by Michael Collins, Investment Commentator at Fidelity
Amid all the threats and counter-threats between Russia and the west over recent events in Ukraine was a warning by Kremlin aide Sergei Glazyev that Moscow might orchestrate the end of the US dollar’s role as the world’s foremost reserve currency.
While Glazyev’s threat was risible, he is one of the many to give voice to a likely shift in the international payments system in coming years. This is the mooted decline of the US dollar’s premier reserve status as the yuan becomes a reserve currency, which is one that is widely held by governments and institutions among their foreign-exchange reserves because it is seen as a store of value. At the moment, about 61% of the world’s official forex reserves are held in US dollars, while 24% are held in euros. Other reserve currencies are the UK pound and the yen (each 4% of total reserves), the Australian and Canadian dollars (2% each) and the Swiss franc (0.3%). The currency officially known as the renminbi – the primary unit is the yuan much like the pound is for sterling – barely figures.
China’s significance as the world’s second-largest economy and the biggest global trader and official moves to “internationalise” the use of the yuan – essentially when it is used between non-residents – and to liberalise China’s financial system fan talk that before too long the yuan will become a reserve currency. After all, China is the only one of the world’s six largest economies not to have a currency with such status. So preordained seems the yuan’s ascension that European Central Bank board member Yves Mersch said in February that the yuan might one day “challenge” the US dollar’s prominence as the world’s foremost currency.
Much needs to happen before the banknotes that feature Mao Zedong attain reserve standing, let alone shove aside the US dollar. The yuan is not market determined – the currency is set daily and trades within a daily 2% band – and the government restricts capital flows, two breaches of prerequisites for reserve status. Other missing essentials are deep capital markets and sound political and macroeconomic settings, for investors need to have faith in yuan-denominated securities if they are to hold reserves in yuan. Wider use of the yuan and, by definition, the freeing up of capital flows in and out of China, could come with turmoil that retards the currency’s ascension – after all, in the words of Philip Lowe, deputy governor of the Reserve Bank of Australia, “there is no historical precedent for an economy of China’s size and relative stage of development integrating itself into a global financial system”. But events are moving towards the yuan gaining reserve stature as the Chinese are relaxing controls on the currency and capital flows.
If China’s financial liberalisation is extensive enough to promote the yuan to reserve heights, China will benefit in many ways. Reserve status will make global trade and financing cheaper for Chinese businesses. It will create better foundations for China’s macroeconomic management, deliver more diversified portfolios for Chinese and foreign investors and generate better risk-management (hedging) products and markets for investors. Importantly, when judging the motivation of China’s leaders, it will bolster the country’s international political power.
The title of being the world’s foremost reserve currency is rarely passed on. The last handover was from the UK pound to the US dollar in the decades after World War 1, a shift that only became official in the post-World War II Bretton Woods system. But there is usually room for other currencies to reach reserve status and, by default, diminish the prominence of the incumbents. Now is such a time.
US Congress has done more damage to the US dollar’s reserve allure than Moscow could ever do by, twice in the past three years, taking the country to the brink of default during negotiations to raise the debt ceiling. Investors and officials in other countries were aghast that infighting in Washington put at risk the US$5.8 trillion of US Treasuries they own so they are looking to diversify their holdings into other currencies. (China is the largest US creditor holding US$1.3 trillion of US government bonds, held mainly as foreign-exchange reserves.) The euro’s drawback is that no one can guarantee such a structurally flawed currency will survive.
Even before the debt showdowns in the US, the Chinese were undermining the US dollar’s reserve role. Chinese officials were panicked when, during the credit crunch of 2008, Chinese companies struggled to borrow scarce US dollars. The People’s Bank of China was forced to make the yuan available through currency swaps with other central banks, agreements that now number about 20 (including one with the RBA). Soon after that trauma, Zhou Xiaochuan, the head of the central People’s Bank of China, blamed the US dollar’s dominance as a reserve currency as the root cause of the global imbalance that triggered the crisis because it led to perennial US current-account deficits. Thus Xiaochuan in March 2009 called for the use of IMF special drawing rights, which are based on the value of the US dollar, euro, UK pound and yen, as a global reserve currency as a way to diminish the unsettling role of the greenback.
