In 2016, Chinese President Xi Jinping detailed a decade-long campaign to morph the yuan into a top-tier currency. That year, it scored a spot in the International Monetary Fund’s reserve currency basket alongside the dollar, yen, euro and pound.
Today, we see that the yuan only needed five years to have Japan looking over its shoulder – and put the US on edge.
As 2021 unfolds, surging demand for China’s currency is turning heads everywhere. In London and beyond, options in the yuan are topping those referencing the yen, which has traditionally been Asia’s most liquid unit of exchange. The increase in yuan trading can be seen from New York to Tokyo, too.
“This,” says Wells Fargo strategist Erik Nelson, “could be a significant paradigm shift in FX markets,” with the offshore yuan “pulling more weight in the battle for global currency supremacy.”
This, in other words, is no market quirk. Many of the biggest banks in the currency realm are positioning their trading floors for steady increases in China-related transactions. In London, New York and Singapore, Citigroup and Deutsche Bank are following the lead of HSBC Holdings in adding new staff focused on China-related dealing.
Part of the jump in yuan demand is yield-related. In a world of zero interest rates and negligible bond returns, China is that rarest of things: a top-five economy that is growing, offering a 3.2% yield on 10-year debt. Moreover, it is opening its financial system ever wider to ensure steady inflows.
It also reflects Xi’s success since 2016 in liberalizing his financial system. His strategy to internationalize the yuan includes getting mainland debt added to bond indexes, most recently the FTSE Russell.
Scale is also part of the plan. China is now too big for pension funds around the world to ignore. At US$16 trillion and counting, China’s A+ rated sovereign market is generating the kind of gravitational pull Japan once did.
European punters are finding China, for all its opacity and idiosyncrasies, a welcome respite from the region’s aging populations, sometimes sub-zero yields and political gridlock.
American investors, too. A case in point is Ray Dalio seeing the need for his Bridgewater Associates, with $148 billion under management, to have a “significant portion” of its portfolio in Chinese assets. Foreign funds, in general, added mainland debt at the fastest pace on record in January.
Can the momentum continue?
Xi is certainly determined to increase exponentially the yuan’s use in finance and trade – and there is massive scope for rapid growth.
At present, the yuan accounts for only 2% of central bank reserves globally, compared with about 60% for the US dollar and 21% for the euro. This presents a stark contrast given the size of China’s gross domestic product. China’s $14.7 trillion of output is more than 3.8 times Germany’s. And yet China’s share of global payments is barely 3%.
Morgan Stanley reckons the yuan will account for 5%-10% of foreign exchange reserve assets by 2030.
That range, says bank strategist James Lord, “is not unrealistic in light of the financial market opening in China, the growing cross border capital market integration we see across equities and fixed income and an increasing proportion of China’s cross-border transactions being denominated in RMB. All of this suggests global central banks will need to hold more RMB as part of their reserves.”
Lord’s team makes an important observation: the cumulative $3 trillion of investment portfolio inflows into China that Morgan Stanley expects over the next decade will become more important than foreign direct investment. The bank reckons that annual inflows will range between $200 billion and $300 billion between this year and 2030.
But this trajectory depends on the ability of Xi’s team to keep China on the reform path.
Too much, too soon?
“The dimensions of the Chinese economy and the geopolitical power currently attained by the country definitely enable the internationalization of its currency,” says economist Bruno De Conti at Brazil’s University of Campinas. “Nevertheless, for the RMB to eventually become an important reserve-currency additional steps are needed involving further deregulation of the Chinese financial account.”
This, De Conti notes, “may be contradictory to some objectives of the country’s development model.” What’s vital, he says, is “further development of its capital market. In concrete terms, Chinese assets generally, but more specifically Chinese public bonds, have to become reliable receptacles for the global financial wealth. This requires appropriated policies, but also non-trivial changes in the conventions ruling the world financial community.”
The trade war of the last four years clearly threw those conventions out of whack. Its fallout, though, put Xi’s China ahead of schedule in rivaling the dollar.
