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China Rising

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China's Currency Ambition

February 26th 2013

Soldiers

"Yuan expected to be int'l currency around 2020", read the headline of the People's Daily On-Line, the Chinese Communist Party's English publication. 

"Experts believe that the yuan will be fully eligible to be an international currency by around 2020. Experts believe that China has made significant progress in internationalizing its currency in recent years. However, these experts are quoted saying that there is still need 'to foster financial market development, and further improve corresponding supervision and regulation systems.'"

However, the internationalization of the yuan will lead to a loss of control of the value of the yuan and conflicts with China's desire to control the value of its currency. The conflict is reflected in recent statement by the Deputy Administrator of State Administration of Foreign Exchange, People's Bank of China, Wang Xiaoyi. According to him, "First, a free-floating exchange rate regime is usually applied to countries that issue reserve currency, which helps to immunize their domestic firms against exchange rate risk.

"Second, empirical studies show that the random walk behavior of G7 currencies cannot be rejected.

"Third, China's foreign trade has two different components, namely, processing trade, which is dominated by foreign-funded enterprises, and general trade, which is traditionally carried out by small and medium-sized domestic firms. The enterprises in the first group enjoy a surplus equivalent to around 140% of the total trade surplus, while those in the second group run a deficit equivalent to 40% of the total trade surplus. Thus, the export enterprises specialising in general trade need a transition period in which to absorb the impact of appreciation.

"Fourth, the banks need time to acquire risk management expertise and to build the necessary infrastructure under the new exchange rate environment, and more hedging instruments have to be designed and introduced into the foreign exchange market.

"In short, it takes time to prepare for structural and financial reform, so as not to endanger expectations and domestic demand in these sensitive and fragile post-crisis conditions."

It is obvious from the very first line in the statement that there are obvious contradictions between China's actions and its stated currency policies. While the above suggests that China does not desire the internationalization of its currency, the China Daily, another publication of the Communist Party, claimed:

"A 'bloc' has been formed in East Asia, as nations in the region abandon the US dollar and peg their currency to the Chinese yuan--a major signal of China's successful bid to internationalize its currency.... China has long vowed to raise its currency's global sway, along with the rise of its economy, which became the world's second-biggest last year"

Meanwhile, long-suppressed news concerning weaknesses in the largely state-owned banking system have reached a point where it can no longer be denied. In May 2006 global auditing firm Ernst and Young issued and almost immediately withdrew a report saying that China's non-performing loans (NPLs) totaled over $900-billion (about 40% of commercial bank loans). Withdrawing the report, EY apologized for what it called an "erroneous" publication. The Chinese Government ridiculed the report's findings, insisting that its own estimate of $164 billion (8 percent of commercial bank loans) was the better figure.

Many felt, however, that the EY's report must have been pretty close to reality, especially since the government was so quick to discredit it. EY's decision to withdraw the report was made to allow it to continue its business in China. Nevertheless, by 2011 ratings agencies such as Fitch were warning that China's banking sector is burdened by a significant NPL problem.

In March 2011, China Business News reported:

"The head of Fitch Ratings' Asia-Pacific sovereign debt unit cautioned it's 'not inconceivable' that Chinese banks' bad debt ratio may reach 30 percent, which would in turn be 'negative' for China's sovereign rating. A 30-percent sour loan ratio for Chinese lenders would 'likely be negative' for China's sovereign rating,' said Andrew Colquhoun, head of Fitch's Asia-Pacific sovereign group."

Then, Société Générale's China macro strategist Wei Yao, using different criteria, suggested that the credit expansion undertaken after the Global Financial Crisis of 2007-2008 could lead to a NPL to GDP Ratio of between 25-35 percent.

Internationalizing the yuan will insure China's oil imports against US dollar price hikes that could rise if China's sovereign rating and with it the yuan are downgraded, as Fitch has warned. Thus, China is reported to have convinced Iran to accept settlement for oil imports in yuan, and there are talks underway to convince other Middle Eastern producers such as Saudi Arabia to do the same.

Supporters outside China talk up the yuan as challenger to the greenback as the world reserve currency. Should this initiative take hold, the problem of a falling yuan, brought on by weaknesses in the banking sector and a consequent downgrading of the sovereign rating, will be a problem that China will share with the world. Then, like the US, China could expect that despite its internal economic problems, it could still maintain an upper hand in international trade, finance and political negotiations. The Chinese, as other investors who sought safe haven, will increase their purchase of Treasury bonds.

But China's attempts to denominate its trade in yuan and provide the world an alternative reserve currency have more to do with addressing a weakness in the financial sector rather than a consequence of its growing strength. China's banks are facing a growing loan-deposit ratio gap, as reported in The China Daily:

"Although Chinese banks currently have sufficient capital, pressure to maintain cash flow and to refinance is increasing, according to a report by The Chinese Banker, a Beijing-based monthly publication that focuses on China's banking industry. For many banks in China, the difference between assets and liabilities will expand in the near future because of stronger regulations and banks' growing difficulties with refinancing, the report said.

The differences for the five biggest banks in China - the Industrial and Commercial Bank of China Ltd, Agricultural Bank of China Ltd, Bank of China Ltd, China Construction Bank and Bank of Communications Co - will be equal to more than 30 billion yuan ($4.7 billion) by the end of this year, and will rise further in 2013, the report estimated.

The report based its estimation on statistics and annual reports provided by these banks, said Zhang Xiaochuan, spokeswoman for The Chinese Banker. The difference for ICBC will rise from 60.4 billion yuan by the end of 2012 to 69.1 billion yuan in2013, while that for the Agriculture Bank of China will go up from 63.5 billion yuan to 83.8 billion yuan. Bank of China's will reach 37.6 billion yuan by the end of 2012 and will double in 2013, reaching 78.7 billion yuan. China Construction bank will see its difference hit 35.4 billion yuan by the end of 2012, and rise to 39.9 billion yuan in 2013, while the Bank of Communications' gap will reach 47.8 billion yuan by the end of 2012, which will further expand to 68.7billion yuan in 2013."

Put in another way, China is not necessarily the pool of limitless capital that Western policy makers imagine it to be. It remains a country with very many poor people, on whom it has been able to rely for cheap labour as the basis of its highly successful export driven policies. In the meantime, boasting that China's (weak) economy would soon equal that of the United States' remains wishful thinking. Giving the yuan an equal of higher value than the US dollar is foolhardy.

Ganesh Sahathevan, an ACD/EWI Fellow, investigated financial mismanagement in Malaysia prior to the financial crisis in the 1990s. He continues to research and report from Sydney, Australia, with a focus on Southeast Asian business, economics and politics. This work has led him into research of structures that support terrorist and jihadist activities in the region, and their links to similar structures in other parts of the world. He obtained the degrees of Bachelor of Economics (majoring in Accounting), and LLB from Monash University, and LLM from the University of Sydney.


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