|The Yuan Standard; Internationalization and Impending Inclusion in SDRs
By Alex Davis
“The strongest reserve currencies serve as safe havens when others are in turmoil.” For governments and central banks worldwide, reserve currencies are those that are generally deemed the safest assets to hold due to their stability and liquidity on international markets. The status of global reserve currency is reflected in the inclusion in Special Drawing Rights (SDR) for the International Monetary Fund (IMF). The SDR is an international reserve asset created to supplement official reserves of IMF members, and the basket that determines its value currently consists of the United States Dollar, Euro, British Pound, and Japanese Yen. The IMF holds meetings every five years to propose changes to the currencies included in SDR and their weights; during the last meeting in 2010, a Chinese bid to join the basket was rejected due to the IMF’s determination that China met the criteria for its export volume, but that the Yuan lacked sufficient usability. Since then, economic liberalization and financial reforms in China have dramatically changed the future prospects of its currency. The Yuan will become a global reserve currency because of its increasing dominance in international trade, the rapid global expansion of the Yuan-denominated bond market, and the worldwide establishment of offshore Yuan trading centers that facilitate cross-border financial flows and encourage the opening of China’s capital account.
In the wake of decreased global export demand caused by the Global Financial Crisis, the Chinese government began allowing domestic importers and exporters to open offshore Yuan-denominated bank accounts, most notably in Hong Kong, to conduct cross-border transactions. This was an attempt coordinated by the People’s Bank of China (PBoC) and the Chinese government to make the Yuan more accessible to international markets. This relaxation of capital controls generated a swift increase in Yuan usage; in 2013 only 16.4% of China’s international trade was conducted in terms of Yuan, however in 2014 this figure was nearly a quarter. Despite this being a relatively low fraction of China’s overall trade volume, the immense growth rate (an economic attribute that China has consistently demonstrated for 35 years that it is capable of sustaining) shows that the Yuan is capable of transforming the landscape of global trade within a matter of years. Significant forces increasing the ratio of Yuan-denominated trade in China include the popularity of free trade zones (FTZ’s) and the Silk Road Economic Belt and the 21st Century Maritime Silk Road initiative. China will continue to use these programs and others to encourage greater internationalization of its currency in order to capitalize on resurging global demand. Eventually, the Yuan will progress to the status of “freely usable”—the integral prerequisite for IMF recognition of global reserve currency status.
At the beginning of 2007, the People’s Bank of China was the only entity that could issue Yuan-denominated bonds. In an effort to “promot[e] its currency in global trade and investment,” China allowed a selective number of Hong Kong banks in July to issue Yuan-denominated bonds, the first of these being the China Development Bank. Following their electrifying increase in popularity—growing from a nonexistent to $72.9 billion world market in just seven years—these “Dim Sum” bonds have been made increasingly available internationally since July 2010. Today, the bonds are issued in Europe, Australia, and North and South America. As China continues to liberalize its capital account and currency speculators drive the Yuan to further appreciate against the Dollar, Dim Sum bonds are often being deemed low risk investments. The attractiveness of investing in these bonds will further bolster demand for Yuan, elevating the currency to global reserve status.
Currently, the world’s largest offshore Yuan trading center lies in Hong Kong. As the global market continues to open to foreign investors and the Yuan approaches full convertibility with other SDR component currencies such as the United States Dollar, there will be increasingly intense competition between financial centers worldwide to overtake Hong Kong. This competition will accelerate demand for the Yuan and thereby increase China’s overall cross-border financial flows, causing the Yuan to surpass certain components of the established basket of reserve currencies, such as the Pound, in total usage. According to Gwynn Guilford, “China can…probably trounce…the British pound—even without having made much headway on internationalizing.” Chinese officials have also hinted that they may be more amenable to running lower current account surpluses in the near future, implying that a net outflow of Yuan may be on the horizon. If this is the case, the benefits for offshore Yuan trading centers would increase exponentially further.
As China’s real annual growth rate begins to slow as a result of Deng Xiaoping’s initial economic reforms reaching the extent of their effectiveness, Beijing has begun to recognize that sustaining high rates of economic growth by increasing China’s overall trade volume is integral to carving out a greater international role for the Yuan. Increasing cross-border, Yuan-denominated trade flows is critical to its transformation into a “freely usable” currency—the prerequisite for inclusion in SDR that characterizes the global reserve currencies. The shift in policy to allow international trade to be settled in Yuan accounts was the first step towards the creation of tangible Yuan accessibility, although much more extensive reform is necessary if full internationalization is to occur. As capital controls that prevent free movement of Yuan are loosened, greater usability of the currency will lead to a natural increase in the total amount of international trade. The increased presence of the Yuan in global trade flows that will result from the reduction of capital controls will ensure its dominance of international currency markets (the Yuan has already surged past the Euro to become the second most used currency in global trade finance). The granting of SDR will inevitably follow as central banks around the world recognize the value of holding Yuan-denominated assets.
