The yuan lies in waiting
By Francesco Sisci
BEIJING - Pundits in China are scratching their heads over the future of their
currency, the yuan, which has been brought to the fore by the present financial
crisis. Their thinking has recently become urgent, compared with previous
perceptions that the yuan could be kept not fully convertible - and thus
shielded from foreign interference - for many years.
Certainly, there will be no problem if the US economy recovers soon and the
dollar makes a robust comeback as the world currency. In that case, the yuan
can continue to piggyback on the dollar, or with the exchange rate slowly and
steadily crawling upward according to the necessities of trade.
Yet, what if the US economy and its dollar do not come back? David Goldman
(also know as ATol's Spengler) already made this suggestion: "I believe that
China and other Asian countries will decouple from the United States during the
next five years, partly
because the American economy will remain moribund, partly because American
policy will continue to be incompetent, and partly because their own domestic
market and financial systems will be able to bear the burden." 
He draws his conclusion from a report in the Far Eastern Economic Review about
the May 3 agreement on the implementation of the Chiang Mai Initiative (CMI),
involving the 10 members of the Association of Southeast Asian Nations and
China, Japan and South Korea, known as ASEAN Plus Three.
"These bilateral currency-swap agreements will now be transformed into a single
regional pooling arrangement, comprising at least $120 billion in reserves.
Twenty percent of the funds will be provided by the 10 ASEAN members and the
remaining 80% by the Plus Three countries. The ASEAN Plus Three finance
ministers also agreed to create an independent surveillance unit to monitor and
analyze regional economies and support CMI decision-making processes."
Actually, this is not the only move China is taking in the direction of
diversifying its de facto peg with the dollar, which came back with the crisis
last autumn after three years of crawling appreciation from 8.3 to 6.8 yuan to
In the past few months, Beijing has concluded yuan swap agreements with a dozen
countries. With some, like Russia and Brazil, China will pay yuan in return for
a set amount of commodities. In this way, China will hedge future price
fluctuations for commodities, which would influence its domestic industry, and
these countries will receive payments in a currency that is bound to become
The swap agreements are still minimal. By the end of May, China's central bank
had signed swap agreements totaling 650 billion yuan (US$95 billion) with a few
countries, including South Korea, Malaysia, Indonesia and Belarus, as well as
Hong Kong. Furthermore, in June, Beijing signaled it would be willing to
purchase some $60 billion of International Monetary Fund bonds.
These amounts are not very significant. They will barely dent the $2 trillion
purse of China's foreign reserves and will not rock the stability of the
dollar. Beijing is sitting on about $1.7 trillion worth of US-related bonds in
total. China is just too committed in America to try pulling out of it. The
dollar's collapse would engender the collapse of China's economy before causing
the collapse of the whole global economic system.
Yet, something more significant would be necessary to hedge China's money,
which is now at the mercy of America's policymakers. On June 1, during his
visit to Beijing, US Treasury Secretary Timothy Geithner promised the security
of China's dollar-denominated assets. The Chinese fear that, with all the money
pouring in to revive the US economy, inflation and devaluation will ensue,
cutting the value of the Chinese-held bonds. His promise is important, but
certainly not sufficient.
In a 2005 paper, Blanchard, Giavazzi, and Sa  calculated that for the US
economy and the dollar, "The effect of the 15% depreciation is then to reduce
the ratio of net debt to GDP by 10 percentage points ... This implies that,
after the unexpected depreciation, interest payments are lower by 4% times 10
%, or 0.4% of GDP. Putting things together, a 15% depreciation improves the
current account balance by 1.4% of GDP, roughly one-third of it due to
valuation effects." 
Economists saw the beginning of the problem in what they called "the dance of
the dollar", it has swung up and down since the late 1970s. They blamed foreign
central banks for buying dollars and pegging to the dollar, saying it kept the
American currency artificially high, which prevented what should have been a
fall in the price of American assets.
"What the foreign central bank is effectively doing is keeping world demand for
US assets unchanged by offsetting the fall in private demand. Pegging leads to
a steady increase in US net debt and a steady increase in reserves offsetting
the steady decrease in private demands for US assets." 
Since 2005, their recipe is both a decrease in the exchange rate, and the yuan
has indeed appreciated, and a reduction in the budget deficit. It is impossible
to think of depreciating the dollar when the United States still needs China
and Japan (its second-largest creditor) to keep bankrolling its debt. But the
pressure of the sheer computations could become irresistible in the near
future, if things get worse or simply do not improve.
