Commentary | 11 June 2015

Yuan deserves a place in the IMF basket

Yuan deserves a place in the IMF basket

Stephen Grenville

Nikkei Report

11 June 2015

Click here for the online text.

 

 

  • Stephen Grenville

Yuan deserves a place in the IMF basket

Stephen Grenville

Nikkei Report

11 June 2015

Click here for the online text.

 

 

  • Stephen Grenville

Executive Summary

China's ambition to make the yuan an "international currency" is still some distance from fruition -- not least because it is unclear what the term means. However, the yuan's status would be notably enhanced if it were to be included later this year as one of the currencies used in calculating the International Monetary Fund's notional currency, known as Special Drawing Rights.

In practical terms, inclusion in the SDR basket is no big deal. The SDR is not the key element of foreign exchange reserves that the British economist John Maynard Keynes, a leading architect of the IMF, hoped for when the institution was founded in 1944. The move to floating exchange rates in the 1970s trivialized its operational role in international policy.

That said, there would be considerable prestige involved in joining the group of just four currencies currently included in the SDR basket -- the U.S. dollar, the euro, the British pound and the Japanese yen. It would symbolize China's arrival at the epicenter of international transactions.

China is pushing hard for its currency. In 2009, central bank governor Zhou Xiaochuan made the case that the SDR should be given a key position in international reserves, diminishing the role of the U.S. dollar, which still enjoys what the former French President Valery Giscard d'Estaing once called the "exorbitant privilege" of being the dominant reserve currency.

However, few commentators believe that the SDR can metamorphose into this central role in international reserves. At the April IMF meeting in Washington, Zhou's focus was on a more achievable goal -- including the yuan in the SDR basket when it comes up for its regular quinquennial reappraisal at the end of this year. The U.S. has signaled its opposition, with the Treasury holding out for more reform before the yuan is included, particularly in the external capital account.

IMF Managing Director Christine Lagarde has been more welcoming. And China has eased its capital controls since April, particularly on outward flows, despite the potential for disruption caused by surges in response to global events. China intends to retain enough controls to avoid these pitfalls. But this is no longer a key issue -- doctrinal calls for completely deregulated capital flows have been replaced since the 2008 global financial crisis by a widespread understanding that some management may be necessary to avoid currency crises. The continuing restrictions envisaged by the Chinese authorities should not stand in the way of the yuan being seen as an international currency.

Capital account openness cannot be measured solely in terms of regulatory barriers. As a trade transaction currency, the yuan is a freely usable currency employed in global transactions; around a third of China's international trade is denominated in yuan. But being a transaction currency for trade is not enough for the yuan to be considered an international currency. International integration has to extend, as well, to the capital account, with foreigners free and willing to buy yuan assets in China, thus linking China's capital markets with global investors.

Central banks' embrace

This presents a greater challenge. The domestic bond market is far from trivial. In terms of outstanding bonds on issue, it is about the same size as Germany's. However, foreign participation is tiny, thanks to capital controls. Time will tell whether this changes as capital controls are dismantled. Will foreigners participate? Domestic bond issuers are a disparate collection of private-sector companies, state-owned enterprises, regional governments and the central government. Even with the opening of the capital account, this market would still lack reliable information and legal certainty.

Among foreign investors, the group that could deliver the greatest boost to the yuan's international status is foreign central banks -- particularly the key ones such as the European Central Bank and the Bank of Japan. If foreign central banks decide to include a substantial holding of yuan assets as part of their foreign exchange reserves, that would be a powerful endorsement of the currency.

But central banks favor low-risk assets in deep markets with ready liquidity and assured security. Until the Chinese bond market develops substantial foreign participation, these criteria will be hard to meet. Foreign holdings of Chinese government bonds are minimal, with domestic banks the main buyers. While foreign central banks may hold token amounts of yuan assets in their foreign reserves, the U.S. dollar will remain dominant in this respect for many years to come.

One factor bolstering the yuan is that the IMF and influential commentators no longer see it as a source of international currency disruption. China has in the past been accused of artificially promoting its exports by "manipulating" the exchange rate to boost the country's international competitiveness. This is an old story, and the IMF has belatedly come to acknowledge that the situation has changed. It recently declared that the yuan was appropriately valued.

Whatever the earlier criticisms, the currency has appreciated by more than 30% in nominal terms in the past decade. Over the past year, it has maintained its parity against an appreciating U.S. dollar, which means that it has lost competitiveness against just about every other currency. According to the Bank for International Settlement's index of real effective exchange rates, which adjusts for different rates of inflation, the yuan has appreciated by nearly 15% since mid-2014.

Since 2007, China's current-account surplus has fallen from 10% of gross domestic product to 2%. Blaming China for the global savings and investment imbalance was always a trumped-up charge. It is now a hollow accusation. Some U.S. critics (including the Treasury and influential members of Congress) are slow to acknowledge the change, but China has by now removed this source of opprobrium.

Almost a decade ago, Robert Zoellick, then U.S. deputy secretary of state, urged China to become a "responsible stakeholder" in the international governance framework. Since then, China's integration into the global economy has proceeded apace. This has not always been matched by corresponding adaptation of global governance to give China a role commensurate with its expanded importance.

The U.S. Congress is still standing in the way of revisions to IMF voting rights -- endorsed at the 2010 meeting of the G-20 group of large economies -- that would give China greater clout. Giving the yuan a place in the SDR basket would not compensate Beijing for the continued obstruction of IMF voting reform, but it would signal that the institution and its shareholder countries acknowledge how far China has come in its journey toward full participation in the global economy.

 

Stephen Grenville, a former deputy governor and board member of the Reserve Bank of Australia, is a visiting fellow at the Lowy Institute for International Policy in Sydney and a consultant on East Asian financial issues.