One of the most significant ways in which China is attempting to increase its trade flows by selectively relaxing currency restrictions is through the establishment of free trade zones (FTZ’s), which act as “laborator[ies] for ambitious free market reforms.” FTZ’s allow the central government to instill progressive and experimental economic policies in specialized areas and test their successes and faults before possibly implementing them nationwide. The only operational FTZ today is in Shanghai, however its success has led to the State Council approving the creation of three additional FTZ’s in the coastal areas of Guangdong and Fujian provinces as well as Tianjin municipality, with another in the process of being approved in Lanzhou, the capital of the inland province of Gansu. The Shanghai FTZ is contributing to the Yuan’s rise by allowing multinational firms like Amazon to create and manage connections between small and medium-size Chinese enterprises and international consumers that would otherwise be impossible due to capital controls such as excessive taxes on cross-border transactions. Because FTZ’s make the Yuan more accessible to international markets, the natural rise in demand for Yuan that results from their implementation will increase its usability, and therefore its viability as a global reserve currency. Utilization of FTZ’s shows that Beijing sees increasing its trade volume as a means of bolstering its relatively stagnant rate of economic growth and encouraging currency reform, which slowed to a 24-year low of 7.4 percent last year from 7.7 percent in 2013 and failed to reach the annual growth target set by the government for the first time in 16 years.
China will also attempt to sustain its growth rate and increase its trade volume with the Silk Road Economic Belt and 21st Century Maritime Silk Road initiative, a 40 billion Dollar infrastructure fund with the goal of rejuvenating cross-border trade along the ancient route that once connected China to the Mediterranean via the Middle East. This fund includes plans to build a railway from Shanghai to as far as Madrid: a project that could vastly decrease transportation costs for Chinese exports to Europe—increasing European demand for Yuan amidst the weakening of the Euro. A secondary goal of the fund is to boost the amount of currency trading between China and nations along the Silk Road such as Kazakhstan. The formation of additional export markets that occurs as a result of greater regional connectivity will contribute to the internationalization of the Yuan by allowing easier domestic market access for foreign enterprises. If the initiative is successful, as many as 60% of the world’s consumers could be directly connected to the Chinese economy. The effect that this extent of interdependence would have on the Yuan’s global importance is immense.
Chinese exporters themselves also have a vested interest in increased global Yuan usage. Currently, exporters engaging in Dollar-denominated transactions generally lose 2-3% on transaction and exchange rate costs as a result of the Yuan’s recent and steady appreciation against the Dollar. A fully internationalized and tradable Yuan would introduce a degree of uncertainty as a result of the floating exchange rate, making these exporters subject to currency fluctuations in both directions. Ideally, the internationalized Yuan will lead to cross-border transactions being fully settled in Yuan, shielding the exporters from any potential volatility.
The increase in Yuan-accessibility that the Dim Sum bond market has created for investors outside of China is “paving the way for the Yuan to be fully convertible and held by central banks as reserve currency,” according to Frank Song, an economics professor at the University of Hong Kong. To the bankers and traders in Hong Kong that depend heavily on the Chinese economy, the advent of externally issued Yuan-denominated bonds was a revolutionary financial event. So-called “Dim Sum” bonds—named after the popular style of dining in Hong Kong’s teahouses—quickly became “the hottest financial innovation in town.” The unofficial designation for these bonds was intended to reflect their location of origin, however the expansion of the market has resulted in an evolution of the terminology: a Dim Sum bond now refers to any Yuan-denominated bond issued outside of mainland China. Investors were initially excited to invest in these bonds because their issuance required no regulatory approval from authorities in either China or Hong Kong. Although the initial shock of the Dim Sum bonds’ introduction caused a short-term macroeconomic contraction in Hong Kong, their contribution to long-term economic growth in the special administrative region and in turn the Chinese mainland has been unquestionably positive. These positive effects extend to the Yuan’s future as a global reserve currency. By removing restrictions on the issuance of Yuan-denominated bonds, China has made it easier for corporations to settle transactions in the Chinese currency, thus driving up the offshore demand for Yuan. Additionally, there is a greater demand to conduct Yuan-denominated transactions in Hong Kong rather than Mainland China, due to the Hong Kong Dollar’s peg to the United States Dollar—allowing investors from the mainland to take advantage of near-zero interest rates set by the Federal Reserve. In the future, the competition to win investors will increase global Yuan-demand as offshore centers race to make their Yuan-denominated financial assets more attractive than others.
