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Internationalizing the Yuan |
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Written by Philip Bowring
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Friday, 17 July 2009 |
 It isn't as easy as it looks
China, like some other countries, has good reason to want to reduce the
dominance of the dollar in international finance. But it is being
carried away by dreams of glory for the yuan, dreams fostered by
financial institutions anxious to ingratiate themselves with Beijing
and promote Hong Kong as an offshore yuan trading center.
HSBC
is, perhaps not surprisingly, in the forefront of the push, suggesting
that yuan denominated trade could hit $2 trillion by 2012.
The
logic of the proposed surge in the use of the yuan in international
trade from near zero to as much as half of China's trade within a few
years may at first glance sound plausible on the assumption that it is
now the world's second largest trading country and third largest
economy. It also holds the world's largest foreign exchange reserves
and thus in theory may appear to have a very strong currency, which is
likely to appreciate over time as China's economic growth outstrips
mature economies, making it attractive to foreigners looking for
alternative stores of value to the dollar.
However,
there is a whole range of reasons why this looks not only improbable
but demonstrates contradictory trends in China's policies.
Just
on an historical basis such a sudden rise in the internationalization
of a currency looks unlikely. The fact that sterling is still the
number three traded currency, on a par with the yen, when its economy
has slipped far down the rankings is one indication. Another is that
though the yen increased in usage in trade and reserve holdings quite
rapidly in the 1970s and 1980s, its role has since stalled and is used
mostly only in invoicing Japanese exports to southeast Asia, Korea and
Taiwan. So even after nearly forty years of full convertibility it has
yet to reach the percentage of Japanese trade now forecast for China
and the yuan by 2012.
Then there is the case of the
euro, a currency underpinned by mature and stable economies headed by
Germany, the world's top believer in the merits of a strong currency.
The euro's role as a reserve asset has been rising but it is little
used in trade transactions outside Europe – other than by a dollar and
yen-shunning North Korea.
The next problem for China is
the nature of its trade. So much of its exports consist of processing
of imported materials and components so the suppliers will need a very
good reason to switch from dollars (and Asia is a dollar zone) to yuan.
Exports still mostly go to countries in the west – the US and the
Eurozone – which general expect imports to be priced in their
currencies.
Unlike Japan at a similar stage, a large
proportion of China's exports are by foreign-invested companies which
sell internationally and use the dollar for internal accounting and
thus would be reluctant to switch to yuan. That may well change with
time as mainland owned companies play a larger role and exports become
less important as a percentage of turnover. But that will be a very
gradual process.
Trading in yuan with Laos and Myanmar
or even Vietnam is not going to take the the currency very far even in
a decade. Indeed, the region already has currencies such as the baht
and Singapore dollar which are used in some regional trade and in
practice accepted for cash payments.
China's
expressions of desire to reduce the role of the dollar are anyway
contradicted by its actual policy of maintaining a de facto peg to the
US currency, meanwhile continuing to accumulate dollars in reserves now
totaling $2 trillion. The modest yuan appreciation after 2005 came to a
halt more than a year ago as China has sought to sustain exports in the
face of the global slump. There is conflict between macro-economic
stabilization goals and pressures from industries and employment
creation not to put more pressure on exporters. China is still wedded
to high growth and a cheap currency.
Nor has there
been any significant move towards full convertibility as the financial
crisis has, with good reason, made the authorities nervous of
liberalization.
Yuan appreciation and convertibility
could of course come sooner than expected and might well lead to an
outflow of speculative funds and sharp drop in reserves. However, any
significant use of yuan requires and significant offshore stock of the
currency. That is incompatible with China's expressed desire to reduce
its dollar reserve dependence.
Even assuming that China
does move to an era of external deficit on current as well as capital
account, it will likely take a long time to run down its dollar
reserves to more appropriate levels.
Capital outflow
and the development of yuan offshore bond markets are certainly likely
to some degree. Foreign investor demand is clear enough and yuan
equivalents of Samurai bonds are also likely, giving foreign countries
access to the domestic bond market. But as Japan has showed, these
markets are slow to develop because borrowers naturally shy away from
borrowing in currencies seen as likely to appreciate and thus offset
any interest rate advantage.
China may well be able to
expand yuan use by offering trade credits in its currency but these may
have to be at heavily subsidized rates if they are to prove more
attractive to long term borrowers in, for example, Indonesia than
borrowing dollars or yen in the marketplace.
Currency
swap deals with Asian central banks, now formalized by the Chiang Mai
Initiative, would only boost yuan usage if they have to be used. That
may happen, particularly if dollars get scarce and Asian neighbors run
into balance of payments crises, but that is more possibility than
probability – and also assumes that swaps with the US Federal Reserve
or European Central Bank or IMF support were not available.
Yuan
boosters often miss the point about the dollar. It is China even more
than Japan and Singapore which has put such misplaced faith in it as a
store of value by accumulating massive reserves. For most of the rest
of the world the dollar is simply the most readily traded transaction
currency. Its exchange rate in three or 10 years time is of no
relevance. The sheer volume of dollars has lubricated global trade and
only dollar shortages induced by a return to US current account surplus
are likely to change that in the foreseeable future.
Internationalizing
the yuan may make good headlines but a realistic China also knows that
promoting China's role at the IMF and the role of the SDR in the
international system is likely to be more significant in terms of its
own global influence and as a way of reducing the risks of holding too
many dollars.
The other issue which China has to
address is trust in its longer term macro-economic and political
stability. Trust is only acquired – or lost – over extended periods of
time. As yet, no developing country, however large, has played a
significant reserve or trading currency role. Trust in America has
evidently fallen sharply as a result of the Greenspan era of easy money
for the Wall Street playboys. But China has a long way to go in
providing a substitute.
China's money supply growth
of 28 percent in the past 12 months may to many seem a suitable
response to global recession. But for anyone with worries about the
health of its banks or the longer run stability of the yuan may see a
row of red flags not green economic shoots.
Trust in
institutions is also important – which means in the legal and
accounting systems as well as in the competence of the central bank.
Even once established they take time to be appreciated by foreigners.
Yes,
the yuan will gradually merge onto the international stage. But don't
believe the latest hype from financial sector peddlers of
self-interest.
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Economics/Business 
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