Yuan way to new monetary order

CHINESE New Year has come and will soon go. The eurozone debt crisis is well past two years. Yet uncertainty persists. The World Bank's January 2012 Global Economic Prospects reports:
“World
economy has entered a very difficult phase characterised by significant
downside risks and fragility and as a result, forecasts have been
significantly downgraded. However, even achieving these much weaker
outturns is very uncertain Overall, global economic conditions are
fragile.”
This week's IMF World Economic Outlook says more
of the same: “The global recovery is threatened by intensifying strains
in the euro area and fragilities elsewhere.” China, India, South Africa
and Brazil have entered a slowing phase.
No country and no
region can escape the consequences of a serious downturn. Nevertheless,
growth in the East Asia and Pacific region (excluding Japan) is expected
to slowdown to about 7.8% in 2012 (8.4% in 2011) and stabilise in 2013.
This
reflects continuing strong domestic demand (evident in third quarter or
3Q 2011 GDP) while exports will slow to about 2% due to Europe heading
towards recession and sluggish rich “Organisation For Economic Coercion
And Direction (OECD)” demand.
The middle-income nations are, I
think, in a good position to weather the global slowdown, with
significant space available for fiscal relaxation, adequate room for
interest rate easing, ample high reserves and rather strong underpinning
for domestic demand to rise.
I see the modest easing in China's
growth being counterbalanced by a pick-up in GDP gains in 2013 over the
rest of the region. Outside China, growth has slackened sharply to 4.8%
in 2011 (6.9% in 2010), but is expected to strengthen in 2012, reaching
5.8% in 2013.
China
GDP growth in China, which
accounts for 80% of the region, had eased to about 9.1% in 2011 (10.4%
in 2010) and is expected to slacken further to a still robust 8.2%-8.4%
in 2012.
The World Bank projections point to growth moderating at
8.3% in 2013, in line with its longer-term potential GDP. Expansion is
expected to emanate from domestic demand, with private spending and
fixed capital outlays contributing most of the growth in 2012.
For
China, the health of the global economy and high-income Europe in
particular, represents the key risk at this time. Domestic risks include
property overheating, local government indebtedness, and bloating bank
balance sheets.
The 4Q 2011 growth of 8.9% annoy investors who
are looking for indications either weak enough to justify further policy
easing or strong enough to allay fears of a hard landing. Bear in mind
the forecast growth for 2012 will be the weakest in a decade, and may
cool further as exports slump.
The Chinese economy is buffeted by
two very different forces: (i) slow global growth will hurt Chinese
exports (especially to its largest trading partner, European Union)
which rose by 7% in December, and exporters foresee more trouble ahead;
however, (ii) analysts point to strong retail sales (up 18% in December)
reflecting rising wages and domestic spending which represented about
52% of GDP in the first quarter, higher than in 2009-11.
China is
counting on its massive effort to build low-income “social housing” to
provide enough demand to keep the real-estate market from collapsing.
It
is unclear whether China can accelerate this program to build 36
million subsidised housing by 2015enough to house all of Germany's
households. But financial markets are anticipating worse news ahead.
After all, the Shanghai Composite Index fell 21% in 2011. As the adage
goes, stock analysts did forecast 10 of the past 3 recessions!
The yuan
Appreciation
of the yuan (renmimbiRMB) against the US dollar in 2012 is expected to
slow to about 3%, from +4.7% in 2011. The yuan closed at 6.3190 at end
2011, up about 8% compared with June 10 (when China effectively ended
its 2-year long peg to the US dollar and has gained 30% since mid-2005
when it was last revalued.
The slowdown reflects growing demand
for the US dollar amid uncertainty, lower growth, diminishing trade
surplus, and growing US military presence in Asia, according to China's
Centre for Forecasting Science (of the Chinese Academy of Sciences)
which reports directly to the State Council, China's Cabinet.
Much
of it will be in the latter year as China is likely to keep the yuan
relatively stable in the first half to allow time to assess the impact
of goings-on in the euro-zone. Dollars are pumped in via state banks,
providing markets with a clear signal it will not allow the yuan to
depreciate, while not in a hurry to let it appreciate either. The yuan
has since moved sideways.
Off-shore yuan
To make
the yuan a true reserve currency, China begun to liberalise currency
controls and encourage an offshore yuan market in Hong Kong, creating an
outlet for moving the currency across borders. However, foreign
investors in China have been slow in using the yuan.
In practice,
it is still difficult to buy & sell yuan because of paperwork &
bureaucracy. It is still easier to settle in US dollar as it is the
universal practice. Its convenience outweighs the potential costs of any
unfavourable move in the US dollar-yuan rate. Nonetheless, China is
encouraging more businesses to use the yuan and more US banks to step-up
their yuan-settlement business.
This market will grow as China
diligently moves to internationalise its currency. Encouraged by the
authorities, a vibrant offshore yuan market has blossomed in Hong Kong.
Beijing still controls the currency and how the yuan bought in Hong Kong
can be brought back to China.
Yuan deposits in Hong Kong rose
more than 4 times to 622.2b yuan (nearly US$100bil) at end September
2011 from a year earlier according to the Hong Kong Monetary Authority,
and now account for 10.4% of bank deposits.
Growth in offshore
yuan stalled in late 2011 as China slowed its currency appreciation
against the dollar. Given Beijing's gradualist approach to reform, the
market will soon revive.
An audience poll at the recent 2012
Asian Financial Forum in London indicated 63% believes full yuan
convertibility is more than 5-years away.
The very fact that
London wants to be a yuan-trading centre now says a lot. Only 10% of
China's international trade is settled in yuan, rising to 15% in 2012.