One of the main reasons that the Dim Sum bond market’s popularity is contributing to greater use of the Yuan is that from its inception, there has been interest from nonfinancial companies. The first of these to act, McDonald’s, issued a 200 million Yuan debt in August of 2010. By 2012, the global amount of Yuan debt issued outside of mainland China was projected to total 310 billion Yuan, by 2014: 2 trillion. By encouraging the market for these bonds to expand so rapidly, China is effectively hedging against the risk that it assumes by holding over $3.2 trillion in Dollar-denominated foreign exchange reserves. As the sum of global Yuan flows increase, there is less pressure on the PBoC to hold a great deal of Dollar-denominated assets, allowing for increased macroeconomic self-determination. Although the Dollar’s remarkable strength is driving the Yuan up today due to its daily fluctuation within 2% bands, the PBoC recognizes that there is an impending global shift away from a US-dominated macroeconomy and that nonfinancial institutions have a large role to play.
The recent doubling of Yuan volatility has increased the potential yields on Dim Sum bonds, causing some investors to worry that the Yuan is no longer the safe bet that it used to be. In other words, appreciation against the Dollar is not a guarantee and safer investments may be made elsewhere. Their logic implies that the explosion of popularity in the market for Dim Sum bonds was a bubble that has since burst—this could not be further from the truth. In fact, the increase in Yuan volatility is immensely helpful for its future viability as a global reserve currency. Its rampant fluctuations, within 2% bands around the Dollar, demonstrate that the central bank is taking a step back from strict control over the manipulation of its currency; this has generally been the main concern of the United States with regard to China being including in the SDR basket. In response to the concerns of currency traders in November 2014, Deputy Governor of the People’s Bank of China Hu Xiaolian said that the central bank has basically withdrawn from regular intervention, reflecting a shift towards the allowance of market forces to dictate the value of the Yuan. Governor Zhou Xiaochuan added that there is no exact timetable for achieving full Yuan convertibility, but that the offshore market for Yuan-denominated assets is developing faster than expected, implying that a change in the global reserve currency basket may occur sooner than most anticipate.
The most prevalent factor influencing China’s chance of being granted SDR is the massive increase in usability that the Yuan is currently experiencing as a result of the rapid development of the deliverable Yuan market through the establishment offshore trading centers. These trading centers allow for the conversion of Yuan into other currencies without using the United States Dollar as an intermediary, substantially reducing costs for businesses dealing in cross-border, Yuan-denominated transactions. The largest obstacle to the Yuan’s acquisition of SDR in the past has been its lack of usability—the attribute cited by the IMF as most integral to global monetary relevance. Today, however, offshore trading centers that make the Yuan accessible to investors worldwide are increasing the currency’s usability by allowing relatively free movement as a result of the opening of China’s capital account. Historically, China has intentionally minimized international capital flows due to the difficulty they impose on sustaining high current account surpluses, however the PBoC has begun to recognize that tangible internationalization cannot be achieved without fair competition between the Yuan and the established reserve currencies—implying that a decline in their current account surplus may be expected as China seeks to emulate those it is attempting to unseat.
According to Tee Choon Hong of Standard Chartered, “Hong Kong is a unique place for the experiments and initiatives to promote Yuan as a global currency because it’s much closer to the international financial community.” In November 2003, the State Council of China in conjunction with the People’s Bank of China approved a deal with the Hong Kong Monetary Authority (HKMA) that would make the Yuan publicly tradable in the special economic zone as of early 2004. The demand for Yuan that businesses in Hong Kong exhibited as a result of its availability led to a progressive relaxation of regulations as authorities on the Mainland balanced cross-border financial flows and became increasingly optimistic about the Yuan’s future as a floating currency. Encouragingly, the government of China formally expressed support for Hong Kong’s development as an offshore Yuan trading center in the Twelfth Five-Year Plan that encompasses 2011-2015. Their recognition of the importance of these offshore trading centers makes the competition to become one even more intense; as these centers increase both in number and size, so does the probability of the Yuan’s inclusion in SDR.
