IMF blesses China's yuan but the dollar is still dangerously dominant
'A dollar-centric financial world has created powerful and sinister distortions,' says SLJ Macro. The world will be safer as the Chinese yuan comes of age
By Ambrose Evans-Pritchard
IMF chief Christine Lagarde gives China's yuan the thumbs up
The Chinese yuan is to join the elite currency basket of the International Monetary Fund, opening the way for a surge of investment flows that could send tremors through the global financial system.
The watershed moment marks an end to increasingly unhealthy era of US dollar dominance that has failed to keep pace with dramatic changes in the world economy, and it weakens Western control over the machinery of global markets and the economic rulebook.
The yuan will be become the fifth currency to make up the IMF’s basket of "Special Drawing Rights" (SDR) later next year, alongside the dollar, the euro, sterling and the Japanese yen.
The Fund deemed the yuan to be “freely usable”, even though China still has tight capital controls and badly bungled the Shanghai stock market crash earlier this year.
The IMF's decision was clearly a political move aimed at drawing China into the college of global governance.
The IMF's decision was clearly a political move aimed at drawing China into the college of global governance.
David Marsh, from the official monetary forum OMFIF, said it is the first time that a developing country has been anointed in this way and marks a "momentous shift in the global power balance".
"Acquiescence by the US in this landmark move is recognition that China’s march to the top table of the world economy is unstoppable," he said.
Christine Lagarde, the IMF’s managing director, said China’s reform drive would bring about a “more robust international monetary and financial system”.
Stephen Jen, from SLJ Macro Partners, said premier Li Keqiang and reformers in China’s central bank are using the IMF push – with its allure of global prestige – to defeat vested interests within the Communist Party and push through free-market policies that would otherwise be impossible. “This is more than a vanity project,” he said.
He called the move a “cunning tactic” to outmanoeuvre opponents by inducing them to accept a commitment that looks symbolic and innocuous, but in reality implies a series of far-reaching steps that open up the Chinese financial system. It is economic revolution by stealth.
The world will be a much safer place if they can pull it off. Mr Jen said the global currency system has become dangerously unbalanced, a financial edifice based on dollar hegemony with a record $9 trillion of cross-border lending in dollars - most of it entirely outside US jurisdiction.
The world has never been so dollarised.
“This increasingly dollar-centric financial world has created several powerful and sinister distortions,” he said. It was a cause of the "global savings glut" before the Lehman crisis, and it then swamped emerging markets with excess liquidity created by the US Federal Reserve – a process now going into reverse.
This global “dollar standard” is incompatible with a multipolar trading system where many of these same emerging markets are much more dependent on China’s economy than they are on US demand. Finance and trade are out of alignment.
Yet China faces huge risks trying to open its system and free the yuan. Nobody knows whether capital will flood out of the country, or into it, and either could cause trouble.
Yang Zhao, from Nomura, said there is $17.3 trillion sitting in Chinese deposit accounts, and a big chunk is held by rich Chinese who will be allowed to switch half their assets into foreign stocks, bonds and real estate under the new "QDII2" liberalisation scheme.
Markets remain skittish over the risk of capital flight after a devaluation scare in August, which set off an exodus of hot money and forced the authorities to defend the yuan. The police launched an assault on “underground banks” accused of smuggling money abroad.
Diana Choyleva, from Lombard Street Research, said there could be a “torrent of outflows” as soon as China lifts restrictions, setting off a yuan devaluation that would send a deflationary shock through the world economy. “This will be the moment of maximum danger,” she said.
Analysts say the pent-up money waiting to leave is roughly $2.2 trillion but it could be higher, and could snowball in a crisis.
The authorities know this and are keeping tight control over the exchange rate after burning their fingers over the summer. The yuan has been steady for four months on a trade-weighted basis.
Yet this currency stabilisation is untenable. Mr Jen said China faces the “Impossible Trinity”: it cannot have an independent monetary policy, an exchange target and an open capital account at the same time. One must give.
The central bank thinks the easiest of the three is to open up the capital account, but they do not yet know how to do so safely.
Set against the outflows is another great stash of capital likely to pour into the yuan as a result of liberalisation and the IMF effect. Foreign funds may want a bigger share of China’s bond market, already $6.5 trillion and growing fast.
There will come a time China’s A-share market is fully included at a 20pc weighting on the MSCI emerging market index, which would theoretically entail $340bn of equity purchases. On top of this, Nomura expects China’s current account surplus to approach $800bn next year, drawing a constant stream of money into the country.
The yuan weighting in the SDR will be 10.92pc, implying that central banks could switch $500bn to $1 trillion into Chinese bonds over coming years to keep their portfolio balanced, chiefly at the cost of the euro, yen and sterling. Whether they will actually do so is far from clear.
