China's Global Economic Power

COMMENTARY
Table of Contents
Vol 49, No 50 - December 13, 2014
China's Global Economic Power
A V Rajwade
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The dollar has been the world's reserve currency for decades, but it is not difficult to
see it yielding place to the yuan of China, a country that is already the world's largest
economy in purchasing power parity terms, and the world's largest manufacturer and
exporter.
A V Rajwade (avrajwade@gmail.com) has been a long-standing commentator on the
external sector and financial services.
The US dollar became the dominant reserve currency after the second world war.
Earlier, in the gold standard era (roughly 1870 to the start of the first world war), the
pound sterling was the most widely-used currency in global markets. Broadly speaking,
the United Kingdom (UK) and the United States (US) were the largest economies in
most of the 19th and 20th centuries, respectively. The gold standard collapsed in the
interwar years, as did the importance of sterling. Under the Bretton Woods agreement
of 1944 all currencies had a fixed parity with the dollar, the only currency that was
freely convertible into gold at a fixed price. After the unilateral suspension of gold
convertibility by the US in 1971, and relaxation of capital controls by most major
economies, the fixed parities became difficult to maintain, and since the 1970s we are
in an era of floating, volatile exchange rates. But the dollar has retained its status as
the principal reserve currency: central banks hold over 60% of their reserves of foreign
exchange in dollars.
The dollars role as the principal reserve currency also gives the US enormous political
power. US economic sanctions can hurt any country badly: Iran and Russia are
examples of two major countries whose ability to receive/make cross-border payments
has been crippled by US sanctions. Many banks have been fined heavily for
infringements of the sanctions: from Arab Bank to Standard Chartered to HSBC to BNP
Paribas. As for US courts, recent decisions have disabled countries like Argentina from
servicing their external debts. And the US has the exorbitant privilege of getting its
external deficits financed in its domestic currency.
The US dollar is also the most traded currency in the world: over 85% of currency
trades in global markets involve the dollar. Global commodity markets also use the
dollar as the pricing currency.

As the USs share of global output and trade keeps diminishing, will the dollar retain its
status as the principal reserve currency, if only because of TINA: There is no
alternative? At one time, it was expected that the euro may gradually become another
major reserve currency. But that possibility has receded for the foreseeable future
after the crisis in the eurozone exposed the euros fragility.
Another future alternative is the Chinese currency. China is already the worlds largest
economy in purchasing power parity (PPP) terms. It is now the worlds largest
manufacturer, cross-border trader and exporter and the worlds largest commodity
buyer. Over the last three decades, China has gained enormous financial power, as
reflected in its $4 trillion reserves. Despite this, its voting power in the International
Monetary Fund (IMF) and the World Bank does not reflect this reality. The US continues
to have a veto power since policy decisions of the IMF require an 85% majority. Even in
the Asian Development Bank (ADB), the chief executive has traditionally been a
Japanese national. Are Chinas promotion of the BRICS Bank and the Asian
Infrastructure Development Bank the first steps to start rivals to the IMF and ADB?
If the IMF continues to remain committed to Washingtons libertarian and market
fundamentalist agenda, the attraction of the Chinese model for developing/emerging
economies will surely grow. Almost 30 years ago, Francis Fukuyama proclaimed the
end of history, with liberal democracy as the accepted model for the political economy.
In a recent article in the Wall Street Journal, however, Fukuyama conceded that, The
only system that would appear to be at all competitive with liberal democracy is the socalled China model, which mixes authoritarian government with a partially marketbased economy and a high level of technocratic and technological competence. Martin
Jacques makes the same point in his book titled When China Rules the World: The End
of the Western World and the Birth of a New Global Order.
One issue is whether (or when?) the Chinese currency, namely, the yuan (I prefer
yuan to renminbi, partly because the former is easier to pronounce, and also because
the standard three letter symbol for the Chinese currency is CNY), would become a
reserve currency, given Chinas rapidly growing global economic and financial power.
In a recent book The Dollar Trap, Eswar Prasad has argued that this is unlikely at least
in the foreseeable future.
1Chinese Loans/Investments
Annual foreign direct investments (FDI) by Chinese companies are expected to cross
$100 bn in 2014 (and exceed inward FDI), growing from just $2.7 bn in 2002. China has
already become the largest lender and investor in Africa and in Latin America. Chinese
institutions have lent $650 bn to other countries in the last two years alone in support
of Chinas exports and investment projects. To put the number in perspective, compare
it with the US Exim Banks loans/guarantees aggregating $590 bn in its 80-year history.
More importantly, for Chinas global economic and financial power, its investments in
European businesses, particularly in infrastructure and manufacturing, have grown
rapidly after the crisis in the eurozone. It could then make investments in existing
assets and businesses in southern European countries relatively cheaply. One example
is that the Peoples Bank of China, the central bank, has bought minority stakes in the

