assessments

The Gradual Evolution of the Yuan

10 MINS READJan 25, 2017 | 09:15 GMT
The Gradual Evolution of the Yuan
(FRED DUFOUR/AFP/Getty Images)
International pressure may increase on China to hasten the liberalization of the yuan, but Beijing is likely to take a cautious approach to easing currency controls, at least until the Communist Party holds its congress in the fall.
Forecast Highlights

  • China will not allow its currency to float freely ahead of the Communist Party congress in the fall.
  • Beijing will put short-term stability ahead of its longer-term goals of internationalizing the yuan.
  • Barring a policy decision that reshapes the global economic climate, the new U.S. administration is unlikely to have a direct effect on China's currency policy.

Will 2017 be the year that Beijing finally allows the yuan to float freely? That's the pre-eminent question that comes to mind as China continues the process of internationalizing its currency. The list of advocates of such a policy shift has been growing and now includes an adviser to the esteemed Chinese Academy of Social Sciences, a government-linked think tank. In addition, U.S. President Donald Trump's statements on Chinese trade practices have intensified interest in the course Beijing will take regarding how to value the yuan.

Floating the currency — allowing its value to be set exclusively by the foreign exchange market — would advance China toward its long-term goal of internationalizing the yuan, and it would alleviate pressure on the country's diminishing but still significant pile of foreign exchange reserves, which are currently being spent to battle the effects of capital flight out of the Chinese economy. Allowing the yuan to float, however, would almost certainly result in an immediate and sizable drop in its value, a destabilizing event for China's economy, at least in the short term. The Communist Party of China will hold its 19th Party Congress in the fall, making stability even more important than normal to the administration of President Xi Jinping, so it is unlikely that it will allow a free float of the currency before the plenum is held.

On a Path Toward Currency Liberalization

China is on a long-term path toward liberalizing the yuan, a course chosen by necessity rather than preference. China's economy has outgrown the economic model — exporting products to the rest of the world — that carried it through its period of rapid growth from 1978 to 2008. The success of that model led to increasing wages and diminishing returns on infrastructure investment. And the very size of China's economy makes the model unsustainable: The saturated global market cannot absorb the sheer volume of Chinese products flooding it. This means China must reorient its economy toward encouraging domestic consumption. One problem with this picture is that with a smaller percentage of products flowing out of the country, less foreign capital will be naturally flowing in. China, which like most countries is not self-sufficient, depends on foreign currency inflows to help it pay for foreign products. The solution to this problem is to make the yuan, also known as the renminbi, valuable in its own right by promoting its use overseas. If China develops the ability to print a currency with international power, a consumption-led economic model then becomes feasible.

Extending the yuan's usage abroad, however, entails giving up control over it. Since 1949, the Communist Party has ruled China with a strong focus on stability over all other considerations, and it considers tight control over most aspects of life, including the currency, the best way to achieve this. But foreign investors are generally wary of investing in any product with a price directly controlled by a government. In such a system, the investment decision becomes more about trying to predict what the government is thinking (which gives the advantage to those closest to the government) over analysis of market information. Thus, before granting the yuan the same level of influence and usage as the U.S. dollar or the euro, foreign investors will need to think that they, more than the Chinese government, are deciding its price.

The Means Toward China's End

Progress toward currency liberalization — or normalization — has been occurring steadily since at least 1994, when China reduced its two exchange rates to one and pegged the value of the yuan to that of the dollar. In 2005, this peg was broadened to allow the market to push the yuan's value up or down by about a third of a percentage point each day, though the People's Bank of China (PBC) set the next day's price against a basket of currencies (the dollar was still the key one). This means the currency's value was still ultimately a government decision. The band was widened to 0.7 percent in 2007, 1 percent in 2012 and 2 percent in 2014.

As it pursues liberalization, China will seek to keep the yuan's value stable. Between 2001, when it acceded to the World Trade Organization, and 2014, China generally kept its currency artificially weak by printing yuan and using that to buy foreign currency. The result of this policy was that China amassed a sizable amount of foreign exchange reserves.

This strategy effectively encouraged Chinese exports while also allowing Beijing to build up a "rainy day fund." But it worked for only so long. The collapse in external demand for Chinese products that followed the 2008 global financial crisis rapidly increased the need for China to shift its economy from the export-driven model toward one encouraging domestic consumption. Such a massive economic change could not happen overnight, so to maintain stability, China embarked on a campaign of debt-fueled investment to sustain strong growth, a strategy that is also ultimately unsustainable. Meanwhile, the undervaluation of the yuan along with the tight control of its daily trading left China open to accusations of currency manipulation. The United States has often made that complaint but has not taken direct action against China since labeling it a currency manipulator in 1994. (That label was partially responsible for setting China on its course to liberalization.)

