China is the world’s second largest economy and a leading global investor so the move on November 30th to include the Chinese yuan as a world reserve currency by the IMF (International Monetary Fund)was inevitable. As international demand for the yuan will now increase, the action also continues to undermine the present hegemony of the United States dollar (USD) in global trade.
The yuan will join an elite status of currencies that include the American Dollar, the Euro, the Japanese Yen, and the British Pound Sterling as the fifth member of the IMF special drawing rights currency basket (SDR). It marks a major policy goal of the Chinese government. It finally officially recognizes the importance of the Chinese economy to worldwide finance and trade.
The complete impact will be somewhat delayed, as the full implementation will not take place until October 2016. However, there will be some immediate effects that will be of a benefit to the Chinese economy. It will reassure foreign investors about the stability of the Chinese economy and the recent upheaval in the domestic stock markets
At the beginning of the year, it looked like the addition of the yuan also known as the renminbi was a all but a done deal. Money was being poured into Chinese markets at an enormous rate. Valuation of Chinese shares had increased 150% from June 2014 to the middle of 2015. Much of the rise was being financed by borrowing on a massive scale.
Then came the summer and a dramatic decline of more than 40% in value, which called into question the sustainability of Chinese stocks. Since then the market has slowly recovered, but investors are a bit more wary now.
There was another dip in the Chinese market in the past two weeks, as regulators seemed to put further restrictions on leveraged buying. The government appears to be intent on preventing another bubble in the market, which would require a massive regime intervention once again.
However, it was the surprise devaluation of the yuan over the summer that set the stage for what is now happening. The Chinese government is increasingly allowing the world market to determine the value of their currency. It is one of the basic requirements in order for the yuan to be considered as an SDR.
There are a number of financial analysts that predict that the Chinese yuan will rapidly catapult to become one of three most important currencies in the world, after the American dollar and the Euro. The change will be most evident in East Asia, where there will no longer be any need to convert local currencies into dollars, in order to facilitate trade with China.
The SDR basket determines the amount of a currency mix countries that are receiving financial aid by the IMF are given. This can boost demand for the yuan by some $600 billion USD according to a number of monetary experts.
The move to legitimize the yuan is still seen as controversial by critics who still claim that China has kept the valuation of its currency artificially low, to help fuel its huge export market. It has been a contentious issue between major trading partners for many years. It is also what has prevented an earlier inclusion of the yuan as a reserve currency. The yuan has dropped almost 3% against the American dollar this year alone. It is the biggest change in valuation since 2005.
The SDR list has not been altered in 15 years. Once every five years changes are considered by a special executive board that represents the 188 member nations, which will decide if alterations in the present currency configuration need to be made. The last time was in the year 2000, when German Mark (Deutschmark) and the French Franc were folded into the Euro.
The inclusion of the yuan as an SDR, will facilitate the buying of the currency by other world central banks. It will certainly boost further foreign investment in Chinese assets including equities and stocks. A number of analysts are looking at an increase of over $1 trillion USD in the next five years. Chinese media is already predicting over $150 billion of foreign investment arriving for domestic bonds in the year ahead.
Both Japan and the United States continue to oppose the inclusion of the yuan by the IMF, but are unlikely to prevail in preventing its addition to the SDR. Critics continue to point to the fact that the yuan is still tightly controlled by the Central Bank of China, known as the People’s Bank of China.
Although the new status for the yuan will put increasing pressure on monetary authorities in China to open up the currency to more market forces, they will most likely continue attempting to manipulate it.
The IMF counters that the addition of the yuan to the SDR, will bring a new impetus for financial and monetary reform within China. It will certainly be an endorsement to economic reformers in China, but now that the goal has been achieved, the pace of change is likely to decline. This is especially true because of the other issues confronting Chinese authorities, including the rapidly cooling domestic economy.
Some observers fear it may well be a repeat of what happened after China joined the WTO (World Trade Organization) in 2001. Once the government of China was permitted entry into that organization, the economic conservatives inside China seemed to gain the upper hand again and the pace of reforms slowed significantly. The effort to restructure the state sector of the economy slowed substantially once membership was achieved.
