As markets fret about the stability of US President Donald Trump’s dollar, more attention should be focused on why China’s currency is still so unready for prime time.
Has there been a better moment, as Sino-US tensions explode, for the yuan to take its rightful place among the world’s top units of exchange than now?
Faced with the prospect of Trump’s administration restricting Beijing’s access to the reserve currency, Chinese President Xi Jinping’s government is confronting something bigger: its failure to get more investors and businesspeople to use the yuan.
Internationalizing the yuan has been a Communist Party priority for well over a decade. The extent to which the global share of transactions is conducted in a country’s currency has grown in importance since the 2008 global financial crisis.
Since then, officials from Beijing to Moscow to Riyadh have searched for dollar alternatives to reduce financing costs and decouple from US influence.
China, the world’s No. 2 economy and its leading trading nation, is a natural stand-in. And as Washington’s balance sheet erodes and the Federal Reserve becomes a financial fountain, the time has never been riper for China’s currency to step up and at least rival the dollar.
However, the opposite is happening, reminding global punters that 2016 sure seems like a long time ago.
In October of that year, the International Monetary Fund (IMF) invited the yuan into its elite basket of reserve currencies along with the dollar, euro, yen and British pound. It was a milestone for Beijing’s campaign for recognition as an economic power.
In particular, it was a win for Zhou Xiaochuan, the then-People’s Bank of China governor.
From 2002 to 2018, Zhou was perhaps Beijing’s most important change agent. Like his mentor Zhu Rongji, China’s reform-minded premier from 1998 to 2003, Governor Zhou believed in the “Trojan Horse” method of globalizing a rigid financial system.
Premier Zhu did it in 2001 by welcoming the World Trade Organization and its transparency imperatives behind China’s Great Wall. For the PBOC’s Zhou, it was opening Beijing to IMF scrutiny.
Stepping into the IMF’s special drawing rights, or SDR, basket meant accepting global norms of currency management. Staying in the Washington-based lender’s good graces meant adhering to certain levels of openness about foreign exchange reserve holdings and going easy on currency manipulation and capital controls.
It was a big deal, marking the first time the IMF’s basket had pulled a new currency into its orbit since the euro’s 1999 launch.
At the time, Zhou’s team called it “a milestone in the internationalization of the renminbi and is an affirmation of the success of China’s economic development and results of the reform and opening up of the financial sector.”
Nearly four years on, the yuan’s global role in payments and central bank holdings is essentially negligible at roughly 2%. And despite Beijing’s assertive efforts to open equity bourses in Shanghai and Shenzhen and internationalize its bond market, overseas ownership is still paltry.
So what went wrong? China put the cart before the proverbial court. China’s government, meaning officials above the paygrade of PBOC officials, seemed to view the opening up process as the reform, not the other way around.
Instilling trust in a currency means upgrading the micro-economy, increasing efficiency, cutting red tape, rooting out graft, accepting a truly free-floating exchange rate and allowing for full currency convertibility.
Chinese regulators made the same presumption in 2017 when indexing giant Morgan Stanley Capital Index, or MSCI, added mainland shares to its basket. That was another milestone in an era when Beijing was pursuing capital market liberalization.
Yet getting local equity markets ready for global prime time requires doing the painstaking and disruptive work of modernizing the financial system.
And nothing about inclusion in MSCI makes China’s financial system sounder, the government less opaque, local CEOs more shareholder-friendly or the shadow-banking universe any more controllable.
That would have required greater political will than Xi’s team has displayed so far to reduce the scale of the state-owned enterprises towering over the economy. And it doesn’t accelerate the private-sector Big Bang that a succession of governments has promised but not delivered since Premier Zhu’s day.
Nor do China’s efforts to open its $13 trillion onshore bond market to overseas investors do much to tame China’s dueling bubbles in credit and asset prices. Heavy lifting on domestic reforms needs to come before Beijing’s haste to expand its global financial footprint.
Done in the wrong order, putting the cart before the horse, means China is sharing its froth and imbalances with the world, not changing from within.
After all, that has often been the case with Beijing’s flashy “Belt and Road” and Asian Infrastructure Investment Bank initiatives. Global exposure tends to work best when based on solid underpinnings at home. The same is true of Beijing’s currency ambitions.
“The fundamental problem faced by the Chinese leadership,” argues Enea Gjoza of Harvard’s Kennedy School, “is a tradeoff between maintaining control of the domestic economy for the sake of political stability and the financial market openness required to make a currency truly global.”
China, Gjoza notes, “has attempted to pursue both of these goals simultaneously, trying to allow freer flow of capital while also intervening to manage the RMB’s exchange rate.”
The trouble is internationalization does not come without disruption – perhaps more than any control-minded government is willing to withstand. These costs include unpredictable exchange rate fluctuations that hurt giant exporters, many with close ties to government bigwigs.
The Trump era has clearly increased currency volatility for a variety of reasons.
One is the policy chaos emanating from his White House. His threats, dispensed mainly via Twitter, to take action against China, Japan, Europe and others Trump views as manipulating exchange rates to notch trade surpluses has certainly kept markets on edge. So does his constant prodding of the US Federal Reserve to ease monetary policy evermore.