Even if Xiaochuan’s speech was of little help, the yuan in recent years has advanced its ability to achieve reserve status. The first step in this process was for the yuan to become widely used in trading and investment. The country’s export prowess has led to the yuan’s elevation to a trading currency while the government is helping it accomplish a bigger role in investing.
The yuan’s use in commerce is spreading because Chinese companies offer discounts when trading is settled in their currency. Accordingly, the yuan in 2013 overtook the euro as the world’s second-most used currency in traditional trade finance. The Belgium-based Society for Worldwide Interbank Financial Telecommunication said the yuan had an 8.7% share of letters of credit and collections in October of that year, compared with 6.6% for the euro. While well short of the US dollar’s 81% share, the yuan’s share had jumped from 1.9% only 20 months earlier – and zero if you go back to 2009 when the first trade was settled in yuan over the Hong Kong border. HSBC estimates that about 25% of China’s trade is now settled in yuan and this portion could reach one third by next year.
China’s trade performance promotes the yuan’s use in investment and the government is doing its best to capitalise on this trend by nurturing China’s financial markets. Among other steps, officials have relaxed controls on foreign institutional investors buying Chinese securities, eased restrictions on interest rates and the exchange rate, allowed capital to flow freely into and out of the just-launched Shanghai Free Trade Zone and are trying to develop China’s money and bond markets. The latter is meeting with some success. International companies are happy to sell bonds denominated in yuan for their China-related financing and risk-management needs. Global investors are keen buyers because these securities offer attractive yields and the yuan has been viewed as a currency that only rises – which it did until recently, anyway. HSBC estimates that the amount of bonds denominated in yuan sold outside China has doubled each year since 2008 and the pool of such assets, which includes deposits, bonds and bank certificates of deposits, now totals 1.8 trillion yuan (A$315 billion).
Another promising sign of the yuan’s wider use in investing is that there are now four “offshore” yuan trading centres; namely Hong Kong, London, Singapore (the largest) and Taiwan – and Sydney could be one soon. An official yuan “trading centre” gives Chinese and other businesses the ability to convert yuan directly into other currencies via an official clearing house rather than pay the higher transaction costs of swapping into US dollars as an intermediate step. Less encouraging signs are that the ability to hedge the exchange rate risk of the yuan is still limited as such markets are underdeveloped and that the market for yuan-denominated equities sold outside China is still a fledging one.
The Brookings Institute of the US names five factors that determine the speed with which a currency attains reserve status. The first is the size of its economy and China’s easily passes on this score. China is making progress on opening its capital account, adopting a flexible exchange rate and deepening its capital markets, key determinants two, three and four. It’s the fifth factor that could prove problematic even though China’s has met this hurdle in recent years. This is that investors must be confident that authorities will achieve sound macroeconomic outcomes such as tame inflation, steady growth and sustainable debt levels before they will invest in a country’s financial assets (and thereby demand the currency). China’s wobbly financial system could undermine confidence in China’s economy in coming years.
A more long-term challenge for investors is that China’s political risks are bigger and different from those emanating from the liberal western democracies that boast the other reserve currencies. Financial markets depend on the rule of law for their smooth operation. China’s government is one-party dictatorship so, by definition, rule of law is absent, as is proper corporate governance. It will be harder for Beijing to convince investors that the People’s Bank of China is an “independent” central bank in the way they perceive the Federal Reserve and RBA to be. These flaws could give other governments and official bodies pause before investing too much in yuan-denominated reserves.
It is unlikely that the US dollar will soon give way to the yuan as the world’s foremost reserve currency. Chinese policymakers will be careful to make sure liberalising interest rates, the capital account and the exchange rate don’t get ahead of domestic conditions – the removal, say, of ceilings on interest rates would disrupt China’s state companies and banks that are a large part of the economy. Who knows when the yuan will be market set, when capital flows will be fully convertible or when Chinese government and corporate bonds will be readily available and easily traded. But at the very least, policymakers and investors everywhere should prepare for a world where the yuan will play a mightier role.
Financial information comes from Bloomberg unless stated otherwise.