The Yuan Under the Spotlight

By Zhou Xiaoyan

The central parity rate of Chinas currency weakened to 6.8796 against the U.S. dollar on November 18， an eight-year low， according to data from the China Foreign Exchange Trade System （CFETS）， triggering market worries that the currency could be about to tumble.

Eswar Prasad， a professor of economics at Cornell University， a senior fellow at the Brookings Institution and former head of the IMFs China Division， told Beijing Review that the main reason behind the recent yuan depreciation against the dollar is because of the dollars strengthening on anticipations of a possible interest rate hike in December. Prasad made the remarks at the launch of his new book， Gaining Currency： The Rise of the Renminbi， organized by the BrookingsTsinghua Center for Public Policy in Beijing on November 3.

“The Peoples Bank of China （PBOC） has said that it is managing the yuans value against a basket of currencies rather than the U.S. dollar， ... [which] certainly appreciated against a basket of currencies in the last few weeks，” he said.

Chances are that the dollar may appreciate even more if the U.S. Federal Reserve moves forward with the rate hike and the European Central Bank and central bank of Japan concurrently loosen monetary policy， projected Prasad.

So far theres been no big panic in terms of capital outflow. The PBOC， therefore， may feel quite comfortable letting the currencys value dip down a little more relative to the dollar. But what happens to the dollar next has become very important， he said.

Experts including Prasad have reached a consensus that the RMB will be a more important international currency in the next three to five years. The yuan becoming a global currency， however， will bring risks along with benefits.

Ups and downs

Zhang Liqun， a senior researcher with the Development Research Center of the State Council， told Beijing Review that the yuan-U.S. dollar exchange rate is mainly determined by changes in the two nations monetary policies.

The current depreciation is related to the yuans overvaluation more than a year ago， when the monetary policy of the United States was still loose， while that of China was more prudent， he said.

Now， the situation has turned around. Chinas monetary policy is leaning toward being looser， amid mounting downward pressure， while the United States is gradually ending its quantitative easing and is seeking to raise interest rates. Thus， a readjustment of the RMB-dollar exchange rate is inevitable， Zhang said. “But there wont be much space for the readjustment.”

The impact of U.S. interest rate hikes usually plays out before the actual increases. In combination with big uncertainties over the dollars future value amid U.S. economic uncertainties， the yuan will keep moving against the dollar in both directions， Zhang claimed.

He said Chinas healthy economic fundamentals， improving economic data and the yuans inclusion in the IMFs special drawing rights （SDR） currency basket underpin the yuans long-term stability.

According to CFETS data， the yuan strengthened by 0.16 percent against a basket of currencies in October despite weakening against the U.S. dollar.

The yuan exchange rate composite index， which measures the yuans strength relative to a basket of 13 currencies， including the U.S. dollar， euro and Japanese yen， came in at 94.22 at the end of October， up from 94.07 a month earlier， CFETS said in a statement.

The yuan exchange rate composite index was first released in December 2015 to more comprehensively reflect exchange rate changes. Previously， analysts mainly fixated on the yuan-U.S. dollar rate.

The figures show that the yuan is basically stable against a basket of currencies， though expectations for an interest rate hike in the United States and fears over Britains European Union exit have led to a stronger dollar， the CFETS said in an online statement.

According to Ben Shenglin， a professor of banking and finance at Zhejiang University， people have focused too much attention on the RMB-dollar exchange rate while Chinas foreign exchange system has already started using an RMB exchange rate index， which involves over 10 currencies.

Ben said in terms of Chinas trade with and investment in other nations， what matters is not only the exchange rate against the U.S. dollar， but also the many other relevant currency exchange rates.

Growing influence

The renminbi rose to become the fifth most used global payment currency in September， with a market share of 2.03 percent， said global payment services organization SWIFT on October 27. Over 100 economies used RMB as a payment currency in transactions with the Chinese mainland and Hong Kong.

Yuan payments increased in value by 10.02 percent from August to September. At a global level， payments in all currencies increased in value by a mere 0.93 percent during the same period， SWIFT data showed.

