THE YUAN IS NO DOLLAR
By
Not Enough to Be in the
IMF’s SDR Basket
There is a big
difference between being included in the IMF's SDR (Special Drawing Rights)
Currency Basket and being an effective world reserve currency! That the Chinese
Yuan’s inclusion marks a symbolic coming of age for the world's second-largest
economy as Hughes (2015) pointed out - is the kind of prestige with which the
Chinese government is obviously pleased.
Many experts feel that –
either the time was not ripe - or the inclusion was more symbolic than
meaningful with China wanting to show it has a big role in the global financial
market and has become a big grown-up country
The rationale about the
pride is understandable. All along China wants to prove that it’s
Communist System is as good as the capitalistic system in achieving economic
breakthroughs! But, that is not the case, because the capitalist system
is, since the Industrial Revolution, unmatched in terms of creating wealth and
lifting masses out of poverty. Even the Chinese economic “miracle” only
started when China adopted some form of capitalism with the Green Revolution
back in 1970s, yet still almost fully-controlled by the State.
in admitting the Yuan
into the SDR Basket, the IMF placed too much emphasis on China’s share of
global exports in its deliberations. China has been encouraging foreign
traders to accept yuan, but it has been mostly as a way of speculating on yuan
appreciation - rather as a way of reserve accumulation. However, “the figures
on the Yuan’s share in the world’s foreign trade have been overstated. They
were largely based on the Yuan’s share in letter of credit arrangements for
trade and the mainland relies proportionately more on letters of credit than
other countries do.”
Perverse Growth
The cleverly crafted economic numbers that are used to indicate
the Chinese economic growth miracle need to be taken with many grains of salt.
In the high gear speed for catching up with the United States there is a
syndrome whereby the pursuit of greater production volumes at all costs takes
precedence over – not only the returns on investments - but also crucial social
and political issues.
Sooner or later such
growth perverts and the economy runs into a crisis, such as was the case of the
implosion of the Soviet Communist Block, largely because the system was not
based on solid fundamentals and sound policies for a long-run sustainable growth
process. The Chinese economy will also make a landing towards normal
economic growth. The question is how this adjustment will be managed to
avoid a hard landing.
Reserve currency status
is achieved naturally when the social, political, financial, economic and
geopolitical conditions are ripe – not through hard statecraft and promotion.
This is to say that there are prerequisites that China has to show to
global money managers - including sovereign fund managers - so they may build a
comfort level convincing enough for them to confidently take refuge into Yuan
reserve assets, once the winds of a financial storm start blowing. At
this point in 2015, that comfort prospect is very slim.
Global Geopolitical
Superpower is the Key Factor
China has already a hard
time in projecting itself as a regional superpower in its neighborhood because
its neighbors such as India, Russia, and Japan are vying to project the same
power! Furthermore, the smaller powers such as Vietnam, South Korea,
Thailand, and Singapore are not pushovers and have developed a mosaic of
geopolitical ties with the United States and Europe to keep China’s ambitions
in check. Without exerting a geopolitical superpower influence globally,
it is hard for the Yuan to compete or dethrone the U.S. Dollar from the
leadership position as the world reserve currency.
China’s political system
is not that appealing to much of the world community either as the latter
aspire to exercise full human rights such as freedom of the press, freedom of
religion, rule of law and justice for all. These basic tenets are not
transpiring well throughout the Chinese political system which is described by
Lawrence and Martin (2013) from the Congressional Research Service (CRS) as the
only Communist Party-led State in the G-20 grouping of major economies and as a
Party that dominates and wholly permeates China’s State and Society. The
Communist Political Establishment is showing no sign of shrinking from its
commitment to “maintain a permanent monopoly on power, and to stay intolerant
of those who question its right to rule (Lawrence and Martin, 2013).”
With such
quasi-political dictatorship, it is not easy for China to shine by example and
for the rest of the world to wholly embrace its values. It becomes even
harder for global money managers to park their money and the funds of their
investors in such a market while waiting for a financial upheaval to wither.
In crisis, it is the safe return of the money – not the return on the
money - that counts the most.
