A Silk Road for China’s yuan


  • Business
  • Saturday, 28 Mar 2015

Pace of the currency’s internationalisation seems to be gaining momentum

THE launch of Asian Infrastructure Investment Bank (AIIB), the Silk Road Fund as well as the various speeches by the People’s Bank of China on the yuan currency in the last month or so signal that the pace of yuan internationalisation seems to have gathered momentum.

What are the real benefits and risks of yuan internationalisation? Basically, there are five major reasons why the yuan should be more internationalised.

First, China achieved a US$10 trillion gross domestic product (GDP) status last year, becoming the second largest economy in the world after the United States, if one were to exclude the European Union as one entity.

As one of the largest trading nations in the world, China today accounts for roughly 13% of world GDP, slightly more than 10% of global trade, but turnover in the yuan in global foreign exchange (forex) markets remains still less than the Australian or Canadian dollars and way behind the greenback (roughly 60% of forex turnover), the euro (20%), the pound sterling and the yen.

It seems natural that the currency of a major economy should have roughly the same share in global trading and exchange.

The second reason is that since China is a major importer of commodities and exporter of consumer goods, payments and settlements in the currency of your major supplier is good for currency risk management for both buyers and sellers.

With the growing sophistication of Chinese financial institutions in supporting trade and the creation of a global yuan clearing and settlement system by this year, transaction costs in trading through the yuan could be as cheap and robustly settled as in the dollar or the euro.

Third, since China is already the largest importer of commodities, such as iron and coal, as well as crude oil, increasingly more commodities are likely to be priced in yuan and not necessarily in dollars.

The Chinese would like to pay in yuan and if the sellers feel comfortable investing in yuan because of liquidity and long-term returns, there is no reason why some of the key commodities will not be priced in yuan.

Fourth, yuan internationalisation is good for China as a reform driver. Major reforms in China have historically come from “reverse pressure”, not just from internal needs, but because China becomes more engaged in global affairs and becomes subject to global standards and rules.

The move to join the World Trade Organisation (WTO) in 2001, which required huge internal adjustments and concessions to comply with WTO rules, was initially considered by many within China as a “sellout” but China was a major beneficiary from joining WTO in terms of both trade and investments.

Hence, yuan internationalisation, which will require more capital account liberalisation, internal reforms in interest rate and exchange rate liberalisation, and more liquidity and competitiveness in domestic banking, insurance and capital markets, are seen to be good not only for China, but also for global financial markets.

Fifth, and this is not obvious to many observers, there is an imperative for the yuan to join the international reserve currency group, such as the International Monetary Fund (IMF)’s Special Drawing Rights’ component currencies.

Some people think that China wants this for the prestige, but in reality if China does not join soon, the IMF and the World Bank will not have enough liquidity to deal with the coming global financial crisis.

Global financial assets have risen to roughly US$275 trillion (not counting derivatives), roughly 3½ world GDP, mainly because, as the McKinsey Global Institute recently pointed out, global leverage is growing faster than GDP.

At the same time, the central banks’ balance sheets have ballooned to nearly 8% of total financial assets, mainly because of quantitative easing by the advanced central banks, primarily the US Federal Reserve, European Central Bank and the Bank of Japan.

Because central banks lend against collateral, a lot of the so-called risk-free bonds are tied up in central banks. Liquidity in such sovereign debt has become more volatile, as the large global banks are required to maintain higher capital for them even to market-make in these assets.

As the emerging market debt begins to rise in the face of higher real interest rates, more volatile capital flows and geopolitical risks, it would not be surprising if in the next decade there is another round of financial market spikes, if not outright crash.

Currently, the Bretton Wood twins, the World Bank and the IMF have total balance sheets of US$800bil (or slightly more than 3% of global financial assets).

Since the US and European members, which control the majority shares of the multilateral institutions are unwilling to increase their capital because of fiscal constraints, these safety nets will not have enough money to deal with impending financial crises that require more and more funding to resolve.

China’s Silk Road and Maritime Silk Road strategies, plus the AIIB, BRICS Bank and the Silk Road Fund are all attempts to fulfil the global need for infrastructure spending, improving trade and global liquidity in the event of another shock to the system.

Thus, for the United States to openly lobby against their creation and membership is a little bit like cutting one’s nose to spite one’s face.

Getting yuan totally internationalised is likely to be a long and tortuous road. After all, it took the US dollar 70 years to overtake the pound sterling, emerging as the dominant currency backed by an overwhelming dominant military force after the World War II.

One cannot but reflect that the yen challenged the dollar in the 1990s, only for the euro to overtake it as the number two reserve currency in the last decade. Was it pure coincidence that both economies got into crises because their internal structures were not ready to take the stresses and strains of internationalisation?

In other words, the road to yuan internationalisation will not be smooth as Silk, but it could come sooner and in more different ways than most people think.

Andrew Sheng writes on global issues from Asian perspectives.

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