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Prestige Over Power: Including China's Yuan In International Reserves

John Lee

There is growing expectation that the International Monetary Fund’s inclusion of China’s Renmimbi (RMB) in its basket of reserve used by the central banks of IMF members for Special Drawing Rights (SDR) represents a watershed moment in global finance and even China’s emergence as an economic superpower.

Such speculation is seductive but incorrect. The reality is much less than that. The RMB is a long way away from replacing the U.S. dollar as a genuine global currency, and is not yet even close to being a match for the Euro, British pound or Japanese Yen for that matter. The decision by the IMF will offer China some of the global prestige that it craves, but little by way of any real avenues of financial leverage or power that the country did not have before.

On the face of it, there seems to be an irresistible narrative about the RMB’s rise with it joining the IMF construction of a basket containing the currencies emanating from the four most successful economic zones from the second half of the previous century. As the argument goes, the RMB’s inclusion by the IMF is done with an eye to the future of a dominant RMB commensurate with the size of the Chinese economy. But those predicting a world where the RMB is as ubiquitous as the other four currencies are likely to be waiting a very long time.

Bear in mind that SDRs represent less than 5% of official global reserve asset holdings with total SDRs issued amounting to around $300 billion currently. It is expected that RMB will constitute around 15% of the IMF’s basket of reserve when inclusion is formalized in October 2016, meaning that the demand by central banks for RMB will amount to an estimated $45 billion or less than 0.75% of asset holdings by central banks. In short, the mechanics of RMB inclusion in the SDR’s basket will have little meaningful impact on demand for China’s currency.

The RMB as a “store of value”

Some might argue that including RMB in the SDR’s basket of currencies has more significance beyond a highly technical form of central bank borrowing for purposes of stabilizing balance of payments and currency transactions. For example, the IMF’s managing director Christine Lagarde is largely selling the decision as acknowledgement of China’s importance to the international economy and the future role its currency will play in global prosperity and financial stability.

The big-picture or game-changing argument depends on whether the RMB can emerge as an international ”store of value” which characterizes the other currencies sharing the basket with the RMB. For the moment, central banks are skeptical. Most estimates are that total global central bank reserves in RMB denominated assets amount to between $70-120 billion, or less than 1% of total central bank reserves. As central banks are the ultimate seekers of dependable “store of value,” it seems like there is less confidence among the world’s central bankers in the stability of the Chinese political-economy than might be the case of the IMF.

This is now, but what about the future? For the moment, RMB is used primarily to settle trading accounts and even then constitutes only around 1.5% of all international foreign-exchange transactions–less than 0.8% if we exclude RMB entering in and out of Hong Kong which is the route used by currency speculators and those seeking to circumvent the mainland’s capital controls. This puts the popularity of the RMB on par with the Norwegian Kroner. Will there be a dramatic surge in central bank and private sector demand for the RMB as a result of the latter’s inclusion in the SDR basket of currencies?

Reasons to be pessimistic

This still comes back to whether the RMB can emerge as a genuine and trusted “store of value” in the way the greenback, Pound, Euro and Yen are perceived. On this account, we have reasons to be pessimistic that the RMB can realize the potential mapped out for it by the IMF and others.

For a start, foreign governments, firms and individuals will remain reluctant to hold too much RMB denominated assets for the simple reason that there is not much use for the currency outside China (and Hong Kong). This will remain the case until China substantially opens its capital account, abandons the managed peg and allows the RMB to be fully convertible and openly traded with other currencies, liberalizes its domestic interest-rate regime (deposit and lending rates), and removes obstacles currently in place to restrict the presence and operation of foreign firms in Chinese financial and other domestic sectors.

Without an open capital account, foreign holders of RMB denominated assets will not be able to transfer capital in and out of China freely and without restriction. Without a fully convertible and fully traded currency, investors cannot properly price value and risk of the RMB vis-à-vis the state of the Chinese economy at any given time. Without a liberalized interest rate regime, deposit and lending rates in China will remain artificially suppressed and inaccurately reflect the risks accumulating from years of excessive fixed-investment, declining returns and enormous accumulation of troubled loans, even if they remain undeclared for the moment.

Foreigners own less than 3% of bonds in the Chinese market

All these factors will diminish the international incentive to “park” too much capital inside China. Moreover, without being able to invest freely and openly in major domestic sectors of the Chinese economy, there will be limited utility and therefore demand for RMB denominated assets for investment purposes.

Indeed, and due to Beijing’s determination to maintain the dominance of its state-owned banks in the domestic financial sector, corporate bond markets will remain relatively undeveloped, meaning that RMB fixed income options will remain shallow and relatively illiquid compared to assets in the other major currencies.

As it stands, foreigners own less than 3% of bonds in the Chinese market and external demand for Chinese bonds are anemic, even as the domestic bond market is growing rapidly and yields are above 3%. Even if bond yields increase further to adequately reflect the high risk in the Chinese economy, public and private investors will remain reluctant to park money in a political-economy that has a heavily restricted capital account, has a currency that is not freely convertible, and a system still defined by rule-of Party rather than rule-of-law.

More about prestige than power

In short, China’s state-dominated and Communist Party controlled political-economy still belongs in the past and remains ill-suited to underpin a future of Chinese financial leadership, much less dominance. And this does not look like changing anytime soon despite the 13th Five Year Plan talking a similar language of liberalization as the previous two Plans. Until there are lasting and credible reforms to the Chinese political-economy, the role of the RMB in global financial markets will be far smaller than it could be, given the size of the Chinese economy.

This means that RMB inclusion is more about offering China prestige, and perhaps encouraging reformers inside its system, than recognition of the RMB’s power.

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