Page 1 of 2 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
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 .
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 . China continues to buy newly issued
Treasuries and there is no evidence yet that it is diversifying its reserves
away from US dollars .
"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.