Watch Out China: A Reserve Currency Brings Boom and Busts
A big shift in currency markets is afoot now that the International Monetary Fund has decided to add the Chinese renminbi -- commonly known as the yuan -- to its Special Drawing Rights list of currencies. That means that the IMF approves of countries holding yuan as foreign-exchange reserves. The other currencies on the list are the U.S. dollar, British pound, Japanese yen and the euro, so the yuan is joining a pretty elite group.
The IMF's decision doesn't have official regulatory implications -- being on the Special Drawing Rights list doesn't actually give you any special rights. It really just represents the IMF's opinion about which currency is safe for asset managers to hold. If asset managers decide that the IMF's stamp of approval is important, then they'll hold more yuan. If not, then they won't.
QuickTake The People's Currency
Asset managers may decide that the IMF's decision was mainly political, and that recent liberalizations of China's capital account are mostly skin deep. On the other hand, this may be an important signal that China is ready to end its strategy of rapid investment-driven catch-up growth, and is hence no longer very concerned with keeping its currency weak in order to spur exports. So far, no one knows.
Why would China want the IMF to put the yuan in the SDR? It may want to engineer a bump in capital inflows, at a time when money is trying to leave China. Generating some foreign demand for yuan-denominated assets might help stabilize the Chinese currency, which is expected to depreciate a bit in the months ahead. The IMF might be motivated to help China limit the moves in its currency in order to promote global macroeconomic stability, or it might want to lure China into making sovereign loans through the fund instead of on its own.
Ultimately, the yuan's status as a reserve currency will be driven by China's further liberalization of its capital account. The easier it becomes to move money in and out of yuan, the more asset managers will be willing to put their money in. And if China ascends to true reserve currency status, the most important effects will be in the long term -- not all of them good.
True reserve currency status makes it cheaper for a government to borrow, which means that -- all else equal -- more borrowing will happen. That will increase net capital inflows. And as many countries have learned during the last decade, capital inflows can cause trouble.
That doesn't make a lot of sense, intuitively. How could it harm a country to allow it to borrow cheaply? If countries were rational and foresighted, they would borrow no more than is healthy. But sovereign borrowing decisions are the result of government decisions not market ones, and no one would argue that governments always make wise choices.
Even the private sector, though, could be harmed by capital inflows. As economists Gianluca Benigno, Nathan Converse, and Luca Fornaro have found, large influxes of foreign money can lead to booms and busts. They can also cause a country to shift resources out of manufacturing, where productivity growth is often high, into service-oriented industries where productivity is relatively stagnant.
Over the past several decades, the U.S. dollar has been the main reserve currency, and the U.S. has experienced huge capital inflows, especially from countries such as China. Those capital inflows in turn have caused a large, persistent trade deficit. Perhaps not coincidentally, U.S. manufacturing hasn't grown very fast since the late 1990s.
In the year ahead, reserve-currency status might help cushion the country's economic slowdown. But in the long term, it might be a poisoned chalice for China.
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