by V Anantha Nageswaran
“In a burst of patriotism, China’s central bank swore loyalty to the country’s Communist leaders on Monday by vowing to ‘always walk with the Party’. Whereas most central banks around the world try to assert their independence from the government and politicians, China’s central bank has exercised no policy autonomy. The nationalistic ardour from the People’s Bank of China is the latest pledge of support for the ruling Communist Party ahead of the 90th anniversary of its founding on Friday.
‘The central bank marked in Beijing today the 90th anniversary of the founding of the Communist Party with celebrations around the theme of “always walking with the Party”,’ the central bank said in a statement on its website.
‘We sang about the good of the Party; the good of socialism; the good of reforms, and the good of the great motherland,’ it added.”
This story captures the uniqueness of the country and the currency that we are analysing. China is no ordinary country. Based on official World Bank data, its nominal gross domestic product (GDP) growth averaged 16 per cent per year between 1979 and 2009. Real GDP growth averaged 10 per cent. This is an incredible achievement. How has China managed its currency and what are its ambitions and contradictions?
If the central bank of an aspiring superpower can behave as though it is nothing but an extended arm of the ruling party, then it goes without saying that the currency would be more an instrument of political power than an economic unit. China has deployed the yuan only in that fashion. But, unmistakably, the quest for tight political control has and will continue to clash with the country’s aspiration for international dominance and for international acceptance of its currency and its financial assets in general.
The international implications of how China managed its currency were felt a few years after the Chinese government devalued the currency by about 55 per cent in December 1993 (some think that it was effective from January 1994). The yuan was devalued from around 5.5 to 8.3 against the US dollar.
The World Bank, in 1993, had published a report on the success of the East Asian tiger economies of Taiwan, Singapore, Hong Kong and South Korea. It was a story of successful economic transformation to the first world from the third world. Barring the two city-states, the other two had also begun to develop robust democracies. Thailand, Indonesia and Malaysia were next in line to become economic success stories and join the first four in a flying geese formation towards “developed nation” status. First was Japan; then these four and then the next three. The yuan devaluation put paid to those hopes. Many Southeast Asian nations and South Korea were caught in an external funding crisis and then a banking crisis. Their economies endured a deep recession in 1998. Their currencies plunged against the US dollar. Many banks had to close down as many borrowers in foreign currencies could not repay their loans and, in turn, banks had to close because their assets thus turned sour. In fact, South Korea had been admitted to the rich countries’ club — the Organisation for Economic Co-operation and Development (OECD) — in 1997. But, in 1998, it had to go hat in hand to the International Monetary Fund (IMF). It was a big national humiliation.
Of course, one does not rule out domestic policy failures, hubris, excessive risk-taking and complacency for the crisis that these nations endured in 1997-98. But, the yuan devaluation of 1993 had a big part in their crisis. Their exports lost competitiveness. Chinese exports cut into their market share. Their current accounts swung dramatically from surpluses into deficits. That is what triggered the funding crisis, as Western banks refused to roll over short-term foreign currency loans. The game was up.
The Asian crisis had a salutary lesson for the countries affected by it. They swore never to turn to the IMF for funding, for it came with humiliating conditions. China too learnt an important lesson. It decided that it would keep its currency undervalued, since overvaluation was always an invitation for a speculative attack. Keeping a currency cheaper than it should be simply means, in layman’s terms, creating an excess supply of it and buying up foreign currencies with that.
China was admitted into the World Trade Organization (WTO) thanks to the enthusiastic support that America, under former US president Bill Clinton, extended for that endeavour. In December 2001, China formally joined the WTO. In 2001, the American economy endured a mild recession due to the collapse of the technology bubble the year before. Then, 9/11 happened. The Federal Reserve cut the interest down to 1.0 per cent. Central banks in other countries — Japan, Switzerland and the Eurozone — followed with aggressive rate cuts of their own, for two reasons. One was that their economies too experienced a slowdown and were in need of lower interest rates to stimulate growth. Two, drastically lower interest rates in America meant that investors would be happy to sell their dollars and buy their currencies. That would push up the value of their currencies too much too soon. These economies were dependent on exporting their goods to the US for economic growth. They did not want their goods to become too expensive for the American consumer.
Thus, interest rates in some of the leading currencies in the world — the US dollar, the Swiss franc, the Euro and the Japanese yen — fell to historically low levels. Hence, it became attractive for investors to borrow cheaply in these countries and lend in developing economies at higher rates to profit from the interest rate differential. Conversely, it is also cheaper for companies and governments in developing countries to borrow in these currencies at lower interest rates for projects in their countries that have a higher rate of return. Of course, there is exchange rate risk and it does strike eventually. But, a permanent feature of international capital markets is that lessons are learnt only to be forgotten too quickly.