For this reason, the Chinese are proposing, at least since last September, to
start issuing to America "panda bonds", bonds denominated in yuan that would
insure Beijing against currency fluctuations. America so far has turned down
the offer, which would limit its room for maneuvering in working with its
currency. Yet, the idea did not die in China.
China has too much money in reserves, and there are limited options for what to
do with it. China's image abroad is not good, and Chinese companies have no
experience managing foreign companies abroad. Therefore, it is unlikely that
Beijing will encourage Chinese companies to go on a buying spree abroad as the
Japanese did in the early 1980s.
Chinese economists are now playing with a similar idea: yuan-denominated loans
to foreign countries, mainly neighbors. This could be a powerful tool to make
the yuan stable against future currency fluctuations. If the yuan appreciates,
the loan will keep its value and thus the Chinese assets will not decrease; if
the yuan depreciates, the increase in Chinese exports would compensate for the
depreciation of the loan. In fact, there could be a mechanism inducing each
country to keep exchange rates stable.
If neighboring countries accept yuan loans, they would de facto pressure the US
to keep the dollar-yuan exchange rate stable, thus helping China in dealing
with the US. But it would only work if there were enough incentive - that is,
if the yuan loans were substantial enough to make a difference for a country.
The consequences could be huge. A pool of countries accepting these Chinese
loans would push China's yuan to the center stage of world currencies. China's
yuan could de facto become the currency of reference for international trade.
This could further push China to fully liberalize its exchange rate, and thus
update its backward domestic financial structures.
Further pressure in this direction could come from sluggish American demand.
"If US demand for Chinese goods does not return, China must concentrate on the
expansion of the internal market, which, in turn, requires improvements in
financial infrastructure (consumer lending, mortgage lending, business loans,
municipal finance, and so on). This is very hard to accomplish without
convertibility - investors want liquidity and convertibility. Thus, it is the
requirements of an internal capital market that would push China toward greater
use of the yuan." 
These perspectives are very real and could start very soon. China has a lot of
money to move around, while US investment looks increasingly scary. Many
countries are knocking on China's door and asking for loans. They fret about
the dollar's volatility and appreciate the very conservative attitude of
China's central bankers.
Here the euro, so far, is no alternative. It has no political head; it is
influenced by the difficult ties among different national agendas. Unless, in
the next few months, it manages to come up with a coherent and unified
long-term proposal about future financial balances in the world, it will de
facto be irrelevant.
Japan, America's second-largest creditor and home of the world's second-largest
domestic debt, will try to carefully navigate between the currents. It will
have to rescue its dollar-denominated assets, but also its large Asian trade,
which is possibly becoming more dominated by the yuan.
The real issue is with the dollar. The uncertainties about America's future
economic prospects make the dollar objectively volatile. This would be no
problem if the euro, yen or British pound were its competitors as reserve
money. But because of their shaky economies, these currencies are even more
volatile than the dollar.
Yet, if the yuan, with its priming domestic economy, comes to the fore, the
whole game is bound to change. The Chiang Mai Initiative can get real, the swap
agreements become alluring, and yuan loans become attractive.
This puts more pressure on the US to establish some form of broad financial
agreement with China on the dollar. That would limit America's currency
options, but it would also hedge America against possible further economic
downturns by anchoring the US economy to China's, and it could help stabilize
the dollar. If America's economy fully recovers in a timely manner, it will
have no significant drawbacks.
Will America do it, then? Actually, this will also depend on how actively China
pursues the many financial options on the table. Beijing is in no hurry. It is
naturally conservative, and now even more so. It could start to slowly explore
its options, while seeing how they are working and how America fares in the
next few months. If things go well for Washington, so much the better. If they
do not pick up, the US can still talk to China, yet at a different price level.
If in a few months, US economic prospects still look gloomy, China may want to
get a higher price for its yuan-dollar agreement.
Then the United States would have an incentive to talk to China as soon as
possible. But the game is not only about economics; it is also - or mainly -
about politics. Here it's clear to Washington and Beijing that America has many
cards up its sleeve. The reality is that China might have to trade part of its
economic strength for some of its many political weaknesses. And this is a
different, very complicated story.
1. "An Asian Commodity-Based Currency?" June 3, 2009,
2. Olivier Blanchard, Francesco Giavazzi, Filipa Sa, "The US Current Account
and the Dollar," May 14, 2005. Blanchard has since become the IMF's chief
3. op cit, p 22-23
4. op cit, p 33
5. David Goldman, in a private exchange with the author.
Francesco Sisci is Asia Editor of La Stampa, based in Beijing. (Copyright
2009 Asia Times Online (Holdings) Ltd. All rights reserved. Please contact us
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