The Chinese Yuan Grows Up--Slowly

In the aftermath of the global financial crisis in the autumn of 2008, Chinese officials identified the US-dollar based monetary system as a contributing cause of the crisis and an ongoing source of systemic risk for the global financial system. In response, they began a program for internationalizing the Chinese currency, the yuan, whose circulation was hitherto largely restricted to mainland China. This led to much excited commentary about the possibility that the  might be on its way to replacing the dollar as the world’s principal reserve currency, and that China might seek to intimidate the United States by threatening to sell off its holdings of US Treasury bonds.

These expectations are vastly overblown. Much analysis continues to conflate three distinct concepts: currency internationalization, reserve currency, and principal global reserve currency. The yuan is rapidly internationalizing, and it is likely that by 2020 a significant share of China’s trade will be settled in yuan rather than in dollars. It is possible that by then that central banks will hold a small portion of their official foreign exchange reserves in yuan, making the yuan a secondary reserve currency similar to the pound sterling or the Japanese yen. It is extremely unlikely, however, that the yuan will be anywhere close to achieving the status of a principal global reserve currency (like the US dollar or Euro). And there is no chance at all that the yuan will replace the dollar as the world’s principal reserve currency within the next couple of decades.

Yuan internationalization: the facts

Following the global financial crisis in September 2008, China launched a broad-based program to internationalize the use of the yuan. So far, the main elements have been:

• Currency swap agreements with foreign central banks
• Allowing Chinese companies to settle trade transactions in yuan, rather than US dollars
• Relaxation of restrictions on yuan deposits in Hong Kong
• Allowing Chinese and foreign companies to issue yuan-denominated bonds in Hong Kong

The first step was a series of yuan swap agreements with foreign central banks, which began in December 2008 and now encompasses eight agreements with a total value of 800 billion yuan (US$121 billion). Theoretically, these lines could be used to provide emergency funds for trade settlement in the event of another financial crisis. Since the major immediate impact of the 2008 financial crisis on China was a plunge in exports as global trade finance dried up, such insurance policies appear prudent. (For similar reasons, the US Federal Reserve initiated an even larger volume of international dollar swap lines, totaling US$617 billion, after the 2008 crisis.) But the fact that several lines were arranged with countries that are not significant trading partners – Belarus, Argentina and Iceland – suggests that the main purpose of the swap agreements was to symbolize Beijing’s intent to carve out a more international role for its currency.

Another signaling move came in March 2009, when Zhou Xiaochuan, the governor of the People’s Bank of China (PBOC, China’s central bank) published an essay suggesting that the current global monetary system, in which the US dollar is the main reserve currency, is inherently flawed and subjects the global economy to unnecessary risk of financial crisis. He proposed that, in the long run, the role of major reserve currency should be played by a supra-national currency, for instance the special drawing rights (SDRs) used to denominate reserves that central banks hold at the International Monetary Fund (IMF). That essay, which came out a few weeks before the first G-20 heads of state meeting, was widely interpreted in the media as an attack on American global economic leadership and as a covert call for the yuan to replace the dollar as the main global reserve currency. This interpretation is obviously mistaken. Zhou simply restated worries about the inherent problems of a reserve currency that economists have had since John Maynard Keynes proposed a special global currency at the Bretton Woods conference in 1944. His article makes no reference to the yuan as an alternative to the dollar – indeed, Zhou’s criticism of the dollar as the main reserve currency apply equally to the yuan or any other national currency. It was, however, clear that Zhou favored a more diversified international monetary system in which the yuan presumably would play a larger role.

More substantive measures began in July 2009, when Beijing launched a pilot program allowing some companies in five Chinese cities to settle trade transactions with counterparties in Hong Kong, Macau and southeast Asia directly in yuan (such settlements must occur in Hong Kong). A year later this pilot was expanded to include 20 Chinese provinces and counterparties in all countries, and in December 2010 the number of Chinese companies allowed to participate in the program was expanded from a few hundred to nearly 70,000. So far the trade settlement program is mainly used by Chinese importers. Standard Chartered Bank estimates that in the third quarter of 2010, 3.7% of Chinese imports, but just 0.3% of exports, were settled in yuan.

In February 2010, the Hong Kong Monetary Authority (HKMA, Hong Kong’s central bank) approved non-financial corporations from the mainland to issue yuan bonds in Hong Kong. This move followed the Chinese Ministry of Finance’s first offshore yuan issue, in Hong Kong the previous September, and prompted a flood of issuance by Chinese, Hong Kong and foreign companies. Between September 2010 and January 2011 yuan bonds outstanding in Hong Kong rose from about 5 billion to around 50 billion yuan.