Open Markets
Foreign investors must
be able to get in and get out at will without FX regulatory encumbrances.
But this is not what is happening in China where – not only tight
controls over foreign exchange are in force – but also there does not exist a
fair level playing field for foreign investors vis-à-vis domestic competitors –
mainly State-owned corporations.
According to the U.S.
Bureau of Economic and Business Affairs (2015), in spite of attracting a flood
of foreign direct investment (FDI), that reached a record of $120 billion in
2014, in search of opportunities in its vast domestic market, China maintains
very restrictive controls over foreign investments as compared to its major
trading partners.
The Bureau cited the
United Nations Conference of Trade and Development (UNCTAD) reporting that
broad sectors of the economy remain restricted or prohibited to foreign
investors – mainly in order to “shield inefficient or monopolistic Chinese
enterprises from competition” and relentlessly incubate them into “global
market leaders.”
Even in the sectors
accessed by the foreign investors, rising operational costs, difficulties in
finding qualified human resources, market access limitations, discriminatory
industrial policies, opaque and selectively enforced investment approval
procedures, licensing barriers that favor domestic firms, a lack of effective
administrative and legal recourse along with an overall unclear and
inconsistent enforcement of laws and regulations are cited as significant
challenges to establishing and operating businesses in China (U.S. Bureau of
Economic and Business Affairs, 2015).
Capital Flight
Given the above
challenges, and as it could be predicted, the Yuan-inclusion into the SDR
triggered international arbitrage and speculation and the "Yuan came under
heavy depreciation pressure amid massive private capital flight that pulled
away the disguise of a market-led exchange rate – raising doubts about its
credibility as a global currency.”
The inclusion increased
capital outflows that have been indeed observed on a large scale – meaning that
money has actually been fleeing China. According to Hewitt (2015), the
number of foreign and Chinese investors shifting assets out of China is growing
and capital flight out of the country trends at an escalating pace.
It is estimated that in
2015 alone, “more than $600 billion of assets have been moved from Chinese
Yuans into foreign currency” and in “August and September, the pace quickened
to more than $100 billion in each month” (Hewitt, 2015) – mostly heading to tax
heavens such as Cayman and Virgin Islands.
Some economists are
advancing economic and financial reasons to explain such an intensified capital
exodus out of China such as “the recent spectacular boom and bust on China’s
stock markets, which fell some 30 percent during the summer of 2015, and the
alarm over the government’s August 2015-decision to suddenly devalue the
Chinese currency along with slowing exports and economic growth” (Hewitt,
2015). But other experts sense deeper underlying political conditions
and legitimately question the extent to which the Chinese Communist Political
Establishment could possibly maintain its iron grip over China’s economy and
finances before a crisis situation arises.
Economic Growth Model
Questioned
Ganziro and Vambery
(2016) contended that if it can be boldly assumed that China’s impressive
economic growth will be sustained in long run, then, there are compelling
arguments that China could be the next economic superpower – but not global
geopolitical superpower! However, to maintain this level of growth even
in the foreseeable future is an uncertain suggestion.
Among the chief
impending challenges to the sustainability of the Chinese economic growth
miracle is the very soul of this growth; that is, heavy dependence on
export-led growth articulated upon external demand, because of China’s
financial repression and restrained domestic demand from its middle-income
class.
This mercantilist
strategy has already upset its major trading partners – led by the United States
and Europe and their protectionist resistance will be stiffening if China
doesn’t change the course as its policies are being blamed – rightly or not -
for worsening global imbalances and causing severe economic disruptions to its
trading partners due to its sheer economic size. You can’t expect to get rich
on the backs of others for so long!
Technology Is Changing the
Manufacturing at an Accelerating Pace
Technology keeps
changing the economic paradigm. That is an empirical fact and China is not
be spared from storming technological changes in spite of its
government-sponsored technological hacking. In his article “The End of
Chinese Manufacturing and Rebirth of U.S. Industry”, Wadhwa (2015) rightly
opined that “the real threat to China’s economy is bigger and longer term: its
manufacturing bubble.”
