IMF Elevates Yuan to Elite Currency Status: So what?

© 2015 Prof. Farok J. Contractor, Rutgers University

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)

Source: Statista

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[1]. 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).

Figure 2: The US Dollar Still Dominates

Source: Michael Lingenheld. Forget the Military, America’s Greatest Weapon Is the Dollar. Forbes, March 13, 2015

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.[2]

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.

Figure 3: The Formula for the SDR

Source: Yomiuri Shimbun. IMF gives yuan reserve asset status. The Japan News, December 1, 2015

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.[3] 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).

Figure 4: Offshore Trading Centers for the Yuan

Original Source: Standard Chartered

Final Thoughts: Zhou’s story is China’s story

Zhou Xiaochuan – Photo Credit Vincent Yu/AP

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.[4]

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[1] RMB internationalisation will benefit from stronger transatlantic, transpacific coordination. Standard Chartered Bank, June 22, 2015. 

[2] 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.

[3] Factsheet: Special Drawing Right (SDRs). IMF, November 30, 2015. 

[4] See China now has more billionaires than U.S. CNN Money, October 15, 2015. However, according to Robert Frank, Countries with the most millionaires. CNBC Inside Wealth, October 13, 2015, the numbers of millionaires in the US—15.7 million—greatly outnumber those in China, at only 1.3 million (at least according to official data). That is to say, if you are a billionaire in China, it is difficult to conceal your wealth; but a mere millionaire in China can lie low, under the radar of official statistics.

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Is China a “currency manipulator”? Donald Trump says so

© 2015 Prof. Farok J. Contractor, Rutgers University

After 20 years, the Chinese government must be used to it—being bashed by US politicians and Congress as a “currency manipulator.” Indeed, the exchange value of the yuan (or renminbi [RMB]) is fixed each morning by its central bank, the People’s Bank of China (PBoC), with a narrow band of only + 2 percent allowed, up or down, within which market forces can have their say. In effect, it is an exchange rate set and controlled by the PBoC.

But why pick on just China?

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Most countries “manipulate” their exchange rates…

According to the IMF (International Monetary Fund), well over half its member countries’ governments meddle, in a mild or total fashion, to influence or fix their exchange rates. As shown in Figure 1, “Fixed Peg” and “Currency Board” are countries with currency values fixed for a considerable period of months or years. In “Managed Float” cases, market forces are allowed to play, but with the government intervening (buying or selling) to bias the exchange rate upward or downward. “Adjustable Pegs” are situations where the government fixes the rate temporarily—for months at a time or daily, as in the case of China. It is only with a few major currencies, such as the dollar or euro, that the government allows a “Free Float” with minimal or no intervention.

Figure 1: Percentages of IMF Member Nations Intervening in Foreign Exchange Rates (Source: IMF)

What exactly is behind the accusation of “currency manipulation”?

Generally, the accusation alleges that the government is keeping its currency too weak, overly devalued, or undervalued in order to give an artificial boost to exports while keeping out imports. This has the effect of boosting jobs in that country.

Take China as an example. A Chinese exporter earning a dollar turns it into the bank and gets 6.4 RMB yuan. By comparing costs in China and elsewhere, IMF and other economists calculate a hypothetical purchasing power parity (PPP) rate of 5.7 RMB/$, which would supposedly prevail under market equilibrium and without government meddling. At 6.4, some economists argue the RMB is still undervalued. But if the theoretical rate of 5.7 RMB/$ were to happen, the Chinese exporter would get only 5.7 RMB per dollar at the bank counter. The 6.4 RMB/$ rate provides a 12 percent higher revenue to the Chinese exporter, compared with the hypothetical 5.7 RMB/$ rate that some economists say should prevail. The still-undervalued 6.4 RMB/$ rate, they allege, gives the Chinese exporter an advantage.

By the same token, imports into China cost 12 percent more at the allegedly undervalued 6.4 RMB/$ rate than at the PPP 5.7 RMB/$. This, they allege, makes imports into China 12 percent more expensive than they should be, thereby keeping some foreign products out of China and benefiting (or protecting) Chinese firms that produce substitute products that compete with imports. On both the import and export side, an undervalued exchange rate boosts or preserves jobs in China (at the expense of jobs in the rest of the world).

But the Chinese have already massively appreciated their currency since 2005…

It must be particularly galling to the Chinese to hear accusations of currency manipulation since, succumbing to pressure from Western countries, they have already massively appreciated their currency in the 10 years since 2005. In June 2005, following more than a decade of a fixed exchange rate at 8.27 RMB/$ (when it was indeed undervalued), the Chinese gradually appreciated their currency all the way to 6.2 RMB/$ by July 2015. In the minds of many Chinese economists, their currency is no longer undervalued at around 6.2 for three reasons:

1. Between June 2005 and July 2015, the RMB appreciated/strengthened by 36 percent (see Figure 2)

This means that Chinese exporters in 2015 earned as much as 33 percent less that they would have at the 2005 exchange rate. Several Chinese exporters found themselves uncompetitive with the stronger currency and had to shut down their operations in China and relocate production to Vietnam, Bangladesh, or Africa.

