The debate: Is the yuan on the verge of becoming an international reserve currency?

Chief Economist at Dubai International Financial Centre, Dr Nasser Saidi, and Chief Economist for Emerging Markets at UBS AG, Hong Kong, Jonathan Anderson, debate whether or not the yuan is on the verge of joining the dollar and the euro as one of the world’s main reserve currencies

Dr Nasser Saidi (left) is the Chief Economist and Head of External Relations for Dubai International Financial Centre (DIFC). He makes the case for why he thinks the yuan is soon to become one of the world’s main reserve currencies

China is now the world’s second biggest economy and is set to surpass the US by 2016 in real terms* and by 2020 in absolute terms. But despite the growing economic and financial international role of China, its currency, the renminbi (or yuan), remains largely a domestic currency. There are increasing calls for the renminbi (RMB) to become an international payment, investment and reserve currency. The move towards renminbi internationalisation requires domestic structural reforms and financial market development.

China’s 12th Five Year Plan objectives provide for gradual capital account convertibility and removal of internal financial distortions. This requires interest rate liberalisation and the development of money market instruments and debt capital markets; the ‘Redback Market’. To achieve these goals requires gradual renminbi convertibility, a progressive removal of remaining interest rate controls, development of the non- financial corporate debt market, along with greater exchange rate flexibility. However, the speed of adjustment and the sequencing of financial sector reforms are also important. External account liberalisation should be preceded by domestic financial sector reforms to avoid volatile, speculative capital flows.

China can open its financial markets… this would allow it to export its savings providing higher return to its citizens than low rates on deposits and getting the benefits of international diversification’

Dr Nasser Saidi, Chief Economist and Head of External Relations for DIFC

The coming decade will witness the rise of the Redback as an international currency increasingly used in international transactions and payments. The world needs the Redback to become a global currency in order to deal with global imbalances, to wean the US away from its addiction to debt and external deficits that were allowed it as an exorbitant privilege for supplying global liquidity.

The world needs China to play a stabilising role in the world economy and new financial architecture. And China needs a globalised Redback in order to efficiently export capital. Why should China’s labour work hard to accumulate international reserves (running in excess of US$3.4tn) to invest them in low yielding (negative in real terms) foreign government securities (mainly US), when the real return on productive investment is double digits in capital-poor China and in other emerging markets? Rationally, China will gradually reduce its exposure to low yielding and increasingly risky assets. It has started diversifying its portfolio investments and become a major capital exporter through foreign direct investment and by supporting the international expansion of Chinese multinationals. This trend will accelerate in the coming decade.

However, there is a more efficient way of deploying capital internationally. China can open its financial markets allowing foreign governments and corporations to list securities in its markets. Shanghai’s Exchange is technically ready for international listings. This would allow China to export its savings providing higher returns to its citizens than low rates on deposits and getting the benefits of international diversification.

The process of renminbi internationalisation has started with the growing use of the renminbi in banknote circulation in HK and in neighbouring countries; the settlement of trade with China, and the beginning of an offshore bond market, and the establishment of renminbi swap lines between the People’s Bank of China and a number of central banks, notably the central bank of the UAE. We should start pricing and settling our trade with China in RMB. The DIFC has the technology and players to emerge as the payments hub for RMB in the Middle East. I expect that the renminbi will be part of the IMF’s SDR (Special Drawing Rights) by 2015, confirming the move to a tri-polar global currency system, assuming, that is, that the euro survives.

*Measuring GDP using purchasing power parity rates (PPP)

Jonathan Anderson is the Chief Economist for Emerging Markets at UBS AG, Hong Kong. He argues that the yuan will not become one of the world’s main reserve currencies any time soon due to China’s problematic future financial role

The debate over China is not whether it takes over economic leadership of the world, but when. China already has a US$7tn economy, roughly half the size of the United States or the European Union. If it can continue to grow, not at 10 per cent or 11 per cent as it did through much of the 2000s, but even at six per cent or seven per cent in real terms, then in five years’ time the Chinese economy could easily pass the US$15tn mark, where the US is today. By 2020, China should be larger than the US and equal in size to developed Europe.

But the outlook for China’s financial role is more problematic. Although it is likely that in 10 years’ time China’s currency will play a marginally more important role in global affairs, the yuan (or renminbi) will not take over from the US dollar as the world’s reserve currency. In fact, it may not even be challenging the Japanese yen or the pound sterling for the number four slot.

Why? Well, it’s one thing to hold the yuan for trade invoicing, but if you’re going to hold it as a liquid “safe haven” portfolio investment choice you need free and unfettered access to deep domestic fixed income markets. This is what the dollar historically offers, and the euro offers, and essentially what the yen and other G10 majors have offered as well.

But not China. Far from being “free and unfettered”, China maintains one of the most closed capital account regimes in the emerging universe. And it’s not simply that China “won’t” open its capital regime. In a very real sense, it can’t, at least not fast enough to matter. For more than two decades China’s entire philosophy of monetary management and financial system development has been based on a closed-economy system: maintaining low and stable interest rates without having to worry about external arbitrage; breezily adopting economic stimulus when needed without concern about underlying banking system asset quality; propping up banks with historically high NPL (or non-performing loan) ratios and fixed-cost pricing, and keeping iron-clad control over the value of the exchange rate. All of these only work when foreign portfolio funds cannot influence asset prices, and when locals have nowhere else to go.

Even if China were to somehow see its way clear to removing external controls, this still leaves the second issue of creating “deep domestic markets”. Put simply, there’s nothing to invest in; you need a local bond market, and China really doesn’t have one. This is not just a niggling comparison with developed markets. Relative to its size, China has a much less developed bond market than most of its major emerging peers as well.

Some argue that the recent expansion of offshore yuan trading in Hong Kong and other global financial centres is a de facto opening up of both capital controls and the Chinese bond market in another guise. I see it as confirmation that China prefers to assiduously ring-fence offshore trading in an artificial environment rather than relax controls for markets at home. Moreover, even the most optimistic forecasts put issuance in these markets at a few US$100bn in five years’ time. That’s still small relative to the Chinese economy (and just a sliver of the US$30-plus tn United States bond market).

Making the yuan into a true global reserve currency doesn’t solve any of China’s current problems, and could create very painful new ones along the way. That’s why it’s not going to happen any time soon. China may be an economic giant on the world stage, but in this sense it will remain a financial midget.

• A longer version of this article first appeared in the Asia Wall Street Journal

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