It's still a small market in the global context.
The yuan is used
for just 0.29% of all global payments in November 2011 according to
financial messaging network Swift. By comparison, the euro's share is
about 40%.
Dim-sum bonds
A booming business in
dim-sum bonds (offshore yuan denominated bonds) followed, with companies
including Caterpillar and McDonalds issuing such bonds. In September
2011, a spurt of capital flight towards “safe haven” assets in the US
tied to the worsening debt crisis in Europe caused currencies of
emerging nations to depreciate against the US dollar.
In East
Asia, modest declines were recorded compared with South Africa (the rand
fell 22%) and Brazil (the real dropped 18%). Only the Indonesia rupiah
(down 5.8%) and the Malaysia ringgit (fell 5.4%) come under some
pressure.
This event slowed the appreciation of the yuan and with
it, trading in dim-sum bonds eased as investors were no longer in a
hurry to invest. Over the medium-term, most analysts expect this yuan
market to grow in the face of its massive US$3.18 trillion in reserves,
as China moves to build its international status.
When dim-sum
bonds started to hit the market in 2010, investors were enthusiastic,
bidding up prices and driving down yields. But in the second half of
2011, the average price of investment grade dim-sum bonds fell 3.3%,
amid a broad flight towards quality spooked by euro-zone turmoil and
Chinese accounting scandals.
Bankers hope new entrants (private
banks, commercial banks, mutual funds & life insurers) will give the
market more stability this year. They would add depth & breath to
the market, which tripled to 185b yuan (US$30bil) in dim-sum bonds
issued in 2011. Expectations are for such bond issuance to reach 240
billion yuan this year, as new issuers (including more foreign
companies) join early adopters such as government entities & state
run banks.
This offshore bond market has developed well over the
past year. Investor diversification in both types & geographics is
still evolving, which is key to the healthy growth of the market.
Equally important, investors look to the continuing appreciation of the
yuan.
In addition, its average yield has risen to 3.8% (from
2.35% since mid 2011) and most now trade at higher yields than
comparable US dollar bonds.
This rise in yields reflects
expectation for (i) slower yuan appreciation; (ii) increase in supply;
and (iii) investors desire for a higher liquidity premium during market
downturns. Overall, the dim-sum market is turning into a buyer's market.
Bilateral arrangements
China
is forging ahead in laying the groundwork to internationalise the yuan
via bilateral arrangements with foreign companies, nations &
financial centers, particularly Hong Kong (mainly because it can fully
control the terms of the market). More mainland-based financial
institutions will be able to issue yuan denominated bonds in Hong Kong.
This
is part of a broader effort, first started in July 2009 when it
encouraged enterprises in Shanghai & Guangzhou province to use the
yuan when settling trade with Hong Kong, Macau and some foreign
companies (see my column “China: RMB Flexibility Not Enough” of July 3,
2010).
The post-X'mas direct yuan-yen trade deal forms part of a
wide-ranging currency arrangement between China & Japan to give the
use of the yuan a big boost. After all, China is Japan's largest trading
partner with 26.5 trillion yen in 2-way transactions last year.
Encouraging direct settlement in bypassing the US dollar would reduce
currency risks and trading costs. Also, Japan will buy up to US$10bil in
yuan bonds for its reserves even though it represents no more than 1%
of Japan's US$1.3 trillion reserves. And, it is now easier for companies
to convert Chinese and Japanese funds directly into each other without
an intermediate conversion to US dollar. About 60% of China-Japan trade
is settled in US dollar, a well-established practice.
The package
allows Japan backed institutions to sell yuan bonds in the mainland
(instead of Hong Kong) helping to open China's capital market.
In
recent weeks, China has taken new steps to promote the use of yuan
overseas, including allowing foreign firms to invest yuan accumulated
overseas in mainland China; widening the People's Bank of China
(its central bank) network of currency swaps with other central banks
to enable their banks to supply yuan to their customers, including with
Thailand, South Korea and New Zealand totalling 1.2 trillion yuan.
It
already has completed arrangements with the big Asean counterparts.
Berry Eichengreen (University of California at Berkeley) observed:
“Japan appears to be acknowledging implicitly that there will be a
single dominant Asian currency in the future and it won't be the yen.”
But
Harvard's Jeffrey Frankel is more down to earth: “This hastens a
multicurrency world, but this is just one of 100 steps along the way.”
China
still has a way to go in: (i) getting the yuan fully convertible (ii)
reducing exchange rate interventions (iii) liberalising interest rates,
and (iv) reforming the banking system. In all, so the yuan can really
trade freely.
What to do?
The China-Japan deal
points the way, nudging the yuan towards the inevitable becoming a
reserve currency alongside now discredited US dollar and the euro. This
is to be welcomed by all.
China must realise a fully
internationalised yuan should be free to float (and to appreciate) part
of its overall reform. Over the longer term, though, avoiding huge
imbalances is good for everyone, not least China. While it is
understandable for its Prime Minister to label China today as “unstable,
unbalanced, uncoordinated and ultimately unsustainable,” opportunities
to take advantage of new openings don't come often.
Alexander
Gerschenkron, my professor at Harvard (in my view, the best economic
historian of his time) points to economies like China as having
“advantages in backwardness,” including China's ability to weather
shocks: high reserves, robust fiscal situation and comfortable external
position.
Shakespeare's Hamlet sums it up best: “If it be not
now, yet it will come - the readiness is all.” A grown-up yuan is good
for China's welfare.
It also means a more stable world economy
which benefits the United States. For China, there will never be enough
cushion. Politicians need to seize the moment and act boldly.