In an increasingly complex domestic and global economy, the natural instinct of Chinese officials will be to maintain control and even tighten efforts to keep the yuan under central direction. There are indications already that after the turmoil of the summer of 2015, many governmental leaders have lost their enthusiasm for more experimentation in currency flows across territorial borders.
Chinese regulators watched with fear and near disbelief, as the domestic stock market plunged in value from the middle of June to the end of August. The tendency was to blame most of the fiasco on the influx of foreign capital, which in their minds over-inflated the market and therefore destabilized it.
The response was to interfere further in currency markets both on and offshore. They also took steps to make it more difficult for money to leave China, to reduce additional downward pressure on the yuan. These officials are now more concerned with risk, rather than extra reforms.
Still there is plenty of evidence that indicates that China as a whole, has pushed to make the yuan far more international in the past few years. There has been a flurry of activity in setting up currency swap agreements, with an ever increasing number of countries to facilitate more trade. The government has also widened the yuan’s trading band, as well as moving forward with freeing up interest rates.
A truly free flow of currency in and out of China does contain substantial risk. There are many inefficient industries and businesses that without government assistance would be pushed into bankruptcy. These would be unable to survive in a truly competitive market.
Such results are viewed as destabilizing by many officials in the Chinese government. The leaders of China’s often ineffective and unprofitable state banks share this dim outlook.
It is no wonder that under the present circumstances that foreign access to domestic financial markets remain strictly regulated. There is also some activity to reverse a number of measures that were taken earlier, to allow the yuan to leave China for investment purposes.
Once China is given the nod to join the SDR, there are many who are forecasting a further decline in value for the yuan. Further liberalization of the currency in their view will necessarily mean more market determination in valuation. That in turn would mean fewer capital controls and a widening of the maximum daily trading band for the yuan. These individuals point to the sharp drop in the value of the yuan, when the trading band was expanded to 2% last August.
The drop in the yuan gained for China a further advantage in the export sector. It resulted in a fall in most Asian currencies in an attempt to mitigate this benefit. Of course this pummeled the global commodity market further. Australian coal and iron ore exporters in particular took a hit. A lower valued yuan gave Chinese competitors, an extra advantage both domestically and internationally.
The devaluation of the yuan in August of about 3%, was a major factor in the Federal Reserve of the United States to postpone a rise in interest rates last September. Yet the yuan itself it still up 7% in value for the year. Despite the criticism of China trying to maintain an undervalued currency for keeping the present global market share in exports, the recent evidence suggests otherwise. Chinese export volumes are actually declining.
In the past few months, Chinese monetary officials seems far more concerned with stability, less risk, and making sure that capital outflows do not result in a compression of domestic liquidity. Over the past decade, foreign exchange reserves grew to an incredible $4 trillion USD just before the recent economic slow down in China.
Since the beginning of 2014 to the middle of 2015, the equivalent of nearly $450 billion USD has left China. An additional $300 billion USD was expected to leave in the 3rd business quarter alone. Of course, the present capital outflows increase the pressure for more devaluation. At the same time Chinese authorities fear that if this action is taken, it will accelerate capital flight at least in the short term. It is a dilemma for any country trying to maintain some form of currency control.
Rising interest rates in the United States is likely to increase the flow of capital out of the emerging world including China. If the slowdown in the Chinese economy continues as the United States economy expands, it will create even more pressure for a further devaluation of the yuan in relation to the United States dollar.
So far there has been a minimum of movement in valuation for the yuan in comparison to USD, but analysts are predicting a much wider movement once the currency is part of the SDR. One only has to consider what has happened to other world currencies in the past year. The Australian dollar is down by about 17% and the Euro has slipped by 14% in value against the American dollar.
The devaluations in many parts of the emerging world in relation to the United States dollar has softened the blow in the near collapse of commodity prices. It has also allowed producers to continue production for local markets. This development keeps markets oversupplied with commodities, which will keep prices depressed for some time to come. If the Chinese yuan weakens further, the downward price trend for commodities will continue apace.
Although the full impact of the Chinese yuan becoming a major world currency will take years to develop, what is clear is that the role of the American dollar, the Euro, the pound of the United Kingdom and the Japanese yen as well as a number of other leading currencies, will be further diminished in the larger global economy.