According to a report on yuan internationalization released by the PBOC， a better infrastructural system was established in 2015 for yuan internationalization： crossborder use of the yuan under Chinas current account was expanded； cross-border investment and financing channels were broadened； and steady progress was made in bilateral currency swaps.

In that year， cross-border yuan payments totaled 12.1 trillion yuan （$1.8 trillion）， up 21.7 percent from 2014， according to PBOC data.

“The next three to five years are going to be very exciting years. As an international currency， the RMB will bring even more progress during the period，” Prasad said.

On October 1， the IMF officially appointed the RMB as a major global reserve currency by including it in the Special Drawing Right basket of currencies that make up the funds international reserve assets.

According to IMF standards， the prerequisites for a nations currency to become a reserve currency include large economic size， an open capital account， flexible exchange rates， well-developed financial markets and macroeconomic stability in the country.

Prasad said that although China has yet to meet all the criteria， the RMB is now officially a reserve currency and， according to IMF estimates， around 1.5 percent of global foreign exchange reserves are already held in RMB. “So， the markets are not waiting for what the IMF has to say，” said Prasad.

In addition to being a major currency used in trade settlement， the RMB is going to become a significant reserve currency as well， if China plays its cards right with a more open capital account， exchange rates more determined by markets， and a broad range of economic reforms that stabilize growth， he said.

The yuan could rival smaller reserve currencies like the Japanese yen and even the British pound， accounting for somewhere in the range of 3-5 percent of global reserves， and could possibly surpass the euro as well， he said.

Prasad， however， ruled out the possibility of the yuan becoming a safe haven currency with the potential to dethrone the U.S. dollars dominance in global finance.

Ben agreed， saying that he doesnt foresee the RMB supplanting the dollar anytime soon.

“If theres anything that can strip the dominance of the U.S. dollar， it may be the technology ... that will fundamentally change the way financial transactions are conducted， rather than the RMB，” he said.

Xiang Songzuo， Deputy Director of the International Monetary Institute of Renmin University of China， forecasts the RMB as likely to surpass the yen and the pound within two years to become the third largest currency after the U.S. dollar and the euro.

Zhao Xuqing， a researcher with the Bank of Chinas Institute of International Finance， said the next five years will be a key period for yuan internationalization， and four opportunities should be seized to make the yuan a more prominent currency globally.

“First， the yuans inclusion into the SDR basket has greatly lifted market sentiment， consolidating its role in financial transactions and international reserves. Second， Chinas ongoing financial reforms will underpin yuan internationalization. The countrys economy will maintain mid- to high-speed growth during the 13th Five-Year Plan period （2016-20）， and full convertibility of the yuan is an inevitable trend，” said Zhao in a research note.

“Third， the China-proposed Silk Road Economic Belt and 21st-Century Maritime Silk Road Initiative will be a major platform to boost global use of the yuan. Finally， as the yuan clearing system expands globally， yuan payments and yuan-related banking business will increase unremittingly，” Zhao said.

Controversy

At the book launch， Prasad urged more bold steps in Chinas reform and opening up， including exchange rates more determined by markets， a more developed capital market and， most importantly， the opening of the capital account.

According to him， although China does not need foreign money， as it has hefty domestic savings， there are indirect， collateral benefits to an open capital account， which allows capital to flow relatively freely across national borders.

“Technology transfers， corporate governance， managerial practices， ... all of these may be even more important than the money itself，” he said， adding that capital account opening could help domestic investors diversify their investment portfolios and， more importantly， generate momentum for Chinas ongoing and sometimes impeded financial reforms.

Ben， by contrast， expressed caution about capital account opening.

According to him， the costs of becoming a global currency need to be considered and weighed against the benefits. He said the advantages include less exposure to exchange rate fluctuations for Chinese companies investing overseas. But， he also warned the costs could be enormous if China fails to lay the necessary groundwork.

“Im absolutely against capital account convertibility—not now， and not in the next five years，” he said.

According to a report by Renmin University of Chinas International Monetary Institute， capital account opening， if implemented， ought to be carried out in a prudent manner.

“Monitoring of capital inflows and outflows should be strengthened， the supervision framework should be readjusted from a national strategic perspective， and the central bank should be given a larger role in guaranteeing financial stability and strengthening financial supervision，” read the report.