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Prasad Says Yuan SDR Status Helps Push Zhou’s Reform Agenda: Q&A

  • Former IMF China chief says inclusion helps push for openness
  • Yuan may be significant reserve currency, but not a safe haven

The yuan’s Oct. 1 addition to the International Monetary Fund reserve currency basket along with the dollar, euro, yen and pound marks a key accomplishment for People’s Bank of China Governor Zhou Xiaochuan that will lock in financial reforms.

That’s according to Eswar Prasad, a former head of the IMF’s China division whose book "Gaining Currency: The Rise of the Renminbi" will be out Oct. 11.

Joining the IMF Special Drawing Rights basket reflects rising economic clout after years of financial liberalization, said Prasad, who is now a professor of trade policy at Cornell University in Ithaca, New York. While the yuan will erode the dollar’s dominance, it won’t challenge it among global investors seeking a safe haven, he said.

The yuan could account for 5 percent to 10 percent of global foreign exchange reserves in a decade, Prasad said, if China continues financial market development and reforms.

Here’s an abridged transcript of a recent interview with Prasad:

Question: 

What’s Zhou’s legacy after reserve status?

Answer:

To have the currency of an emerging market be viewed in the same category as other elite currencies is certainly a significant accomplishment. It party reflects China’s economic strength but also quite effective maneuvering by Governor Zhou, who has found the notion of making the RMB an important global currency and to get it into the SDR basket very good for pushing through a series of domestic reforms that in the long run are going to be difficult to reverse. It set China on a path toward at least some aspects of financial market liberalization.

Question:

What’s the risk with that?

Answer:

Zhou I think saw an opportunity to push forward capital account reforms and saw that as creating an unstoppable momentum toward financial sector liberalization reforms. Once you open the capital account to outflows it creates competition for the domestic banking system because there’s no longer a captive source of deposits, and bringing in capital inflows helps domestic financial market development because foreign investors bring in not only money which adds to depth in the markets but also best practices and better governance practices. The risk of course is that if the capital account opening doesn’t result in better financial markets, better regulatory factors and so on, that could lead to an outflow of capital which could create difficult-to-manage currency depreciation.

Question: 

Will yuan internationalization hit a ceiling, allowing dollar dominance to continue?

Answer: 

If China plays its cards right it could become a significant reserve currency, but there’s one important distinction between reserve currency and a safe haven currency to which investors turn in times of turmoil. Until now, that distinction wasn’t material because every reserve currency, like the euro, pound, yen, the Swiss Franc, and U.S. dollar, have all been safe havens.

The yuan will not become one because a safe haven currency needs to have the trust of foreign investors, and for that you need not just an open capital account, a flexible exchange rate, and good financial markets, but you need what they call institutions. By that I mean an open and transparent form of democratic government that has checks and balances, good trusted public institutions, especially an independent central bank, and the rule of law.

President Xi Jinping has made it abundantly and explicitly clear that he is committed at least in word to economic and financial reforms, but broader political, legal, and institutional reforms are off the table. The yuan has the potential to become a significant reserve currency, but there’s little chance it becomes a safe haven. It will I think conceivably rival the yen, the pound, and could even significantly erode the euro’s dominance in international finance, but there is little prospect of it rivaling the dollar.

Question: 

How does the yuan meet reserve standards?

Answer: 

There’s an apparent contradiction. The yuan doesn’t meet traditional attributes of a reserve currency because China doesn’t have an open capital account and doesn’t have a flexible market-determined exchange rate. On some level it’s remarkable it has become both de facto and now also a de jure reserve currency.

Markets will determine how significant a reserve currency the yuan is, and what financial markets, especially private investors, need are a more open capital account in China, a more market-determined exchange rate, and most importantly, better developed financial markets so that there are good high-quality yuan denominated assets that foreign investors can acquire and trade.

Question: 

How symbolic is inclusion?

Answer: 

The significance is largely symbolic, but this IMF decision is very important because it served as an impetus for domestic reforms. If one looks at what was accomplished during 2015, things like lifting the cap on deposit interest rates offered by banks, the explicit deposit insurance system being put in place, the number of capital account opening measures, the ostensible move toward a more flexible exchange rate, every one of those could be seen as coming off the checklist that the IMF set out for China.

It’s a Trojan horse strategy to do a lot of things that ultimately are going to be very good for China, like financial market liberalization reforms. But given all the domestic opposition to those reforms, they would never have happened if there wasn’t this big objective of getting the yuan into the SDR basked and a very specific deadline that forced all of those things to happen.

Question: 

Is China more cautious on further capital account opening after the last year’s volatility?

Answer: 

Even during and after the turmoil in currency markets after the Aug. 11, 2015, moves they didn’t officially roll back any capital account opening measures. They did tighten up many administrative controls and other measures, and although it seems like they did roll back, essentially what they were trying to do was control capital flight through illegitimate channels, so they cracked down on trade mis-invoicing, money going out through Macau casinos, excessive use of UnionPay cards to take cash out, and so on. But if one looks at what happened in terms of liberalization reforms since the beginning of this year, all of that is still on the capital account. They gave foreign investors access to government and corporate bond markets.

Question: 

Does reserve status require more transparency and clarity in policy making?

Answer: 

The hope of the international institutions like the IMF and the hope of the PBOC is that the increasing international use of yuan, and with the more open capital account, it’s going to become increasingly difficult to manage the currency’s value within a tight range. So I think the IMF and the PBOC would like to see a more market-determined exchange rate. In order to have more stable monetary policy, if one has a market-determined exchange rate, you need more clarity in terms of central bank communications and also clarity in terms of central bank strategy and policy.

What the PBOC would like, and what the IMF might like, isn’t exactly what the PBOC might be able to deliver because there are political constraints and it’s not an independent central bank. I suspect that those of us who hope this leads to more transparency and a little more room for the PBOC to actually focus on domestic monetary policy objectives, that’s not quite going to happen at least in the short run. Realistically the Chinese government more broadly isn’t going to tolerate significant volatility in the exchange rate.

— With assistance by Jeff Kearns

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