China’s Currency Now Part of Global “Basket”

At a dinner four years ago, I sat opposite a senior official of the New York Federal Reserve, and was making the case that, whenever the People’s Republic of China “fixed” its currency overnight, its actions directly affected the movements of the euro, U.S. dollar, and various Asian currencies the next day, as Chinese interventions were always followed by a diversification of currency reserves. The official stated that he saw this as irrelevant.

As we can see from the first trading days of 2016, however, China’s actions regarding its currency, the yuan, are a critically important barometer for markets around the world. And they affect not only currencies, but also equity and fixed-income investments.

The current problems in China’s economy do not belie the country’s status as a major player in world currency markets. In fact, China is now widely recognized as being just as important as the U.S. Fed when it comes to assuaging — or, indeed, exacerbating — market fears.

China’s position as a global financial powerhouse was not so easily won. For five years, the Chinese government continuously used its influence to fight for a seat at the table. It finally succeeded on November 30, 2015, when the International Monetary Fund (IMF) accepted the yuan as a member of the IMF’s Special Drawing Rights (SDRs) basket of major currencies, alongside the U.S. dollar, Japanese yen, the euro, and the British pound sterling. This event is notable for a number of reasons, some of them market-related.

Currencies can be divided into two camps: locally traded and globally traded. Typically, locally traded currencies are primarily used by a country’s neighbors to facilitate trade. Global currencies are used by every country, both to facilitate trade and to store value in the form of international currency reserves.

Examples of locally traded currencies include the Hungarian forint, South African rand and Chilean peso, all of which are frequently traded currencies, but rarely used outside of their local spheres of trade significance. True global currencies are those included in the IMF’s SDR basket. And these currencies—the U.S. dollar, euro, yen, pound sterling and now the yuan—are used for all types of cross-border trade, including the trade of many commodities. In addition, they make up most of the global currency reserves.

Countries around the world hold international reserves for two main reasons: as a store of value and as an insurance policy against economic stress. When holding international reserves, the reserve manager has to keep in mind three important factors for each currency: (i) if the currency is liquid, (ii) if the currency is that of a prominent trading partner, and (iii) how deep is the market of underlying financial instruments in which the currency could be readily invested. This all boils down to one simple maxim: Can I get in and out of my investment quickly.

The IMF’s promotion of the yuan into the SDR basket now puts the Chinese currency on the menu for global reserve managers. While they had kept minimal reserves in the currency before, the seal of approval from the IMF moves the yuan from the back of the menu to the special of the day.

Over the past decade, China has quickly risen to take its place among the top three trading partners of much of the world. In Asia it holds the number-one spot, while in Latin America it jockeys with the United States for that honor.

In 1740, Scotsman James Thomson wrote a poem titled “Rule Britannia,” which celebrated Great Britain’s dominance of “the waves,” and thus of global commerce. At the time, the British pound sterling was both the dominant currency used for trade and the reserve currency of choice. This situation lasted until the mid-1900s, when Great Britain rebuilt its reserves following the Second World War. But at this juncture, the United States picked up the baton, and the U.S. dollar quickly filled the void left by the British pound.

The past 75 years have been largely dominated by the United States, with the rest of the world taking a backseat. In the cases of Russia and China, isolationist policies halted their growth during most of this period. However, the past 20 years have seen these sleeping giants waken, particularly China, which has quickly transformed its rural economy into an industrial one. Whether as a buyer of commodities or as a seller of finished goods, China has taken a dominant position in global trade, in many ways surpassing the United States. For much of this time, trade between China and other countries was conducted in U.S. dollars. But as China has cemented its position in world markets, it has begun to demand payments in its own currency, much as the United States has done, and as Great Britain had done before that. With a fully floating and deliverable Chinese currency expected this year, prompted by the IMF’s inclusion of the yuan in its SDR basket, we will likely see a dramatic growth in the use of the yuan as a trade currency and a reserve asset.

This demand for the yuan will come at the expense of other SDR currencies. Although the yuan’s basket weighting of 10.9% appears to have come at the expense of the euro, we can be sure that, given the U.S. dollar’s dominant share of international reserves, that currency will ultimately bear the greatest cost, as reserve managers diminish their holdings of U.S. dollars in favor of yuans. In fact, although the initial weighting of the Chinese currency looks quite low, it was purposefully crafted that way because the internal treasury market demanded by reserve managers is still in its infancy. Over the next five years, as the yuan grows exponentially, its weight in the IMF’s SDR basket and in the portfolios of reserve managers will also rise.

The yuan’s entry into the SDR basket is the first stage of many that will establish the yuan as a global currency — favored in international trade and, in due course, in international reserves as well. In the meantime, the yuan’s prominence is demonstrated by the fact that its movements are already front-page news.

Photo Credits: iStockphoto.com/vinnstock, iStockphoto.com/ma-no