Most studies on yuan internationalization focus on how it affects trade and investment
flows and GDP growth. They typically neglect the balance sheet aspects, as well as
the profits, or return on equity, issues and how to balance the trade-offs between
short-term competitive and long-term imbalance considerations, which are decided
not on a global level, but on the basis of individual national cost-benefit analysis. The
present system is already called a non-system, because no single country can now
dictate the rules.
In essence, we must consider yuan internationalization as a process within a total
systemic change, rather than from a national, departmental or partial perspective. It is
difficult enough to coordinate different departmental views to arrive at a coherent
policy, let alone a policy consistent for the world as a whole.
The exchange rate is both a price that determines international trade flows, portfolio
shifts and an asset price in its own right. Most conventional economists still look at
the exchange rate that affects imports and exports and therefore jobs and growth.
However, the recent yuan experience shows that gross capital outflows of nearly
US$1 trillion were three times that of the current account surplus of US$220 billion.
This flow perspective is incomplete.
Recent analyses showed that about half of the capital outflows since April 2015 was
in the repayment of foreign exchange debt, 10 percent in foreign direct investors
hedging their yuan exposure and the balance in domestic capital outflows. There is a
balance sheet explanation for such outflows.
The first is a reversal of carry trades by enterprises that borrowed in US dollars when
the yuan was on an appreciation trend and domestic interest rates, or credit
availability, were greater than dollar debt. The possibility of yuan depreciation after
August 11, 2015 caused those with net foreign exchange debt to hedge their
exposures before they lose more on a stronger dollar.
Next, foreign investors must also hedge their yuan exposures when there is fear of
yuan depreciation.
Domestic resident capital outflows in China is also a reflection of some long-term re-
balancing of household and enterprise balance sheets, because most net assets
have been held in real estate that may be peaking.
China’s Net International Investment Position (NIIP), a reflection of over three
decades of running net current account surpluses was US$1.7 trillion or 13.6 percent
of GDP. By comparison, Japan had net foreign assets of 72.7 percent of GDP,
whereas the United States had a net liability of -40.8 percent of GDP. The Eurozone
had a small net deficit of -8.1 percent of GDP, but within the Euro area, Germany had
a NIIP surplus of 72.7 percent of GDP.
Other than Japan, the United States and Europe were able to acquire more and more
foreign assets, which they are able to fund from issuing more reserve currency
liabilities, typically foreign sovereign debt that are used as “risk free” financial assets.
Indeed, China’s gross foreign assets and liabilities are small relative to the reserve
currency countries. For example, China’s foreign liabilities were only 46.3 percent of
GDP at the end of 2014, much lower than 171.7 percent for the United States, 206.2
percent for the Euro area, and 118.5 percent for Japan. This suggests that if China
had allowed its citizens to diversify their portfolios into foreign currency when the
yuan was strong, then there would be less likelihood of outflows when the currency
begins to weaken.
The final consideration is the effect of the exchange rate on return on equity. From
1994, when the yuan was devalued, to 2008, investing in China was very profitable
for everyone because labor and land were cheap by global standards. Today, with
real estate prices comparable to advanced countries in leading cities and rising labor
costs, even Chinese companies are investing abroad for profit opportunities.
The real concern with the yuan exchange rate is not whether it is pegged to a basket,
but if the link to the U.S. dollar remains very strong, the yuan will appreciate with the
dollar, creating huge deflationary pressure on the domestic economy. The Eurozone
and Japan have been able to depreciate against the dollar and the yuan, on the
pretext of quantitative easing, not ostensibly to depreciate their currencies.
This is why geopolitical considerations lie at the heart of exchange rate
internationalization. It took the United States over 70 years to reach premier reserve
currency status, even though by 1870, the country’s GDP had matched that of Great
Britain. The dollar’s march to currency hegemony occurred without capital controls
and America was a major producer of gold and silver. The United States never
worried about current account deficits, because she was a net importer of labor and
capital from Europe, which lost both gold and human talent after fighting two world
wars.
Even though the U.S. dollar was in a better position to overtake the Sterling Pound
after World War I, the New York money and capital markets were inferior to London
at that time. Only after major reforms following the 1929 Great Crash and the 1930s
banking reforms did the United States emerge as the dominant military, financial and
economic powerhouse.
We can draw at least two lessons from this systemic and historic overview of the
international monetary system. First, there is no simple straight line rise for any
reserve currency. To do so requires very strong, diversified and resilient domestic
financial systems, with deep human trading and investment talent. Both the Yen and
the Euro paid the price with financial crises in 1997 and 2007 respectively when
stress conditions tested their big but weak banking systems.
Next, as the world moves to a multipolar system, no single country is big and powerful
enough to dictate the rules and pull the world out of its global secular debt-driven
deflation. A new international monetary order has to emerge to accommodate the rise
of the yuan and in the next two decades, the rise of the Indian rupee.
The recent experience with the yuan shows that even with large foreign exchange
reserves, self-insurance is not enough in a world of volatile capital flows. A global
mutual financial stability system must be found to prevent large imbalances, including
the growing net foreign liability of the U.S. dollar, to be managed in a stable and
sustainable manner.
In short, the issue is no longer a national consideration, but a global geo-political one
that deserves urgent G-20 Leaders’ attention.
Andrew Sheng is a Distinguished Fellow of the Asia Global Institute at the
University of Hong Kong
This article first appeared in Caixin Online, 5 April 2016
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