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    China Business
     May 29, 2009
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Yuan in the ascendancy
By Pieter Bottelier

Since People's Bank of China governor Zhou Xiaochuan's proposal for reforming the international monetary system was published on March 23, there have been new developments with regard to the international use of the Chinese currency, the renminbi, also referred to as the yuan.

The historical context of governor Zhou's proposal and the prospects for the international use of the renminbi are interrelated. In spite of the generally negative press reports in the United States, Zhou's proposal was couched in careful, professional and non-provocative language. Although the proposal may have been partly motivated by domestic politics, it does reflect deep-rooted concern in China that the international financial crisis and


subsequent US responses to it could undermine the purchasing power of the dollar.

Since most of China's US$2 trillion plus reserves are invested in dollar-denominated financial assets, Beijing's concerns are understandable. While some in the United States argue that China should not fret about excessive dollar exposure - because that is the result of its controversial exchange rate policy - it should be recognized that China's worries about the future of the US dollar are widely shared and that Zhou's proposal appears to have been well received in many quarters around the world.

Background to Zhou's proposal
China is afraid that the vast increase in US fiscal deficits combined with the US Federal Reserve's efforts to keep interest rates low by injecting large amounts of liquidity in the economy will leave the US federal government overleveraged and unable to maintain macroeconomic stability while at the same time protect the international value of the dollar.

China is also concerned that continuing uncertainty surrounding resolution of the toxic asset problem of US and European banks will slow global economic recovery. It is too early to know whether US Treasury Secretary Timothy Geithner's plan (announced on the same day as Zhou's proposal) will work, but China would have preferred more drastic, coordinated trans-Atlantic action to remove the toxic assets from the banking system once and for all.

In China's view, this could have been done in ways similar to what the Chinese government did a decade ago in removing huge amounts of non-performing loans from the balance sheet of its banks. The Chinese realize that such action might have required the temporary nationalization of many banks, which would have been highly controversial and problematic in practice [2].

Although international agreement on Zhou's proposal seems highly unlikely, its launch may set in motion a process of gradual change in the global monetary system, including the growing international use of the renminbi.

China's central bank and other government-owned financial institutions, including China's sovereign wealth fund (CIC) hold an estimated $1.5 trillion - $1.6 trillion in US dollar-denominated financial assets. The rest is denominated in other convertible currencies. Official gold reserves amounted to 1,054 tons at the end of March 2009, accounting for about 1.5% of total reserves at the current gold price.

China is not only the largest foreign creditor of the US federal government, but also of government-sponsored enterprises (GSE) Fanny Mae and Freddie Mac. To protect the value and the liquidity of its reserves, China has been quietly changing their composition from GSE bonds to Treasuries and from long-maturity Treasuries to short-maturity ones [3]. China continues to buy newly issued Treasuries and there is no evidence yet that it is diversifying its reserves away from US dollars [4].

"In the interest of international financial stability," Zhou proposed the creation of a new international reserve currency that is disconnected from individual nations, issued in accordance with agreed rules and stable in value. For this purpose he proposed to modify the IMF's Special Drawing Right (SDR), a synthetic reserve asset and unit of account created by international agreement in 1969 to supplement official reserves of member countries and to support the Bretton Woods fixed exchange rate system.

A brief history of the SDR
SDRs were created in light of serious concern at the time that a shortage of gold and gold-linked US dollars (or dollar-denominated financial instruments) to finance international trade would slow global growth. The IMF was given authority to issue SDRs to central banks of member states to supplement their reserves in accordance with an agreed-upon formula.

The creation of the SDR marked the most significant international financial agreement since the emergence of the Bretton Woods system at the end of World War II, which was based on the gold-backed US dollar. That system was created against the advice of John Maynard Keynes who, at the Bretton Woods conference of July 1944, proposed the creation of a synthetic reserve and settlement currency (which he named the bancor), based on the weighted average value of a basket of 30 commodities. In addition, Keynes proposed the establishment of an international financial clearing house with rules aimed at automatically redressing large international trade imbalances.

The SDR in its original form was a much simpler instrument than Keynes' still-born bancor. It was not a currency, but a unit of account, initially linked to gold at the fixed rate of 1 SDR per 0.888671 grams of fine gold - the same as for the US dollar at that time - to be used as reserve asset and for settlement between member central banks only.

The SDR became largely redundant a few years later when the United States, under the Nixon administration, was forced to abandon the gold standard in 1971. That marked the beginning of the present floating exchange rate system for major currencies, with the US dollar - since then a fiat currency - serving as the world's premier reserve asset and settlement currency.

The value of the SDR was redefined as a basket of four currencies, which today consists of the US dollar (44%), euro (34%), Japanese yen (11%) and British pound sterling (11%). Under the current international monetary system, there is no "natural" limit to the issue of US dollars as there was under the Bretton Woods system, when the dollar was backed by gold at a fixed rate of exchange. Under the floating rate system, the US is under no obligation to protect the international value of the dollar, but the system is nonetheless stable, at least in principle, as long as the rest of the world is willing to hold all Treasuries not held by Americans.

Zhou's proposal brings the limits of that willingness into view, but there is at present no viable alternative to the US dollar as the global reserve currency. The significance of the euro - accounting for about 26% of international reserve holdings at present - is unlikely to increase much, because, in the absence of a European ministry of finance, the market for euro-denominated bonds will remain segmented.

Buyers of euro bonds have to choose between bonds issued by 16 different EU member countries using the euro as their national currency; the pricing of euro bonds differs with market perceptions of the credit worthiness of issuing countries. The euro bond market is large, but not nearly as deep and liquid as the market for Treasuries. Other convertible currencies are too small to serve as reserve currency on a large scale.

Zhou proposes to enhance the use of the SDR as a reserve asset and to make it usable as an invoicing and settlement currency in international trade and financial transactions. With those objectives in mind, he proposes: 1) to make the SDR convertible into other currencies; 2) to promote the use of the SDR for commodity pricing, investment and corporate book-keeping; 3) to create SDR-denominated tradable financial instruments; 4) to update the formula used for the allocation of new SDRs by the IMF; 5) to update the valuation base of the SDR by including other currencies in its base (presumably including the renminbi); and 6) to promote confidence in the value of the SDR by shifting from a purely unit-of-account system to a system that is backed by real assets such as a reserve pool. 

Continued 1 2  

Yuan trade move 'far reaching'
(Apr 21,'09)

Before the stampede
(Mar 14,'09)

Wen puts US honor on the debt line
(Mar 14,'09)

Sri Lanka wards off Western bullying

2. World powerless to stop North Korea

3. Last hope for survival

4. The greatest swindle ever sold

5. Insanity gone rampant

6. Beijing weighs its options

7. Iran courts the US's allies

8. Kim Jong-il tests US-China cooperation

9. Taliban stuck between anvil and hammer

10. Liquidity drowns meaning of 'inflation'

(24 hours to 11:59pm ET, May 27, 2009)


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