The yuan as a global reserve currency? Don’t hold your breath

China's Transition
China's Transition

The IMF is already clearing a berth in its basket of reserve currencies for the Chinese yuan. Once official, the yuan will be the first new currency to be added to the IMF’s special drawing rights (SDR) currency basket since the modern SDR system began in 1981. (The euro replaced the Deutsche mark and the French franc in 1999). The Wall Street Journal hails the approval (paywall) as a “milestone in China’s efforts to establish the country as a global economic power.”

That’s probably overstating things a tad. The re-weighting will boost demand for yuan-denominated assets by at most $40 billion, says Societe Generale. Beyond that, whether the yuan becomes a global reserve currency depends on whether central banks want to hold it—and the IMF’s imprimatur alone won’t do much to influence them. More important are both confidence in the yuan’s stability and the availability of yuan-denominated Chinese government bonds, and on both those fronts, China has long way to go. Above all, though, the Chinese government has so far shown itself to be unwilling to swallow the tradeoffs that come with the reserve-currency role.

Let’s start with confidence. Despite incremental financial reforms, the government’s stock-market bailout and lousy communication about its currency revaluation have turned investors skittish. “If anything, the [yuan’s] chances of being taken seriously as a reserve asset have gone backwards recently,” says Mark Williams, economist at Capital Economics, in a note today (Nov. 16).

As for availability, the Chinese government clearly has to issue more bonds. As of Q1 2015, only 0.6% of international debt securities outstanding were denominated in yuan, according to Mizuho—compared with 43% in dollars and 39% in euros.

But let’s say confidence is restored and central banks are suddenly hankering for Chinese government bonds. China will still face ugly tradeoffs between creating the bonds necessary to be a major reserve currency and managing its economy, as Michael Pettis, an economist at Peking University, explained in a blog post last April.

Demand for government bonds will drive up the yuan’s value, forcing China to run current account deficits (which essentially means trade deficits). Of course, China currently runs record trade surpluses, and doesn’t seem much inclined to change course.

There’s one alternative: The People’s Bank of China can step in to buy foreign currencies, preventing the yuan from strengthening. But that leaves the PBoC with a huge pile of foreign exchange burning a hole in its coffers. To invest that money, it will buy foreign debt. In other words, it must lend to another foreign government (or company) by buying its bonds.

But wait—if China buys bonds sold in dollars, pounds sterling, yen, or euros, it will weaken the yuan’s status vis-a-vis those other global reserve currencies. That defeats the whole purpose of global yuan gambit. Instead, the PBoC will have to buy bonds from emerging markets, which are more prone to default. This riskiness is why Pettis argues that the only way the yuan can gain reserve currency status is for China to run big current account deficits.

Why wouldn’t China want to open up its capital account and run big current account deficits?

Doing so means trillions of dollars a year of capital to flow freely across its borders, something the Chinese government doesn’t seem too comfortable with given the recent stealth tightening of capital controls. Same goes for its stock markets—freezing trading won’t fly with international investors. And making the yuan a store of global savings is likely to put a good chunk of its exporters out of business, driving up unemployment.

Yuan use for trade will likely continue to rise. But once China’s leaders realize that the price of global glory is control, the yuan’s march on international finance centers will surely stumble.

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