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Viewpoints > William H. Overholt
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Challenges put brakes on yuaninternationalizationRenewed momentum possible with Chinese structural reforms
Chinese 100 yuan banknotes © Reuters
China's drive to turn the yuan into a major international currency has slowedamid economic developments unforeseen by the currency's strategicadvocates.
Enthusiasm for yuan internationalization peaked in late 2015 when theInternational Monetary Fund welcomed the Chinese currency into the elite
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basket of currencies that constitutes its special drawing rights. Since then,the yuan's progress has been hampered by its own weakening, slowingeconomic growth, mounting debt, bank weakness and capital outflows. It isunlikely to regain momentum until these higher priority issues areaddressed.
In the run up to SDR membership, Chinese officials declared that the yuanwould remain stable and also become more market-driven but these aimshave proved contradictory as debt, outflows and slowing growth have cometo the fore. Meanwhile, to fulfill its promises, China has revised the way thePeople's Bank of China sets the daily value and range of movement for theyuan and has spent hundreds of billions of dollars of foreign reserves tostabilize the currency.
After rockiness in the first half of 2016, the yuan indeed remained stableduring the second half against a basket of its trading partners' currencies, theproper measure of its equilibrium. But the effect of government expendituresto prop up the yuan have left it above its natural market level. Yet theseexpenditures have become so large that if downward market pressurescontinue, they could become unsustainable.
While the yuan depreciated against the dollar during the latter part of 2016,this was caused by dollar strength, not yuan weakness. Doubts though aboutthe stability of the yuan will reduce market participants' willingness todenominate deals in the currency.
Currency order
China's strategy for yuan internationalization has been audacious.
Western economists prescribe a sequence of prerequisites for theinternationalization of a currency. First, the currency must be madeconvertible, otherwise market participants will not be able to judge its valueand a sudden burst of demand could result in a squeeze and instability.
Full convertibility implies an open capital account. For the capital account tobe open, domestic bank interest rates must move freely, otherwise marketparticipants may rush in and out of the currency depending on the differencebetween international and domestic rates, which can result in instability.
If interest rates are freed from controls, then the banking system must befully stable and well-regulated. If not, banks could become vulnerable tocollapse if they have lent too much long term with money borrowed shortterm.
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