China could place the currency on a par with global biggies. But it has to wait to be a serious challenger, explain Abheek Barua & Bidisha Ganguly.
Shorn of technicalities and jargon, the Chinese currency yuan’s inclusion in the International Monetary Fund’s Special Drawing Rights (SDR) basket simply means that it is now officially accepted as a global medium of exchange like the US dollar and the euro.
Its inclusion is certainly a pat on the back for China’s establishment but it had been anticipated by the financial markets.
Thus the news did not lead to any wild swings in the markets.
The yuan’s inclusion primarily reflects China’s heft in global trade: it tops the list of exporters and comes second on the list of importers.
Second, it is an important milestone in the Chinese government’s sustained campaign over the past few years to “internationalise” its currency and its more focused effort in 2014 and the current year to get SDR status.
In June 2014 for instance, direct yuan-pound trade was allowed in the Chinese interbank market followed by yuan-euro trades in September.
In November the government allowed a trading link between the Hong Kong and Shanghai stock exchanges, allowing 23.5 billion yuan ($3.7 billion) of daily cross-border transactions.
In a complementary gesture, Hong Kong also removed a yuan conversion limit on its residents.
In September 2015, the Chinese central bank allowed other central banks and sovereign wealth funds to enter its domestic bond market following this up with a 5-billion yuan issue in London.
What difference will the inclusion make to the world of currencies and exchange rates? Some economists see it as a symbolic move with little immediate impact.
A former US Federal Reserve chairman likens it to the gold stars he got in elementary school.
To quote his blog: “The gold star was not valuable itself - you couldn’t deposit it in the bank - but it recognised your good efforts and, maybe, motivated you to work hard on the next assignment. China received the equivalent of a gold star this week.”
We would argue that the SDR inclusion could help accelerate a number of processes that have been in motion for some time.
More export and import transactions could be invoiced in the yuan as more direct bilateral exchange rate quotes become available.
Currently bilateral quotes are predominantly available vis-à-vis the Hong Kong based offshore shadow of the yuan, the CNH. While the CNH does mimic the yuan, the underlying demand-supply dynamics are different.
Fundraising in yuan, particularly through the onshore “Panda” bonds, is likely to grow with the SDR inclusion.
In the past China has been squeamish about letting foreign companies borrow in its domestic markets but has over the last few months been slowly opening the market up to foreigners.
Dim Sum bonds issued in Hong Kong in the CNH have been around for a while and quite popular but tend to be short-term. “Panda” bonds will tap the large household saving pool of mainland China and open a market for long-term bonds.
That said, the yuan has a long way to go before it catches up with the euro and finally the US dollar as a reserve currency.
For one thing, despite its moves to clean up and liberalise its financial system, there are questions about how much progress it has actually made.
Investors or institutions prefer to park their reserves in a currency that is backed by liquid and transparent financial markets.
Markets are wary of sudden policy changes. China needs to do much more on this front.
The credibility of the Chinese government’s promise not to mess around with its financial markets is a critical issue.
There is, for instance, a view that now that China has achieved its objective of inclusion in the coveted SDR basket, it is likely to focus on competitive devaluation to prop up its economy.
No doubt this is a minority view and it is unlikely that the central bank would actively manipulate the currency.
However, this just goes to show that investors are wary of the government and the central bank’s financial policies.
The consensus seems to be that the yuan’s inclusion is a key milestone in a process of transition that China hopes will place its currency on a par with other global heavyweights.
However, it is still a work in progress. China will have to wait awhile to be a serious challenger.
Abheek Barua is chief economist, HDFC Bank. Bidisha Ganguly is principal economist, CII.
