x Abu Dhabi, UAESunday 21 January 2018

China takes it slowly over internationalising the yuan

Monetary internationalisation is a fine balancing act that may well leave the country one of the world's leading currencies. But it is not a foregone conclusion.

China has made significant progress in the use of the yuan as a settlement currency.Kevin Lee / Bloomberg News
China has made significant progress in the use of the yuan as a settlement currency.Kevin Lee / Bloomberg News

Recently, HSBC bank released an upbeat survey predicting China's currency, the yuan, will become one of three global settlement currencies alongside the US dollar and eurothis year.

It seems the yuan's internationalisation has been progressing without anyone really noticing. The key remaining questions concern whether or not the yuan will become an important international currency anytime soon, and whether it is poised to pose a serious challenge to the dollar's domination of the international monetary system.

An international currency is used and held beyond the issuing country's borders, and plays the role of unit of account, medium of exchange and store of value for residents and non-residents alike.

Certainly, there are many potential benefits for China to be gained from the Yuan's internationalisation: elimination of exchange-rate risks to which Chinese firms are exposed; greater funding efficiency for Chinese financial institutions, thus strengthening their competitiveness in global financial markets; a boost to China's trade with its neighbours, owing to the reduction in transaction costs; less need for China to hold US dollar assets and risk capital losses on the country's foreign-exchange reserves; and eventual status as one of the world's major reserve currencies, which would provide China more freedom to manoeuvre in domestic and international economic policy.

China's enthusiasm for yuan internationalisation since 2009 partly reflects its frustration with the lack of progress in reforming the international financial architecture. Chinese officials believe yuan internationalisation is a way for China to set its own agenda without being overly constrained by external conditions beyond its control.

Thus far, China has made significant progress in the use of the yuan as a settlement currency, in the issuance of yuan-denominated bonds and in signing currency-swap agreements with foreign central banks. Despite these achievements, however, yuan internationalisation could still easily go awry. Various incentives have been provided to encourage enterprises to use the yuan to settle transactions. But, with an undervalued exchange rate and strong expectations for the yuan to appreciate in the future, foreign importers of Chinese products refuse to use the currency to settle transactions, while foreign exporters are happy to accept it. So far, yuan internationalisation has shown a clear pattern of asymmetry - and not only as a settlement currency for China's imports, but not for exports. Yuan-denominated bonds meet strong demand, yet non-residents have no great incentive to issue them. And, while foreign lenders are happy to extend yuan loans, they are not welcome by foreign borrowers. Given strong expectations of yuan appreciation, internationalisation will inevitably lead to a serious currency mismatch, with possibly detrimental consequences for China's welfare.

A more fundamental problem for internationalising the currency is what it implies for China's capital controls. Although such a move is not tantamount to capital-account liberalisation, the degree of internationalisation is conditional on it. Internationalisation of the yuan has opened a new hole in China's wall of capital controls. When a currency endures a prolonged process of one-way appreciation, speculative capital aimed at exchange-rate arbitrage is bound to seek all chances to flow in. Hot money will increase currency appreciation pressure and complicate macroeconomic management. The profit-taking by speculators at the end of the game will lead to huge welfare losses to the recipient country, in this case China.

Fear of hot money was the main reason China refused to de-peg the yuan from the dollar until July 2005. While China did decide to allow its currency to appreciate gradually after that, it has relied on capital controls to prevent hot money from flowing in. The controls are leaky, to be sure, but they have worked (so far), which is why China has effectively maintained macroeconomic stability over the years.

The key objective of China's capital controls is to prevent non-residents from holding domestic yuan-denominated assets unrelated to trade and long-term capital flows. But yuan internationalisation encourages non-residents to hold more of the currency and yuan-denominated assets. As a result of internationalising the currency, yuan deposits held by Hong Kong residents have reached 370 billion yuan (Dh209.31bn), and the amount may reach 1 trillion yuan by the end of the year.

One might wonder what difference there is between hot money and yuan deposits held by non-residents. The answer depends on why non-residents hold these deposits. The attraction of the currency should come from China's strong economic fundamentals and faith in its economy. If it comes from expectations of currency appreciation, the success of yuan internationalisation can be easily reversed and will cause more problems for China's monetary authority.

Fortunately, the authority has already noticed the subtlety of the distinction between legitimate demand for yuan-denominated assets and hot money. This means the pace of currency internationalisation could become more measured than international investors have expected.

While internationalisation of the yuan is necessary (and inevitable), it should be guided by market principles and pursued in a cautious manner. To get the sequence of policy adjustments right is vital. In any case, the Yuan's path to becoming a truly international currency promises to be a bumpy one.

* Project Syndicate