HONG KONG (MarketWatch) — China’s latest progress on getting the yuan accepted as a reserve currency has focused attention on the big payoff: that eventually investors and central banks will load up on trillions of yuan-denominated equities and bonds.
But has Beijing really got the nerve to also proceed with the dangerous process of capital-account opening that this requires?
The Goldilocks scenario sees a fresh fund infusion driving Shanghai’s soaring equity markets even higher and delivering a much needed capital boost to China’s debt-burdened industry. But it could also turn into a bad dream. Some analysts warn that if the opening of the capital account is mishandled, it risks triggering a systematic financial crisis.
Last week, China moved another step closer to the currency big leagues after receiving the blessing of the Group of Seven finance ministers to be included in the International Monetary Fund’s (IMF) benchmark currency basket. German Finance Minister Wolfgang Schaeuble said there was agreement the yuanUSDCNY, -0.0403% USDCNH, -0.0483% should be part of the IMF’s basket of international currencies, once technical and other issues are sorted out.
Analysts predict the move could come at this October’s IMF vote, putting the yuan on course for mainstream acceptance and beginning a process of reshaping global capital flows.
This is the second piece of positive news for the yuan, as days earlier the IMF announced that it no longer considered the yuan undervalued. Dropping this longstanding complaint looks overdue, as Chinese authorities have recently been intervening to weaken the yuan.
For some time, China has sought to have the yuan reflect its new status as the world’s biggest trading nation and second-largest economy. Acceptance as one of five currencies included in the IMF’s Special Drawing Rights would accelerate its acceptance as a bona fide reserve currency.
The rewards could be substantial, say analysts. Standard Chartered Bank forecasts that if inclusion were to happen this year, it could lead to cumulative foreign net purchases of China’s bonds and equities to reach 5.5 trillion to 6.2 trillion yuan ($890 billion to $1 trillion) by 2020. That would be roughly 10 times this year’s amount.
And China has other plans to challenge the U.S. dollar DXY, -0.06% as this year it plans to launch crude-oil contracts in Shanghai denominated in yuan.
Investors are being asked to focus on China’s final destination, as it still has a considerable journey ahead.
While a recent study by Swift puts the yuan as the fifth-biggest global currency for payments, the Chinese unit still hardly registers in overall currency trading due to its lack of convertibility on the capital account.
To really become a heavyweight currency, China must lift capital controls. Although this brings the carrot of access to foreign capital, there is also a stick: A freer yuan will force transparency on the financial system and state-owned enterprises, and it may ultimately curb much of the ruling Communist Party’s influence over the economy.
Evidence that Beijing is really ready to make these sacrifices is mixed. So far, reforms — including setting up offshore yuan-trading hubs, a Stock Connect between Shanghai and Hong Kong, as well as free-trade zones — have all been structured so authorities retain a tight grip. The Stock Connect is billed as a trial and operates under a closed loop, while the Shanghai Free Trade Zone still comes with strict quotas.
The huge challenge for Beijing is accepting it must step back and allow markets to set interest rates, to price risk and to determine who gets funding.
According to Société Générale, for liberalization to be successful, authorities need to have strong regulatory oversight, prudent monetary policy and a deep capital market.
Some progress has been made this year on domestic reform with the introduction of bank-deposit insurance in May and new measures to increase flexibility on setting deposit rates.
The belief is that domestic liberalization must proceed in tandem with lifting capital controls to help counter the prospect of capital flight. To have any chance of offsetting outflows, the yuan has to gain the confidence of international capital and also offer investable options.
This explains why creating a deep and liquid bond market where the market can price risk is deemed critical. Here, China has some way to go as it still operates with an implicit state-guarantee on debt and has yet to develop a functional insolvency regime.
To maintain confidence in the yuan during the liberalization phase, sound and sustainable macroeconomic policies are also crucial, particularly given China’s already-high debt levels, says Société Générale. Further, they add, if Beijing attempts to run another credit boom while liberalizing, a systemic financial crisis is inevitable.
This gives policy makers a further dilemma, as it is appears evident more stimulus is needed to meet the Chinese government’s 7% economic-growth target.
The odds are Beijing will opt for a cautious approach to liberalization, meaning it will also be a slow march for the yuan to reach reserve-currency status.
By CRAIG STEPHEN
APAC Financial Markets • #China, #ReserveCurrency, #Yuan #MarketNews
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