five largest Italian enterprises, including Mediobanca. It has invested even larger sums
in the UK and France. Lately, it is also focusing on countries in central Asia.
The US has banned Chinese high technology firms like Huawei from investing in the
country: the worry is that they may be used for spying. (The irony is that the US itself is
the worlds largest spymaster, snooping on even the German Chancellor.) But this has
not stopped Chinese businesses from investing in real estate (recent purchases include
New Yorks famous Waldorf Astoria hotel), and many other assets.
Asia is Chinas backyard. No wonder it has made investments in businesses and
infrastructure projects in Myanmar, Sri Lanka, Pakistan, etc, but not so much in India,
at least so far. The earlier thrust in investments abroad was in resource-rich countries
to develop, and import, their natural resources to satisfy Chinas insatiable hunger for
commodities. More recently, the investments seem to be driven by a strategy to
diversify investments abroad away from US treasury bonds of which China is the
largest holder. China has become a large capital-exporting economy like the UK was in
the 19th century, and the US after the second world war.
2Internationalisation of Yuan
China is taking steps to internationalise the use of the yuan in many ways. Some of the
more important ones are discussed here.
2.1Trade Account and Settlements
China has been encouraging the use of the yuan in cross-border trade for the last
several years. While the percentage is still not very large (around 20% of Chinese
trade), it is growing rapidly. Today, however, it is only the seventh most widely used
currency in global trade, accounting for something like 2% of the turnover of the global
foreign exchange market. In terms of invoicing, China is following the Japanese
example: in the 1950s and 1960s most of Japans cross-border trade was denominated
in the US dollar. As the economy developed, it started invoicing more and more
exports, particularly of capital goods, in the yen. China seems to be following this
pattern, as the experience of Indian importers of power plants from that country
evidences.
As for settlements, at present, direct quotes for the yuan are available against the
Japanese yen, the Australian and New Zealand dollars, the euro and the British pound
sterling, apart, of course, from the dollar. Settlement banks have been agreed for
clearance of such direct trades. There is also an active EUR/CNY currency options
market.
The recently signed long-term gas deal with Russia is expected to be priced in CNY.
There is an active and growing rouble/yuan market in Moscow. And, as a way around
US sanctions, oil imports from Iran are being settled in the yuan for some years. There
is also a market for clearing CNY currency exchanges, forwards and swaps in Shanghai.
2.2Offshore Market

