China’s Ambitious Plan to Make the Yuan the World’s Go-To Currency

By Robin Ganguly and Cedric Sam Sept 28, 2016

China’s long-held desire to provide an alternative to the U.S. dollar will get a boost on October 1, when the yuan enters the International Monetary Fund’s basket of reserve currencies, placing it alongside the pound, euro, yen and dollar. The yuan’s ascent
is a validation of the importance of the world’s second-biggest economy and the work policy makers have done to allow freer access to the nation’s markets.

China’s currency hasn’t kept up with its global ambitions

Still, there’s a long way to go. While China’s the biggest trading nation, the yuan is barely used in world markets. Even in U.S.-China trade, just 2.4 percent of all payments by value were conducted in yuan.

Comparison of international trade and currency use

Sources: IMF and SWIFT

The yuan’s elevation could bring billions in investments

The yuan’s inclusion in the Special Drawing Rights (SDR) basket will prompt central banks and fund managers to buy more Chinese assets, with estimates of as much as $1 trillion of inflows in a five-year period. China needs the cash, with its economy growing at the slowest pace in more than two decades.

Among the main beneficiaries will be the onshore bond market, which foreign investors have been flocking to since the government accelerated the lowering of barriers in February 2016. Global funds boosted their holdings of Chinese government debt by the most in two years in June, while the benchmark yield touched a record low in August.

Global sovereign bond market projections

Sources: BIS, Oxford Economics, Credit Suisse estimates

Then there’s the issue of interest rates: with SDR entry, Chinese sovereign bond yields will decline further, lowering the government’s borrowing costs. The yield on 10-year Treasuries is now less than 1.7 percent, compared with more than 2.7 percent for Chinese sovereign debt.

Ten-year bond yields


Sources: ChinaBond, Bloomberg

The world will only play along if China leaves the yuan alone

One of the basic definitions of a reserve currency is that it must be freely traded. And the yuan is not quite there yet. The People’s Bank of China is often suspected of intervening in the market to nudge its exchange rate one way or the other. The central bank also limits onshore daily moves to 2 percent on either side of a fixing that it sets. Then there are capital controls, which restrict the ability to move money out of the country.
 
Despite this, people have found ways to move money out to escape yuan depreciation pressures and a volatile stock market. An estimated $1 trillion has flowed out of China since September 2015.

Estimated China capital flows


The Federal Reserve Bank of Dallas suggested in July that the yuan failed a safe-haven test, finding that China’s currency underperforms as market volatility increases.

SDR inclusion is likely to prompt the Chinese government to push ahead with reforms to its exchange-rate policy, as part of its efforts to bolster international usage of the currency. But challenging the dollar’s hegemony will take more than a while, with the memory of the shock August 2015 devaluation relatively fresh in investor minds. The greenback has maintained its dominance since the mid-20th century, fighting off competition from the yen and the euro.

After the IMF in 2010 rejected China’s request to include the yuan in the SDR basket, the nation took several steps to support its claim. It made the yuan’s fixing more market-based, allowed greater access to its bond market and closed the gap between the currency’s rates at home and abroad. In November last year, the IMF deemed that the yuan was freely tradable enough to become a global reserve currency.

In the long run, a stronger yuan could be a much-needed fix for the global economy as it would increase the purchasing power of China, the biggest consumer of commodities in the world.    source

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