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Photo: AFP
Photo: AFP

The ‘magazine cover’ decision

The IMF announcement of including the yuan as a reserve currency is likely signalling a turn for the worse in the Chinese currency

Amid much fanfare and “thumbs up" signs, the International Monetary Fund (IMF) has announced the inclusion of the Chinese yuan as a reserve currency. According to the Fund, the decision acknowledged the progress made in liberalizing and improving the infrastructure of China’s financial markets. It carries nearly 11% weight in the Special Drawing Rights basket of currencies. The IMF executive board took this decision in November 2015 and it was meant to become effective on 1 October 2016. The decision carries with it the potential to be the “curse of the magazine cover" on the Chinese currency and even the economy.

It is well known that when a story is carried on the cover of a popular magazine, it probably marks the end of the story. That fate could befall the yuan. The Chinese yuan is not freely convertible and it is quite unlikely to become so in the near future even though there is a promise to do so by 2020. An article by Mansoor Mohi-uddin of the Royal Bank of Scotland, published in Financial Times on 25 August, points out that the use of renminbi (RMB) has declined. He pointed to some strands of evidence.

One is the persistent decline in offshore renminbi deposits—down by nearly a third to $180 billion in the 12 months to August. He suggested that this was indicative of continued capital outflow despite the apparent calm in the exchange rate. Two, there was also a simultaneous decline in the claims of offshore banks (foreign banks) on China’s banks. Together with the reduction in offshore renminbi deposits, this too suggested low confidence in the currency’s future prospects.

Recently, Tom Orlik of Bloomberg tweeted that the yuan’s share of international payments peaked at a little over 2.5% around the time that IMF announced its decision last year and has declined steadily since then to around 1.86% now.

The internationalization of the Chinese currency is wholly incompatible with the renewed centralization of power and concentration of economic decision-making authority with the president and his coterie. Nor does it go with the heavy-handed and interventionist approach to managing declines in the stock market and centrally directed flow of credit to public-sector investments this year. China is not only not progressing towards being a market economy but it is regressing.

That China is nowhere near close to reforming or restructuring its economy is evident in the resurrection of its real estate bubble in 2016 as a replacement for the collapsed stock market bubble. Wang Jianlin, the billionaire-owner of the Dalian Wanda Group, called it the biggest bubble in history. Zhiwei Zhang, the chief China economist for Deutsche Bank, points out, in a Bloomberg article on 29 September, that the unit price of land in auctions exceeds that of the price of the finished apartments in a case of the flour being more expensive than the bread. That is a clear sign of the bubble because these land purchases are sustainable only if there is confidence in the greater fool theory of investing. The “greater fool" theory is the theory of asset bubbles where investors buy assets only if they are confident that someone else would take them off their hands by paying a higher price.

The Bank for International Settlements (BIS) released its “early warning indicators for stress in domestic banking systems" in the third-quarter review of international banking and financial market developments published recently. China’s credit-gross domestic product gap is more than 30 percentage points, the highest of all nations tracked by BIS. That is, China’s credit to GDP ratio is 30 percentage points above trend. Hong Kong is placed second.

There are rumours that some cities in China have imposed buyer restrictions, in response to the raging housing bubble. Consequently, if the housing price appreciation slows in the coming months, the People’s Bank of China would cut rates and rekindle credit growth. It will lead to a weakening of the yuan, something that China cannot afford because capital outflow will re-accelerate. Thus, the Chinese economy is wedged between the devil and the deep sea. It is at this point that IMF has chosen to bestow the honour of “reserve currency" status on the yuan. Now, the reader can understand why the decision is the equivalent of the magazine-cover curse on the currency and the country.

It is worth recalling what John Williams, the president of the Federal Reserve Bank of San Francisco, said nearly a year ago in Reuters: “As long as they have the threat and reasonable expectation that in a moment of panic or crisis they would clamp down on the movement of capital so it doesn’t disrupt their economy, there is no way that anyone would view the RMB as a reserve currency."

He might just as well have said that as long as there is a reasonable expectation (and threat) that in a moment of panic or crisis the Chinese would clamp down on the movement of capital so it does not disturb their economy, there was no way that RMB would become an international currency.

The IMF announcement is likely signalling a turn for the worse in the Chinese currency.

V. Anantha Nageswaran is an independent financial markets consultant based in Singapore.

Comments are welcome at baretalk@livemint.com. Read Anantha’s previous Mint columns at www.livemint.com/baretalk

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