|Economic Outlook logo 130|
China has become a global economic superpower, accounting for a third of global growth in 2010. Companies both in the United States and abroad now offer to invoice their Chinese customers in yuan, and the yuan is growing as an international medium of exchange. Concerns that the yuan could replace the dollar as an international reserve currency are premature, however. To become a global financial superpower, China would have to relinquish control over capital outflows and the exchange rate between the yuan and other major currencies. Chinese officials are unlikely to undertake such liberalization anytime soon.
Key points in this Outlook:
- China is an economic superpower, but it is not yet a financial superpower.
- China’s currency is gaining more widespread use in trade, but not as a reserve currency.
- For the yuan to become an international reserve currency, China would have to allow capital outflows, respect property rights more consistently, and guarantee full convertibility of its currency.
During his recent visit to the United States, Chinese president Hu Jintao asserted that the global financial crisis reflected "the absence of regulation in financial innovation" and the failure of financial institutions "to fully reflect the changing status of developing countries in the world economy and finance." President Hu called for an international financial system that is "fair, just, inclusive, and well managed."
Among President Hu’s assertions was the claim that "the current international currency system is a product of the past." More specifically, he has been critical, along with other Chinese officials, of the primacy of the US dollar as a reserve currency and its use in international trade and investment. This criticism, coupled with the observation that China has rapidly become the world’s second-largest economy, has made the internationalization of its currency--the renminbi (RMB), alternatively known as the yuan--a widely discussed topic. (For one of the more noteworthy articles, see "Yuan Direction," an analysis published in the Financial Times on December 14, 2010.)
The Next Financial Superpower?
China’s rapid emergence as a global economic superpower is well established. Who could deny it, now that the country has become the world’s second-largest economy? Perhaps more importantly, China accounted for about a third of global growth in 2010, the year of global economic recovery. China’s share of global growth last year was nearly equal to the share of all advanced economies combined. In 2009, as the only growing major economy, China accounted for almost all global growth--just below 90 percent. India accounted for the rest. Just a decade ago, China, rapidly growing as it was, accounted for just about a tenth of the growth in global output. Clearly China is an economic superpower. Now, many are asking if it is ready to become a financial superpower too.
As part of its quest for financial primacy, over the last year the Chinese government has cautiously experimented with steps toward internationalization of the yuan. China has encouraged international trade conducted in yuan. In June 2010, China expanded the yuan settlement scheme that allowed imports and exports to be invoiced and paid in yuan. According to the Financial Times article noted above, the People’s Bank of China says that trade settled in yuan totaled about 340 billion yuan between June and November. While that is a substantial sum, given that such trade settlement was virtually zero a year ago, the absolute level (the equivalent of about $50 billion) is modest.
There are good reasons to expect a growing role for the yuan as a medium of exchange in coming years. Global companies aiming to expand business in China can offer to invoice their Chinese customers in yuan, thereby saving them the cost and inconvenience of paying in dollars or other convertible currencies. Since such transactions generate what amount to yuan-denominated receivables, global companies may also find it advantageous to generate yuan payables to effect a hedge for their yuan receivables. They can do this by borrowing with bonds denominated in yuan, issued in China or elsewhere. Caterpillar, a US company that produces earth-moving equipment, issued a one-billion-yuan bond offering in November 2010. Similarly, McDonald’s undertook yuan-denominated borrowing in August 2010. For companies like McDonald’s and Caterpillar that undertake substantial business operations in China, yuan-denominated borrowing makes sense. It provides a natural hedge, as already noted, for the yuan receivables generated by allowing Chinese customers to make payments in yuan, while underscoring the companies’ commitment to expanding their operations in China.
The Chinese government has permitted banks based in Hong Kong--which is sometimes called China’s laboratory for yuan internationalization--to accept deposits from residents denominated in yuan. Something of a rush has developed among Hong Kong-based Chinese to add to their yuan-based deposits. Hong Kong shops widely accept yuan for payment in goods. Hong Kong residents, of course, may only convert up to US$2,500 per day into Chinese currency, but many have multiple accounts along with computer-driven instructions to convert US$2,500 worth of Hong Kong dollars into yuan daily. Since the Hong Kong dollar is pegged to the US dollar, conversion into yuan amounts to a vote in favor of China’s currency versus the dollar. Beyond that, cash machines issue yuan along with Hong Kong dollars, further underscoring the growing role of China’s currency as a medium of exchange in Hong Kong.
These developments suggest that the yuan’s role as an international medium of exchange and unit of account has begun a period of rapid growth, from a starting point of virtually zero use as recently as a year ago. Given the sound economic reasons for this development, the practice of invoicing in yuan and borrowing and lending denominated in yuan will probably continue to grow, especially among international companies with extensive and growing dealings in China.
A Global Reserve Currency?
