China’s leaders want to establish the yuan as a global asset and transaction currency. But this won’t work as long as exchange rates are driven by conflicting domestic policy targets rather than by global markets.

In 1971, US treasury secretary John Connally coined this famous statement: “The dollar is our currency, but it’s your problem.” Back then, the dollar’s status as the leading international mode of payment and store of value was unchallenged – and the US enjoyed all the privileges. The US enjoyed – and continues to enjoy – the benefit of paying low interest on its sovereign debt, which is denominated in dollar and therefore faces no exchange rate risks. It can finance domestic consumption through access to external savings, and it can foot foreign bills by printing its own currency.

With these advantages in mind, China’s leadership looks to establish the yuan as a global currency. But there is no free lunch. A currency will gain the trust of global markets if it is seen as an anchor of stability. This is the case for the US, but not for China. The US’s financial markets are well developed, and its domestic financial system is stable and mostly shock-resistant. Unlike in China, the exchange rates of the dollar are determined by world financial markets and not by domestic monetary authorities that intervene into foreign exchange markets to serve domestic purposes. Markets trust markets, and US monetary authorities respect this fact by not meddling with dollar exchange rates.

The yuan has a long way to go

This is the essential difference to the Chinese yuan, which still has a long way to go before becoming a global currency. Other than offering the world a hugely absorptive market for goods and commodities, China has not yet delivered public international goods as the US does by providing global political and military security beyond own needs. Its domestic financial markets are being reformed, but they are still distorted as policymakers use them to discriminate against private loan-takers, to confer privileged treatment on state-owned enterprises, to protect state banks against default and to cap interest rates. Restrictions on capital transfers abroad have been relaxed but not fully dismantled. The yuan does not float, but is pegged against a basket of reliable, freely traded currencies, in which the dollar dominates.

Abandoning the rigid peg against the dollar in favour of a more flexible basket peg has not fostered confidence in the yuan. On the contrary: The composition of the basket is not transparent and interventions into foreign exchange rates continue. This situation sends confusing signals and creates distrust on global financial markets.

China faces several dilemmas

If China wants to build trust on the global markets, it has to allow the yuan’s exchange rate to float more freely. Even a former senior Chinese official recently acknowledged this, but the current global economic environment and China’s own domestic policy priorities cause a number of dilemmas for its monetary authorities.

First, China wants to reduce the discrepancy between the high use of the yuan as an invoice currency in trade and the very low use as an asset currency in which investors store value. Yet it also wants to prevent financial markets from speculating against the yuan.  This is inconsistent, because the price for becoming an asset currency is the acceptance of exchange rate volatility and speculation.

Second, China cannot simultaneously achieve three objectives: a pegged exchange rate, an autonomous monetary policy and free international capital flows. Further relaxing capital controls to globalise the yuan while continuing exchange rate targeting would reduce the effectiveness of monetary policy to stimulate domestic demand. In light of current economic uncertainty, China’s authorities have a strong incentive to maintain and even temporarily tighten capital controls to raise the effectiveness of exchange rate interventions and monetary policy. But the price for pursuing these goals is that the asset currency target has to be postponed.

Third, China wants to re-balance its economy towards more consumption. Decoupling its currency from a currently very strong dollar would fly in the face of this goal as it would risk a sharp depreciation of the yuan. This would lower real incomes and create inflationary trends – with strong dampening effects on domestic demand. In order to keep these effects under control, China’s monetary authorities intervene ad hoc into exchange markets.

Fourth, China wants to reform its financial sector and state-owned enterprises. But a yuan depreciation caused by a more flexible exchange rate would threaten the stability of Chinese companies with high levels of dollar-denominated debt. As the authorities are not prepared to let these companies fail, they are compelled to support them in one of two ways. They either jettison their reform goals by continuing to pump liquidity into these companies or they retain their ability to limit depreciation by interventions into the currency markets.

Fifth, allowing the yuan to drift would also impede China’s foreign economic policy goals. China tries to win the trust of recipients of loans for infrastructure projects through a number of new finance institutions that are all primarily powered by China: the Asian Infrastructure Investment Bank, the New Development Bank and the Silk Road Fund.  Competitors of Chinese construction companies in Asia could fear unfair competition if the depreciation of an unpegged yuan were to go too far, raising the spectre of a currency war.

Financial markets do not trust China

For all these reasons, China will not set the yuan free any time soon. And as long as the value of the currency is determined by domestic policy goals and not by global markets, the issuing country will not gain the trust that is needed for its currency to become a global asset and transaction currency.

The rest of the world may feel relieved that the yuan remains China’s problem for now.  But this is just the present view. The turbulence in Chinese asset markets that sent jitters across the world in the early weeks of 2016 showed that China’s internal struggle to balance its conflicting monetary policy goals can be rapidly transmitted to global markets. China is increasingly relying on global financial markets, but these markets neither depend on China, nor do they trust China. Building the necessary trust is China’s task, and this will take more than money.    

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By Rolf J. Langhammer

China’s leaders want to establish the yuan as a global asset and transaction currency. But this won’t work as long as exchange rates are driven by conflicting domestic policy targets rather than by global markets.