China’s Yuan Faces Long March to Challenge Dollar After SDRby
Yuan to be included in IMF’s global reserves basket this week
Chinese officials want ‘best of both worlds,’ Invesco says
The yuan’s journey toward challenging the dollar as a global reserve currency is only just beginning.
The yuan will join the International Monetary Fund’s Special Drawing Rights this Saturday, marking a milestone in China’s efforts to build a currency that reflects the country’s economic and political sway. The SDR, created in 1969, gives IMF member countries who hold it the potential right to obtain any of the currencies in the basket -- currently the dollar, euro, yen and pound -- to meet balance-of-payments needs.
Inclusion could be a catalyst for central banks and sovereign wealth funds to shift funds into the yuan. Yet the size of SDRs are small relative to global reserves, while the Chinese currency’s international appeal is being dented by suspected state intervention and tougher capital controls. The yuan constituted 1.1 percent of official reserves in the latest IMF survey, compared with 63.7 percent for the dollar.
China wants "the best of both worlds," said John Greenwood, London-based chief economist at Invesco Asset Management and architect of Hong Kong’s currency peg to the dollar. "They want the status of an international reserve currency. They also want control. If you look at the history of international reserve currencies, that’s not the way they’ve achieved the status. They’ve achieved the status because they’re freely accessible or free to use."
SDR entry was won last year after China took steps to loosen restrictions over the yuan, including allowing the reference rate to be more market-based and expanding overseas access to the bond market. Inclusion comes seven years after People’s Bank of China Governor Zhou Xiaochuan called for SDRs to play a greater role to lessen the world’s reliance on the dollar.
From Oct. 1, the yuan will have a 10.92 percent weighting in the basket, behind the euro and the dollar, in the first addition since 1999. There were 204.1 billion SDRs as of March this year, equal to around $285 billion, compared with some $11 trillion of global reserves.
While China has made it easier for foreign investors to access the nation’s financial markets, policy makers have also intervened to maintain stability. Curbs on outflows were tightened after a devaluation of the yuan last year spurred an exodus of funds, while the overnight cost to borrow the offshore currency in Hong Kong surged above 20 percent twice this year amid speculation the PBOC mopped up liquidity to boost the exchange rate. The central bank last week denied it intervened recently.
For the yuan to be a major international reserve currency, China would need to "fully open its capital markets and convince world markets that the openness would remain during any period of stress," said William Overholt, a senior fellow at Harvard University’s Asia Center and author of ‘Renminbi Rising.’ "That degree of opening will require a number of years and is not possible to do immediately because of domestic financial stresses and pressures for capital flight," he said, adding that "for the foreseeable future, the renminbi will see wide but very thin use as a reserve currency."
Some argue that the benefits of being a member of the IMF’s basket will give the government the confidence to lower capital barriers, thereby boosting the yuan’s standing on the world stage.
SDR inclusion and a global hunt for yield will drive foreign inflows into China’s bond market, enabling policy makers to ease restrictions on outflows, according to a note last week by strategists led Paul Mackel, head of emerging-market currency research at HSBC Holdings Plc. Overseas ownership of the nation’s debt accounts for only 1 percent of the nation’s outstanding notes, even after rising 37 percent in two years to reach 764 billion yuan at end-June.
Still, currency volatility and tighter controls have taken a toll on yuan internationalization. Deposits in the largest offshore hub of Hong Kong have dwindled to the lowest since 2013, and the yuan’s share of worldwide payments reached a two-year low of 1.72 percent in June. The currency was little changed at 6.67 at 3:14 p.m. local time.
The currency is poised for its third year of depreciation, with analysts seeing further weakness in 2017. A warning indicator for banking stress rose to a record in China this year, according to the Bank for International Settlements, as growth slowed amid a rapid debt build-up.
"China is facing a complicated domestic situation now, with economic growth slowing, still high financial risks, the reduction of capacity and leverage," said Chen Xingdong, chief China economist at BNP Paribas SA in Beijing. "There needs to be favorable conditions in the domestic economy for the yuan to internationalize. If conditions aren’t favorable, it’s not a good idea."
While having a major reserve currency boosts demand for that country’s assets and to some extent its geopolitical influence, the degree of financial openness required puts domestic markets at the mercy of global fund flows, undermining independence in monetary policy.
For the U.S., accommodating large inflows from foreign central banks -- most notably, China’s -- has fueled persistent current-account deficits. This would pose a challenge for Beijing, given domestic demand is too weak, said Michael Pettis, a finance professor at Peking University. The nation has the world’s second-largest annualized current-account surplus.
SDR entry is "large symbolic," said Invesco’s Greenwood. "They will continue with the current style of liberalization -- that is to say opening up individual pipelines and setting quotas on those flows so that they retain control. I don’t think they’re ready to open up on a broader basis."