Political chaos in the US slammed trust in the dollar. So did a Covid-19 crisis driving US government debt toward $30 trillion.
Here’s the catch. The trade brawl, coupled with the coronavirus, is pushing China onto center stage arguably before its financial system is ready for prime time.
Here is the tricky part
One major hurdle is restrictions on the movement of capital across mainland borders. The bigger problem, though, is how Beijing is putting the cart before the proverbial horse.
As healthy as opening up China’s financial system is, it does not in and of itself represent reform.
That requires the hard work of building international trust in Xi’s willingness to let market forces play a “decisive” role in decision-making, cutting bureaucracy, increasing transparency and efficiency, creating a trusted credit-rating system, curbing corruption, ensuring economic institutions have their priorities straight, allowing for big debt defaults to happen and tolerating full exchange-rate convertibility.
The yuan’s 2016 inclusion in the IMF’s top currency club is an example of the problem. Great headlines aside, the milestone matters little if Xi’s team doesn’t roll up its sleeves to liberalize the capital account faster, accept the tactics of speculators and publish increased amounts of credible data on foreign exchange reserves and credit conditions.
The same goes for the 2017 inclusion of mainland stocks in the MSCI global index. It’s merely the beginning of a multi-year effort to upgrade the financial system.
Beijing must keep pace with galloping demand for mainland shares by strengthening corporate governance, making markets less opaque and CEOs more shareholder-friendly. Xi’s team must accelerate moves to reduce the scale of the state-owned enterprises towering over the economy and rein in the multi-trillion-dollar shadow-banking universe festering with risks.
All these changes require greater political will than Xi’s Communist Party team has displayed so far.
Collateral issues
The broader economy must be ready for any potential side-effects from opening up. Economist Junko Shimizu of Gakushuin University warns, for example, that “the strong prospect of the Chinese yuan’s appreciation also pushed up housing prices in China.”
It also is pushing up the level of foreign involvement in China Inc, raising the stakes if Xi’s team disappoints the globe’s biggest pension funds and institutional investors.
The good news is that Xi is indeed recalibrating growth engines. His “Made in China 2025” vision puts China on the path to dominate industries including aerospace, artificial intelligence, biotechnology, digital currencies, electric vehicles, 5G advancements, renewable energy, robots, semiconductors and creating new herds of tech “unicorns.”
Xi’s Greater Bay Area project, a Silicon Valley East, is equally ambitious. It groups Hong Kong and Macau with Shenzhen and eight other southern Chinese municipalities all destined to become innovative powers all their own: Guangzhou, Zhuhai, Foshan, Huizhou, Dongguan, Zhongshan, Jiangmen and Zhaoqing.
Yet these endeavors require liquid and globally competitive equity bourses on which to list and a trusted currency with which to price deals. China is well on its way to making the yuan a cornerstone of global finance. Ahead of schedule, even.
Potential versus risk
Now, the pressure is on for Xi’s government to ensure reforms keep up with surging demand for the yuan.
A rising currency works two ways. As much as investors are flocking China’s way, Xi’s government is communicating confidence in China’s wherewithal to handle the whims of global investors. To Herbert Poenisch, a former Bank for International Settlements economist, the important thing is that Beijing isn’t worried about a rising yuan crimping exports.
Chinese officials, he says, “want to demonstrate that renminbi investment is a two-way bet, encouraging market participants to hedge their foreign exchange positions.”
At the same time, Poenisch notes, “inflows allowed Chinese financial intermediaries to increase their overseas holdings and lending without affecting foreign exchange reserves or the monetary policy framework.”
Such evolution is vital. It demonstrates the capital account really is opening up. It gives Chinese companies issuing dollar bonds greater latitude to make repayments. Finally, Poenisch says, “a stronger renminbi should help the currency’s internationalization, as holders of renminbi assets will be rewarded.”
And, five years ahead of schedule, to boot. The key, though, is for Xi’s men to stay on the reform path for the next five.
If not, the markets that are now China’s for the taking will turn on Xi’s government – and quick.