A Time of Significant Change

A period of great change for China's economy began in 2014. The yuan's peg to the dollar, which had been more or less sustained since 1994, suddenly became a curse, as U.S. economic strength relative to the rest of the world led to rapid appreciation in the dollar, taking the yuan with it. At the same time, the buildup of Chinese debt was creating doubts in the market about its long-term economic health, and the flow of investment into the Chinese economy began to reverse. The period of accumulation in China's foreign exchange reserves suddenly ended, and the pool of money started to be spent down to support what was suddenly an overvalued currency.

This marked the first time in decades (except in times of crisis such as the 1997 Asian financial crisis and the 2008 global crisis) that the yuan would have depreciated had its value been set strictly by the market. In August 2015, the PBC took the next step and devalued its currency by 1.9 percent against the dollar. In addition, it announced that it would henceforth let the market guide the currency's value by setting its daily rate at the level of the previous day's close. It transpired that the market did believe the yuan to be overvalued, and the pace of the currency's subsequent depreciation was rapid enough that the PBC opted to once again take control to reduce the speed of the fall. Over the past 18 months, the yuan's value has dropped gradually against the dollar, managed by the PBC in part by its continued spending of foreign exchange reserves.

Meanwhile, China has been working to internationalize the yuan. The government has increased the amount of Chinese trade that happens in yuan and struck numerous agreements with other countries, including direct trading with currencies such as the ruble and the yen and encouraging yuan-denominated bond issuance in London and other financial centers. Adoption of the yuan has partially tracked the currency's value — when it was strengthening, more foreigners wanted to hold it — and the yuan rose rapidly through the ranks of global currencies from the 20th-most-used currency in 2012 to fifth. Despite that rapid bump in popularity, the yuan remains below the threshold of 3 percent of total global usage, an area where most global currencies reside. The falloff in value, however, has been matched by a drop in international usage, as fewer outsiders have wanted to hold a depreciating asset.

The Future Course of the Yuan

During his campaign, Trump railed against China's trade practices and promised that on his first day in office, he would brand China a currency manipulator. That did not happen, but his administration still could pursue the issue. Under U.S. law, however, to consider a country a currency manipulator, it must have regularly intervened in the market to weaken its currency. This condition has not applied to China since 2014. If the U.S. administration can overcome this hurdle and legally label China a currency manipulator, it would begin a process of bilateral negotiations during which the United States would attempt to reshape Chinese policies.

Despite their domestic political appeal, though, the efforts of the U.S. administration in this regard are unlikely to have a strong effect on China's currency decisions in 2017. As described, the yuan is now on a naturally weakening path, meaning that any increased liberalization, including allowing it to float freely, would likely have the effect of pushing its value down, possibly quite sharply, and not up, which would be the United States' preference. China would also be unlikely to pander to the preferences of the United States by accelerating its foreign currency reserve spending to strengthen the yuan against the dollar. Instead, any confrontation between the two is likely to play out in a different sphere, most likely trade.

When it comes to currency, China, at least for now, is likely to focus on its domestic priorities. In the runup to October's 19th National Congress of the Communist Party, an event of the utmost political importance at which the leadership in Beijing reaffirms its goals and sets the country's policy course for the next five years, the government's priority will be to minimize the possibility of any domestic instability. Before the plenum convenes, it is unlikely to risk the disruption to the Chinese economy (and the blow that would have on its citizens' confidence) that would follow the sharp drop in the yuan's value that a float would likely entail. While its foreign exchange reserves have been dropping relatively swiftly over the past two years, at $3 trillion, they are still at levels most countries would consider incredibly high, and there has been no sense of urgency to taper the drawdown. After the Party meeting, China's long-running liberalization/internationalization campaign could resume. This will likely include a painful but necessary process of reform that would allow it to deal with its large debt problem, a step that must be taken before China's economic progress can continue.

There are two factors that could advance the timetable for a free-floating yuan. The first is the possibility that portions of China's foreign exchange reserves may be tied up in ways that make them illiquid, meaning that the reserves available to be used to prop up the yuan could be a far smaller amount than the reported $3 trillion figure. But this is information held by the rulers in Beijing and not publicly available. If that indeed is the case, a free float of the currency may come sooner than expected. Second, there is the possibility that the pace of China's reserve drawdown might increase rapidly. China's reserves recently have been falling at around $40 billion per month, which would give the country a significant cushion before it might be in danger of reaching its spending limits. But should a U.S. policy decision or a massive loss of faith by the market in China's economy boost the tempo of its reserve spending, Beijing might need to advance the moment it floats the yuan in an effort to preserve a larger portion of its savings.

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