China’s currency needs reform at home before gaining more traction internationally

In Chinese, renminbi means the currency of the people. Yet for so long Chinas currency has been an institution of state-run capitalism, serving vested interests under an investment driven growth model. The reforms that accompanied the yuans globalisation have helped transition China to a more sustainable economy by empowering consumers and private investors.

The yuan (or renminbi, RMB) was recently includedin the basket of currencies called the Special Drawing Rights (SDRs), used to value the International Monetary Funds (IMF) de facto monetary unit. This means the yuan has been accepted as an IMF endorsed international reserve currency, which is often widely used by central banks to hold foreign exchange reserves. Mediaestimatessuggest the SDR inclusion should lead to about US$42 billion of reserve assets being rebalanced into the yuan by central banks and reserve managers, at least in the medium term.

The yuans joining of the SDR reserve currency club, with the dollar, pound sterling, yen and the euro, is comparable to Chinas accession to the World Trade Organisation (WTO) in 2001. Both heralded further opening up of the Chinese economy.

However, a notable difference with the SDR is that, compared with just commitments to enter the WTO, joining the SDR requires concrete reforms to meet the IMFs standards. Apart from years of lobbying the IMF, the Chinese government has used a whatever-it-takes approach, supported from the very top of the political echelon, in its quest for the yuans international appraisal.

Peoples Bank of China Governer Zhou Xiaochuan and US Treasury Secretary Jacob Lew are pictured at the annual meetings of the IMF and World Bank Group soon after the yuans inclusion in the IMFs basket of reserve currencies.James Lawler Duggan/Reuters

The yuan has become stronger in the global scene as China becomes the largest trader and the second largest economy in the world.

The government is promoting trade settled in yuan, it relaxed its control on capital and opened domestic financial markets. Yuan-denominated assets have multiplied and diversified and the setting of the yuans exchange rate is now more market-oriented.

Relegation of the yuan lower down the priority list

During my recent interviews, one official from the Peoples Bank of China (the central bank) candidly said, the last thing we want to talk about is the renminbi at the moment. I heard the same a decade ago when the Chinese government was facing mounting pressure from the US over alleged undervaluing of the yuan. This time, however, its more of a domestic concern.

A largely speculative property market is sucking in capital from the real economy whose growth has been lacklustre in recent years, and forced an increase in the household debt level.

The 2016IMF review of the Chinese economyalso waved a red flag over Chinas ballooning debt, which rose to a record 237% of gross domestic product (GDP) in the first quarter of 2016. The biggest chunk of the debt pile, 145% of GDP, goes to its corporate debt, a level that was very high by any measure.

Worries of a potential debt crisis and a lack of alternative investment channels have seen renewed flow of capital out of the country. A widely anticipated shakeup of the financial regulatory regime has been in disarray sincethe stock market crash last year.

So its not surprising to see that, although the government ensures stability of the yuans value, it hasdevaluedby more than 1% after the SDR inclusion, approaching a new low in almost six years.

The future of the yuan

Its worth noting that being part of the SDR basket is not a permanent status. The IMF reviews its elite currency group every five years, and those that fail to meet the standards may be removed.

In addition, an SDR membership is a milestone, but far from the final point in the yuans march of internationalisation. Its convincing the market to accept the yuan that really matters. To achieve this, China needs to further liberalise and open up its economy and financial markets.

But perhaps the Chinese governments logic in macroeconomic management is what is problematic. Instead of seeing yuan-related financial reform as hindering stability and growth, further reforms can not only consolidate and promote the yuans global status, but also hold the key in solving the big-picture issues at home.

Enhancing the power of the central bank, a liberal force in Chinas financial governance and staunch promoter of the yuan, will enhance Chinas macroeconomic capacity and overall financial and economic stability. Allowing freer capital flow will help deflate the overheated housing market and liberalising interest rates will increase the efficiency of financial resources and foster market-oriented debt.

Any efforts by Chinas central bank to further align the yuans exchange rate to market expectations, ultimately leading to its free float, are likely to prepare domestic businesses for international competition. Businesses need the governments shield, to establish international confidence in the currency and the Chinese economy.

The reforms have to go on. The yuan must serve the people before conquering the world.

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