Wadhwa contended that
the policies - such as “subsidies, cheap labor, and lax regulations and rigging
its currency” - at the substratum of the export-led strategy to produce cheap
products will not be enough to seduce transnationals – especially American
multinational corporations to relocate some of their manufacturing in China.
Technologies such as
“robotics, artificial intelligence (AI), 3D printing, and nanotechnology”
continue to change the manufacturing landscape into sceneries never seen
before. This is happening on large scale and it is reducing the costs of
production – making US manufactured goods accessible and affordable to the
end-users.
Sooner or later the low
cost competitive advantage of China is bound to diminish because the robots or
3-D Printing will make manufactured products on “small-scale production of
previously labor-intensive crafts and goods” less costly than human labor. In
other words, it will be less expensive to produce things here in the US than in
China as the United States continues to be at the forefront of technological
advancement.
When it comes to reserve
currency status, financial and trade openness are not negotiable. They
must take firm roots in its economy, if China wants its currency to be one of
the leading reserve currencies on the level with the US dollar. But as we
speak, the current accounts are not freely open and they are claimed to be in
big surplus. If this is the case, how is the rest of the world going to
get Yuan assets for reserve accumulation purposes and for global payment
settlements without China's current account deficits?
If China decides to meet
the above prerequisite and create the required level of current account
deficits and incur subsequent external debt like the United States does, its
exportled growth strategy, which is mainly geared towards trade surpluses and
towards accumulating foreign exchange reserves in the mix, will be turned on
its head and the Yuan will have to appreciate. Such prospects towards
China becoming the leading provider of liquidity to the global economy will
necessarily turn its international investment position into a net debtor nation
in no time.
Additionally, the
Triffin Paradox will kick-in and it will unfailingly lead to deficits in terms
of global confidence in the Yuan as deficits and debts will be continuously
created to provide Yuan-denominated liquid assets to the ever-growing global
economy.
Tough macroeconomic
adjustments will be necessary towards domestic demand rather than towards
betting on increasing global demand for Chinese products. Such
adjustments will necessarily lead to transitory unemployment and a host of
economic malaises - a potential cocktail for social unrests that the Chinese
political establishment will unlikely be willing to swallow.
SDR Cannot Be a Reserve
Currency
To put in the right
context, the Renminbi’s inclusion in the IMF’s SDR basket of currencies means
joining an IMF's construct of a unit of account which works only between the
central banks of its country-members, not on global financial markets. It was
originally designed to serve as a rescue fund for deserving developing
countries with imbalance international payments. Unless the SDR is
promoted to acquire reserve currency status, the Yuan will stay confined in the
SDR basket.
Recently, China and the World Bank are becoming proactive in
pushing the Yuan to challenge the US dollar's preeminence as the dominant
global reserve currency. On August 31, 2016, the World Bank issued
US$700 million worth of bonds denominated in 500 million Special Drawing Rights
Units. The experiment of SDR-denominated bonds was tried in the
late 1970s and early 1980s and went nowhere. Why this time should be
different? The World Bank believed that China's strong support and
its onshore bond market will guarantee the success of the new
experiment.
The World Bank claimed that the bonds were 2½ times
oversubscribed, but most of the buyers are the big State-Owned Banks which were
probably instructed to buy them. Obviously, market traders rightly
question the real purpose of the SDR Bonds since the SDR has little use in
investment and trade. How will the SDR Bonds be priced and transacted
is another headache - especially since the SDR doesn’t have a yield curve –
suggesting it lacked a benchmark to price the SDR-bonds.
Ganziro and Vambery (2016) in their new book “The Exorbitant
Burden: The Impact of the U.S. Dollar’s Reserve and Global Currency Status on
the U.S. Twin-Deficits” dismiss the contemplation about the SDR becoming a
reserve currency as a near impossibility! This would require the IMF to
become an effective global central bank - but without the backing of any
government financial regulator or a Treasury Department – a predicament that
has been rocking Euroland since it entered into the diabolic crisis loop made
of three crises which keep feeding on each other: the sovereign debt crisis,
the banking crisis and the economic growth crisis.