The combination of the two effects — low interest rates and the consequent capital flows from the developed world to the developing world — meant that, under normal conditions, currencies of developing countries that are in demand would appreciate. That happened to many currencies that had higher interest rates — currencies of Brazil, South Africa, Turkey, Indonesia, Australia, New Zealand and India.
China was a special case. It did not have a very high interest rate that attracted as a magnet for international capital flows. In any case, China had restrictions on how easily foreigners could own the Chinese currency for speculative purposes.
What created pressure on the Chinese currency to appreciate were its booming exports and strong foreign direct investment as many companies from the West sought to establish production facilities to take advantage of lower wage costs in China but also with an eye on the domestic Chinese market. China’s export growth went up several notches post WTO accession. According to OECD data, Chinese export growth was above 20 per cent for the six years following its entry into WTO. In 2003 and in 2004, it was above 30 per cent. To be clear, India too experienced high export growth in that period, but China was starting from a much higher export base than India.
China’s trade surplus soared and, under normal circumstances, the currency should have appreciated considerably. The currency did appreciate but not to the extent that economic theory or the strong export performance and capital flows would have warranted. China’s effective exchange rates — real and nominal — stayed below 100 throughout this period. Effective exchange rates are weighted average exchange rates of a currency against that of its trading partners. If it is adjusted for inflation rates in the country and inflation in its trading partners, it is called real effective exchange rate (REER). Otherwise, it is nominal effective exchange rate (NEER). A number below 100 means that the currency is competitive and that it has not appreciated much either in nominal or in real terms. A number above 100 means that the currency has strengthened against its trading partners’ currencies (in the case of NEER) and/or its inflation rate is higher than that of its trading partners (REER).
The concerted and deliberate attempt to keep the currency undervalued meant that China accumulated foreign exchange reserves by the billions in that period. Foreign exchange reserves that were only around $200 billion around the time China joined the WTO rose 10 times to over $2 trillion by 2008. It doubled to $4 trillion by 2014 when it peaked.
The government viewed the foreign currency assets held by the Chinese central bank as a strategic asset. It was used to acquire financial and other strategic assets around the world — from oilfields to movie theatre chains to hotels. The Chinese government also accumulated plenty of US government Treasury securities. After all, foreign exchange reserves are foreign currency cash. They have to be invested somewhere. On a couple of occasions, China had threatened to use its holdings of US Treasury securities as a weapon against the US. By dumping in the market, it could, in theory, cause interest rates in America to spike.
But, it soon realised that the shoe was on the other foot. The headache of accumulating large claims against another government or corporation is that of the creditor and not for the debtor. Dumping of US Treasuries would create big losses for the remaining holding of US government debt in its foreign exchange reserves.
Then, the crisis struck the global economy in 2008. That ended China’s export-led growth. China resorted to a big domestic economic stimulus and also began to change its currency strategy, partly because of the external situation and partly because it was no longer a low-cost export economy. It wanted to use its currency strength to expand its presence overseas, buy assets overseas both for economic and strategic purposes. More importantly, China saw in the crisis an opportunity to end the dominance of the US dollar. Its central bank governor floated some discussion papers in 2009, arguing that too much dependence on the US dollar made the world economy unstable and that the world economy needed a truly multipolar world, including for international currencies. Hence, the Chinese currency began to appreciate steadily after the crisis. In parallel and in line with the goals set out in the discussion papers, China began efforts to get the yuan included in the basket of currencies that made up the IMF Special Drawing Rights (SDR). It also began to persuade many countries exporting to China to accept payments in yuan rather than in other established hard currencies such as the US dollar and the euro.
Effective 1 October 2016, the yuan was admitted into the SDR, a “virtual” or notional drawing rights that the IMF issues member countries. Countries that are allotted SDR can convert it into component currencies. There were four of them before: the US dollar, the euro, the British pound and the Japanese yen.
As China celebrated its currency becoming an international currency, it was also the year that marked one of the most draconian tightening of foreign exchange controls by the Chinese government in a long time. China’s foreign exchange reserves, excluding gold, had peaked at around $4.02 trillion in June 2014 and had declined since then. It is around $3.18 trillion as of January 2018. Anecdotal evidence mounted that even routine payments by foreign companies to their parents overseas were considerably delayed as authorities neither denied nor granted approvals. Dividend payments by foreign subsidiaries to their international headquarters were also held up. That China was forced to go back on its promise of letting the currency be determined by market forces so soon after being admitted to the SDR basket was a huge embarrassment.
