The Coming of Age of the Chinese YuanMay 8, 2015
According to the May 4th Wall Street Journal, the International Monetary Fund (IMF) is expected to declare in a forthcoming report that China’s currency, the yuan, is “fairly valued.” As stated on the IMF website, “The IMF’s primary purpose is to ensure the stability of the international monetary system – the system of exchange rates and international payments that enables countries (and their citizens) to transact with each other.” The IMF’s statements on currencies and exchange rates carry great weight. This development follows years of IMF criticism of China’s managed currency policy. The US Treasury has supported those past criticisms and reportedly still maintains the position that the yuan is “significantly undervalued.” This is despite the 30 percent appreciation of the yuan against a basket of currencies over the past decade. The IMF’s change of position undercuts the US view, as do some estimates by market participants. Indeed, Barclays, in their latest “Global FX Quarterly,” estimates that the yuan is now 20 percent overvalued.
There is no agreement on how one can precisely calculate the fair value of a currency. As Credit Suisse stated in a 2013 report titled “In Search of FX Fair Value,” “… the ‘holy grail’ of FX monitoring, obtaining robust and precise currency fair value estimates, remains elusive.” A currency’s fair value is an equilibrium market price in the absence of intervention or other restrictions. There are a wide range of factors affecting currencies. One approach is to evaluate purchasing-power parities, PPP, which are defined by the OECD as the rates of currency conversion that equalize the purchasing power of different currencies by eliminating the differences in price levels between countries. Another approach is to look at fundamental economic factors affecting a country’s trade surplus or deficit and evaluating whether the actual trade balance is what one would expect given those factors. More complex models seek to combine both PPP calculations with fundamental economic factors. In view of the absence of agreed precise estimates of the yuan’s fair value, the US Treasury will likely have sufficient “wiggle room” to maintain their position, despite the weakening of support.
This development comes at a time when the Chinese are pushing to have the IMF officially label the yuan as a “reserve currency.” A reserve currency is a foreign currency held by central banks and other major financial institutions as a means to pay off international debt obligations. More specifically, China is seeking to have the yuan included in the basket of reserve currencies that make up the IMF’s special drawing rights (SDRs). That basket now contains US dollars, the Japanese yen, the European euro and the British pound. China is seeking to have the yuan added as the fifth currency.
The yuan is the currency that is the fifth-most important currency for global trade, but that is not enough to be included in the SDR basket. A critical criterion is that the currency must be judged to be “freely useable,” in other words, freely convertible. The yuan is under an administered peg regime in which the exchange rate with the US dollar is permitted to fluctuate within a band that is 2 percent above and below a value set daily by the central bank. The regime is backed up by a number of strong exchange controls. There would have to be some significant changes before the IMF judged the yuan to be “freely usable.”
China has made clear at the IMF that it intends to meet the Fund’s current criteria for a currency’s inclusion in the SDR basket. The process of reform – opening up China’s capital account and deepening its financial markets –is clearly being accelerated. Several important moves were announced recently. First, it will be possibly for capital to be taken out daily from the $150 billion Qualified Foreign Institutional Investor (QFII) program, which provides foreign institutions access to domestic stocks. The current rule limits these cross-border flows to a weekly basis. This change will, in effect, make the yuan convertible within this program and should help attain the objective of having Chinese stocks included in global benchmarks.
A second and wider-reaching development is a scheme to allow the yuan and other foreign currencies to be freely traded with few restrictions by firms in the Shanghai Free Trade Zone (FTZ). The plan is to then expand the scheme across China’s other FTZs and eventually across China by year-end. Under this scheme, firms would be able to move funds in and out of China for capital account transactions. The firms could raise funds abroad for real investment in China. This would mark a very major step in liberalizing China’s capital account.
China is not undertaking these changes just to raise its global standing. China’s central bank and economic policymakers understand that capital account liberalization will be a powerful stimulus for reforming China’s financial markets, which in turn, should strengthen China’s economy. The record of the post-World War II development of the advanced economies clearly illustrates the contribution made by the liberalization of capital movements as economies benefit from the resulting market allocation of financial resources. Financial liberalization is essential for any country that wishes to participate fully in the global economic system.
These reforms by China should be welcomed. The likely eventual inclusion of the Chinese yuan in the elite rank of “reserve currencies” will not threaten the global leadership position of the US dollar, which currently accounts for over 60 percent of global currency reserves. The yuan’s position in global reserves is likely to increase at a slow rate over the years following its inclusion. In view of the greenback’s current strength and interest rate advantage, its share in global reserves may well rise in the coming years.
The ideas and opinions expressed in this blog are those of the author, and they should not be perceived as investment advice or as any other kind of advice.
The preceding is an abridged commentary by Cumberland Advisors and has been reposted with permission. Cumberland Advisors commentaries are available at http://www.cumber.com/commentary_archive.aspx.
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