Ever since the financial crisis, China has chafed against the global financial order. The U.S. was the source of the crisis, yet Washington continued to dominate the system as much as, if not more than, before. It blocked China’s efforts to gain greater influence in the International Monetary Fund, while the Federal Reserve’s quantitative easing reduced returns on China’s massive dollar-denominated reserves to near zero and weakened the greenback. For policymakers in Beijing the response was clear: Create a greater international role for the renminbi, and forge a financial sphere that China could dominate for its own purposes.
Washington emerged from the crisis wary of China’s growing economic might and eager to find new sources of global demand to help get the American economy back on its feet. The renminbi would have to play a vital role. The Obama administration, like its predecessors, pressed Beijing to loosen controls over its currency and allow it to rise. Such policies would boost U.S. competitiveness and foster China’s transition from a manufacturing and exporting powerhouse to an economy driven more by consumer demand.
Now both sides are about to get what they wanted. The consequences may not be exactly what they expected.
On August 11 the People’s Bank of China (PBoC) stunned markets by announcing a sudden change in its method of calculating the daily renminbi fixing, giving greater weight to market forces. The shift, which came in the midst of a vicious bear market in Chinese stocks that has fueled doubts about the health of the country’s economy, led the currency to decline by a little more than 3 percent against the dollar in three days — its biggest depreciation in more than two decades. Although the authorities have since intervened to stem the slide, many analysts and investors expect the renminbi to decline further in the months ahead.
Some observers regarded the currency move as a devaluation designed to boost a flagging economy. But Chinese officials say the larger motivation is strategic: Making the renminbi’s value more market-oriented will facilitate a domestic reform agenda driving China’s economic transition and persuade the IMF to include the unit in its currency basket, the Special Drawing Right. “We really need to make the exchange rate more flexible because it makes the economy more flexible,” says Jin Zhongxia, a senior PBoC official who serves as China’s executive director at the IMF. “China will have a more independent monetary policy. Fundamentally, the economy needs a lower interest rate.”
The SDR contains only four currencies: the dollar, euro, Japanese yen and British pound. Adding the renminbi, which Fund officials appear likely to endorse later this year or early next, would be the biggest change since this currency basket was created in the early 1970s and signal China’s emergence as a global financial power.
In addition to the economic and monetary reforms, China is pushing ahead with the launch of three new development lenders with deep pockets and ambitious plans to support infrastructure development — and project China’s economic power — in Asia and beyond. The Asian Infrastructure Investment Bank (AIIB) and the New Development Bank, Chinese-led multilaterals with a projected $100 billion each in capital, are staffing up following formal launches this summer and plan to begin lending operations in the first half of next year. The Silk Road Fund, a $40 billion private equity vehicle, began operations in April by investing $125 million in a Chinese company developing energy projects in Pakistan.
The combination of a growing international role for the renminbi and the creation of new development lenders — based in and dominated by China, with resources exceeding those of the World Bank — represents the biggest challenge so far to the global financial order that Washington forged with the creation of the IMF and the Bank at Bretton Woods in the dying days of World War II. “The international financial system is on the cusp of an epochal change,” says Rakesh Mohan, India’s executive director at the IMF.
The inclusion of the renminbi in the SDR could have a profound impact on financial markets. Central banks around the world held just over 1 percent of their reserves — about $72 billion worth — in renminbi last year, an IMF survey found. Entry into the SDR could encourage central banks to raise that share to 4 or 5 percent over the next three to five years, boosting those holdings by as much as $300 billion, some analysts project.
Private markets have even greater potential. China has been opening its financial markets to foreign investors as part of its domestic reform agenda and to meet the IMF’s criterion that SDR currencies be “freely usable.” The Shanghai–Hong Kong Stock Connect program, launched last November, gives foreign investors much greater freedom to buy A shares on the Shanghai market, and China is expected to extend the program to Shenzhen in coming months. In July the authorities gave foreign central banks unrestricted access to the interbank bond market.
Such liberalization should hasten the inclusion of Chinese markets in major international indexes, like MSCI’s global equity benchmarks, and foster private portfolio inflows of anywhere from $400 billion to $1.2 trillion over five years, according to a recent paper by analysts at Morgan Stanley. “RMB assets may become the next big thing,” the report says.
China’s reforms “will make the market deeper,” says Arminio Fraga, co-founder and co-CIO of Gávea Investimentos, a $5.1 billion Brazilian hedge fund that is part of J.P. Morgan Asset Management. A keen observer of the mainland economy, Fraga serves on the international advisory board of the China Securities Regulatory Commission. “There will be more research,” he says. “There’ll be more noise, too. It’ll make for a more complete world for us to invest in.”