All this said, it would be a mistake to assume--as some, including President Hu, have done recently--that China’s rapid emergence as an economic superpower and the limited use of its currency as both a medium of exchange and unit of account necessarily entail emergence of the yuan as a global reserve currency. While China’s prominence in global trade has led to an increased role for the yuan as a global medium of exchange and an invoicing currency, as well as to more yuan-denominated borrowing and lending by global companies operating in China, the yuan’s emergence as a global reserve currency cannot begin until China establishes full currency convertibility by ending the strict controls on private capital outflows.
Consider some history. After World War II, the rapid emergence of the United States as a global superpower carried with it the dollar’s ascent over sterling as the world’s preeminent currency. The dollar became the dominant reserve currency accumulated by central banks around the world. The Bretton Woods system, whereby gold and dollars were used as international reserves, developed out of a dollar shortage after World War II and was fostered further by the peg that set the dollar’s value against the price of gold, at $35 per ounce. The system broke down in August 1971, as the United States ended the dollar’s peg to gold, but the dollar’s role as a global currency has continued in a world of mostly floating exchange rates. The United States’ large share in global trade, along with the preeminence of dollar-based financial markets, has continued to support this role.
While China certainly has emerged as a global economic superpower, alongside the United States, it is too early to tell whether the yuan can serve as a global reserve currency. Such a role requires that three basic conditions be satisfied by the currency’s supplier: 1) it must provide and guarantee full convertibility for the currency for all international transactions, including capital transactions; 2) it must fully respect the property rights of all holders of its currency inside and outside its national borders; and 3) it must eschew further controls on global capital flows and avoid persistent currency intervention. Without the latter condition, reserve currency systems break down, as the Bretton Woods system did in 1971, because it is impossible to foresee what exchange rates are appropriate in a constantly changing global environment.
China currently meets none of these conditions. Yuan convertibility is limited to transactions tied to trade in goods and services and is largely prohibited for capital-account transactions. The Chinese government closely regulates the use of the yuan even for cross-border settlements and is not ready to relinquish its control over that process, let alone its control over the exchange rate between the yuan and other major currencies. As President Hu has said, making the yuan a full-fledged international currency "will be a fairly long process."
The pace at which the Chinese government allows the internationalization of the yuan to develop will depend on the benefits that process confers on China. Parallel benefits will emerge for the global economy if China’s move toward full yuan convertibility enhances unfettered capital flows into and out of the country, alongside free flows of goods and services.
It is probably fair to say that full yuan convertibility, as yet a highly uncertain prospect, is a necessary condition for China to emerge as a true global power, with a financial sector that matches the prominence of its production sector. Presently, China’s prominence in global trade of goods and services is inconsistent with its laggard role in global capital markets save as an importer of capital under controlled conditions. China is also an importer of foreign currencies, heavily buying major currencies to prevent appreciation of the yuan. Those purchases leave the Chinese government struggling to store wealth by way of international investments that are unavailable to China’s skillful private investors.
China’s restrictions on capital outflows may end up denying China’s financial institutions a full role in yuan-denominated financial intermediation, just as America’s post-1965 controls on capital outflows helped foster the growth of the euro-dollar market. Euro-dollars--dollar-denominated accounts offered by financial intermediaries outside the United States--substantially benefited the non-US banks that fostered their growth and ultimately contributed to a dismantling of the US controls on capital outflows that were imposed in 1965. Perhaps the euro-yuan market will emerge outside of China to expedite growth of the yuan’s role as a global medium of exchange and invoicing currency for trade and financial flows. Euro-yuan borrowing and lending facilities might be offered by, say, JPMorgan or Deutsche Bank, growing at a pace far in excess of that desired by Chinese authorities. Perhaps the potential for such growth will help convince China’s regulators, wary of a loss of control given unfettered international yuan capital flows, that faster movement toward full convertibility of the yuan, including a removal of restrictions on capital outflows, would be in China’s interest.
Even if a thriving euro-yuan market develops inside the global financial system, widespread accumulation of unhedged yuan balances or expediting of unhedged international yuan flows will not likely occur until the yuan is established as a viable global store of value. Such a stature for a national currency--like that enjoyed by sterling for a century before World War II, and by the US dollar since World War II--requires full convertibility at a minimum and confidence in the stability of the future purchasing power of that currency.
Presently, the yuan is an inconvertible currency that is depreciating against Chinese goods and services at the current Chinese inflation rate of more than 5 percent on a year-over-year basis and more than 10 percent at an annualized rate over the last three months. It is difficult to imagine why anyone, including a Chinese firm or household, would wish to use yuan-denominated cash or financial assets as a means to store purchasing power either inside or outside China, especially since China’s inflation rate means that most yuan balances inside China are actually losing purchasing power. That is the result of an inflation rate over and above the nominal interest rate (about 2.5 percent) paid on yuan balances.