Mark Williams, from Capital Economics, said China’s hopes for reserve currency status have gone backwards since the heavy-handed intervention in the stock market. “Managers of foreign exchange reserves will think twice before entrusting their assets to policymakers who have shown themselves willing to steamroller the rights on investors when it suits them,” he said.
In the end, China’s plan for a superpower currency that can match the dollar entirely depends on the whether the Communist Party establishes the rule of law, competent supervision, consistency and global trust.
Beijing has won the coveted blessing of the IMF and Washington. Now it has to deliver.
"Acquiescence by the US in this landmark move is recognition that China’s march to the top table of the world economy is unstoppable," he said.
Christine Lagarde, the IMF’s managing director, said China’s reform drive would bring about a “more robust international monetary and financial system”.
Stephen Jen, from SLJ Macro Partners, said premier Li Keqiang and reformers in China’s central bank are using the IMF push – with its allure of global prestige – to defeat vested interests within the Communist Party and push through free-market policies that would otherwise be impossible. “This is more than a vanity project,” he said.
He called the move a “cunning tactic” to outmanoeuvre opponents by inducing them to accept a commitment that looks symbolic and innocuous, but in reality implies a series of far-reaching steps that open up the Chinese financial system. It is economic revolution by stealth.
The world will be a much safer place if they can pull it off. Mr Jen said the global currency system has become dangerously unbalanced, a financial edifice based on dollar hegemony with a record $9 trillion of cross-border lending in dollars - most of it entirely outside US jurisdiction.
The world has never been so dollarised.
“This increasingly dollar-centric financial world has created several powerful and sinister distortions,” he said. It was a cause of the "global savings glut" before the Lehman crisis, and it then swamped emerging markets with excess liquidity created by the US Federal Reserve – a process now going into reverse.
This global “dollar standard” is incompatible with a multipolar trading system where many of these same emerging markets are much more dependent on China’s economy than they are on US demand. Finance and trade are out of alignment.
Yet China faces huge risks trying to open its system and free the yuan. Nobody knows whether capital will flood out of the country, or into it, and either could cause trouble.
Yang Zhao, from Nomura, said there is $17.3 trillion sitting in Chinese deposit accounts, and a big chunk is held by rich Chinese who will be allowed to switch half their assets into foreign stocks, bonds and real estate under the new "QDII2" liberalisation scheme.
Markets remain skittish over the risk of capital flight after a devaluation scare in August, which set off an exodus of hot money and forced the authorities to defend the yuan. The police launched an assault on “underground banks” accused of smuggling money abroad.
Diana Choyleva, from Lombard Street Research, said there could be a “torrent of outflows” as soon as China lifts restrictions, setting off a yuan devaluation that would send a deflationary shock through the world economy. “This will be the moment of maximum danger,” she said.
Analysts say the pent-up money waiting to leave is roughly $2.2 trillion but it could be higher, and could snowball in a crisis.
The authorities know this and are keeping tight control over the exchange rate after burning their fingers over the summer. The yuan has been steady for four months on a trade-weighted basis.
Yet this currency stabilisation is untenable. Mr Jen said China faces the “Impossible Trinity”: it cannot have an independent monetary policy, an exchange target and an open capital account at the same time. One must give.
The central bank thinks the easiest of the three is to open up the capital account, but they do not yet know how to do so safely.
Set against the outflows is another great stash of capital likely to pour into the yuan as a result of liberalisation and the IMF effect. Foreign funds may want a bigger share of China’s bond market, already $6.5 trillion and growing fast.
There will come a time China’s A-share market is fully included at a 20pc weighting on the MSCI emerging market index, which would theoretically entail $340bn of equity purchases. On top of this, Nomura expects China’s current account surplus to approach $800bn next year, drawing a constant stream of money into the country.
The yuan weighting in the SDR will be 10.92pc, implying that central banks could switch $500bn to $1 trillion into Chinese bonds over coming years to keep their portfolio balanced, chiefly at the cost of the euro, yen and sterling. Whether they will actually do so is far from clear.
Mark Williams, from Capital Economics, said China’s hopes for reserve currency status have gone backwards since the heavy-handed intervention in the stock market. “Managers of foreign exchange reserves will think twice before entrusting their assets to policymakers who have shown themselves willing to steamroller the rights on investors when it suits them,” he said.
In the end, China’s plan for a superpower currency that can match the dollar entirely depends on the whether the Communist Party establishes the rule of law, competent supervision, consistency and global trust.
Beijing has won the coveted blessing of the IMF and Washington. Now it has to deliver.
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