To be sure, the road ahead is not without risks. Talk of China’s financial ascendancy may seem out of place at a time when the country’s markets are a source of global instability. A collapse of nearly 50 percent in mainland stock prices this summer has sent equities tumbling around the world. The authorities’ blunt efforts to stem the rout — including some $200 billion of state-directed stock buying, curbs on short-selling and sales by major holders, and even prosecutions of journalists — have led some analysts to question Beijing’s commitment to market-oriented reforms. Capital has been rushing out of the country over the past year, eroding China’s mountain of reserves.
Yet Jin, China’s IMF board member, points out that the U.S.’s rise to financial dominance in the early 20th century, with the dollar replacing the pound as the leading reserve currency, was replete with crises, from the Panic of 1907 to the Great Depression. China’s transition to a consumer-oriented economy will inevitably have corrections, he adds, but they can be managed.
The political challenge for China may be even greater than the financial one. The country’s reformers, led by PBoC governor Zhou Xiaochuan, see financial reform as essential for weakening the stranglehold on credit that China’s inefficient state-owned enterprises have enjoyed for decades and steering more capital toward innovative companies, small enterprises and consumers. But shifting to a market economy requires the Communist Party to relinquish many of the levers it has pulled for decades. For President Xi Jinping, who has grasped more power than any leader since Deng Xiaoping in the 1980s, letting go may prove difficult. This is a leader, after all, who ordered factories around Beijing shut for weeks and reportedly told officials to steady the stock market so the government could hold its World War II anniversary parade on September 3 under blue skies and against a tranquil financial background.
To “get reforms going to correct the imbalances in the economy, Xi had to amass power and centralize it,” writes George Magnus, an independent analyst and former chief economist at UBS, in a blog post. “There is little question that he and his senior colleagues understand they have to implement deep and meaningful economic reforms to unlock new sources of economic growth and productivity. The risk, as they know even better, is a loss of control.”
The contradiction between “galvanized Communist control” through policies like Xi’s anticorruption campaign and the government’s oft-stated goal of increasing market forces in the economy will take years to work out, says Stephen Jen, co-founder and partner of SLJ Macro Partners, a London-based hedge fund and advisory firm. “It will take a while for Beijing to feel totally comfortable trusting markets in deciding capital allocation,” he adds.
Yet most of China’s trade partners believe Xi is sticking to his economic reform agenda. The IMF applauded the recent shift in policy on the renminbi, calling it “a welcome step as it should allow market forces to have a greater role in determining the exchange rate.” Even the Obama administration has given a cautious welcome to the move. At a Group of 20 meeting in Turkey on September 5, Chinese officials expressed their determination to continue with market-oriented reforms and avoid competitive devaluations.
China’s “commitment to market-based reforms is still very strong,” says World Bank president Jim Yong Kim, who met with Premier Li Keqiang in Beijing in July. “I think one of the things the world has to get used to is the more they move toward market reforms — which they know they have to do and which they continue to stress that they’re doing — there is going to be fluctuation. There could be potential fluctuations in their growth rate.”
The sdr is an unusual focus of attention. It doesn’t exist physically; you can’t use it at the corner store or get an SDR loan from your money center bank. It’s an accounting tool, a basket of currencies stitched together in 1973, when U.S. deficits and inflation triggered the collapse of the fixed exchange rate system. The Fund sets members’ quotas and determines loan amounts in SDRs, but actual disbursements are made in the basket’s underlying currencies. The weights in the basket — the dollar makes up 41.9 percent of the SDR, the euro 37.4 percent, the pound 11.3 percent and the yen 9.4 percent — are set every five years in a process notable until now only for its obscurity.
“There are not more than a few hundred people in the world who know what an SDR is,” says Timothy Adams, president of the Institute of International Finance, only partly in jest.
Yet the Chinese have placed great emphasis on the SDR, for reasons of both prestige and practicality. Beijing has long sought to gain a greater voice in international institutions, reflecting the leadership’s desire to reclaim the nation’s rightful place in the world. Adams recalls being surprised by China’s determination to be admitted as a nonborrowing member of the Inter-American Development Bank a decade ago, when he was serving as the Treasury Department’s undersecretary for international finance, during the Bush administration. (China gained entry in 2009.)
