising economic clout but, without these broader reforms, it will never gain the trust of foreign investors," said Eswar Prasad, a professor at Cornell University in Ithaca, New York and author of "Gaining Currency. The Rise of the Renminbi."
An example of the hurdles the yuan confronts can be seen in its role in President Xi Jinping’s ambition to extend China’s influence in the region.
Officials who planned the Chinese-backed Asian Infrastructure Investment Bank initially envisaged the new lender as a vehicle that could promote yuan usage, people familiar with the matter said at the time. But since its launch, the $100 billion AIIB’s initial projects -- which include a motorway in Pakistan and a slum clearance project in Indonesia -- have featured loans made in dollars.
So it’s baby steps for now. The World Bank in August sold in China a rare type of bond denominated in the IMF’s SDR. That gels with China’s wider push to promote the unit as a dollar alternative and to open up the nation’s capital markets.
"It looks like a small event, but it’s an opening-up event," Yi Gang, a deputy governor at China’s central bank, said in an interview on state television. "The progress that has been made is much faster than I originally expected."
China isn’t the first would-be usurper of the dollar’s primacy. Japan’s yen was tipped for global status through the 1980s, until the market meltdown and lost decades of economic stagnation sank such prospects. A similar narrative arose when the euro was launched, with some analysts forecasting the single currency would overtake the dollar. Now, some question whether the euro will endure the anti-unification sentiments rising on the continent.
It’s also the case that a slow and steady approach to freeing up the yuan will suit China. For all the concerns over China’s debt mountain, one force of stability is that the obligations are overwhelmingly domestically funded. Rushing to open capital borders would see Beijing lose control over the flow of money into and out of the country.
"It would be sensible for China to slow down its dismantling of barriers to cross-border financial flows, even if it means slowing down the trend toward internationalization of the currency," said Jeffrey Frankel, a professor at Harvard University’s Kennedy School of Government.
Such risks run both ways. If the yuan, also known as the renminbi, were to become a major reserve currency it could leave the world’s financial system even more vulnerable to an economic shock that’s made in China. That would add to trade linkages that already make regional neighbors vulnerable to Chinese cyclical swings and supply-chain changes.
Over a longer time horizon, China’s quest to promote its currency could be a tonic for a global economy in need of a jump start, said Frederic Neumann, co-head of Asian economic research at HSBC Holdings Plc in Hong Kong.
"It’s an enticing prospect and could offer a fix for the world’s growth malaise," he said, referring to the potential benefits of Chinese purchasing-power gains and investment flows. "Alas, it isn’t bound to happen overnight."