Yuan playing bigger role in global reserve system
For the yuan to become a true reserve currency, further work is needed in three main areas. The fi rst is to maintain economic stability in terms of growth, the exchange rate and low infl ation.
Recently, one of the most powerful central banks in the world, the European Central Bank ( ECB) invested 500 million euros ($ 558 million) of its foreign reserves in yuandenominated assets, by selling a small portion of its US dollar holdings. It is part of the ECB’s diversifi cation strategy to add the Chinese currency into its foreign exchange reserves.
In a bid to assure global investors of the investability of the yuan, China has embarked on an ambitious path to internationalize its currency. Although the ECB’s investment only accounted for 1 percent of its total 68 billion euros of foreign exchange reserves, it marks a big boost for China. It points to growing market confi dence in the yuan as a global reserve currency and acceptance of China’s status as a global economic power in Europe. Since being included in the IMF Special Drawing Rights ( SDR) basket of reference currencies in October 2016, the yuan has been accepted by more and more countries as a reserve currency.
However, that doesn’t mean the yuan will become the dominant reserve currency in lieu of the US dollar or the euro in the near future. In fact, the ECB’s yuan investment is relatively small so far and the dollar still accounts for most of the ECB’s foreign reserves. The yuan is now used in around 2 percent of global payments, which is not on a par with the proportion of China’s GDP in the global total of more than 10 percent in recent years. In spite of be- ing the world’s largest trading country, China settles only 20 percent of its foreign trade in yuan, much smaller than the level of around 60 percent settled in euros for the eurozone’s external trade, and 40 percent in yen for Japanese trade.
Nevertheless, the ECB’s yuan endorsement should be taken as impetus for China to push its economic and fi nancial market reforms. China has made headway with greater use of the yuan globally in trade settlement and yuan- denominated products in off shore markets. However, redoubled eff orts are needed to remove the main obstacles to capital market development, including a fragmented regulatory framework, insuffi - cient or inconsistent information disclosure, and an inadequate proportion of institutional investors in the market.
For the yuan to become a true reserve currency, further work is needed in three main areas.
The fi rst is to maintain economic stability in terms of growth, the exchange rate and low infl ation. China’s increasing share of world trade and the increasing size of its national economy are important to its trading partners, and clearly justify greater use of the yuan. Last November, the lingering expectations of further yuan depreciation induced the regulator to tighten controls on money moving out of the country, including closer scrutiny of outbound investments, large overseas money transfers and individual foreign exchange purchases, which are likely to impede the pace of yuan internationalization.
The second is to deepen capital markets and speed up the integration of onshore and off shore capital markets. Substantial measures have been taken to open up China’s onshore capital markets for foreign investors, such as the Shanghai- Hong Kong stock connect program. The off shore market is also expanding quickly, which allows deeper global yuan liquidity through off shore clearing banks in Hong Kong, Singapore, London and Paris. Some foreign central banks are allowed to hold yuan in their reserves through channels such as the China Interbank Bond Market ( CIBM) scheme and the Qualifi ed Foreign Institutional Investor ( QFII) program. This suggests strong interest in and underlying demand for reserve asset diversifi cation into yuan once the onshore market opens up. In
addition, China’s central bank has signed swap agreements with many foreign central banks to allow them to tap a ready source of yuan liquidity to meet the needs of their local markets. While China’s onshore and off shore markets remain separate, there are clear signs of progress toward a single and accessible market. The third is to build a solid and trusted legal and regulatory framework. China has been using the Shanghai Pilot Free Trade Zone ( SHFTZ) and free trade zones in Tianjin and Fujian to experiment with fi nancial opening and reforms. Most of the restrictions that apply to onshore currency trading in China have been lifted in the SHFTZ. China has mulled other measures to improve banking sector stability, such as deposit insurance, a more comprehensive credit evaluation system, and greater transparency, particularly in areas of monetary policy and foreign exchange. The internationalization of the yuan has been a clear national policy goal for the Chinese government, and is moving forward at a faster pace than expected. We should expect to see improved industry- side infrastructure, strengthened fi nancial regulations, well- structured deposit insurance, and improved market- driven exit mechanisms for fi nancial institutions. China’s record of supportive government policies and macro- economic stability will continue to facilitate the yuan’s internationalization process, and will allow the yuan to contribute to the stabilization of the global multiple reserve currency system.