China’s long journey to an international yuan will mark a milestone on October 1 with the currency’s advent as a global reserve currency. It is also a landmark on China’s journey from a command economy into a free one.
The International Monetary Fund accepted the yuan as the fifth reserve currency in the Special Drawing Rights (SDR) basket last December, a vote of confidence in Beijing’s determination to push difficult financial and monetary reform. Joining SDR will not bring any immediate material benefit to the world’s second largest economy as its capital account is still not fully open. Its significance lies, and will continue to lie, in all the reforms demanded by the IMF.
The IMF uses two major criteria for a currency to qualify as a reserve currency: whether it is widely used; and whether it is freely used.
There is no doubt the yuan is widely used but, at least in terms of trade settlement, it is harder to argue that it is used freely, at least so far.
Even compared with most of its major developing peers, China still lags far behind in terms of three areas: capital account openness; marketisation of the exchange rate; and interest rates.
In fact, the IMF has used the inclusion to encourage the Chinese leadership to push ahead the badly-needed reform of the country’ hybrid monetary system, hoping to start an irreversible process of financial liberalisation.
The IMF demands introducing a market-based exchange rate regime and a market-driven interest rate mechanism. It hopes an exchange rate between currencies is decided by the demand and supply of goods and services among countries. And an interest rate determined by the demand and supply of money between borrowers and lenders is the very foundation of a true free market economy.
The IMF hopes to spur further capital market liberalisation and give Chinese savers access to global markets. That should lead to more global use of the yuan and pave the way for its full convertibility.
To meet the demand of making the yuan a truly global hard currency, China needs to take dramatic reform to give market forces a bigger say – if not a “decisive role” as the government promised – in the determination of the yuan’s price and its cost of borrowing. Beijing also needs to dismantle its strict capital controls to let foreign investors enter its financial markets and let Chinese as well as foreign investors exit its markets.
But there will be challenges. Should Beijing risk sacrificing exchange rate stability while keeping monetary policy independence, or keeping a stable currency at the cost of monetary policy independence? All this amid stubbornly slowing growth, massive capital account outflows and declining foreign reserves upon widespread fear of yuan’s continuous depreciation.
The economic and political processes are also linked, as in a free market the government should remove restrictions and let investors make their own decisions and protect their right to reject attempts by any state organ to exercise power over their choices.
So opening the financial market will be a serious test of the leadership’s political will as reform will eventually demand the government give up its dominant power over economics, and instead value private property, capitalism and individual rights.
Cary Huang, a senior writer with the South China Morning Post, has been a senior editor and China affairs columnist since the early 1990s