What lies ahead for China?
Inclusion of China’s currency – the renminbi – into the special drawing rights (SDR basket by the International Monetary Fund (IMF) is really a recognition of the transition of China from real to financial economy.
So long, China has been a manufacturing giant. Now, China is seeking to get integrated into the global financial community. Normally, Chinese entry into this sphere should have followed after its emergence as a financial power in the global markets. As on date, only 30 per cent of its global trade is denominated in its own currency. But that it got the status well before becoming a part of the free market based global financial system is the power of money-speak. Since money and markets matter, the recognition was readily extended.
IMF considered renmenbi’s inclusion on three broad norms, namely, whether it was a freely usable currency, if the exchange rate was market determined and the extent of its usage.
Renminbi is admittedly not very widely used, particularly in the financial transactions like bond trading and investment; nor is it freely usable currency and convertible and its market value is clearly targeted by the Chinese authorities. Ironically, the day the decision to include renminbi into the SDR basket was taken in Washington, the Chinese authorities intervened in its equity markets heavily to swing a fall into the Shanghai composite index into a hefty gain. That was China’s respect for free market’s operation. If that could happen to equity market, obviously it has been happening in the foreign exchange market as well.
Yet, it was now recognised as part of the SDR basket. This is because China acquired enormous economic power as well as the fact is now indisputable that China is a military power as well. Why is military important for this purpose? If sheer military power was the criterion, Russia would have merited higher respect.
This is because China is a huge military weapons market and the west is looking at its market when the western economies are not particularly very strong or in a position to grow independently. No wonder that Christine Lagarde, managing director, IMF was presiding over the event and France is a major producer of weapons. At $216 billion military spending in 2014, it is a large market and the amount of its military spending is spiking at the fastest clip.
Secondly, of course China’s burgeoning foreign exchange reserve is a huge comfort for meeting disruptions in the global economy. At $3.5 trillion, China’s foreign exchange reserve is the largest in the world and a good part of that is invested in US treasuries and assets. It is putting this into good use as well. China had floated the Asian Infrastructure Bank which is supposed to fund infrastructure projects across Asia and beyond. While the better part of those infrastructure projects should presumably use Chinese resources and companies, some crumbs should fall off table for others as well. Good behaviour should be taken note of. At any rate, now that the Chinese currency has been included into the SDR basket what does it mean for China’s domestic economy and its stabilisation through monetary-fiscal measures? First, there is a misconception that inclusion into the basket will mean that the renminbi automatically becomes what is known as a “reserve currency”. A reserve currency is a depository of value that is other central banks would keep their holdings in the reserve currency. It does not. Because whether central banks keep their assets in renminbi denominated assets will depend on their consideration of the future stability of the currency as well as its capital account status. Thus, for example, although neither Australian nor the Canadian dollar is in the SDR basket, yet close to two per cent of global reserves are kept in these currencies but not so far in Chinese renminbi. Only, Malaysia has been known to have built some reserves of Chinese currency.
That could be because of the perceptions of central bankers about value and convertibility potential of the renminbi so far. As yet, China has not fully opened up its capital account and there are restrictions on in-flow and out-flow of capital. It is hoped that with SDR inclusion, China will further open up capital account and thus make keeping assets in its currency easier.
But then, and secondly, this also places China into what is known as a “trilemma”, that is, facing a somewhat conflicting choice over maintaining exchange rate stability, monetary policy changes for domestic needs and open capital account regime overseen by an independent central bank. These issues assume importance when the Chinese economy is admittedly slowing down. Even today, the reports indicate a contraction in Chinese industrial sector as the PMI measures (which indicate expansion or contraction in manufacturing) are hitting almost three year low.
Take for instance the current situation. China is slowing down and one of its weapons in such a situation would be to fine tune interest rates to encourage domestic growth. However, as you cut interest rate and in an open capital account regime, this could mean foreign exchange volatility. In really difficult situations, this can result in sharp fluctuations in the exchange rate. That can, in turn, influence exports and imports and domestic prices. Of course, interventions are a must to stabilise the situation and often these are conflicting goals for an independent central bank. How far is China’s central bank really independent and how far can the global financial community trust the independence of the central bank. China will have to prove it in the long term. These matter because others have to depend on an independent central bank for future stability of the yuan. It may be noted that the deputy governor of PBoC has reassured global financial markets about the stability in yuan in a press conference after the inclusion of Chinese currency in SDR market.
Maybe, China will have to depend more on fiscal measures for domestic economic stabilisation but then, even fiscal steps have external implications.
Lastly, what will be the implications globally of yuan inclusion in SDR basket. As such, the implications will manifest in the long run and immediately there will hardly much of a difference. Going by the weightage given, the euro as a currency has already suffered most with yuan inclusion. The Japanese yen and British pound have also been related lower in terms of weightage than the newly admitted yuan. The dollar retains its supremacy.
However, in the long run if the yuan gains prestige as a widely trusted currency and emerges as a major reserve currency, the Chinese authorities may be tempted to divest its huge holdings of US treasuries and other assets. That will depress the dollar as a currency. These could lead to many other changes as well. But then, that is a long term affair.