China’s yuan index makes sense after its inclusion in IMF’s SDR

Now that the IMF has deemed the yuan to be ‘freely usable’ it makes perfect sense that the value of China’s currency should not just be viewed through the prism of its level against the dollar

PUBLISHED : Sunday, 20 December, 2015, 3:39pm
UPDATED : Sunday, 20 December, 2015, 3:42pm

It is surely no coincidence that the People’s Bank of China (PBOC) chose to announce a yuan index versus a basket of currencies, in parallel with the bilateral dollar/yuan exchange rate, just a short time after China’s currency was invited into the IMF’s Special Drawing Rights (SDR).

After all, as the posting on the PBOC website said, “Looking at international experiences, the Federal Reserve, the European Central Bank and the Bank of England all publish their own exchange rate indices.” The dollar, euro and pound sterling are all SDR constituents.

So why should China not follow suit and offer a similar point of reference?

In fact, many would argue that given China’s global footprint in world trade, the existing emphasis on the bilateral dollar/yuan exchange rate is already something of an anachronism.

Indeed, now that the International Monetary Fund has deemed the yuan to be “freely usable”, a key characteristic of any currency component in the SDR, it makes perfect sense that the value of China’s currency should not just be viewed through the prism of its level against the dollar.

That said, some may wonder why the announced 13-currency index does not include the Indian rupee, Korean won or Taiwan dollar, themselves currencies of some of China’s key trading partners in Asia.

Of course, in an environment of broad dollar strength, the ability to refer to the yuan’s stability against a basket of currencies would undermine the arguments of people who might take umbrage at the sight of China’s currency depreciating further versus the greenback.

While US Republican candidate Donald Trump, who described the yuan’s depreciation versus the dollar in August as “a disgrace”, might not be impressed, internationally it surely makes more sense to have a focus on the yuan’s value against a wider selection of currencies.

The euro is a case in point. With the euro zone economy, a key export destination for China, still grappling with a host of economic challenges that have driven the European Central Bank to ease policy again and again, the pace of the euro’s fall versus the dollar has outstripped the rise of the greenback against the yuan.

The net effect is that the yuan has substantially appreciated against the euro over the last 18 months and yet 99 per cent of media attention remains fixed on the bilateral dollar/yuan rate.

Equally, since Shinzo Abe’s re-election as Japanese Prime Minister in December 2012, the combination of his government’s policies and the monetary policy measures adopted by the Bank of Japan, have lent themselves to a very substantial weakening of the yen against the dollar and the yuan.

Yet, again, merely emphasising the dollar/yuan bilateral exchange rate as a point of reference fails to capture the fact that the yuan has risen appreciably against the yen.

In truth, using the announced basket index which was 102.93 on November 30, the yuan had “appreciated 2.93 per cent from the end of 2014”, noted the post on the PBOC website.

“This shows that, even though [the yuan] has depreciated against [the dollar] since the beginning of this year, it has appreciated modestly against a basket of currencies. Therefore, [the yuan] is relatively a strong currency among the major international currencies.”

Of course, in this scenario, if the dollar continues its broader upward path, China arguably can afford to allow some greater degree of depreciation of the yuan against the greenback if it chooses to keep more of an eye on the Chinese currency’s value against a weighted 13-currency basket.

Also, the timing of the PBOC posting, just days before the Federal Reserve hiked US rates on December 16, surely gives the Chinese central bank some wiggle room on the yuan if the greenback suddenly “takes off” again.

Yet, using a basket of currencies as a point of reference is no panacea. If the external value of the home currency is out of kilter with macroeconomic realities, the foreign exchange market will normally force change anyway.

As for Hong Kong, there might ultimately be implications for the local dollar’s peg against the greenback if, over time, China itself starts to put a disproportionate emphasis on the yuan’s value against a basket of currencies rather than just on the bilateral US dollar/Chinese yuan exchange rate.

But perhaps right now, it is simply a case of recognising that the yuan’s growing international profile means it should no longer be solely defined by its value against the dollar. Basket making makes sense.