Examination Regarding the Entry of the Chinese Yuan into the SDR Currency Basket

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1 Examination Regarding the Entry of the Chinese Yuan into the SDR Currency Basket News from the China Advisory Division Ryo Maeda/Ling Kong Treasury Division Mizuho Bank (China), Ltd. 1.Introduction On October 1, 2016, the IMF (International Monetary Fund) added the Chinese yuan to the SDR (Special Drawing Rights) currency basket with the third largest share of 10.92% after the U.S. dollar (41.73%) and the euro (30.93%). The Chinese monetary authorities had been aiming to add the Chinese yuan to the SDR currency basket for a long time, and there have been animated discussions, both domestically and internationally, about what consequences this may have in the times ahead. This article will summarize the important points that are being discussed, introducing a report written by a Chinese intellectual after the entry of the Chinese yuan into the SDR currency basket, in order to examine the possible consequences. This article thus aims to deepen understanding regarding the current situation, as the Japanese media seldom report on local opinions in China regarding the Chinese yuan s entry into the SDR currency basket. It should also be pointed out that said report was contributed to the Modern Bankers website by Mr. Tao Guan, who is the senior research fellow of the China Finance 40 Forum, the former director-general of the Balance of Payments Department at the State Administration of Foreign Exchange (SAFE), and currently also a member of the Chinese Economists 50 Forum. While Mr. Guan has agreed that the report can be introduced in this article, readers are advised to keep in mind that the translation in this article reflects the personal view of the author to some extent. 2.Overview of the SDR What is the SDR? The SDR is an international reserve asset that was created in 1969 by the IMF in order to supplement its member countries' official money reserves. It is a potential claim against the freely usable currencies of IMF members (the U.S. dollar, the euro, the Chinese yuan, the British pound, and the Japanese yen). The picture below shows an example of how it s used. Country A, in short of foreign reserves, requests the use of SDR to Country B. IMF member country "A" IMF member country "B" Country B provides funds in a freely usable currency for Country A. (Country A can choose from among USD, EUR, RMB, GBP, and JPY.) Source: Compiled by Mizuho Bank (China) Treasury Division 1

2 China s efforts to add the Chinese yuan to the SDR currency basket The entry into the SDR currency basket means that the currency is recognized as a freely usable currency by the IMF (as is the case with the U.S. dollar, etc.). It is therefore an ideal situation for China, which is making efforts to internationalize its currency. Even though the possibility of adding the Chinese yuan to the SDR currency basket was considered during the revision in 2010, the IMF did not feel that the Chinese yuan fulfilled the required conditions. Thus, there were a series of reforms made to the Chinese yuan for the following revision in In particular, the Shanghai Hong Kong stock connect was launched in 2015, and a series of measures were taken in an accelerated manner in order to liberalize and internationalize the Chinese yuan market, by opening the onshore bond market and the foreign exchange market to overseas financial institutions, as well as by lifting the upper limit on the Chinese yuan deposit interest rate and reforming the central parity rate rules. 3.What changes due to this entry into the SDR currency basket? Are the effects difficult to see? Thanks to the reform measures mentioned above, the Chinese yuan finally managed to enter the SDR currency basket. However, the majority view is that the impact in the market would be limited, from a short-term perspective. It is likely that demand for foreign exchange reserves will increase worldwide in the times ahead. (If 10% shifts to the Chinese yuan out of the world foreign exchange reserves of USD 7.5 trillion, excluding that of China shown in Fig. 1, demand for the Chinese yuan would be approximately USD 750 billion.) However, given the liquidity and regulation risks related to the Chinese yuan, it is difficult to expect this to happen immediately. Furthermore, it will be easier for the Chinese yuan to be used as a settlement currency in trade, as it is now more trusted as an international currency. As a result, the share of the Chinese yuan in international settlement may start expanding again, even though the pace of its expansion had previously hit the ceiling, which is shown in Fig. 2. However, some deregulation would be necessary for that to happen, which keeps the future outlook uncertain. Fig. 1: Foreign exchange reserves (USD trillion) Fig. 2: Share of the Chinese yuan in international settlement (%) World foreign exchange reserves China's foreign exchange reserves Japan's foreign exchange reserves Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Sep Source: Bloomberg Source: Bloomberg Realistic perspective As is discussed above, the short-term effect of the Chinese yuan s entry into the SDR currency basket is likely to be limited. Under such circumstances, how should the Chinese yuan be internationalized in the times ahead? 2