Figure 2: China’s RMB Exchange Rate History (Source: Oanda.com)

By the same token, imports into China costing 33 percent less in 2015 than in 2005 means that some Chinese domestic production was displaced by imports.

In both cases, the appreciation of the yuan (RMB) has meant reduction of jobs in China, although this is consistent with the peaking of the Chinese labor force (partially as a consequence of the one-child policy). Indeed, several areas in China have labor shortages.

2. The yuan (RMB) has appreciated even more against other currencies

The PBoC fixes the RMB only against the US dollar. But in the last two years, this has meant that as the dollar has risen against most other currencies (such as the euro or emerging-country currencies such as the Brazilian real), the RMB has appreciated or strengthened even more, piggybacking on the dollar (see Figure 3).

Figure 3: The Yuan (Reluctantly) Piggybacking on the US Dollar
(Source: The Economist, May 30, 2015)

If one combines the RMB appreciation in Figure 2 (36 percent) with the dollar’s appreciation against most other currencies since 2013 (15 percent), the local currency cost of importing Chinese products may have risen by more than 50 percent since 2005 for many prospective buyers in a large swathe of nations from Europe to Brazil.

3. Chinese wages and costs have risen

On the east coast of China, where most of its manufacturing and economic activity takes place, wages have recently been rising at least 15 percent each year. Some jobs go unfilled. The one-child policy (reversed in 2015) has led to a plateauing of the labor force. Other costs, such as real estate, have also risen sharply. Chinese exporters are beginning to feel a squeeze between (i) rising costs and (ii) the falling RMB conversion value for the dollars or foreign currencies they earn.

So, why pick on China?

By massively appreciating their currency, the Chinese have succumbed to Western government pressure. While most economists aver that the yuan (RMB) is still undervalued, they agree that in 2015 it is not undervalued by much.

Indeed, if one were to search for a more egregious recent example, it would be the Japanese yen, which has been consciously devalued by the Shinzo Abe government by around a third since November 2012.

Figure 4: Yen per Dollar Exchange Rate November 2012–November 2015 (Source: Oanda.com)

One of the Abe government’s top priorities on taking office was to drive the yen downward (devalue it) from a historically high overvaluation of 80 yen/$ (at which rate few Japanese exporters could make any money) to a more devalued rate of 124 yen/$ (by 2015 when Japanese exporters could make profits). The math is simple. At 124 yen/$, each dollar earned by the Japanese exporter converted into 55 percent more yen, compared with the 80 yen/$ rate. In retrospect, it seems astonishing that so many Japanese governments prior to Abe’s allowed the yen to remain at an overvalued rate of 80–100 per dollar, which not only grossly dampened Japanese exports, but also put the economy into the doldrums for so many years. Most economists would agree that at around 115 yen/$, the yen would be appropriately valued—that 80 was too high and that perhaps the 124 yen/$ at end 2015 is a tad too low. At any rate, the Abe government’s actions have jump-started the Japanese export engine and restored a plethora of Japanese exporters to profitability.

But is this not also a case of currency manipulation by the Japanese? And, as noted above, the IMF reports that more than half of the world’s governments have a hand in influencing or adjusting their exchange rates.

So why then pick on only the Chinese, especially if, at 6.2 RMB/$ and with rising costs inside China, they are not too far from a realistic PPP rate in 2015?

Donald Trump, please read this post.

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Also see my May 8, 2014 post: Whither the Chinese yuan? Is the RMB still undervalued?

Why a Single Currency Works in the US, but Not Very Well in Europe: Three Minimal Conditions for the Eurozone to Function

© 2015 Prof. Farok J. Contractor, Rutgers University

America has been using a single currency since 1793, when the United States Mint in Philadelphia first began issuing US dollar coins. However, it is not the longevity of a currency that determines whether it succeeds, but institutional mechanisms. Such mechanisms are weak or lacking in Europe. To understand why, we need to examine how such mechanisms could help countries in a common zone to ride out economic cycle “booms and busts.”

When a country gives up its own currency (say, the drachma) in favor of a supranational one (such as the euro), it loses two important levers to help soften the blow of a recession: (1) It cannot unilaterally adjust its interest rates downward to stimulate its own economy in a downturn; interest rates could be held uncomfortably high by the supranational monetary authority if the economies in the other member states remain healthy. (2) And it is unable to devalue its currency in order to stimulate the nation’s exports.

For a single currency to function well, three conditions, or institutional pillars, must be in place: (1) fiscal discipline by member states, (2) labor and capital mobility, and (3) inter-regional balancing through transfer payments managed by a central government.