During a visit to London in June 2014, Chinese Prime Minister Li Keqiang announced the beginning of direct trading between the Yuan and Pound, using London as a hub. This was a massive victory for Britain’s capital and financial center, which manages almost 60% of Yuan-denominated trade payments between Asia and Europe and is competing with other hubs such as Frankfurt, Paris, and Singapore to increase the size of its Yuan-denominated financial flows. Reuters recently reported that, “London has been keen to attract Chinese banks and encourage offshore trade in the Yuan to bolster its position as the world’s main centre for foreign exchange trading.” This competition has increased global Yuan usage dramatically—it surpassed the Canadian and Australian Dollars to become the fifth-most-used currency in the world as of November 2014, rising from 13th only two years ago.
China is also promoting greater use of its currency in the Western Hemisphere with the launch of the Renminbi Trading Hub for the Americas in March 2015, which allows firms in numerous North- and South-American countries (including the United States) to conduct Yuan-denominated transactions through certain Canadian banks. Canada is becoming increasingly dependent on the success of the Yuan as the relationship between the countries is now worth $78 billion in two-way trade. The international traction and credibility that the Yuan is gaining as a result of its increased usage in the Western Hemisphere further strengthens its case to be included in SDR. In a meeting between European Union business executives and Chinese officials, European Union Chamber of Commerce in China President Davide Cucino was told that the culmination of efforts to make the Yuan available worldwide would result in its full convertibility by 2015. Although Yuan internationalization has not yet reached this extent, the attitude of Chinese officials demonstrates that they are committed to the Yuan’s involvement in international markets through the creation and development of offshore Yuan trading centers. The worldwide emergence of and fierce competition between these trading centers demonstrates that China’s push to promote greater use of its currency in international trade and investment will continue to be successful and will contribute to the Yuan’s progression to global reserve currency status.
China’s economic rise is undeniable, and the increased usage of their currency is inevitable as the government continues to liberalize the trade sector and financial apparatus. Since the 2010 rejection of the Yuan’s inclusion in SDR, IMF Managing Director Christine Lagarde has reportedly become frustrated with how the United States has handled the prospects of China acquiring global reserve status. Following a pitch at the recent China Development Forum in Beijing by Zhou Xiaochuan to add the Yuan to the SDR system, Lagarde indicated that, “the Yuan clearly belongs in the SDR basket,” and that the IMF is working bilaterally with China to achieve this. In March 2015, Lagarde cited the contribution that China’s financial reform has made to global financial stability and added, “Timing is something that we will be discussing amongst ourselves but I think we welcome this introduction,” implying that the Yuan’s inclusion in the SDR basket is simply a matter of time.
The implications of the Yuan becoming a global reserve currency are both differentiated and extensive. The most obvious is that the Yuan would experience a massive spike in demand after being added to the SDR basket, because entities wishing to carry out transactions in the international marketplace would need Yuan to do business. Governments and central banks worldwide would also desire to hold Yuan as a share of their foreign exchange reserves. This spike in demand would also lead to an appreciation of the Yuan, particularly relative to currencies that are not components of the SDR basket. Additionally, “Reserve status will make global trade and financing cheaper for Chinese businesses. It will create better foundations for China’s macroeconomic management, deliver more diversified portfolios for Chinese and foreign investors and generate better risk-management products and markets for investors,” according to Michael Collins, an Investment Commentator at Fidelity. Lastly, there is a degree of international prestige associated with having reserve currency status, and the acquisition of SDR may grant China greater diplomatic capital.
The internationalization of the Yuan, accompanied by a relatively open capital account and market-driven exchange rate regime, will create a “seismic shift in the global monetary and financial landscape.” The shift towards exposing a currency to the world market is an inherently risky action, particularly in the case of China, where the process of post-communist economic liberalization is not fully complete. Despite systemic challenges, China’s economic leadership is working diligently to prepare its monetary and financial infrastructure for global usage and scrutiny. The Yuan’s acquisition of Special Drawing Rights through the International Monetary Fund will profoundly accelerate China’s impending economic hegemony, despite speculation that China’s inclusion will undermine international economic and financial stability. In fact, a multipolar reserve currency system may introduce greater stability into the global macroeconomic order because it would solve the Triffin paradox, which states that there is a conflict of economic interests in countries with global reserve currencies. The paradox applies mainly to the United States, where short-term domestic and long-term international currency objectives have generally proven to be mutually exclusive. Inclusion of the Yuan in SDR would therefore decrease the financial responsibility associated with the Dollar and increase the economic security of all states. As the world looks for an alternative to the dominance of the Dollar, the Yuan’s role in the international economic system is becoming clearer and it is a matter of time until the proper conditions are met for its recognition as a component of SDR—putting reserve currencies that are clinging to relevance, such as the Euro, at risk of being overtaken.
IA Forum Student Writing Competition Semi-Finalist Alex Davis attends George Washington University.
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