What The IMF’s Yuan Decision Will Mean For China – And Global Markets by [email protected]
This week’s decision by the International Monetary Fund (IMF) to include the Chinese renminbi, or RMB, as an international reserve currency beginning in October 2016 may have limited market impact in a world dominated by the U.S. dollar. The move would have a bigger geopolitical impact in providing China a voice in international monetary decisions; in enabling China to create a money transfer system to compete with the widely used “Swift” system; and in limiting the dollar’s use in enforcing political sanctions, experts say. It could also encourage China to accelerate its financial sector reforms, in turn depreciating the RMB to levels the U.S. may not relish.
The IMF decision came after its annual meeting on November 30 to review the composition of the basket of five currencies that make up the “special drawing right,” or SDR. The IMF allocates SDR quotas to supplement the reserves of its member countries. The other currencies in that basket are the U.S. dollar, the Euro, the pound sterling and the Japanese yen. IMF managing director Christine Lagarde justified the inclusion of the RMB in that elite club saying it recognized the integration of the Chinese economy into the global financial system, and the progress China has made in recent years in reforming its monetary and financial systems.
On balance, the IMF decision appears to be on the right track, according to Marshall W. Meyer, Wharton emeritus professor of management and a long-time China expert. “China’s commercial expansion depends on internationalization of the RMB,” he said. “The IMF decision is welcome even if it complicates the immediate problem of managing the RMB downward gradually, rather than precipitously, to buoy the domestic economy.”
With the RMB as a reserve currency, “[China] will be part of the center of any kind of discussions about monetary reform,” said Steve Hanke, professor of applied economics at The Johns Hopkins University in Baltimore and co-director of its Institute for Applied Economics, Global Health, and the Study of Business Enterprise. “The Chinese will be able to get more leverage in the international markets; that is how they see themselves positioned to challenge the U.S. dollar.” Hanke is also a senior fellow and director of the Troubled Currencies Project at the Cato Institute in Washington, D.C.
The inclusion of the renminbi as a reserve currency is definitely positive news for China, as other countries may accept it as a trade currency in the future, said Wharton management professor Minyuan Zhao. However, the longer-term impact of that will depend on how China uses the opportunity, she added. “Whether it is a positive or a negative in the long run depends on how China acts. Will it take it as incentive to bring in transparency and reform the financial system, which is not in good shape now?”
“If the U.S. does not like the market outcome, will it muscle in and [try to] influence the system, which the Chinese will not like?” –Minyuan Zhao
Hanke explained why the renminbi’s inclusion as a reserve currency is important in the geopolitical realm, and not as it relates to the market. “The dollar is king. It dominates all trading, all pricing, all invoicing, all reserves held by central banks, etc.,” he said. “That is always the case. If you go back 2,000 years, there [has] always [been] one dominant currency that is preferred by the markets. He noted that the British pound sterling dominated the markets before World War I, after which the U.S. dollar took over. Having a dominant currency worldwide for financial transfers and trading brings economies of scale and helps lower transaction costs, he explained.
Hanke did not expect the renminbi to edge out the U.S. dollar in the global financial marketplace. He noted that the dollar controls more than 90% of all global foreign exchange transactions. “In the market, the RMB is not really a challenger. The market test was that it was a big flop; no one was interested in using it, which is still the case.”
However, “it is a different ball game” in the geopolitical sphere, Hanke said. “China is a big, powerful country; it has been the biggest adder to incremental world growth over the last 20 years.”
According to Zhao, countries around the world have amassed $80 billion worth of RMB in their foreign reserves. Putting that in context, China had about $3.5 trillion in foreign reserves at last count, according to a Wall Street Journal report.
China’s Economic Station
“We’re at an unusual juncture in China’s economic trajectory,” said Meyer. “Investment-driven growth has reached its limit and China must find a new growth model. In the interim there’s a lot of uncertainty. China’s top economists acknowledge this.”
Meyer outlined the major themes economists agreed on at a Xinhuanet-sponsored conference on the next stage of China’s economy last month, where he was a speaker. “One, China’s economy has been in decline for four to five years. The best indicator of decline is the producer price index or PPI, which has dropped for 44 consecutive months; the CPI (consumer price index), though positive, hasn’t broken 2%, effectively zero, in the same period. Two, the main cause of decline is excess capacity spurred by stimulus measures, and further stimulus will only protract the decline. Excess capacity is greatest in industries like coal, petro and steel where state-owned enterprises (SOEs) dominate. Three, unless and until the government permits the normal economic cycle to operate and liquidation of excess capacity, the decline will continue. Four, among other effects, some of which are positive, the anti-corruption campaign has delayed the liquidation of excess capacity since sales of state-owned assets are suspect.”
Dealing with Surplus Capacity
Meyer put those themes against the backdrop of a broader context. “Not only is China awash in capacity, but it is also awash in currency,” he said. He noted that the ratio of M2 (a measure of money supply that includes cash; checking, saving and time deposits; and money market funds) to GDP (gross domestic product) for China is double that of the U.S. “That’s a lot of liquidity. You’d expect inflation with this level of liquidity. But capacity has outrun liquidity, hence there’s deflation.”
China doesn’t have easy options to deal with its surplus capacity. “If China tries to liquidate excess capacity, social unrest will erupt,” said Meyer. He pointed to the worker riots that followed the shutdown last month of Tangshan Songting Iron & Steel, a private firm in the country’s northeastern city of Tangshan. According to a Reuters report, Tangshan produces more steel than the entire U.S.
Long-run, the capacity of the U.S. to isolate rogue nations using financial sanctions could be crimped.”–Marshall W. Meyer
Hanke said the key reform China must undertake is “to get rid of the SOEs that are complete back holes; most of them are almost zombie enterprises sucking up all the credit.” Private enterprises in China are facing a credit crunch as a result, he added.
Zhao felt the shadow of the anti-corruption crackdown would fall on China’s efforts to privatize