China redoubled its efforts to play a greater global role after the 2008–’09 financial crisis. In Beijing’s eyes the crisis exposed the flaws of a U.S.-centric system that left other countries vulnerable to American financial turmoil and policies over which they had virtually no say. The adoption of unprecedented monetary easing by the Federal Reserve, which drove down interest rates and sent trillions of dollars sloshing around the globe, reinforced a resentment widely shared in other emerging-markets countries. “You guys are actually taxing everybody in the world,” says Gao Xiqing, an adjunct professor at Tsinghua University’s School of Law and former president and CIO of sovereign wealth fund China Investment Corp.
Under pressure from China and other emerging economic powers, IMF members agreed in 2010 to double the Fund’s quotas and lending resources, and shift a significant share of voting rights from the advanced countries — mainly in Europe — to emerging-markets nations. The quota reform would increase China’s voting weight in the Fund from 3.81 percent to 6.07 percent, vaulting it past Germany, France and the U.K. to rank third, behind the U.S. and Japan. Five years later, however, the reform sits stillborn because the Obama administration can’t win congressional approval for the changes.
Frustration over Washington’s political dysfunction and lack of reform at the Bretton Woods institutions is a major reason China launched the AIIB and the New Development Bank (also known as the “BRICS bank” because it is backed by Brazil, Russia, India, China and South Africa). “When they couldn’t play a greater role, they decided to create their own institutions,” the IIF’s Adams says.
Gaining a place in the SDR would go a long way toward assuaging China’s frustration. When the IMF last reviewed the currency basket’s makeup, in 2010, officials discarded the idea of adding the renminbi. Although China easily met one of the Fund’s two criteria for inclusion — having a large share of global exports — it flunked the second test: that its currency be “freely usable” for international transactions. At the time, the renminbi’s value was carefully controlled by the PBoC under a managed float, foreigners’ ability to invest in mainland securities markets was limited by quotas, and barely anyone used the Chinese currency for foreign trade.
“They were hardly on the [financial] landscape,” says Siddharth Tiwari, the senior IMF staffer who is overseeing the review of the SDR basket. “That has changed.”
Indeed it has. Over the past five years, Beijing has embraced renminbi internationalization as a major policy goal, promoting the currency’s use in settling trade payments, expanding access to its stock market for foreign investors, encouraging the issuance of renminbi-denominated bonds in offshore markets such as Hong Kong, Singapore and London (so-called dim sum bonds) and establishing currency swap agreements totaling more than 3 trillion yuan ($471 billion) with more than 30 foreign central banks to provide renminbi liquidity.
The results are significant. The renminbi ranked sixth by issuance of international debt securities last year, ahead of the Swiss franc and behind the Australian dollar; it was a distant 11th in 2010. According to a survey of IMF members, 38 countries now hold renminbi in their reserves; it ranks seventh globally as a reserve currency, behind the four SDR constituents and the Australian and Canadian dollars. Although the renminbi’s market share in most categories is still small, its rate of growth is more than 100 percent a year in many cases. Crucially, the IMF has judged that the foreign exchange market for renminbi is deep enough that it could extend a large sum to a borrower like Greece, say, and the country would be able to convert it to dollars, euros or whatever currency it needed to service its debts without adversely moving the market.
In a speech at the IMF’s spring meeting in Washington, the PBoC’s Zhou noted that China had opened up its markets progressively, making its capital account fully or partly convertible in 35 of 40 categories tracked by the Fund. He promised further measures, including extending the Stock Connect program to the Shenzhen market and allowing foreigners to issue securities on the mainland. In July the PBoC took a big step by allowing foreign central banks to invest in China’s interbank bond market without restrictions. The move should facilitate greater use of the renminbi as a reserve currency by giving central banks a deep market in which to invest or hedge their holdings of the Chinese currency.
“Opening up the market for investment purposes was an important step forward,” says the IMF’s Tiwari. “It allows all the Fund members to enter the onshore market and invest in fixed income or derivatives in the manner in which they want to, and satisfy their reserve needs.”
Tiwari and his staff are due to submit their recommendation on the SDR’s makeup to the IMF board in November, and all indications are that they will call for the renminbi’s inclusion. In August the Fund announced it would delay any revision of the currency basket by nine months, to the end of September 2016. Although the IMF said reserve managers had asked for the change so they wouldn’t have to adjust their holdings in thin year-end markets, sources say the delay could boost the renminbi’s chances by giving Chinese authorities more time to further liberalize their markets. A final board decision could be deferred until early 2016, sources say.
The board held a first discussion on the SDR in July. Sources say it focused mainly on technical issues such as the potential impact on the interest rate borrowers would pay if the basket was enlarged. Injecting the renminbi into the SDR will almost certainly raise the rate borrowers like Greece pay, because Chinese rates are higher than European and U.S. rates. But officials say any increase would be modest; in any event, Chinese rates seem to be heading lower while the Federal Reserve contemplates raising U.S. rates.