Finally, in July 2010 HKMA issued new rules that greatly relaxed restrictions on the yuan activities of banks in Hong Kong. Most important, HKMA for the first time allowed financial institutions to open yuan accounts, clearing the way for a wide range of yuan financial products. Hong Kong banks were permitted to open yuan deposit accounts for individuals and some businesses in 2004, but strict limits meant the yuan market was stagnant. At the end of 2009, yuan deposits in Hong Kong were a mere 60 billion yuan. A year later, they soared five-fold to over 300 billion yuan.

As a result of all these measures, daily trading of yuan on the Hong Kong foreign exchange market soared, from close to zero in mid-2010 to over US$250 million by the end of the year. Market participants are unanimous in their belief that yuan bank deposits, trade settlement, bond issuance, and currency trading in Hong Kong will continue to grow at very rapid rates for several years, and the variety of yuan-denominated financial products available to individuals and companies in Hong Kong will proliferate. There is no doubt that the yuan is well on its way to becoming a major international currency.

A good start, but the race is long

But to understand just what this means, it is necessary to know the starting point. Even after the impressive growth of the past two years, the yuan plays a negligible role in global currency markets, accounting for 0.9% of average daily turnover, a bit less than the Russian ruble and a bit more than the Polish zloty. By contrast, the US dollar figures in 85% of transactions, the euro in 39% and the yen in 19%. The yuan clearly has several years to go before it reaches parity even with secondary currencies like the Australian dollar and Swiss franc, let alone joining the ranks of major international currencies.

Second, the rapid internationalization of the yuan – which is inevitable given that China is now the world’s biggest exporter, and will soon surpass the United States to have the world’s biggest total trade volume – does not necessarily imply that the yuan will become a reserve currency at anywhere near the same rate. The reason is simple. Internationalization simply implies that a large number of people and companies will buy and sell yuan every day to settle trade and other current transactions. But gaining reserve status means that foreign central banks will hold on to large balances of yuan, which they will need to invest in yuan assets – preferably safe, liquid debt securities. Despite the emergence of an offshore yuan bond market in Hong Kong, there is nowhere near enough supply of such bonds to make the yuan an attractive reserve currency.

The domestic bond market is far larger, but it suffers from two major problems. First, it remains essentially closed to foreign investors, although in August 2010 Beijing did grant limited access to foreign banks involved in the offshore yuan trade-settlement scheme, and to some foreign central banks. Although these restrictions will certainly be gradually relaxed in the coming years, the pace will be slow as regulators will be nervous of the risk to domestic financial markets and institutions, and to their own ability to control interest rates. Direct control of bank lending rates is an important tool of Chinese monetary policy, and also indirectly enables the Ministry of Finance to minimize the interest rate it pays on the bonds used to finance the government budget deficit. Beijing will be reluctant to loosen its grip on these instruments of control.

Reserve currencies are far more concentrated than international currencies. Seven currencies have at least a 5% share of global currency trading, but only two – the US dollar and Euro – have at least a 5% share of global reserves. Moreover the combined dollar-euro share of global reserves remained essentially unchanged in the decade after the introduction of the euro, at around 90%. The only major shift has been an increased share of euro reserves, at the expense of the dollar. The UK pound and Japanese yen, the third and fourth ranking reserve currencies, account for just 4% and 3% respectively of global reserves.

These observations should make clear that even if the use of yuan for trade settlement and other current transactions increases to many times its current volume, it is likely to be at least a decade before the yuan becomes a secondary reserve currency on a par with the pound or yen. The prospect of the yuan replacing the US dollar as the principal global reserve currency is even more remote. The dollar replaced the pound sterling as the world’s major reserve currency in the mid-1920s, about a decade after the US surpassed Great Britain as the world’s largest exporter and about 50 years after the US became the world’s largest economy. Since then the dollar’s share of global reserves has suffered some large oscillations – contracting sharply in the 1930s during the Great Depression, and expanding vastly after World War II – but over the long run has varied around a share of about 60%. Since the 1999 introduction of the euro as a major competitor, the dollar’s share of global reserves has fallen from around 70% to 64%, but still remains higher than it was as recently as 1995. Taking account of this long-run historical context, we have no evidence that the dollar’s position as the principal global reserve currency is now under serious threat. If there is a serious challenger on the horizon, it is obviously the euro, not the yuan.

