The Yuan: China’s Final Test for Supremacy
Author: Rick Harrell, 2019.
“Whether measured by the size of its economy, the amount of trade flowing across its borders, or its military capabilities, there is no question China is a force to be reckoned with. However, the country lacks one critical feature that prevents it from achieving the status of a true superpower…”
Image from Pixabay.
Since embarking on structural reforms 40 years ago, the People’s Republic of China has become a major economic player on the world stage. Whether measured by the size of its economy, the amount of trade flowing across its borders, or its military capabilities, there is no question China is a force to be reckoned with. However, the country lacks one critical feature that prevents it from achieving the status of a true superpower. Until its currency, the yuan, is accepted as one of the major global reserve currencies, China will never carry the economic and political clout that other nations have enjoyed, such as the United Kingdom before World War II, and the United States after WWII. This article will provide a brief historical context of China’s economic development and evaluate whether or not the Chinese yuan qualifies as a dominant reserve currency. The article concludes with a summary of the findings from the evaluation and offers recommendations on structural reforms that could improve China’s competitiveness and the prospects of its currency becoming a more widely used reserve currency.
In the centuries leading up to the early 1800s, China was already the world’s largest economy. As the great economic historian Angus Maddison has noted, China was roughly ⅓ of global GDP at the dawn of the Industrial Revolution, only to fall to less than 5% of global GDP a century later (Maddison 44). For much of the 20th century, China’s political landscape and economic framework were characterized by communist ideology and closed economic policies. The country lagged behind Western industrialization, and living standards actually worsened significantly over this period.
Following decades of economic decline, it wasn’t until 1978 when President Deng Xiaoping launched a new economic policy regime of gaige kaifang, or “reform and opening-up”, that China finally began to embark on possibly the greatest economic catch-up ever recorded world history. China re-engaged in global trade and gained observer status with the General Agreement on Tariffs and Trade in 1986 (predecessor to the World Trade Organization or “WTO”). Fifteen years later, after numerous structural reform requests by the US, Western Europe, and Japan, China was granted WTO membership – paving the way for the country’s dramatic economic rise (Oshikawa). Indeed, since 2001, China’s GDP in nominal US dollar terms grew tenfold from $1.34 trillion to a remarkable $13 trillion in 2018, becoming the second largest economy in the world after the United States according to IMF statistics. Although based on a conversion method used extensively by the IMF to measure the implied exchange rate at which a set of goods and services across countries is valued equally (known as purchasing power parity or “PPP”), China’s GDP theoretically surpassed the US sometime in 2014 (World Economic Outlook).
Since the beginning of President Deng’s reform and opening-up campaign, China’s share of global trade has increased from less than 1% in 1978, to almost 12% today, the single largest share in the world (“WTO Statistics”). It should come as no surprise then that in recent years China has been a dominant topic in matters of foreign trade policy in the U.S., Europe, and elsewhere.
With its rapidly-expanding economy and dominance in international trade, China has naturally sought to protect its commercial interests. In the last decade it has increased military expenditures more than any other nation and its annual defense budget is now second only to the United States (Tian et al.). Beijing plans to add four more aircraft carriers to its fleet, a profound increase considering only two are in operation at present (Madhur).
Even with one of the largest economies in the world and with major military capabilities, China still lacks the geopolitical clout of other superpowers. A critical shortcoming is the fact that its currency – the renminbi or “yuan” – does not qualify as a major reserve currency. Countries of major reserve currencies enjoy several benefits. Banking institutions in these countries receive more business as natural dealers in the currency both domestically and overseas. More importantly the political power and prestige that comes with being the issuer of a major reserve currency is difficult to quantify (Frankel 331). Since the beginning of the modern monetary framework of the late 19th century, there have only been two principal reserve currencies: the British pound from the 1870s until World War II and the U.S. dollar since then (Kroeber 2). It is no coincidence that the geopolitical potency of Great Britain and the United States has been accompanied by their respective tenures as issuers of the primary reserve currency. Until the yuan passes the test of being a major reserve currency China is unlikely to become a true superpower on the world stage.
Internationalization vs Major Reserve Currency
It is important to distinguish between a major reserve currency and an international currency since there are many currencies used internationally, but not all internationally used currencies are major reserve currencies. Reserve currencies are commonly held by central banks as part of their official reserve holdings. They tend to be those that are most frequently used in international capital and trade flows. The US dollar and euro are major reserves currencies as they account for 62% and 20% of global reserves respectively (according to IMF statistics).
In the fall of 2016, the prospect of the Chinese yuan becoming a major reserve currency received a significant boost when it was entered into the IMF’s Special Drawing Rights currency basket (IMF News). The yuan received a weight of nearly 11% in the basket making it the third largest currency after the US dollar and Euro in the IMF system. Today, more than 60 central banks or monetary authorities include the yuan as part of their foreign exchange reserves (“Yuan internationalization making steady progress” ). Despite this official acknowledgement from the IMF and allocations to the currency from many central banks, questions still remain. The lack of participation from private investors and the markets at large suggests that the yuan is still far from becoming a truly dominant reserve currency. Former New York Fed President Bill Dudley has said “While the status of being a reserve currency can be conferred, the stature of being a reserve currency must be earned” (Dudley).
