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Economy

George Magnus: Can the redback ever replace the greenback?

The significance of the yuan in global finance is increasing steadily, reflecting China's status in the world economy and financial policy initiatives by Beijing. The notion, though, that the yuan could become a major reserve currency, even displacing the U.S. dollar one day, is far-fetched.

    The spotlight on the yuan has increased in light of three developments.

     First came the major blow to the U.S. economy and its prestige in the wake of the global financial crisis, when China's response was swift and robust.

     Second, China started a few years ago to permit offshore trading in the yuan in the so-called CNH market, where the currency can be traded against the dollar. The onshore CNY market was also liberalized, albeit to a much more limited extent, with the CNY/dollar exchange rate remaining under the control of the Chinese central bank.

     Third, an increasingly strident view has emerged from Beijing that the global financial system, based around the primacy of the dollar, needs to be changed.

"Yuan zone" ambitions

Justin Yifu Lin, a former chief economist at the World Bank who is now a professor at Peking University and an adviser to the Chinese government, is among the many senior officials to have articulated China's concerns about the U.S. currency. Earlier this year, he said the "dominance of the greenback" was the root cause of global economic and financial crises and that the solution was to replace the dollar with a "global currency."

     Increasingly, it looks as though China's designs for the yuan are being shaped by foreign policy rather than macroeconomics. In a nutshell, the country wants to create a yuan zone in Asia, together with a larger yuan segment in global finance. The principal instruments include the internationalization of the yuan in currency trading; the settlement and denomination of trade and capital transactions; and backing for a new financial architecture.

     This is intended to comprise the New Development Bank, proposed by Brazil, Russia, India, China and South Africa, and the Asian Infrastructure Investment Bank, proposed and heavily capitalized by Beijing. In addition, national development banks, such as the China Development Bank, will be required to support China's planned Silk Road economic project, which aims to build roads, railways, ports and airports across Central and South Asia to revitalize historic trade routes to Europe. However well-intentioned these global finance initiatives are, they risk fragmenting or Balkanizing the world's financial system.

     The People's Bank of China believes that the evolution of deeper, more liquid and transparent financial markets would contribute to the broader goals of financial and economic reform. The internationalization of the yuan is an important element of this view. According to the Bank for International Settlements' 2013 Triennial Central Bank Survey, the yuan is now the ninth-most traded currency in the world, with average daily turnover rising from next to nothing in 2004 to around $20 billion in 2013. This is still relatively small, but it is likely to grow now that London and Frankfurt have joined Hong Kong, Singapore and Taipei as centers for trading yuan and issuing yuan bonds.

     About a quarter of Chinese trade is settled in yuan. China has created roughly 2 trillion yuan ($325 billion) in bilateral currency swap facilities with about 24 other central banks, and several have agreed to hold yuan in their foreign exchange reserves. Malaysia was the first, but it has been followed by Thailand, South Korea, the Philippines and Nigeria. Japan has agreed to buy yuan-denominated bonds and Australia may soon follow suit.

Connecting to the world

The CNH market now includes a 1 trillion yuan deposit base in Hong Kong that has grown tenfold since 2010, a 500 billion yuan bond market, and some 600 billion yuan in quotas that can be tapped to access onshore bond and other investment product markets and to finance inward foreign direct investment. In a further step to liberalize capital transactions, the long-awaited Shanghai-Hong Kong Stock Connect program finally got underway in November.

     This program allows foreigners significantly greater access to shares trading on the Shanghai Stock Exchange and Chinese residents greater access to Hong Kong equities. The amounts involved are modest, representing barely 5% of the market capitalization of the Shanghai and Hong Kong exchanges, but quotas will probably rise over time. As global index providers increasingly incorporate Chinese domestic stocks, we should expect global investors to allocate more funds to China.

     Internationalization, then, has been fairly rapid and impressive in scope, but the yuan remains a long way from even approximating the dollar as the world's primary reserve currency for three main reasons.

     First, even though China will soon be the biggest global economy and already is the biggest exporting nation, it does not follow that the rest of the world will want to accumulate yuan claims on China as their principal reserve assets. To have a reserve currency, a high degree of internationalization is essential. But you also need things that China will be slow or reluctant to provide: a totally flexible exchange rate, unrestricted inward and outward capital flows, and open, liquid and trusted capital markets that rest on the rule of law.

     Second, to groom a reserve currency, foreigners have to be allowed to acquire yuan claims on China in either of two ways: through a current account deficit, which China does not have and may not have for a long time, or through an open capital account, in which capital flows freely in and out of the country. China will run a current account deficit if and when domestic investment exceeds savings, but it still has excess savings, and its current economic rebalancing is designed to lower investment. So its external surplus is unlikely to disappear soon.

     Third, capital account liberalization is a central goal of the government, but neither the central bank's 2012 timetable envisaging full yuan convertibility by 2015-2017, nor the creation in 2013 of a Shanghai free trade zone -- designed as a pilot for convertibility -- have lived up to expectations. The Stock Connect program is a modest and important step to liberalize capital flows, but like so many others, it is likely to prove incremental, and slow.

At odds with openness

China is, in any event, engaged with key domestic economic management and reform issues, and is reluctant to risk losing control by opening the economy to the influence of global financial flows. Fear of capital flight by residents is ever-present and likely to sustain controls on financial outflows, even if inflows are facilitated. Portfolio investment abroad, for example, is roughly 3% of gross domestic product, compared with almost 50% in the U.S. Inward portfolio investment represents about 4% of GDP in China, compared with 85% in the U.S. These extremes reflect fundamentally different views about capital account openness, legal systems and the role of financial markets.

     Although many people still insist that liberalization, full convertibility and the dominance of the yuan are only a matter of time, the assertion does not sit comfortably with the way China works. For 25 years, the country's management of its monetary and financial systems has been based around a relatively closed and largely controlled economy. It requires stable interest rates, finance markets that are not hostage to foreign arbitrage, a treasured independence to intervene in the economy at will without concern for asset quality in the banking system, and reliance on banks as agents of policy rather than as allocators of capital. None of this is likely to change. From China's perspective, why would it want it to?

George Magnus is an economist, senior independent adviser to UBS and author of "Uprising: Will Emerging Markets Shape or Shake the World Economy?"

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