More than that, such desperate measures do not engender confidence that the currency would be freely convertible. Capital control measures reduce convertibility drastically. Small, powerless emerging economies may want to retain that option from time to time. But, an aspiring superpower doing so is an admission of economic vulnerability.
That is why becoming a SDR basket currency and becoming a reserve currency are two different things. For a currency to become a reserve currency, it means that other countries must willingly hold some of their foreign exchange in that currency and for that, the currency should be a reliable store of value, a widely used medium of exchange and freely convertible. In recent years, the Chinese currency has passed the first test well. Official inflation rates in China are low by the standards of most developing countries. China is almost a middle-income country already, in any case. But, it falls way short of satisfying the other two criteria.
Exactly a year before the IMF made the decision to include the Chinese currency in the SDR basket, John Williams, the president of the Federal Reserve Bank of San Francisco, had made the following acute comment to Reuters in October 2015, as to why the yuan could not become a reserve currency: “As long as they have the threat and reasonable expectation that in a moment of panic or crisis they would clamp down on the movement of capital so it doesn’t disrupt their economy, there is no way that anyone would view the yuan as a reserve currency.”
Xi Jinping’s assumption of presidency for life in March might have dented the chances of the yuan becoming a more internationally accepted currency. So much concentration of power raises the risk of arbitrary decisions such as demonetising the yuan in the hands of foreigners. It might be a remote threat but its probability just went up. Spectrum Asset Management, which manages $23 billion of assets, refuses to buy even dollar-denominated China bonds, and Joseph Urciuoli, its head of research, was eloquent about the reasons, as reported by Bloomberg.com on 22 March:
“‘The thing with China is, it’s a black box,’ Urciuoli said in an interview in Hong Kong on Monday. ‘We don’t know how the accounting is, we don’t even know if the GDP numbers are real. Even if the numbers are real, it’s not a free country.’ And in countries that aren’t free, ‘their leaders can say “you know what, we are not gonna pay US investors,”’ he said.”
Other applications of the yuan as an instrument of foreign policy were with respect to the establishment of two international financial institutions, namely the Asian Infrastructure Investment Bank and the New Development Bank, also sometimes referred to as the BRICS Bank, and the “New Silk Road” initiative. The two banks were China’s answers to the World Bank and the Asian Development Bank. These two institutions were (at least partly) capitalised using the foreign exchange reserves that China had accumulated suppressing the value of the yuan.
The Silk Road initiative, also known as the One Belt One Road initiative, was to extend China’s influence over the Eurasian landmass through a process of neo-colonisation. The project involves developing infrastructure in the countries along the Silk Road so that trade between these nations (including China, of course) is facilitated. The infrastructure development will involve Chinese knowhow, technology, workers and financing. The financing is on such harsh terms that countries find it difficult to repay.
Sri Lanka’s Hambantota Port is a case in point. It could not repay the debt and hence had to transfer part ownership to a joint venture set up with the China Merchants Port Holdings Company and signed a 99-year lease with the joint venture entity. Several African nations have had similar experiences and there is resentment even though some infrastructure development has been happening as well, in those countries.
More recently, in February, China announced that it would launch crude oil futures contracts to be denominated and settled in yuan. This is the first step in the process and the target is the eventual pricing and settlement of crude oil transactions in yuan, instead of the US dollar. But, for now, that looks remote. Sceptics rightly point out that as long as the currency was under the control of the central government, international traders might agree to settle contracts converted into yuan but they would continue to price the oil in dollars.
In all, China had deployed its currency to gain international leverage with considerable success and, in the process, with considerable embarrassment too. Given the party’s determination to extend its control and influence over all aspects of the country’s affairs — in society and in economics, it is difficult to see how the currency could displace the dollar as the hegemonic currency. The party’s control cannot extend much beyond the borders although it cannot be accused for not trying. Domestic repression and international confidence make strange bedfellows. The internationalisation of the yuan is bound to be a casualty of this inherent contradiction.
A strong and autocratic domestic government can be dominant internationally too only through the might of the “sword”. For certain periods and in certain pockets, it might be feared, and countries could choose to become supplicants or vassal states. China’s size and strength might induce reluctant acceptance but not admiration and willing adoption of its currency. That is unlikely to endure and certainly not in modern times.
Therefore, China eventually might find it difficult to make headway in its quest to dominate the world either with its military or with its currency.
V. Anantha Nageswaran is an independent financial markets consultant based in Singapore
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