Internationalization of the yuan has made some progress and the currency is becoming more integrated into global markets. For example, in order to promote the yuan in international trade and finance, China’s central bank (the People’s Bank of China or PBoC) has setup bilateral swap lines with other central banks in over 30 countries around the world (“Yuan internationalization making steady progress” ). Beijing’s much touted Belt and Road Initiative (or “BRI”) will increase the usage of the Chinese currency over time as well. This modern-day “Marshall Plan” is estimated to bring over $1 trillion of direct investment to nearly 70 countries primarily located along the maritime and overland trade routes spanning Asia, the Middle East, Africa, and Europe. Since formally initiating BRI in 2013, China’s cumulative outward foreign direct investment has reached $730bn, over two and a half times more than the preceding 5 year cumulative period (according to World Bank statistics).
In Africa alone, China has provided financing of nearly $100bn, primarily towards infrastructure projects (Chinese Loans to Africa). Over the next decade annual trade between China and the countries along the Belt and Road route is expected to surpass $2.5 trillion annually. Indeed among all of China’s initiatives, the BRI is expected to have the most significant impact in raising the international use of the yuan (Renminbi Internationalisation Report 2018).
But despite all of these developments, the yuan’s share in world currency reserves is still less than 2% — similar in size to the Australian and Canadian dollar (IMF COFER statistics). When measured by the amount of total foreign exchange transactions in global trading markets, it ranked only 8th in terms of the total amount of total foreign exchange transactions globally (according to the latest Triennial Central Bank Survey from the Bank of International Settlements).
Such low usage in global markets makes it clear that the yuan is a far cry from achieving a similar stature to the US dollar or even the euro.
What does the yuan lack to become a major reserve currency?
In order to gauge the extent to which the yuan is fulfilling the role of an international currency and becoming a more prominent reserve currency, consider how it meets three key criteria. Specifically, a major reserve currency should 1) be issued by a country with a significant share of international economic output and trade 2) provide a store of value and 3) have deep, open, and well-developed financial markets which are free of capital controls (Frankel 2012). Each of these attributes will be addressed in turn below:
1. Share of Global Economic Output and Trade
It has already been established above that China has one of the largest economies in the world, both in terms of GDP and in terms of share of worldwide trade. If this were the only criterion of major reserve currencies then the yuan would easily qualify. However, even though China’s economy accounts for nearly 20% of global output (using PPP), the usage of its currency in global cross-border payments is just 1%. The US dollar, on the other hand, is used in over 40% of global cross-border payments and yet the US economy accounts for about the same share of world GDP as China (RMB Tracker).
2. Store of value
A global reserve currency needs to be a store of value, meaning the currency is able to maintain its value or purchasing power vis-à-vis other major currencies over time. One way to measure whether a currency can hold its value is by observing changes in its trade-weighted, inflation-adjusted exchange rate. Economists refer to this metric as the real effective exchange rate (REER). China’s REER has been relatively stable and, in fact, has appreciated by over 30% in the last 10 years (based on IMF statistics). So based on the maintenance of purchasing power, one could argue that the yuan has successfully been providing a store of value.
This this is not completely fair as the PboC has operated a managed exchange rate regime semi-pegged to the dollar and more recently switched to a managed regime against a broader basket of currencies based on the “CFETS” basket (China Releases Yuan Exchange Rate Composite Index). The central bank’s ability to operate this regime depends critically on the stock of foreign exchange reserves and to the extent which capital is allowed to move freely in and out of the banking system.
Recent episodes of financial stress have provided good test cases to observe whether market participants and investors view the yuan as a store of value. In 2015 after Chinese property prices had slumped, the stock market crashed over 30% from its peak (These 5 Charts Link China’s Stock Market Crash to Problems in Property). This was exacerbated by expectations (and later realization) of a nominal devaluation of the yuan by some 12% against the dollar from the beginning of 2015 through the end of 2016 (based on Bloomberg price data). Rather than flock to safer assets onshore, both domestic and foreign investors pulled money out of the country. While not a perfect measure of capital flows, China’s foreign exchange reserves fell by some 20% over that period and the Institute of International Finance estimates that in 2015 alone almost $700bn fled the country’s borders.
If Chinese residents and foreign investors truly believe the yuan is a store of value, then they will be comfortable keeping their wealth denominated in that currency during both good times and bad. The fact that the PboC was forced to drain a substantial amount of international reserves to “defend” the currency is evidence that the yuan is not yet perceived as a store of value. The ultimate quality of a major reserve currency is to have earned the confidence of markets.
