It seems everyone in the financial sector is talking about the internationalisation of the yuan and how it is going to change the world. I don't buy it. The Chinese currency is highly unlikely to internationalise in any meaningful sense any time soon. First I'd better be clear about what I mean by 'internationalise'. For the sake of argument, I'll say the yuan will be fully internationalised when it is traded and held as freely and as widely as the British pound. That might not sound as if I'm setting the bar very high, considering China's economy is almost three times as big as Britain's, and its international trade greater. But in international currency terms the yuan is a minnow compared with the pound. According to the International Monetary Fund, a little over 4 per cent of the world's foreign exchange reserves are held in pounds. The proportion held in yuan is negligible. And according to the Bank for International Settlements, the pound figures in 13 per cent of all foreign exchange transactions; the yuan in fewer than 1 per cent. The reason for this discrepancy is simple. Britain permits capital to flow freely across its borders. Anyone can buy, sell, borrow or hold as many pounds as they want without seeking permission from the British authorities or breaking currency rules. Despite Beijing's recent measures to promote its currency, China is a long way from allowing such unrestricted use of the yuan. And there are powerful economic reasons why Beijing will retain its currency controls for the foreseeable future. These were originally expounded more than 40 years ago by Nobel laureate Robert Mundell, who set out 'the impossible trinity' of monetary economics. Mundell explained that no country can allow free flows of capital into and out of its economy while fixing its exchange rate and operating an independent monetary policy. The best any country can achieve is two out of the three. Take Hong Kong, for example. The authorities here decided long ago that free capital flows were essential to the health of the city's financial centre, while a fixed exchange rate was needed to ensure economic stability. The trade-off was that the government was forced to surrender all control over local interest rates, which move in line with US dollar rates. Bigger developed economies - Australia, say, or Britain - do things differently. They want free capital flows to encourage inward investment. But in economies driven largely by domestic forces they need to retain control over monetary policy. As a result, they have to allow their currencies to float, with exchange rates dictated by market forces. Now consider China. The over-riding policy objective of the Communist Party is to retain power. The government dominates the economy through an extensive state sector, supported and funded by the state-controlled banking system. Unfortunately, perhaps because of their political role, China's state-owned companies are not particularly efficient. That means the government has to keep interest rates artificially low in an attempt to make sure state companies' funding costs are below their lacklustre returns on capital. At the same time the government has to ensure that the hundreds of millions of workers who have recently left their farms for China's cities can find jobs. That means the authorities also have to ensure the country's low margin but labour-intensive export industries remain competitive. And that means Beijing has to keep the yuan cheap. I realise it may not look as if Beijing is fixing its exchange rate, given that the yuan has strengthened almost 30 per cent against the US dollar since mid-2005. But the US dollar is the wrong yardstick to use here. Since we're talking about trade, it makes more sense to look at the yuan's exchange rate against a basket of currencies from China's main trading partners, weighted according to the value of their bilateral trade. In those terms, despite China's rapid growth, the yuan has not strengthened at all over the past 10 years. As the chart shows, it's actually weakened a touch. So as we can see, China has already ticked two out of the impossible trinity's three boxes. Beijing wants to retain control over interest rates so it can keep the state sector's funding costs down. And it wants to control the yuan's exchange rate so it can preserve the country's 150 million export sector jobs. In other words, there is no way Beijing can allow free capital flows as well. That would be impossible. And without free capital flows, there is not going to be any meaningful internationalisation of the yuan, no matter how much people talk up the currency's prospects.
