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Is the Chinese yuan already the world’s No 3 currency after the US dollar and Japanese yen?
It would be easier to dismiss this assertion by Renmin University of China’s International Monetary Institute as fanciful – or pro-Beijing propaganda – if not for two recent overseas reports suggesting a similar trajectory.
Case in point: findings by the Official Monetary and Financial Institutions Forum (OMFIF) think tank that a “stunning” 30% of central banks will be increasing their yuan exposure in the next one to two years, way up from 10% last year.
That survey of 100 officials at central banks, sovereign wealth funds and public pension funds showed that monetary authorities plan to reduce holdings of dollars by 18% and euros by 16%.
In explaining why, the OMFIF highlights a comment by one top central bank official citing “favorable rate differentials and growth prospects” of China’s economy.
This evolving pivot is backed up by research from the Institute of International Finance, global financial services industry trade group. Last week, IIF cited findings that overseas central banks accounted for 60% of foreign inflows into Chinese bonds in the first quarter, up significantly from 33% a year earlier.
“Given the size of China but still limited role of foreigners in local markets, it’s safe to say reserves in yuan and foreign bond holdings more generally will grow,” says IIF economist Sergi Lanau.
So, the yuan rivaling the dollar could be more a matter of when than if. Yet importantly, Lanau adds, “we refrain from working with scenarios where increases are large and fast.” For example, he says, “the US-China relationship may continue to be tense and complex, possibly detracting from appetite for yuan bonds by risk-averse reserve managers.”
In other words, mutually assured destruction for the stable market conditions needed to give Beijing a clear and lasting advantage in the medium-term.
There’s also a longer-term risk at play, notes Cornell University economist Eswar Prasad, author of The Future of Money: How the Digital Revolution Is Transforming Currencies and Finance. Strong growth and a growing trade position aren’t enough.
To internationalize the yuan at the pace President Xi Jinping desires, Prasad argues, Beijing must first free the People’s Bank of China from Communist Party oversight, ensure that the rule of law is applied equally and transparently, and implement a system of checks and balances between government entities.
In its report, OMFIF highlighted concerns raised by survey respondents about regulatory uncertainty and Xi’s often combative “approach to world politics” as factors impeding broader yuan adoption outside Asia.
From last November’s scrapping of Jack Ma’s $37 billion Ant Group initial public offering to this month’s crackdown on Didi Global, many international investors aren’t sure what to make of Xi’s policy direction. Concerns about Beijing’s lack of capital account openness remain a pervasive concern.
Yet the OMFIF report’s conclusion that there’s “broad dissatisfaction with the existing currency system and that this dissatisfaction is growing” will work in China’s favor.
By March 2021, Standard Chartered’s Renminbi Globalization Index had returned to its September 2015 high. Goldman Sachs predicts the yuan will become a top-three currency by 2030.
Over the next five years, Goldman Sacks sees the global share of foreign-exchange reserves in yuan rising to as high as 7%. That fits with Citigroup research that the yuan will be a top-three international payments currency by 2030.
Could it happen sooner?
Though Joe Biden’s White House is still getting up to speed, the Donald Trump era left the US dollar’s credibility in disarray. His trade war, Twitter attacks on exchange rates, threats to weaken the dollar and putting US debt on a path toward $30 trillion left successor Biden with a badly tarnished currency.
Biden’s mere presence in the White House is calming nerves in global markets. Yet with Biden’s team angling to spend trillions more on infrastructure and climate change mitigation, there’s no telling how patient credit ratings companies might be.
This gets at a chicken-and-egg question: is Washington’s AAA rating being saved by the dollar’s reserve status – or does it make credit rating companies reluctant to downgrade the US?
“The US sovereign rating is supported by structural strengths that include the size of the economy, high per capita income and a dynamic business environment,” says analyst Charles Seville at Fitch Ratings.
But, Seville says, it also “benefits from issuing the US dollar, the world’s preeminent reserve currency, and from the associated extraordinary financing flexibility, which has been highlighted once again by developments since March 2020. Fitch considers US debt tolerance to be higher than that of other AAA sovereigns.”
To maintain that deference, Washington must repair Trump-era damage to global trust in the dollar. That begins not just with Treasury Secretary Janet Yellen balancing the need for more fiscal stimulus against the risks of overborrowing. It also means Federal Reserve Chairman Jerome Powell must prove that the most powerful central bank retains autonomy in the post-Trump era.
Though not formally independent, the PBOC has appeared less politically influenced in recent years. That explains why the PBOC’s recent cut in reserve requirements seemed more Governor Yi Gang’s call than President Xi’s.
Says economist Andrew Tilton at Goldman Sachs: “It is a signal, it’s a higher profile message I think, that the authorities are paying attention and alert to the possibility of downside risks” and not necessarily doing Xi’s bidding.
Economist Vishnu Varathan at Mizuho Bank adds: the move “does not detract from PBOC’s prudent monetary stance.”
The Fed’s stance, by contrast, perplexes many as US inflation increases apace. The 5% increase in US inflation in May year on year was the biggest in nearly 13 years. And yet Powell & Co is keeping its foot on the monetary accelerator. Nor is the Powell Fed even hinting at slowing its massive asset purchases.
In China, the challenge is different but no less complex. Whereas Biden needs to regain trust in the US government, Xi has yet to build the level of financial credibility he promised back in 2012. Xi’s pledges to let market forces play a “decisive” role in policymaking remain a work in progress.
Since then, China’s financial system has become less transparent and the international media less free to report on official and corporate shenanigans. Xi is steadily imposing Beijing-like opacity in Hong Kong, risking the laissez-faire ethos for which the city is renowned.
Keeping yuan internationalization on track means getting the cart-end-horse dynamic right. In recent years, Xi’s team has largely pursued a size-matters-most model of building credibility in currency markets. It’s been slower, though, to do the heavy lifting on reforms needed to garner trust organically.
That means removing all currency controls and allowing for full convertibility, building a more credible credit rating system and allowing for the dissemination of news and data germane to becoming a world-class financial destination.
Yuan internationalization, says Hu Xiaolian, chairman of Export-Import Bank of China, is a destination, not just a marketing campaign.
“The internationalization of yuan is based inside China – a natural and long-term process as the Chinese economy deeply participates in the global division of labor and the mutual benefit of international trade and investment,” Hu says.
Liu Yuanchun, vice-president at Renmin University, argues that Beijing must think of strengthening the yuan’s “soft power” in order to increase trust in China as an investment destination.
“The strategic adjustment is not to turn to the capital account, nor make it fully open,” he says. “Instead, it should aim to generate persistent and strong foreign demand for the yuan by enlarging the domestic market and increasing the pricing power of key technologies.”
Clearly, though, future reserve-currency status seems China’s to lose.