By Philip Bowring
China, like some other countries, has good reason to want to reduce the dominance of the dollar in international finance. But it is being carried away by dreams of glory for the yuan, dreams fostered by financial institutions anxious to ingratiate themselves with Beijing and promote Hong Kong as an offshore yuan trading center.
HSBC is, perhaps not surprisingly, in the forefront of the push, suggesting that yuan denominated trade could hit $2 trillion by 2012.
The logic of the proposed surge in the use of the yuan in international trade from near zero to as much as half of China's trade within a few years may at first glance sound plausible on the assumption that it is now the world's second largest trading country and third largest economy. It also holds the world's largest foreign exchange reserves and thus in theory may appear to have a very strong currency, which is likely to appreciate over time as China's economic growth outstrips mature economies, making it attractive to foreigners looking for alternative stores of value to the dollar.
However, there is a whole range of reasons why this looks not only improbable but demonstrates contradictory trends in China's policies.
Just on an historical basis such a sudden rise in the internationalization of a currency looks unlikely. The fact that sterling is still the number three traded currency, on a par with the yen, when its economy has slipped far down the rankings is one indication. Another is that though the yen increased in usage in trade and reserve holdings quite rapidly in the 1970s and 1980s, its role has since stalled and is used mostly only in invoicing Japanese exports to southeast Asia, Korea and Taiwan. So even after nearly forty years of full convertibility it has yet to reach the percentage of Japanese trade now forecast for China and the yuan by 2012.
Then there is the case of the euro, a currency underpinned by mature and stable economies headed by Germany, the world's top believer in the merits of a strong currency. The euro's role as a reserve asset has been rising but it is little used in trade transactions outside Europe - other than by a dollar and yen-shunning North Korea.
The next problem for China is the nature of its trade. So much of its exports consist of processing of imported materials and components so the suppliers will need a very good reason to switch from dollars (and Asia is a dollar zone) to yuan. Exports still mostly go to countries in the west ― the U.S. and the Eurozone ― which general expect imports to be priced in their currencies.
Unlike Japan at a similar stage, a large proportion of China's exports are by foreign-invested companies which sell internationally and use the dollar for internal accounting and thus would be reluctant to switch to yuan. That may well change with time as mainland owned companies play a larger role and exports become less important as a percentage of turnover. But that will be a very gradual process.
Trading in yuan with Laos and Myanmar or even Vietnam is not going to take the the currency very far even in a decade. Indeed, the region already has currencies such as the baht and Singapore dollar which are used in some regional trade and in practice accepted for cash payments.
China's expressions of desire to reduce the role of the dollar are anyway contradicted by its actual policy of maintaining a de facto peg to the U.S. currency, meanwhile continuing to accumulate dollars in reserves now totaling $2 trillion. The modest yuan appreciation after 2005 came to a halt more than a year ago as China has sought to sustain exports in the face of the global slump. There is conflict between macro-economic stabilization goals and pressures from industries and employment creation not to put more pressure on exporters. China is still wedded to high growth and a cheap currency.
Nor has there been any significant move towards full convertibility as the financial crisis has, with good reason, made the authorities nervous of liberalization.
Yuan appreciation and convertibility could of course come sooner than expected and might well lead to an outflow of speculative funds and sharp drop in reserves. However, any significant use of yuan requires and significant offshore stock of the currency. That is incompatible with China's expressed desire to reduce its dollar reserve dependence.
Even assuming that China does move to an era of external deficit on current as well as capital account, it will likely take a long time to run down its dollar reserves to more appropriate levels.
Capital outflow and the development of yuan offshore bond markets are certainly likely to some degree. Foreign investor demand is clear enough and yuan equivalents of Samurai bonds are also likely, giving foreign countries access to the domestic bond market. But as Japan has showed, these markets are slow to develop because borrowers naturally shy away from borrowing in currencies seen as likely to appreciate and thus offset any interest rate advantage.
China may well be able to expand yuan use by offering trade credits in its currency but these may have to be at heavily subsidized rates if they are to prove more attractive to long term borrowers in, for example, Indonesia than borrowing dollars or yen in the marketplace.
Currency swap deals with Asian central banks, now formalized by the Chiang Mai Initiative, would only boost yuan usage if they have to be used. That may happen, particularly if dollars get scarce and Asian neighbors run into balance of payments crises, but that is more possibility than probability - and also assumes that swaps with the US Federal Reserve or European Central Bank or IMF support were not available.
Yuan boosters often miss the point about the dollar. It is China even more than Japan and Singapore which has put such misplaced faith in it as a store of value by accumulating massive reserves. For most of the rest of the world the dollar is simply the most readily traded transaction currency. Its exchange rate in three or 10 years time is of no relevance. The sheer volume of dollars has lubricated global trade and only dollar shortages induced by a return to U.S. current account surplus are likely to change that in the foreseeable future.
Internationalizing the yuan may make good headlines but a realistic China also knows that promoting China's role at the IMF and the role of the SDR in the international system is likely to be more significant in terms of its own global influence and as a way of reducing the risks of holding too many dollars.
The other issue which China has to address is trust in its longer term macro-economic and political stability. Trust is only acquired - or lost - over extended periods of time. As yet, no developing country, however large, has played a significant reserve or trading currency role. Trust in America has evidently fallen sharply as a result of the Greenspan era of easy money for the Wall Street playboys. But China has a long way to go in providing a substitute.
China's money supply growth of 28 percent in the past 12 months may to many seem a suitable response to global recession. But for anyone with worries about the health of its banks or the longer run stability of the yuan may see a row of red flags not green economic shoots.
Trust in institutions is also important - which means in the legal and accounting systems as well as in the competence of the central bank. Even once established they take time to be appreciated by foreigners.
Yes, the yuan will gradually merge onto the international stage. But don't believe the latest hype from financial sector peddlers of self-interest.
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