Yuan goes global: China needs to make deeper financial reforms

The International Monetary Fund (IMF) on November 30, 2015 welcomed China's Yuan - also called the renminbi (RMB) -  into its elite reserve currency basket known as Special Drawing Rights (SDR), recognising the ascendance of the Asian power, already the world's second largest economy after the United States. It is a symbolic victory for Beijing, which has spared no efforts to strengthen the international role of the Yuan and its acceptance as a reserve currency. The IMF announcement was a symbolic marker in China's efforts to become a global economic power, and came despite Beijing's tight controls on the Yuan, including only allowing it to move up or down two per cent against the US Dollar from the mid-rate set daily by the central bank. Analysts say the IMF's recognition of the Chinese currency is a step towards encouraging its global use, but banks will remain reluctant to hold Yuan unless Beijing pushes for deeper financial reforms.      
Yuan is the fifth most widely used currency in international payments but accounts for less than 3 per cent of transactions. Global transactions organisation SWIFT said in October 2015 that it compares with over 43 per cent for the US Dollar and nearly 29 per cent for the Euro. Analysts believe the IMF decision's impact on foreign exchange markets will be muted though it will encourage central banks to speed up diversification of their currency reserves by buying Yuan. Senior emerging market strategist at Credit Agricole Dariusz Kowalczyk said "There is no obligation for central banks to align their forex reserve holdings with the SDR basket, but in practice, they pay a lot of attention to the basket's composition and weights. This pattern will also materialise in the case of the renminbi. It simply makes sense to diversify reserves into an emerging market that is also a global economic superpower". He forecast the move could eventually imply Yuan buying of the equivalent of up to US$110 billion annually.
However, ANZ Banking Group said such a development will not be achieved overnight and depends on reforms to be undertaken by Beijing, including opening of its tightly-controlled onshore financial market, allowing more capital outflows and widening of the trading band for the Yuan. The Yuan can only move up or down two per cent against the US Dollar from a mid-rate set daily by the central bank. ANZ said in a research report last month: "It will take time for the RMB to become a popular global asset". True acceptance of the Yuan as a reserve currency also depends on liquid markets and transparent policies, a challenge for the Communist-ruled country. Andrew Kenningham, senior global economist at Capital Economics said, "We think the world's central banks will be reluctant to invest much in renminbi for many years to come. Central banks, like other risk-adverse asset managers, invest the bulk of their funds in currencies which are fully convertible and for which there are deep and liquid markets for foreign exchange, bonds and derivatives".
The Chinese government intervened in the stock market over the summer after a rout sent shock waves around the world, by tasking an agency to buy up shares as part of a massive bail-out. The People's Bank of China (PBoC), the China's central bank, also unveiled a surprise devaluation of the Yuan against the Dollar, moving it nearly five per cent lower over one week in August 2015. Kenningham added that "investors will also be looking for reassurance that economic policy and financial markets in China will be managed in a more professional and predictable manner. In that respect, this year's heavy-handed intervention by the authorities in China's equity markets will surely have made investors more wary". Despite slowing growth, China has moved gradually to implement economic reforms, liberalising interest rates in October 2015 and pledging to move towards making the Yuan fully convertible by 2020.
The PBoC said the IMF move was an acknowledgement of China's economic development and pledged further reform. Analysts seemed to endorse that view hours after the IMF decision. Ivan Chung, a Moody's analyst said it was 'recognition of China's commitment to reform its financial sector and liberalise its capital account, and will support market-oriented reforms.' Such liberalisation is likely to lead to falls in the Yuan's valuation, but Beijing is far from allowing complete liberalisation to avoid larger falls. DBS Group Holdings Nathan Chow said, "The PBoC should be reducing its currency intervention and the Yuan is likely to decline on weak economic fundamentals in China. China will have to strike a balance between letting the market play a bigger role and not allowing any major depreciation".
Investors remained cool-headed despite the IMF decision to add the Yuan to its reserve currency basket in the biggest shake-up in more than three decades. According to the China Foreign Exchange Trading System (CFETS), the central parity rate of China's currency Yuan, weakened by 11 basis points to 6.3973 against the US Dollar on December 01, 2015. It also weakened against the British Pound, but strengthened against the Euro and Japanese Yen. The benchmark Shanghai Composite Index edged up 0.32 per cent on December 01, 2015 to close at 3,456.31 points. The smaller Shenzhen index was up 0.36 per cent to 12,081.17 points. The HSBC said in a report, "Expectations have been riding high that the IMF board would formally announce the Yuan's inclusion, which implies that a lot of near-term expectations should already be factored into the Yuan movement".
China is capable of keeping the Yuan's exchange rate at a 'reasonable' level and sees no basis for continued depreciation, the PBoC Vice Governor Yi Gang said hours after the IMF announcement. The IMF announced on December 01, 2015 that the Yuan is eligible for joining its SDR basket, alongside the Dollar, the Euro, Pound and Yen. Effective from October 01, 2016, the Yuan will have a weighting of 10.92 per cent in the new SDR basket, while the respective weighting of other currencies in the basket are 41.73 per cent for the Dollar, 30.93 per cent for the Euro, 8.33 per cent for the Yen and 8.09 per cent for the Pound.
The Yuan will be the first developing country currency to join the basket since 1981, when the IMF whittled the basket down from its original 16 currencies in the 1970s to five. The basket was later compressed to current four as the German Mark and French Franc were subsumed into the Euro. IMF Managing Director Christine Lagarde said the Yuan's inclusion into the basket is 'an important milestone in the integration of the Chinese economy into the global financial system' and 'recognition of the progress that the Chinese authorities have made in the past years in reforming China's monetary and financial systems'. Analysts said the Yuan's SDR inclusion may help address the imbalance in the international financial system in which around one per cent of global central bank reserves were held in the Yuan, despite the fact that China made up 13.3  per cent of the world's economy in 2014.
The move came as China strives to stabilise equity market volatility and slowing economic growth. The market consensus is that immediate Yuan demand triggered by the new formula will be negligible considering the limited asset value of total SDR outstanding. A latest Bloomberg Brief special report commented on the issue that over the long run, the balance of risk remains tilted toward depreciation; membership in the IMF's SDR club might encourage more funds to flow into China, but the capital-account opening that SDR inclusion is intended to catalyze may see even larger quantities of funds flowing out. It projected a median forecast for the Yuan to the end of 2015 at 6.4 against the Dollar and drop further to 6.6 at the end of 2016.
However, China's central bank on December 11, 2015 cut the Yuan's value against the greenback to its lowest in more than four years; only a week after the IMF welcomed the unit into its elite reserve currency basket. The Yuan fixing-ahead of the US Federal Reserve's interest rate decision, which is widely expected to see a landmark rise - also saw the normally stable currency down 0.8 per cent in a week, its biggest seven-day drop since August 2015. Then, China devalued it by almost five  per cent in a week in what it said was a push to make it more market-oriented. The PBoC took one more step to relax exchange controls on December 11, 2015 allowing Chinese companies registered in three more Free Trade Zones (FTZs) to freely convert up to US$10 million annually in each direction. China has set up the areas as test beds for financial reforms, and the practice was first allowed in the Shanghai FTZ, in the country's commercial hub, in October 2015.
The writer is a retired Professor
of Economics, BCS General
Education Cadre.
 [email protected]