November 30, 2015 was a red-letter day for China—and for Zhou Xiaochuan, governor of China’s central bank.
Governor of the People’s Bank of China (China’s central bank) since 2002 and a cautious and methodical bureaucrat, Zhou is the essence of his country’s Mandarin class: canny and understated, but relentless in his objective to elevate China’s economy and currency to elite status. Under Zhou’s watch, China’s exports to the rest of the world almost quintupled (see Figure 1), and in 2015 China is the world’s largest exporter, with 13 percent of the global total. If one takes the World Bank’s purchasing power parity (PPP) exchange rate, the size of the Chinese GDP in 2015 is neck-and-neck with that of the US. (See my January 2, 2015 post Is China set to become the world’s largest economy in 2015?This post was also published at Rutgers Business Insights.)
Figure 1: China’s Exports to the Rest of the World (2004–2014)
And yet, few governments or institutions have been willing to hold the yuan (or renminbi yuan [RMB]) as an asset. RMB holdings comprise only around 1 or 2 percent of the rest of the world’s reserve total. Nearly two-thirds of world government reserves (see Figure 2) are still held in US dollars—because of historical habit and because most international transactions continue to be denominated in dollars (gold, as a reserve asset, has a negligible part).
What is a reserve currency and what functions does it perform?
Imagine that an Indian exporter has shipped goods to Malaysia and has been paid in US dollars. Being an Indian company, it turns over the earned dollars to a bank in India in exchange for rupees. The Indian bank, in turn, hands the dollars over to India’s central bank, again in exchange for rupees. The dollars end up being held by the Indian central bank, the Reserve Bank of India, as an official reserve asset.
Imagine then that an Indian importer wishes to import an item from China, payable in US dollars (assuming that most suppliers outside India are loath to accept rupees). The would-be importer goes to a bank with rupees and asks for dollars, which the bank supplies to the importer from the Indian central bank reserves.
A country’s central bank reserve acts like a storage tank. As long as the dollar supply into the tank (from dollar earnings of exporters, remittances, foreign investment, etc.) is equal to or greater than the country’s demand for dollars from the tank (from importers or persons wishing to remit money abroad), the storage tank (reserve) will not go dry. The reserve acts like a buffer against fluctuations in imports and exports.
But a government’s reserve also can perform another function. If confidence in a country’s currency declines, and a sell-off of the currency occurs in the foreign exchange market, the currency’s exchange rate can devalue. Let’s say the Chinese government wishes to counter devaluationary forces and stabilize its currency. One method it can employ is simply to buy RMBs massively in the foreign exchange market. Increased demand for the RMB would prevent its devaluation and stabilize its value. But if the Chinese government buys RMBs in the foreign exchange market, it has to offer the seller something in return. What?
The answer is, for example, dollars from the Chinese government’s previously accumulated dollar reserves. This is exactly what occurred in mid-2015, when the RMB began to fall or devalue from 6.2 RMB/$ to 6.4 RMB/$. The Chinese government spent several hundred billion dollars out of its ($3–4 trillion dollar) reserves in order to stabilize the RMB and prevent it from falling further.
By the same token, if a government considers that its currency is getting “too strong” and wishes to devalue it, or prevent it from appreciating further, it could buy (demand) dollars in the foreign exchange market, offering the counterparties in the market its own currency. The extra supply of the country’s currency could prevent its further appreciation. The dollars the government buys end up increasing its official dollar reserves. (Also see my November 16, 2015 post Is China a “currency manipulator”? Donald Trump says so.)
What is the role of the IMF?
Until November 2015, the RMB comprised hardly 1 or 2 percent of other countries’ official reserves. Despite China’s position as the world’s biggest exporter, even Chinese imports and export orders are largely denominated in other currencies (such as dollars or euros). With the yuan being a controlled and not easily convertible currency, firms and governments outside China are reluctant to hold RMBs.
Zhou Xiaochuan and his government have been chafing and quietly lobbying to change that. Given China’s leading role in trade and in world economic rankings, to them it is humiliating to see the RMB have so tiny a holding outside China. If one counts both private as well as government (international, or non-local) assets, the dollar easily exceeds three-quarters of the value of non-local assets, compared with around 1–2 percent for the RMB.
The IMF is a mutual-assistance club of 188 country members. Its original principal purpose was, and remains, to help nations encountering a balance-of-payments crisis. Consider a hypothetical IMF member country in 2008—let’s call it Fredonia. Because of the global recession, between 2008 and 2012 Fredonia’s exports to the rest of the world fell sharply, and the dollars earned by Fredonia’s exporters fell by 30 percent. (This actually happened to many nations during the recession.) But Fredonia’s imports are essential items—energy, food, medicines, etc.—that could not be cut without hurting its population. And these commodities have to be paid for in dollars. (No one outside Fredonia is willing to accept “Fredos”— they insist that importers pay them in dollars).
So how does a nation like Fredonia continue to import vitally needed commodities if, on the export side, its exporters’ dollar earnings have fallen by 30 percent? It turns to the IMF (International Monetary Fund) for help.
The IMF helps nations facing a currency crisis to get dollar or other “hard currency” loans from other countries that have accumulated dollar reserves. The IMF thus acts as a friendly loan broker between nations and as a facilitator to tide over those countries suffering significant balance-of-payments deficits.