The reason for this is straightforward. A currency gets to be the principal global reserve currency because the issuing country is dominant economically, has a long track record of sound public finance, and is politically stable. Despite its impressive record of economic growth over the past three decades, China does not yet meet any of these three conditions. It is now the world’s second largest economy and will probably overtake the US for the top spot before 2030. But its growth is mainly driven by playing catch-up with the technological leaders – the US, Europe and Japan. It is impossible to know whether it will be able to sustain that growth and become a genuinely dominant economy once it nears the technological frontier and needs to generate gains from innovation rather than copying. While it has avoided major financial crisis, serious doubts remain about the solvency of its banks, which have never been exposed to serious international competition. Taking account of unrecognized losses in the banking system, local government debt, and other hidden liabilities, true public sector debt is probably around 85% of GDP, rather than the 20% indicated by official figures. Finally, serious doubts remain about the ability of China’s authoritarian political system to survive in the long run. Until these questions about China’s long-run economic growth prospects, fiscal sustainability and political stability are addressed, central banks are likely to see the yuan as somewhat less safe than the dollar. 

The true goal: domestic financial liberalization

But while the yuan is unlikely to dethrone the dollar, it is certain to rise in international importance. What are the likely next steps in the yuan’s internationalization, and what economic impacts are they likely to have?

The main things we can expect are a gradual expansion of the number of currencies against which the yuan can trade, and the number of locations for offshore yuan trading; and a gradual relaxation of capital controls to encourage the international use of the yuan not only for trade settlement but for investment purposes as well. Beijing has already announced plans for a limited pilot project enabling some companies to use yuan for international investment, and for Chinese banks to issue yuan loans to finance investments outside China. Hong Kong authorities have indicated that issuance of yuan-denominated shares on the Hong Kong stock exchange could begin soon. And the Bank of China’s New York branch has started offering yuan accounts to depositors.

Each new move is likely to generate headlines, because of its novelty and of the enormous potential implied by China’s vast size. But when reading such headlines, one should bear three facts in mind. First, Beijing will be extremely cautious about the pace of offshore yuan transactions, since it wants to limit risks to its financial institutions and the unpredictable effects of increased capital flows. Second, authorities both in Beijing and Hong Kong clearly intend that Hong Kong, and nowhere else, will be the principal center for offshore yuan activity. And finally, the biggest impact of yuan internationalization may well be within China, not in the wider world.

The final point may seem paradoxical but it is not. An unstated but evident purpose behind the PBOC’s championing of the offshore yuan market in Hong Kong is to create a mechanism for accelerating liberalization of the domestic financial system, which remains very primitive by developed country standards. The basic idea is to use Hong Kong as a laboratory for the development of new financial products and, most important, a vigorous yuan bond market where interest rates are determined by the market, not by regulators. Once Chinese banks have got practice in Hong Kong in managing the risks of a wider range of financial instruments, and managing their balance sheets in an environment where they must compete for funds and deal with market-driven interest rates, these innovations can be gradually introduced in their much larger home market. In the 1970s and early 1980s, Japanese authorities similarly developed an offshore yen market as a prelude to domestic financial liberalization.

Lastly, it is most unlikely that the internationalization of the yuan will lead to China dramatically or suddenly to dump its holdings of US Treasury bonds, as has often been suggested in the financial press. Because the dollar remains the dominant invoicing currency of global trade, and because the US debt markets are by far the deepest and most reliable in the world, a country like China that runs a persistent large trade surplus has little choice but to invest the majority of its earnings from trade in US securities. Yuan internationalization may change that eventually, but it will be many years before the yuan supplants the dollar as the main trade invoicing currency. As Figure 3 shows, China has gradually reduced the dollar share of its reserve holdings, but at about the same pace as the rest of the world; and the dollar share of China’s reserve holdings remains higher than the world average. From 2008 to 2010, when speculation about China dumping its US Treasurys was rampant, China actually doubled its holdings of Treasury bonds, to US$1.1 trillion, and the Treasury bond share of China’s official US dollar holdings rose to an all-time high of nearly 70%.

The internationalization of the yuan is an inevitable consequence of China’s emergence as a major economic and trading power. But at least for the next decade or two, the rise of the yuan will occur within a global monetary system still dominated by the US dollar, rather than creating an alternate China-centric order. Eventually, as the eminent monetary scholar Barry Eichengreen suggested in his recent book Exorbitant Privilege, the world may have multiple major reserve currencies, with the yuan ultimately joining the dollar and euro in a monetary triumvirate. But in order to reach that point, China still has much to prove about the sustainability of its economic and political systems.