Many observers are mistakenly viewing the apparent excess demand for yuan that contributes to heavy pressure for the currency to appreciate as an index of its desirability as a store of value. Actually the pressure for yuan appreciation is, as already noted, a byproduct of the artificial shortage of yuan in global currency markets that results from Chinese government restrictions on capital outflows, that is, the purchase of assets abroad by private-sector Chinese investors. Many of those investors are sorely disadvantaged by a lack of ways to store and further enhance the wealth they are rapidly accumulating as a byproduct of China’s rapid economic growth.
Evolution, Not Revolution
Looking ahead, China’s currency will probably continue to develop as both an international medium of exchange and a unit of account. Global enterprises can and probably will continue to expand the flow of exports and imports invoiced in yuan while simultaneously expanding yuan-denominated borrowing and lending facilities. There are sound economic reasons for this development. However, further development of the yuan as an international reserve currency accumulated alongside dollars and gold by central banks will proceed at a much slower rate. The aforementioned Financial Times article reported that the Chinese government has concluded currency-swap agreements--in effect, a limited role for the yuan as a reserve currency--with central banks in eight countries for a total value of just over $120 billion. Under these agreements, China will lend specified yuan amounts to the central banks for a short period of time. This figure is dwarfed by the $6-$8 trillion of global reserve assets held by central banks, the biggest part of which is the $2.8 trillion held by the Chinese.
The role a national currency can play as an international reserve asset has evolved over time as global traders find it convenient and less costly to denominate trade in goods and financial assets in a familiar currency that originates in a country with large, liquid, and open capital markets. The United Kingdom fulfilled this role for the hundred years before World War II and, as already noted, the United States has fulfilled the role since then. However, the gold-exchange standard, which saw the dollar coexist as a reserve asset alongside gold until 1971, broke down when the international supply of dollars rose so rapidly that it was impossible for the United States to continue to peg the dollar to the price of gold at $35 per ounce. Subsequently, the system of floating exchange rates evolved, within which the dollar continues to play a role as an international reserve asset. That role is a byproduct of the tendency for export countries, such as China, to resist currency appreciation to encourage growth of the export sector. If, as a byproduct of that policy, the stock of dollars held by foreign central banks, including the Chinese, rises too rapidly, inflation may result. When China’s monetary authority purchases dollars to keep them from appreciating, it injects yuan into China’s economy at a pace fast enough to push up inflation. To complain that such inflation is the fault of the United States, when the offending growth of the Chinese money supply is a direct result of China’s aggressive purchase of dollars in the foreign-exchange market, is somewhat disingenuous.
China has displayed buyer’s remorse concerning its dollar acquisitions. In 2009, China’s central bank governor Zhou Xiaochuan called for the creation of a new synthetic reserve currency as an alternative to the dollar. Simultaneously, China’s sovereign wealth fund has sought to accumulate reserve assets other than the dollar assets that have resulted from heavy intervention to prevent yuan appreciation. Such acquisitions include assets denominated in euros as well as investments in global hedge funds that provide more diversification across different asset classes than they do across different currencies.
China’s desire for a substitute for dollars in its reserve accounts, coupled with an apparent desire to increase the international role of its currency, is intriguing, especially in the context of China’s recent more aggressive geopolitical stance in Asia. As a primary trading partner for many Asian nations, the Chinese at times appear to be thinking of an expanded role for the yuan as an Asian trading currency that substitutes for the dollar. Still, the Chinese push for yuan internationalization, which includes the reserve currency role, may be difficult for China to pursue. Internationalization of a national currency tends to be more a "pull" process than a "push" process. As Paola Subacchi, in a recent analysis for the British policy institute Chatham House, has suggested, "Beijing is openly aware of the fact that there is no road map to guide this [yuan internationalization] process." Full-fledged reserve currency roles tend to be borne out of the economic and financial role played by the countries whose central banks issue those currencies. While China’s rapid economic growth and burgeoning role in international trade suggest that the yuan is a logical candidate for invoicing and financing international commerce, especially in Asia, its ambivalence about free capital flows makes a full-fledged international role for its currency, as a store of value as well as a medium of exchange and unit of account, highly unlikely in the near term.
That said, it will be interesting to see if China’s new leaders, who will take up power at the end of 2012, seek to expedite the international convertibility of the yuan by relaxing controls on capital outflows. If that turns out to be the case, a full global role for the yuan as international money may be in the cards.
John H. Makin (email@example.com) is a resident scholar at AEI.
1. See Andrew Browne, "China’s President Lays Groundwork for Obama Talks," Wall Street Journal Asia, January 17, 2011.
4. Paola Subacchi, "One Currency, Two Systems: China’s Renminbi Strategy," Chatham House briefing paper, October 2010.