Shyam Saran, Business Standard
9 June 2015
In a recent report, the International Monetary Fund (IMF) declared that the Chinese currency, the Yuan, was no longer under-valued. The IMF head, Christine Lagarde, also let it be known that in its forthcoming October review, the Chinese currency may well be included in its basket of benchmark currencies, which is used to calculate the exchange value of its Special Drawing Rights (SDR). It has long been alleged by the US that the Chinese currency has been deliberately kept under-valued so as to give Chinese exports an unfair advantage in global markets, leading to a massive accumulation of foreign exchange reserves, currently near $4 trillion. The IMF has given an authoritative rebuttal to this charge. It has also become likely that the Chinese demand for its currency to be included among the reserve currencies viz the dollar, the Japanese yen, the euro and the British pound, in the SDR basket, may finally be conceded despite the fact that the Yuan is neither freely convertible nor in use as a reserve currency except in some central banks of developing countries. This would be a mainly symbolic milestone with more political than economic benefits to China. It would nevertheless mark an important milestone in the steady internationalisation of the yuan in deliberate and measured steps, reflecting China’s economic as well as geopolitical objectives.
I have covered this subject in two earlier columns in this newspaper, “The Asian future of reserves” (May 16, 2012) and “The Chinese (yuan) are coming” (January 15, 2014). This is a good time to review developments since then and assess their implications.
It is becoming clear that China considers the expanded role of its currency as part of a larger strategy to consolidate its position as the pre-eminent economic and military power in Asia. It is now the top currency used to do business with China, including Hong Kong. We are witnessing the beginnings of a renminbi ( the official name of the Chinese currency) currency area in the Asia-Pacific, whose building blocks are the rapid emergence and expansion of the off-shore yuan currency and bond markets, including the circulation of so-called “dim sum bonds”, the increase in the number of currency swap arrangements and direct settlement of accounts with other currencies without dollar intermediation and, more recently, the setting up of the Asian Infrastructure Investment Bank (AIIB), to finance ambitious infrastructure projects in the region, in particular, those associated with the “one belt one road” initiative. The BRICS Development Bank, which groups together India, China,Brazil, Russia and South Africa as founder members, will also give China an added institutional medium to expand its role in development finance precisely at a time when the West dominated Bretton Woods institutions are in relative decline. This has gone hand in hand with the further globalisation of the Chinese currency. The RMB trade settlement was first introduced in 2009 and in five years it has reached a level of 22 per cent and is still expected to reach the targeted 30 per cent by the end of this year. It has been reported that later this year the China International Payments System (CIPS) is likely to be introduced, which would allow much easier and swifter cross-border RMB transactions.
Offshore RMB markets first began to function in Hong Kong, Singapore and Taiwan but have now expanded to London,Paris, Frankfurt and Luxembourg. As a result of these developments, the RMB is now the second most used trade financing currency and the fifth most used currency for payments globally, overtaking the Euro. Despite this the Chinese currency still accounts for only 1.4 per cent of overall global payments, far behind the dollar at 42.5 per cent. This is likely to persist as long as the RMB is not freely convertible and lacks the deep and extensive financial and banking infrastructure which the dollar enjoys.
China is taking modest steps introducing a degree of flexibility in its exchange rates and opening up its capital market . The exchange rate was allowed to fluctuate two per cent on either side of the official rate, up from 0.5 per cent and then one per cent in previous changes. In 2011, China introduced RMB-denominated direct investment both into and out of China. This was through the Qualified Foreign Institutional Investor Scheme and the Qualified Domestic Institutional Investor Scheme respectively. The scope and limits of investment under these schemes have been progressively increased. A more ambitious initiative was introduced in November last year with the Shanghai-Hong Kong Stock Connect, which permits designated foreign and Chinese entities to trade in stocks listed on the Hong Kong stock market and in the Shanghai-A share market reciprocally but within an overall limit. This is now being expanded this year to link Hongkong with the Shenzhen share market. Another significant pilot project is the Shanghai Free Trade Zone, where much more liberal financial and banking rules apply. However, this initiative is making much slower progress than expected.
It should also be noted that China’s outward bound Foreign Direct Investment has also been rising rapidly. This year it is expected that, for the first time, outward FDI will exceed inward FDI. Last year outward FDI was US $108 billion against an inward FDI of US $118 billion. As outward FDI expands, the use of the Chinese currency is also expected to increase.
While the role of RMB as a trade and investment currency has been increasing over the past few years, what about its role as a reserve currency, which is more directly relevant to its bid to become an IMF recognised benchmark currency? China joined the Chiang Mai Initiative Multilateralization (CMIM) in 2010, which was a currency swap arrangement among the 10 ASEAN states, China, Japan and Korea, to help participating states tide over balance of payments difficulties. The swap was pegged at $120 billion in 2010 and raised to $240 billion in 2012. However, this facility has never been used. Since 2009, China has entered into currency swap arrangements with 28 countries and 40 central banks keep part of their reserves in RMB. These numbers show a more modest increase over the past couple of years but the trend is positive.
We see a clear pattern in the continuing internationalisation of the Chinese Yuan. As befits the world’s largest trading nation, the use of the currency in trade settlement has been the first to expand rapidly and this trend will continue. The next phase has been its expanding role in the global capital market and this, too, is likely to see significant increase particularly in the Asian region. It is the third phase, which could see the currency emerging as a reserve currency, which is likely to take place over a much longer time frame. As long as China remains an authoritarian state, it is unlikely to embrace the risks and uncertainty associated with a freely convertible currency, subject to market volatility. While this falls short of the kind of role associated with the dollar, there is no doubt that in terms of other key indices the yuan is already an international currency.