3. Deep and Open Financial Markets Free of Controls
In most instances when large institutional investors or reserve managers store wealth in a given currency, they invest in a high-quality asset, typically a fixed-income security issued by a highly-rated government, supra-national agency, or company. The ability to trade these high-quality assets and other publicly traded securities in the domestic financial market should be relatively easy with limited restrictions on foreign market participants. At $12.5 trillion China’s domestic bond market is already the third largest in the world (behind U.S. and Japan) and deep enough to offer a legitimate alternative for foreign reserve managers (Morgan Stanley Research 11). Unfortunately, access to this market has been limited as foreigners hold only 8% of Chinese government debt, meaning that while Chinese financial markets are deep they are not yet well integrated into global markets.
Dudley’s first criteria of a reserve currency is that it must be “fully convertible – with no risk of restrictions that could limit the ability to convert into cash denominated in the investors’ domestic currency” (Dudley). The yuan is not a fully convertible currency as Beijing maintains significant controls on its capital account; there are many restrictions on foreign exchange transactions. For example, citizens are subject to a $50,000 per year quota on foreign exchange purchases. As mentioned in the prior section the PBoC operates a managed exchange rate regime – this is reflective of a heavily regulated capital account. The IMF classifies China’s exchange rate regime as a “stabilized arrangement”, the same classification as the Nigerian Naira, Tajikistani Somoni, and Yemeni Rial (“Annual Report on Exchange Arrangements and Exchange Restrictions 2017”).
Despite an abundance of financial assets, the tightly controlled capital account and managed exchange rate regime has prevented Chinese markets from becoming fully-integrated into global markets. The yuan does not meet this third criterion of a major reserve currency.
Conclusion & Recommendations
In summary, the yuan only meets the first of the three criteria explored above. While China does account for a major share of global output and trade, its currency is neither a credible store of value nor are its financial markets sufficiently open and free of capital controls for the yuan to serve as a major reserve currency.
What are potential reforms Beijing could take? One feature that prevents the yuan from being viewed as a store of value is the inherent instability of the banking sector. The World Economic Forum ranks China’s financial system 113 of 140 countries in terms of stability (according to the World Economic Forum’s 2018 Global Competitiveness Report). Private sector debt has grown rapidly in the last decade reaching an excess of 250% of GDP (according statistics from the Bank of International Settlements). But the amount of debt in the system is only part of the problem. The scale and complexity of “shadow bank” lending is a key threat to China’s macroeconomic stability. At over $10 trillion, the shadow banking sector is an opaque web of off-balance sheet lending activities by bank and non-bank financial institutions. This usually involves high-risk, high-yielding investment products sold to households, firms, and other institutional investors. The funds from these unregulated financial products are typically used to invest in risky projects such as heavily indebted property developers, small start-up enterprises with uncertain prospects, high-yield corporate bonds. In recent years the Chinese economy has become increasingly reliant on shadow banking raising concerns among investors and regulators alike (Global Financial Stability Report: A Bumpy Road Ahead 32). As a result the fear of a major banking crisis and economic downturn looms large in the minds of investors is likely a key factor behind accelerated capital outflows when signs of economic or financial turmoil arise (as explored earlier in this article). Beijing needs to reduce the vulnerabilities caused by the shadow banking system by improving regulation, increasing transparency, and allow independent rating agencies to provide credible risk analysis of the sector. When the risks of China’s economy can be adequately understood and monitored, confidence from market participants should improve.
Regarding integration into global capital markets, recent developments suggest Beijing is beginning to take transformational reforms to address this. In 2017, the China Bond-connect scheme was launched to facilitate foreign access to China’s domestic bond market. As a result, 2018 saw a record inflow of offshore funds into China Government Bonds (CGB’s) (China’s Bond Market Sees $100b Foreign Capital Inflow in 2018). While the majority of those inflows were from the official sector from foreign reserve managers, these inflows are set to continue. Beginning this year, CGB’s will be included in global bond indices which will bring in hundreds of billions of passive index flows. This index inclusion should attract more private sector flows and put China on a trajectory to integrate with global financial markets. Goldman Sachs estimates that more than $1 trillion in foreign portfolio investment will flow into China’s domestic bond market in the coming decade (“China, Hong Kong Launch Long-awaited Bond Connect Scheme”). There has been some early success increasing China’s integration with global capital markets and Beijing should continue with these reforms.
Finally, even if the gates to Chinese markets open to offshore investors, the country must be an attractive destination for foreign investment. Beijing will need to liberalize foreign investment laws and stay competitive as its economy matures and approaches a slower, but more sustainable growth path. Recent proposals by policymakers indicate the Chinese are attempting to navigate these challenges already. The much touted “Made in China 2025” industrial policy is a roadmap for maintaining a competitive edge and to continue moving up the value-chain. Beijing is also implementing legislation to protect foreign intellectual property rights and prohibit forced technology transfer, hoping to provide foreign firms and investors with the same privileges as their domestic counterparts (China Approves New Foreign Investment Law). More of these types of reforms should be pursued.
As things stand, the prospect for the yuan to become a major reserve currency remains a distant aspiration. Until concerns regarding financial stability are addressed and reforms to liberalize the capital account are made, the yuan will fall short in earning the confidence of global capital markets. China is a powerful economic and political actor on the world stage, but its influence in global affairs will remain limited until it passes this test.
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