However, since 1970, the official government reserves of all 188 IMF members have grown much slower than world liquidity has. Put simply, growth in international transactions (trade or “imports + exports,” cross-border portfolio and direct investment, and private remittances) has been vastly greater than the growth of all countries’ national reserves. And recall our earlier discussion—that a country’s reserves are supposed to act like a buffer against shocks or shortfalls in foreign currency earnings. The typical nation’s buffer (or reserve) has not grown as fast as its international transaction volume, which can be a danger.
To alleviate this danger, the IMF created from scratch, or out of nothing (i.e., in its computers), a notional reserve currency called the SDR (Special Drawing Right), which it then divided and allocated to its member countries. The SDR is not a usable currency, and it does not exist anywhere except in the IMF’s computers and as a notional asset in member countries’ central bank computers. But it adds to each country’s buffer reserve and can be used in a balance-of-payments crisis.
In the example of Fredonia, during the period 2008–2012 when that country’s export (dollar) earnings fell way below its need for dollars to continue necessary imports, it could use the SDRs previously allocated to it by the IMF. Relinquishing its SDRs to the IMF, the IMF would then find another nation with surplus dollars in its reserves and ask that nation to temporarily (for a few years) swap SDRs for dollars with Fredonia. That way, Fredonia’s central bank would receive actual dollars that it could use to continue importing items critically necessary for its populace, augmenting the dollars earned by its exporters.
What’s the big deal about including the Chinese RMB in the SDR?
The SDR, a notional currency, is usable only in exchanges between central banks. Nevertheless, to effect the inter-governmental exchanges, the SDR has to have a formula to calculate its value. After 1999, with the introduction of the euro, the IMF decided that the euro would be allocated a 37.4 percent share or weight in the SDR, the dollar a 41.9 percent weight, the Japanese yen 9.4 percent, and the UK pound 11.3 percent—roughly reflecting these major countries’ role in global commerce at that time. But by 2015, China had muscled in and earned its status as a dominant player in international business, and the RMB or yuan could not be ignored, despite it puny role in international transactions and despite its being a not-easily-convertible currency.
After a debate of several years, and with steady pressure from Beijing, the IMF announced on November 30, 2015 that the yuan would be allocated a 10.92 percent share or weight in the formula for the SDR (see Figure 3). It is worth noting that the Chinese share comes at the expense of reduced shares for the euro, yen, and pound—but not at the expense of the US dollar, whose share and role in international business remains unchanged and paramount.
Is this a great victory for China—or mere symbolism?
Among the Chinese elites that run that nation, and among its increasingly assertive middle classes, nationalism and historical memories run deep. Five hundred years ago, China was the world’s biggest economy, and the humiliation of being overtaken and later suppressed by Japan and the West between 1895 and 1949 still rankles. Any recognition of China’s status in 2015 is appreciated and met with great pride by its people. Indeed, today it is the world’s biggest exporter and (on PPP exchange rate terms) an economy more or less the same size as that of the US. Yet, being allocated a 10.92 percent share in the SDR formula is at present a mostly symbolic triumph, since the SDR is not a real currency. However, it can lead to real changes over the coming decade.
Even with additional SDRs being “created” in IMF computers, the fact is that SDRs amount to a mere $285 billion and comprise only around 5 percent by value of all governments’ central reserves. Moreover, all government reserves amount to a mere $6 trillion equivalent, which, in this author’s opinion, is a dangerously low amount given the huge liquidity in global commerce today. Liquid assets worldwide easily exceed $100 trillion, and daily turnover in foreign exchange markets worldwide exceeds $5 trillion. With only $6 trillion in total world reserves, the ability of governments to fight determined panics and capital flight is today dangerously inadequate. (See my September 10, 2015 YaleGlobal article Seeking Safety Abroad: The Hidden Story in China’s FDI Statistics).
It is therefore likely that the IMF will greatly increase its creation and allocation of SDR reserves to governments in the future. That, together with China’s eminent role, its assertiveness, and its continuing push to have other governments hold and trade RMBs, is very likely to expand the yuan’s role in the years ahead.
Even outside the IMF framework, China has been pushing bilateral swap deals worth 3 trillion yuan with more than 20 nations. For example, in 2013 the Chinese central bank swapped the equivalent of $30 billion worth of yuan for Brazilian real. This increased both countries’ official reserve position, but also provided encouragement to their importers and exporters to stop invoicing in dollars and use each other’s currencies instead. Trading in the RMB has significantly expanded since 2010 to seven offshore locations (see Figure 4), with transactions multiplying 23-fold by 2014 (albeit from a very small base).
Zhou Xiaochuan’s journey has been a remarkable one, from being ordered to work at a farm for four years during the cultural revolution (1968–1972), to being rehabilitated and earning a PhD in 1985 from Tsinghua University in Economic Systems Engineering, and to serving as central bank head for 13 years continuously under three presidential regimes—those of Jiang Zemin, Hu Jintao, and Xi Jinping.
Zhou’s story is also China’s story. A poor, developing nation in 1968 under the dictate of a centrally planned leadership, market forces—even partially unleashed under Deng Xiaoping—have wrought one of the most remarkable transformations in human history, whereby 800 million persons have had their lives lifted from a hardscrabble existence into a tolerable or comfortable middle-class life. And the number of billionaires in China now surpasses the number in the US.
 A bank in India would typically hold some of its own dollars for daily use, but the supply of dollars to an Indian bank comes from the Indian central bank, which in turn receives dollars from the export earnings of Indian firms, remittances, and other external sources.
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