Furthermore, the IMF
must be able to provide large liquidity in time of a major crisis to the tune
of trillions of US dollars, such as the $24 to $29 trillion the Fed provided
during the Great Recession, to avert a global financial collapse. How
such level of liquidity can be created on short notice in a 188
country-member-organization in which every major decision has to go through
layers of decision-making for approval - is highly questionable. The
Fed's response to the Great Recession didn't even go to the Congress for
approval! It did face tough questions from an angry Congress later when the
financial hurricane has more or less withered away.
Even in the remote
possibility of acting as a reserve currency, the SDR basket will run into a
Currency Multipolarity issue - which Ganziro and Vambery (2016) demonstrated to
be a potentially-risky experiment, as the global currency traders will keep
attacking weak currencies while moving between them in search of global
arbitrage-return opportunities, because of differing domestic interest and
inflation rates and other diverging economic conditions in the issuers of the
currencies in the SDR Basket.
In deeper analysis, any
SDR reserve accumulation into SDR “Reserve Currency” would mean an accumulation
spreading over currencies that make up the SDR basket; that translates into a
transfer of some demand pressures from the US Dollar to the other currencies in
the basket. But the other three currencies – namely British Pound, Euro
and the Japanese Yen – are getting what the markets feel they deserve.
This is to say that any accumulation away from the US dollar will go to
the Yuan – implying that it will force China into corresponding current
accounts deficits.
Is China Ready For This?
The political rhetoric
says yes, but it remains to be seen if the economic reality will walk the
political talk. As Ganziro and Vambery (2016) pointed out, to achieve a
full financial openness required by the reserve currency status – especially
for an emerging economy - without encountering disastrous financial and
macroeconomic instability can be economically very difficult and politically
very risky. This is why countries such Germany back in 1960s and 1970s
and Japan in 1970s are believed to have strongly resisted the mark and the yen
to be elevated to such status – given the costs and loss of export
competitiveness involved.
The authors further
opined (Ganziro and Vambery 2016) that it is not desirable for any country –
including the United States - to have its currency as the dominant reserve
currency precisely because of the inherent exposure to the pressures of global
demand and the vagaries of the international capital movements. This a
terrifying prospect to contemplate for a stilldeveloping Chinese economy.
This begs to ask the
following question: if not the United States then who else can provide the
global liquidity to oil the world’s economic activities? No one in the
foreseeable future. With the world nominal GDP standing at $78 trillion
($107 trillion in PPP in 2014), only the US government debt market is big and
liquid enough to handle such a level of liquidity.
While the geopolitical
power along with the depth and stability of U.S. financial markets as a whole
were part of the original reason why nations gravitated toward the dollar as a
reserve currency - the explosive growth of U.S. government debt has made U.S.
Treasury Bonds – not only the most widely held form of dollar reserves – but
also the largest and most liquid multi-trillion dollar market in the world for
a single financial asset - providing the United States the latitude to pay off
its existing debt by issuing new securities (Zoffer, 2012).
On the global FX
markets, the things will not be easy for the Yuan either. The currencies
presently in the SDR basket gulp up over 90% of FX volumes globally and the US
dollar has an 86% lion share. Where and how the Yuan is going to carve its
niche into the volatile FX global markets so as to have its place under the
basket sun is not clear.
Conclusion
It is then the
conclusion of this paper that the Yuan is bound to become an international
currency through Currency Internationalization, because of its sheer global
trade volume. This is understandable. But becoming an international
reserve currency asset is a different animal altogether, because it involves a
different set of quantitative and especially qualitative factors such as faith
in China’s political and economic system, geopolitical political power, trade
and financial openness.
As a final note, we
should not even be hamstrung into a country-ranking exercise. Economic
growth along with geopolitical superpower is not a zero-sum game. Every country
is unique in its own right and its economic rising to the global marketplace
doesn’t mean a growthtakeaway from its peers or a shrinking of an economic
standing from much more advanced countries.
In fact, as Lee (2009)
argued, one of the reasons why the United States is bound to stay an appealing
dominant global superpower is because its dominance is supported by such
balanced geopolitical power makeup that allows the American economy to gain
stronger position as its partners such as South Korea, India and China rise.
In other words, it is in the best interests of the United States – and of
the world at large - for China to succeed – not to fail!
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