Despite high hopes, yuan will remain a second-rate currency
Speaking earlier this week, Premier Wen Jiabao told an audience of policymakers and business bosses that the yuan is heading irreversibly for full convertibility.
'As for yuan internationalisation, when it is coming, you can't stop it even you want to,' he declared at the China Development Forum in Beijing.
Wen's words will have warmed the hearts of those who believe it is the manifest destiny of the yuan to displace an ailing US dollar as the world's foremost trading and reserve currency, providing the mainland with incalculable economic and strategic advantages.
But no sooner had Wen pronounced the yuan's internationalisation inevitable, than he promptly hedged his position.
'But when the timing is not right, then an early implementation of it is not possible,' he said.
So, just to be clear: the internationalisation of the yuan is unstoppable. But if the timing is inconvenient, it is also impossible.
Actually, that's not quite as screwy as it sounds.
Those in the Chinese government who favour yuan internationalisation do so not because they think full and free convertibility is a desirable end in its own right, but rather because they see currency liberalisation as an effective means to promote necessary domestic financial reforms.
The reformers - notably at the central bank - realise that if Beijing were to relax its currency restrictions tomorrow the result would very likely be a mass flow of capital out of China.
That's because savers, fed up after years of receiving interest rates on their bank deposits lower than the rate of inflation, would have a strong incentive to invest their cash abroad in the hope of earning better returns.
As a result, relaxing currency controls without first instituting domestic financial reforms could lead to dangerously destabilising capital outflows.
That means yuan internationalisation can only proceed if accompanied by far-reaching domestic financial reforms, especially interest rate liberalisation.
And that's what the reformers really want. They believe that to maintain rapid growth rates over the next decade the mainland needs to overhaul its domestic financial system to ensure that capital is properly priced and efficiently allocated.
By holding out the prospect of the yuan as a leading international currency they hope to enlist support for their agenda of domestic reforms.
Even so, the reformers will face stiff resistance from the state sector industries that have benefited most from access to cheap capital, and from a banking system that for years has profited from an artificially wide spread between deposit and lending rates.
This situation has two important implications. First, this institutional resistance to domestic reform means that yuan internationalisation is going to be a slow process, hence Wen's caveat about the timing not being right. As Standard & Poor's managing director Ryan Tsang put it last week: 'It's not going to happen any time soon.'
Second, the fact that reform-minded policymakers see yuan internationalisation primarily as a means to an end, rather than as a policy goal in its own right, means that the currency's role on the world stage is likely to fall well short of the expectations many hold for it.
Arthur Kroeber, Beijing-based managing director at specialist research house GK Dragonomics summed up China's ambivalence to yuan internationalisation in a report last week.
'There is scant evidence that Beijing has much appetite for the risks and complications that come with a fully internationalised currency, let alone the even greater headaches that come with managing a global reserve currency,' he wrote.
Kroeber argues that far from displacing the dollar, the yuan will follow a path to internationalisation similar to that of the Japanese yen. With backing from the Japanese authorities that was at best half-hearted, in the 1970s and '80s the yen captured a small share of trading in the international foreign exchange market and was used to settle a modest portion of Japan's foreign trade (see the charts).
Given domestic resistance to financial reform, the yuan is unlikely to surpass the yen as an international currency in the near future. It could still become a significant invoicing currency for China's trade, but as Kroeber writes, 'it is hard to see how it can become more than a very second-rate reserve currency'.