Fiscal Discipline by Member States

While American states are free to set their own budgets and raise money through taxes and borrowing, their excesses are curtailed by state constitutions that recommend or mandate balanced budgets; by an informed media that flags profligate spending; and by the discipline that the bond market imposes. Almost all US states manage to restrict their deficits to a few percentage points.

When the eurozone was introduced in the early 2000s, participating countries that gave up their own currencies made pious promises that they would restrict their budget deficits to no more than 3 percent. But no enforcement mechanism was put in place, and in the go-go years between 2000 and 2007 countries such as Greece ran up sovereign debts well in excess of that limit. By early 2015, Greek debt was estimated to be 177 percent of GDP[1]—in short, unpayable—according to a recently leaked IMF report.[2] In fact, previous Greek governments must have known they were taking huge risks because they hired investment banks such as Goldman Sachs[3] to devise complex swap instruments that hid the true size of their borrowings from other EU states and the public. In 2010, Angela Merkel called this “scandalous.” But she could do nothing about the situation without an EU enforcement mechanism in place.

Labor and Capital Mobility

Recessions and economic downturns impact states differently. If a worker in an Ohio “rust-belt” factory is laid off, he may consider selling his home and loading the family and Golden Retriever into the minivan and driving to Houston or Silicon Valley, where jobs are available. On average, 42 percent of Americans do not reside in the state of their birth. This willing mobility reduces the impact of recessions and unemployment, decreasing the pain in the most affected states. According to the US Census Bureau, after age 18 Americans will move 9.1 times during the rest of their lives.[4] By contrast, 47 percent of Italians, for example, live within 5 kilometers of their mamas. And although jobs are still going begging in Germany, the almost 30 percent of Greeks who are unemployed in 2015 do not wish to relocate because of cultural unfamiliarity and reluctance.

Europe is still a collection of separate cultures, employment regulations, and languages, and therefore labor immobility does not provide the smoothing-out effect seen across the United States. Capital, too, is less mobile across the EU, compared with the US, because varying company regulations and foreign-market unfamiliarity reduce the likelihood of a firm relocating or expanding outside its nation.

Inter-regional Balancing Through Transfer Payments Managed by a Central Government

In the US, most taxes are collected by a centralized federal government, which then allocates money to the states according to their needs. In Europe, each state collects its own taxes and is then reluctant to share any significant amount with the other “foreign” nations in the eurozone. On average in the US, a decline of one dollar in a state budget is offset by a transfer of 28 cents from the federal government.[5] More can be made up by additional taxes raised by the state, providing a cushion to smooth out the bumps over a recessionary period.

True, the EU (Brussels) does reallocate some funds to member states, but these are very small compared with US transfers from the federal government to US states. Moreover, most of the funds Brussels redistributes are project-specific rather than designed to alleviate recessionary suffering or boost flagging economies. Bailouts such as those given to Portugal or Greece have to be painfully negotiated each time and agreed to by all EU member states. And the member states have veto powers. So Brussels really is not a central government, by any means.

Conclusion: Monetary Union Without the Three Institutional Pillars

The euro is a noble experiment designed to foster a sense of pan-European identity (and, incidentally, to reduce currency risk and transaction costs for firms). Its architects had hoped that the façade of unity would then be followed by the construction of three institutional pillars to solidify the structure. Fifteen years hence, European institutions have barely evolved enough to build such pillars or, in other words, to fulfill the three requirements of a monetary union. An appetite for a central fiscal authority is lacking, as is a mechanism to restrain individual states from excess borrowing to boost their budgets. For cultural reasons, cross-border migration of labor remains sluggish, and transfer payments from the rich nations of the EU to support their poorer neighbors is already running into such resistance that countries such as the UK threaten to withdraw from the EU altogether.

Can the noble experiment survive?

Certainly, other nations that received bailouts, such as Portugal, have not only turned the corner, but have begun to pay back their debts.[6] It is possible that the shock of recent events can stem the profligacy of loose fiscal policies, especially if conditions are imposed on them. But the euro will remain a fragile construct, vulnerable to future shocks, whose survival will depend on the continued generosity of the richer members of the EU.

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[1] Eurostat (2014). Government debt as percent of GDP. Government Debt in Europe, August 24.

[2] Reuters (2015). Secret IMF report—Greece needs debt relief far beyond EU plans. Business News, July 15.

[3] Martinuzzi, E. (2010). Goldman Sachs, Greece Didn’t Disclose Swap Contract (Update1). Bloomberg, February 17. Also see Reuters (2015). Goldman Sachs could face lawsuit for helping hide Greek debt—report.RT Question More, July 12.

[4] US Census Bureau: Calculating Migration Expectancy Using ACS Data.

[5] O’Rourke, K. H., & Taylor, A. M. (2013). Cross of Euros. Journal of Economic Perspectives, 27(3), 167–92.

[6] Kowsmann, P. (2015). Portugal on Road to Recovery Post-Bailout, But Scars Remain. The Wall Street Journal, July 17.