- In coming years, China's foreign currency exchange reserve stockpile will continue to decline as capital outflows increase.
- If China cannot stop the outward flow of capital, it will try to constrain its pace.
- Greater capital outflows will promote yuan internationalization as Beijing seeks to limit the dollar's dominance throughout its economy and make the yuan an integral part of the international finance community.
- China will accelerate politically divisive reforms to internationalize the yuan because of China's deteriorating economic health.
Since the 1990s, China's economic growth has relied on the manufacture of exports at competitive prices to generate profits and surpluses. China thus accumulated large amounts of capital and foreign currency exchange reserves through a large trade surplus and foreign investment, eventually holding the largest cache of foreign reserves, reaching nearly $4 trillion by June 2014.
By investing in infrastructure or other projects abroad, Chinese corporations and state-owned enterprises could help spur some additional international demand for Chinese exports and construction products. This will be a windfall for Beijing, because external demand for Chinese products in markets such as Europe is weak, and the weakness of China's housing and construction sector is constricting construction companies and related firms.
In the longer term, these benefits can become even greater if China makes agreements with countries that make them pay back investments or loans to build the projects in yuan, not dollars. This would help the yuan's international profile and incentivize foreign countries to hold the yuan as a reserve currency.
A Broader Shift
Over the last 40 years, as China has accumulated a large cache of foreign reserves, it has reinvested most of these reserves into the U.S. dollar and the U.S. economy; about one-third of China's total foreign currency holdings are in U.S. Treasury securities alone. The United States is seen as one of the most stable financial environments, and though investing in the United States has enabled Beijing's foreign exchange holdings to go into safe assets, it has put Beijing in a precarious position: In essence, China has been financing the U.S. economy and therefore supporting its major geopolitical rival.
Now, as Beijing seeks to raise its status in the world's financial system, China has a greater need to weaken or break this relationship. This is driving Chinese economic statecraft to wean the Chinese economy away from reliance on the U.S. dollar and the dollar's dominance in cross-border economic transactions.
China's strategy is wide-ranging. At home, Beijing is enacting economic reforms for a more flexible currency regime and reduced capital controls to satisfy international markets and institutions like the International Monetary Fund. These reforms will continue moving China toward circumstances in which it can turn capital outflows into something positive for national policy.
If Beijing can satisfy the IMF's list of demands, then the yuan is likely to be eventually included in the IMF's Special Drawing Rights reserve basket. This approval could happen as early as November, and the yuan's entrance could happen as early as September 2016. This would not only reduce China's reliance on the U.S. dollar, but also promote its own currency in other countries as a reliable medium of exchange.
While there is no doubt that the Chinese government strongly supports the internationalization of the yuan, Beijing wants to retain control over both the flow of investment from China into other countries and investment into China itself. The internationalization of China's financial system comes with risks. The outflow of capital has enabled a sizable number of underground banks to emerge and facilitate illicit financial activities. The scale of money laundering is not small, either: In April 2015, several of these banks were shut down after they had laundered more than $67.5 billion abroad, according to the Ministry of Public Security.
Splinters Back Home
China is under no illusion that it can quickly dissipate the dominance of the U.S. dollar. From President Xi Jinping's and others' perspectives, it may be ideal for the country to internationalize the yuan, but other factions in China will resist it. Internationalizing the yuan will certainly require some painful economic adjustments and some changes that are, to some of China's previous political elite, simply unthinkable.
Signs of this political struggle are already apparent in Beijing. Over the last couple of months, Chinese state media have argued that retired officials — such as those aligned with former President Jiang Zemin — need to refrain from interfering in politics. China's anti-corruption campaign can be characterized as not only targeting corruption but also consolidating Xi's power to enable him to push through his reforms.
Nevertheless, in recent months, reforms have become more urgent because of a more immediate issue: China's economic slowdown. China cannot sustain older policies of binge credit and investment-led rescue prompted by massive stimulus. The success of any Chinese reform agenda depends on execution.
And now that the timetable has been accelerated, it is becoming even more politically delicate. Of all of the reforms, those spearheaded by yuan internationalization could be the most politically polarizing. Xi is entering a formative period in his presidency: China is in the midst of planning its 13th five-year plan (2016-2020) that will outline many of Beijing's core policy aspirations. In October, the Communist Party of China will hold the fifth plenum of the 18th Central Committee and could be preparing to unveil the five-year plan guideline document sometime soon. The falling currency reserves and the hastened reforms aiming at financial liberalization will only add to Xi's burden as he seeks to implement his envisioned reforms.