Will Washington support the renminbi’s inclusion? The U.S. has arguably the most to lose if the Chinese currency gains status and challenges the dollar’s preeminence as a reserve currency. Most observers think it’s unlikely that the U.S. will try to block the move. The Obama administration will want to avoid a repeat of the debacle earlier this year, when it pressed U.S. allies to shun the AIIB only to see Britain, Germany and others eagerly join the Chinese-led bank. Washington also lacks a real veto threat. An SDR change is a technical decision that can be taken by a 70 percent vote of the membership, not a fundamental measure needing an 85 percent majority. The U.S. would need to get Japan and several other countries on its side if it wanted to block the renminbi’s inclusion. “At a minimum, they’ve got to draw the lesson with regard to the AIIB fiasco and approve something that is inevitable,” says C. Fred Bergsten, senior fellow at the Washington-based Peterson Institute for International Economics.
Treasury Secretary Jacob Lew reacted cautiously to China’s change in the renminbi-fixing method, saying the administration would watch closely to see how the new system is implemented. In a meeting with Finance Minister Lou Jiwei at the G-20 gathering in Ankara, Lew said China must honor its commitment to “move towards a more market-determined exchange rate system.”
Lew’s comments call to mind the old adage “Be careful what you wish for. You may get it.”
Washington has urged China to move toward a more market-driven exchange rate since the early days of the George W. Bush administration. At first, it was a one-way bet. Beijing had pegged the renminbi at a low level to promote industrialization and manufacturing exports. When China shifted from a fixed to a tightly managed floating rate in 2005, the renminbi inched up slowly but steadily. The picture today is very different. The renminbi has risen by 35 percent against the dollar over the past decade, and Chinese wages have been climbing at double-digit rates. In May the IMF declared that the exchange rate was no longer undervalued.
Meanwhile, capital has been flowing out of China at an accelerating rate. Chinese companies have been stepping up the pace of overseas acquisitions, and investors have been diversifying into foreign assets, a natural consequence of their growing wealth. The perception that the renminbi can fall as well as rise has added to the pressure. Chinese companies that borrowed dollars unhedged in recent years, expecting to be able to repay those debts with a stronger renminbi, have been scrambling to cover their exposure, adding to the capital outflows.
The result: China’s foreign exchange reserves, which hit a record $3.99 trillion in June 2014, dropped by $436 billion over the following 14 months, including a record fall of $93.9 billion in the past month. The depreciation that followed the August 11 exchange rate shift may have caused capital outflows to surge to as much as $200 billion that month alone, Goldman Sachs analysts estimate.
Ultimately, the PBoC will have to choose between intervening to support the renminbi or cutting interest rates and reserve requirements to support the economy — and letting the exchange rate slide. The central bank cut rates modestly in late August, and many analysts believe it will prioritize the domestic economy. David Woo, currency and rates strategist at Bank of America Merrill Lynch, predicts the renminbi will fall to 6.90 to the dollar by the end of 2016. Paul Mackel, head of Asian FX strategy at HSBC Holdings in Hong Kong, sees the rate sliding to 6.50 by the end of this year and becoming more volatile, and data-dependent, going forward. Gávea’s Fraga takes these forecasts with a bit of salt: “Most people have no idea where it ought to go, quite frankly.”
Where does all this leave renminbi internationalization and China’s ambition of achieving reserve currency status? Most analysts expect Beijing to stick with its financial liberalization agenda, but the combination of China’s opaque policymaking process and the inherent volatility of markets could produce some big bumps in the road.
Being included in the SDR “signifies China joining the ranks of the world’s financial powers,” says Barry Eichengreen, an economist at the University of California, Berkeley — but it will be only a symbolic victory. “Real as opposed to symbolic progress requires building deep, liquid and stable financial markets,” he adds. “The events of August remind us that China has some distance still to go in this regard.”
At the IMF, China’s Jin says talk of the renminbi rivaling the dollar as a reserve currency is “too far away.” For the next five years or so, he adds, “our challenge is to see whether we can catch up to the Japanese yen or the British pound.”
Kermit Schoenholtz, head of the Center for Global Economy and Business at New York University’s Stern School of Business, agrees it will take years for today’s policy changes to pan out but says investors would be foolish to play down the issue of SDR inclusion: “There’s a very good chance you’ll be able to look back ten years from now and say it was a major turning point.” •
Visit Tom Buerkle’s blog and follow him on Twitter at @tombuerkle.