3 The major arguments in the report are the following. It is clear that China is now one step closer to being a major world player through its currency s entry into the SDR currency basket. This will lead to the mentality of A better China making a better world. Even though some view that the internationalization of the Chinese yuan and the stability in the foreign exchange market contradict each other, the two constitute two sides of the same coin. To take the example of the U.S., which took measures to strengthen the U.S. dollar, it can be said that the measures were taken not just to lead the U.S. dollar to appreciate but also to stabilize the domestic finances and economy by making every effort to raise and strengthen the status of the U.S. dollar to the leading position in the international financial system. China should achieve the policy target by strengthening the Chinese yuan, following international examples such as the measures taken to strengthen the U.S. dollar. In order to attract foreign investment in Chinese yuan assets by recovering high yields, it is essential to continue structural reforms and strengthen industries, achieving the sustainable development of the Chinese economy and a stable financial environment. In other words, China itself needs to be a stronger country. It is only with a strong economy that China can achieve a stable economy and finances with a strong currency. The author of the report seems to evaluate the Chinese yuan s entry to the SDR currency basket fairly positively. However, from an extremely realistic point of view, he sees it more important to strengthen the economy in order to strengthen the Chinese yuan and to stabilize the financial and foreign exchange markets. The author of the report is thus not seeing the entry to the SDR currency basket as a symbol of the internationalization of the Chinese yuan or expecting short-term profits as a result of the Chinese yuan s entry into the SDR currency basket. 4.Status as an international currency Are international views severe? When it comes to reactions overseas, the financial ministers of both Japan and the U.S. made remarks in the second half of September, right before the Chinese yuan s entry into the SDR currency basket. Secretary of the Treasury Jack Lew (at a meeting with students in Mexico on September 26): He said that it would be a long way still for the Chinese yuan to reach the status of an international reserve currency held by the governments of various countries. While recognizing that reforms were being carried out to liberalize transactions in Chinese yuan, he insisted on the importance of further reforms in the times ahead. Regarding the impact on the U.S., he kept a calm view that there was a striking difference between being a major currency recognized by the IMF and being an international reserve currency. Finance Minister Taro Aso (at a press interview after a cabinet meeting): He stated that currency management needed to be more open in terms of the Chinese market and the foreign exchange, requesting transparency in currency management as necessary to remain an SDR basket currency. 3

4 The above remarks both emphasized that the entry into the SDR currency basket would not necessarily mean becoming an international reserve currency. The liquidity level of the Chinese yuan is low, and there are risks related to changes in regulations. It can therefore be said that the Chinese yuan would not be suitable as a foreign reserve currency even if it is in the SDR currency basket, as there are risks that the currency cannot be converted when foreign currency reserves are most necessary. With great power comes great responsibility. In China, the Chinese translation of With great power comes great responsibility, a quote from an American movie, is frequently used. As was discussed above, some point out that the entry into the SDR currency basket would not necessarily mean becoming an international reserve currency. Under such circumstances, it was explained as below. The entry into the SDR currency basket may not automatically liberalize the capital account or the foreign exchange rates of the Chinese yuan. However, it does mean that the Chinese government has declared a movement toward the international market and that it would continue making every effort to make it easier for the Chinese yuan to be used in the international trade system and in foreign exchange transactions, while also following market rules and international conventions. (Omission) In particular, it is still difficult for overseas private financial institutions to enter the Chinese monetary market, and therefore, China still has a long way to go when opening its financial markets, while also shouldering great responsibility. Even though we do not know whether he has seen the above-referenced film, what he emphasizes is exactly With great power comes great responsibility. Unlike the calm view abroad, the domestic media in China often linked entry into the SDR currency basket with entry into the group of international currencies. However, this comment shows that he maintains a cautious view, seriously considering China s role and responsibility in international society. What would be the responsibility? What would the responsibility as mentioned above mean? The report refers to (1) compliance with international rules and (2) communication with the market, as explained below. It would be important to use international expertise while maintaining a base with domestic conditions in China in order to establish a socialist market economy a characteristic of China. However, in order for China to take a role in international society as an emerging country, the Chinese would have to speak not only dialects but also the standard language. In particular, in order to open and deregulate the market further to enhance transparency in the fields of international economies and international finance, it is essential to comply with basic international rules. (Omission) As the Chinese yuan was added to the SDR currency basket, the Chinese government is required to further enhance its management & supervision capability, its legal system, and its market transparency. 4

