The Chinese yuan looks poised to join a symbolically important international currency basket but differences over its valuation remain between the US and China.
US Treasury Secretary Jack Lew made clear on June 24 that China still has further progress to make in moving toward a market-determined exchange rate. At the 7th US-China Strategic & Economic Dialogue, the US expressed its view that the yuan remains undervalued.
Exchange rate issues have dominated economic discussions between the US and China in past years. While the yuan has risen in value by roughly 30% on a trade-weighted basis, many US lawmakers and officials argue China continues to manage its currency.
China, however, see things differently. China’s Vice Finance Minister, Zhu Guangyao, diplomatically pointed out that the International Monetary Fund (IMF) recently assessed the yuan as fairly valued. He further indicated the IMF’s assessment was consistent with China’s own valuation. While both US and Chinese officials praised the cooperation at the meetings, this exchange stood out as a notable difference in views.
IMF upgrades assessment of RMB valuation
The IMF’s decision to upgrade its assessment of the yuan’s valuation significantly bolsters China’s case.
In the end-of-mission statement after May’s Article IV consultations, the IMF stated that “the substantial real effective appreciation [of the yuan] over the past year has brought the exchange rate to a level that is no longer undervalued.” The IMF cautioned China to intervene only to prevent “disorderly market conditions.”
This, in fact, turned out to be exactly one of the headline agreements that China and the US made at the S&ED. China agreed “for the first time to intervene in foreign exchange markets only when necessitated by disorderly market conditions.” Neither side publicly defined what these conditions might entail, but China’s commitment represented continued progress from years of more active intervention.
These discussions took place against the backdrop of China’s strong push to include the yuan in the IMF’s basket of currencies. Known as “special drawing rights”, or SDR, its value is based on a weighting of the dollar, euro, yen, and pound. Originally created to support the Bretton Woods exchange system, the SDR currently functions as a unit of account for IMF loans and as a medium to exchange IMF member currencies.
The IMF reviews its SDR policy every five years and plans to do so again this November. China badly desires the yuan to achieve SDR status so as to reflect its increased clout in the international financial system. Winning inclusion months after establishing the Asian Infrastructure Investment Bank (AIIB) would be a major victory for China.
Does it pass the test?
The last time around, the IMF decided against including the yuan. It bases its decisions around two guiding principles – the amount of exports and whether a currency is “freely usable.”
For a currency to be considered freely usable, it has to be widely used to make payments as well as widely traded in exchange markets. With its large trade surplus, China has met the exports criteria only to flounder on the second test.
According to the Society for Worldwide Interbank Telecommunication, or SWIFT, the yuan is now the fifth global payments currency in value – coming in behind the four currencies already in the SDR. Since January 2013, the yuan moved up from 13th, reaching its current 2.69% share of the global payments market. Its meteoric rise has been coupled with increased adoption by banks, with over a third using the yuan to make payments in China and Hong Kong. This suggests increased currency exchange.
Will the US approve?
All of this evidence suggests the yuan may have a chance. Notably, the IMF has stated that freely usable does not necessarily mean freely convertible. So the yuan could be included even if China continues to impose controls on how the yuan can be exchanged. But it will take a 70% majority vote of IMF members to approve the yuan’s addition. The US controls a nearly veto ready 16.7% vote share.
At the SE&D, the Chinese side told reporters that the US agreed to respect the IMF process for changing its SDR policy. Many European partners also seem to be in favor of adding it. After the diplomatic walk-back around the creation of the AIIB, some experts see the US agreeing to add the yuan in return for China continuing liberalization of currency markets.
Inclusion might not have immediate concrete effects, but would reinforce the yuan’s role in the global financial system.