Sometimes the mountain peak is
clearer from the valley than from the summit.
It may be easier to understand the changes in China’s currency regime if
we take a step away and try to look at the big picture. To find our path we need to clear away some
undergrowth that is distracting us from rigorous analysis.
With China’s economy slowing and
exports weak, a devaluation could be a way to restore economic vigor. Many accounts in the western financial press
tried placing the depreciation of the yuan in this context, but it is
mistaken.
Consider Japan’s experience. The dollar has appreciated by more than 50%
against the yen over the last three years.
What has happened to the volume of Japanese exports? Very little. The same can be
said for Canadian and Australian exports, for example, who have
experienced significant currency declines without a corresponding rise in
exports.
China is gradually climbing the
value-added chain in manufacturing, but yuan-incurred costs remain modest compared
with other large economies. That means
that China’s exports will likely be considerably less sensitive the yuan’s
fluctuations than Japan. The 3%-4%
depreciation of the yuan is unlikely to have a tangible
impact on China’s exports.
Owing to China’s previous
export-oriented development strategy, the frequent reliance on state action,
and a heavily managed currency, many observers conclude mercantilism is the
driver. This
is exactly backwards. China’s
currency machinations are designed to increase the internationalization of the
yuan. Specifically, China’s actions are
understandable only within the context of its push to join the IMF’s Special
Drawing Rights (SDR).
There are two formal requirements
for joining the SDR: being a larger
exporter and having a currency that is freely accessible. The former has not been an issue for
years. China is the world’s largest exporter. It is the accessibility of the yuan that has
been the stumbling block. However, over
the past few years, China has improved the accessibility
of the yuan.
There have been numerous
measures, including more than two dozen swap lines with foreign central banks,
the development of offshore yuan trading centers, the Hong Kong-Shanghai link,
and the abolition of quotas for foreign central banks and sovereign wealth
funds investing in mainland bonds. This is not meant to be an exhaustive list, but
simply cited to give a sense of the
sustained campaign that China has undertaken.
In addition to these formal
objectives, there are some operational requirements. The SDR is
fixed every day. The
participating central banks give the fix of their currency to the IMF. The fix needs to be a market price. Before
August 11, the fix was not a market price
and had a seemingly little relationship
with the spot market. The PBOC’s
measures were aimed at closing the gap
between spot and the fix.
However, closing the gap between
the fix and the spot market created
another operational challenge. The
offshore yuan diverged with the onshore yuan.
This is a barrier to SDR entry
because the gap between the two meant that the offshore yuan was not an
effective hedging tool. It is important
that if central banks are to hold yuan-denominated bonds, they need a deep hedging market.
With official indications suggesting a high probability of the yuan
joining the SDR, two questions arise.
The first is operational. The
currencies in the SDR are assigned a weight based on its trade and reserve
status. Given China’s export prowess, it
suggests the yuan should be a major
currency in the SDR. However, as a
reserve asset, it is very small. The IMF estimates the yuan’s share of
reserves at a minuscule 1.1%. Entry into the SDR is a sufficient victory for China that if it is
assigned a low weight now, that would be acceptable. The SDR currency weightings are reviewed every five years, and continued
evolution of the yuan may see it get increased weight in the future.
The second question that arises
if we assume the yuan’s entry into the SDR is so what? What does it mean? The direct and indirect economic consequences
are minor at best. On the margins, it
may encourage some central banks to have yuan in reserves but officials move at
glacial speeds. With low interest rates, a currency that is not simply appreciating as it
did for several years, and liquidity issues, maybe this is the not the best
time for foreign central banks to shift reserves into yuan, even if it is
easier.
Being a member of the SDR has not
fostered strong use of the yen or sterling
as a reserve currency. The Australian
and Canadian dollars have achieved reserve
currency status without being part of the SDR. The US dollar has the largest weight in the
SDR, and yet the US pays a premium over nearly every eurozone country and
Japan. The “exorbitant privilege” that
is often attributed to reserve currency may be
exaggerated.
If that is true, it begs another question: Why should joining the
SDR be such an important goal for China? It seems an issue of status and prestige
mostly. This is not a judgment. It is a description. It seems clear that there may be a tendency in
China to feel mistreated at the hands of the US (and other high income
countries) and has not gotten the respect it believes it deserves. It has been blocked, for example, of getting a higher voting share at the IMF because the US
Congress has failed to authorize funding.
The TPP agreement appears to be written
in such a way that it may preclude China for many years.
Joining the SDR is a sign of
recognition of the incredible progress China achieved in opening up its
markets, and internationalizing the use of the yuan. The international goal as helped focus
China’s financial reform efforts, in a similar way that joining the World Trade
Organization in 2001 facilitated earlier reforms. It is an unequivocal acknowledgement that
China is among the great financial powers.
China and the Pull of the SDR
Reviewed by Marc Chandler
on
November 02, 2015
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