5 (Omission) With the monetary market in China a little more open, the Chinese monetary market and monetary markets of other countries would become further merged with shared interests. From the point of view of responsibility toward other countries, it is necessary to enhance the transparency of the framework of the policy and regulatory system of China so as to make it more predictable. It would also be necessary to avoid surprises by strengthening communication with the market. While it is normal to comply with international rules, this idea is expressed in the wordings of not only dialects but also the standard language to the Chinese monetary authorities. This shows that China needs to be ready to take on the responsibility that naturally comes with greater contribution to international society with the Chinese yuan being included in the SDR currency basket. On August 11, 2015, the system used to set the People s Bank of China fixing rate was unexpectedly revised and caused confusion in the market. As is exemplified by this case, many point to a lack of communication between the Chinese monetary authorities and the market. The report recognizes this problem and suggests that an improvement of this issue would become part of the responsibility that comes with the entry into the SDR currency basket, which is a logical explanation. 5.Goals for the Chinese yuan Advice for internationalization The subsequent question would be to what extent the Chinese yuan should be liberalized in order to become an international currency in the end. The report argues at the end that the goal for the Chinese yuan is to play the role of a freely usable currency status, gained on the surface at the time of entry into the SDR currency basket, as the actual meaning to be viewed by the market. (Omission) It is extremely important for China to solve problems in the foreign exchange system or in capital transfer management in establishing a new, open economic structure, as well as to promote the free exchange and use of the Chinese yuan. - Regarding the reform in the Chinese yuan foreign exchange market (Omission) After the reform on August 11 (author s note: this refers to the revision to the mechanism for setting the People s Bank of China fixing rate, made on August 11, 2015), it can be said that the marketization of the Chinese yuan foreign exchange has been completed at the basic level. The next step would be to achieve a clean float (a market with free fluctuation). The ideal situations in the time ahead would be the following. The Chinese yuan exchange rate fluctuates in both directions. The market fluctuations are led by the market and not by policy measures. The exchange rate is a trustworthy one, remaining at the same level both in the onshore and offshore markets. Interventions by the Chinese monetary authorities are the exception and not the rule, and the supply & demand balance is maintained in the market. 5

6 - Regarding the capital account conversion of foreign currency into the Chinese yuan For capital accounts, there is no international standard, as is the case with current accounts. However, there are minimum requirements (regulations), such as the management of the negative list system. The market should maintain the capability to control the risk of or have an external body supervise and manage the negative list, which should be revised in accordance with the current situation. However, the minimum requirement is not to generate local financial risks or systemic risks in doing so. In particular, it seems that the report gives very detailed suggestions regarding the liberalization of the Chinese yuan foreign exchange market. According to the plan announced by the State Council in April 2009, Shanghai would be made to act as China s international financial center by In order for this goal to be achieved, the above reforms would be essential. In November 2016, China appointed a new financial minister, but there seems to be no major change in policy plans. Thus, further liberalization is expected in the times ahead. 6.Conclusion Every economic measure counts. So far, this article has discussed entry by the Chinese yuan into the SDR currency basket based on suggestions made by Mr. Tao Guan. It is clear that his assumptions are based on a realistic point of view, emphasizing that entry into the SDR currency basket should never be over-evaluated, as it is more important to strengthen current economic conditions, taking small steps without counting on superficial measures, having recognized the need for greater responsibility. The suggestions made by Mr. Guan, who was until recently playing a major role in the foreign exchange and international balance of payment under the government of Xi Jinping, are full of wisdom. It seems that the media reports in Japan regarding the Chinese yuan s entry into the SDR currency basket are varied, seeing it as a mere policy target or seeing it as a step for the Chinese yuan to gain the status of a key currency. However, it seems that overall local media reports in China are more realistic, as was discussed in this article. Beyond entry into the SDR currency basket For China and the Chinese yuan, entry into the SDR currency basket is never the end goal, but is part of the long path toward achieving internationalization. This article will conclude with a quote from Mr. Guan regarding the internationalization of the Chinese yuan in the times ahead. (Omission) The entry into the SDR currency basket itself is already in the past. A new chapter has already started for the internationalization of the Chinese yuan, opening up a new path. 6

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