Trump’s White House is now actively mulling reducing China’s access to dollars. This includes an earlier, and now apparently scrapped idea, to hit Hong Kong’s dollar peg as a way to irk and punish Beijing. That is easier said than done, however.
“It’s worth noting that Hong Kong has the autonomy to design its monetary regime, including exchange rate policy,” say analysts at asset management firm Amundi.
Moreover, Hong Kong could simply ask Beijing – holder of some $3 trillion in currency reserves – for some of its US dollars to defend the peg. “Hong Kong and China’s central government are prepared for this,” says economist Raymond Yeung of ANZ Research.
Such reports, says strategist Philip Wee of DBS Bank, are a stark “reminder that US-China tensions are set to heighten again ahead of the G20 Summit in September and the US elections in November.”
As all this unfolds, says economist Chetan Ahya of Morgan Stanley, odds are Beijing will “be more focused on, in the context of geopolitical developments, trying to keep it more stable so that it can be seen as a stored value currency where people are enticed to get into Chinese assets.”
Trump, meanwhile, could be doing just that for China. And Beijing is indeed making important inroads, and stealthily so.
Case in point: China’s charm offensive to get more market participants to use the yuan in trade. Pundits tend to focus on Beijing’s opening of its stock and bond markets. But more attention should be focused on China’s moves to appoint yuan-clearing banks in over two dozen countries.
China is lobbying trading partners to accept yuan for imports heading toward the mainland. The yuan-denominated oil futures scheme Shanghai set up in 2018 to help importers hedge risks is humming along.
Beijing is now lobbying central banks to make yuan a bigger share of foreign exchange reserves. This partly explains why Goldman Sachs sees the yuan rising to 6.70 versus the dollar over the next 12 months, from about 7 to the greenback at present.
As Trump undermines the dollar and bids to limit access to the reserve currency, he is inadvertently buttressing the yuan’s role as a workaround.
Though the yuan’s share of global transactions is still minuscule, Trump’s White House may hasten the yuan’s move toward center stage.
Along with morphing the Fed into his personal ATM machine, Trump’s Twitter pokes at rival currencies have shocked currency traders. So has Trump’s profligacy, pushing Washington’s national debt to $25 trillion and set to bulge to $40 trillion in the decade ahead.
Hints from Peter Navarro and other Trump advisors that the “phase one” trade deal with China might be scrapped have increased market uncertainty. Another terrible idea Trump surrogates have circulated in the media: canceling parts of the $1 trillion-plus debt the US owes China.
It’s a pattern of behavior that does Washington’s credibility no favors.
“It appears this administration is ever so confused as the president says one thing and [his] trade adviser says another,” notes economist Peter Cardillo of wealth manager Spartan Capital. “These types of uncertainties could lead to another round of unsettled markets in spite of the Fed’s printing presses working at full speed.”
They could also make Xi’s case that the yuan’s time has come.
Deutsche Bank’s Trade-Weighted Dollar Index — a barometer that compares Washington’s top trading partners — is now plotting nine-year lows. As the dollar’s reign over the last decade grows shaky, Xi’s team is wisely setting up efforts to raise the yuan’s profile.
The fear of US sanctions on Communist Party officials is upping the urgency, says Yu Yongding, a former PBOC adviser, who fears fallout from a move by Washington to “freeze China financial assets one day.”
In a July 15 editorial, Chinese state mouthpiece Xinhua warned that “if the United States side adopts drastic financial sanctions, it will undermine the stability of the United States dollar system and the stability of the United States dollar.” The fallout, Xinhua warned, “will also seriously harm Wall Street and the interests of US multinationals in the Chinese market.”
China Inc, meanwhile, has about $1.1 trillion of state-owned bank liabilities and nearly $1 trillion worth of offshore bonds and loans. Losing access to the dollar is simply not an option for mainland lenders and companies. Getting out from under that risk is a job that Xi’s economic team must get done as soon as possible.
One priority is dismantling capital controls, particularly those implemented in 2015 amid a chaotic currency devaluation and cascading stock markets. Strict regulations on transferring yuan across borders also need to go.
Doing so, however, could destabilize outflows considerably. As such, it will require a level of political courage Xi’s government has yet to display. Such reforms are fraught in the best of times, never mind amid today’s numerous geopolitical storms.
“So far the Chinese government has been fairly restrained in their substantive responses to US actions,” says Bill Bishop, editor of the widely read Sinocism China Newsletter. However, he wonders if that could change after Chinese officials gather for an annual summer summit in mid-August.
It would be a mistake to rule out the euro as a dollar alternative. Yet over the past two decades, eurozone economies have ricocheted from debt crisis to crisis. Meanwhile, the failure to create a fiscal union to complement the monetary alliance leaves the currency susceptible to further upheaval from Covid-19 — or a wave of populism coursing through the Continent.
This uncertainty, too, plays into Beijing’s hands. Trump’s bluster is forcing China to act faster to raise the yuan’s global game. There is no time like the present to return to then-PBOC leader Zhou’s 2016 drawing board to internationalize the yuan once and for all. That means ensuring the proverbial horse is in front of the cart.
What better way to keep China’s yuan ambitions from ultimately getting trumped?