In recent years, China has also encouraged the establishment and growth of an
offshore banking and capital market in CNY. While Hong Kong is the largest centre,
Singapore and, indeed, London are coming up fast. There is also an active exchange
market in Hong Kong for the Chinese currency, with a market-determined exchange
rate, the so-called CNH rate. Banks can square their open positions in the yuan with the
Bank of China (Hong Kong), only for trade-related transactions. Given the limited
linkage to the domestic market, the two rates (CNY and CNH) often differ, but it seems
players are finding ways to make arbitrage profit on the difference.
Recent reports suggest that there is an active market in Singapore and Hong Kong in
credit derivatives linked to Chinese corporate bonds. A CNY currency futures contract
has started trading on the Singapore Exchange.
This apart, for several years the yuan has been freely circulating in some neighbouring
countries like Mongolia, Korea, Vietnam, Laos, Myanmar and, of course, Hong Kong.
2.3Capital Account
The issue of yuan bonds in Hong Kong by financial institutions was permitted first in
June 2007. The Shanghai and Shenzhen Stock Exchanges have been offering so-called B
shares to foreign investors, and a large number of Chinese companies have made
equity issues in global markets (H shares). Qualified domestic institutional investors
(QDIIs) have been permitted to invest in foreign equity markets.
China has also been encouraging the use of the yuan on the capital account in other
ways as well. Several international development institutions like the ADB and the
International Finance Corporation (IFC) have made yuan issues in the domestic market.
China has also permitted the issuance in Hong Kong of insurance policies denominated
in the yuan and the issue of yuan bonds, initially by financial institutions and recently
by other issuers, in that market. Recently, the government also issued a 6 bn yuan
bond in the Hong Kong market, and the ADB and IFC are planning to do so. Yuan bond
issues in offshore markets (dim sum bonds) have attracted sovereign issuers as well,
the UK being the first. Aggregate issues in the dim sum bond market are estimated to
amount to CNY 600 bn in the current year.
The Chinese authorities have also permitted the floatation of yuan mutual funds in
Hong Kong for investment in the Chinese market. To be sure, foreign holdings are just
1% of Chinas market capitalisation ($4.75 trillion).
Western commentators have been predicting an imminent crisis in Chinas domestic
financial market for some years: so far at least, their fears (or is it hopes?) have been
belied. To be sure, there have been some bond defaults, and accounting scandals,
inevitable in any market economy: Chinese corporate debt is as high as $14.2 trillion,
inclusive of bonds totaling $4 trillion.
2.4Shanghai Free Trade Zone
One indication of steps towards capital account liberalisation is the recent start of a
Shanghai Free Trade Zone (FTZ) for financial inflows and outflows. The stock exchange
in the FTZ would allow foreigners to trade Chinese shares (within daily limits). There is

also a gold exchange. (China is the largest importer of gold in the world despite
domestic output of 400 tonnes.) The gold exchange will trade in the yuan exchanges
for trading other commodities in the yuan are expected to start functioning in the near
future. The settlements will presumably be in the offshore yuan (CNH) market. The
Shanghai clearing house is launching the worlds first copper premium swap, in effect
a forward contract on the tax, freight, and insurance costs involved in physical delivery.
(The basic price is settled on an exchange and the contract specifies the physical
delivery location.)
3Tomorrows Reserve Currency?
While the global economy is today entrapped in the dollar as the principal reserve
currency, it is not difficult to imagine the yuan taking over in course of time. As it is,
China has set up bilateral, local currency for the yuan, swap lines with central banks of
20-odd countries. Many of these are with developing/emerging economies, but recently
the French and Swiss central banks have also started keeping a small part of their
reserves in the Chinese currency, within bilaterally agreed limits.
The IMFs SDR basket of major currencies does not currently include the yuan. (It
consists of the dollar, the pound, the euro, and the yen.) The next quinquennial review
of the basket model is due in 2015, and it will be interesting to see whether that will
give the yuan its rightful place, given the share of China in the world economy and
cross-border trade.
The standard objections to the yuans inclusion in the basket, and its emergence as one
of the principal reserve currencies, also repeated in Prasads book, are: (i) there are
restrictions on capital flows; (ii) the exchange rate is not market-determined; and (iii)
the yuan bond market is not very liquid.
The other side is that when the SDR basket was established in 1969, every country in
the world, other than the US, was restricting capital flows and had fixed exchange
rates. In fact, the SDR formation was a means to support the fixed rate system. The
inclusion of currencies in the basket was based on their importance in the global
economy and cross-border trade.
The third point is perhaps more logical. After all, countries maintain reserves for the
resources to be available when needed. This obviously requires that yuan investments
of central banks should be readily saleable for other currencies when needed. The
yuan government bond market is not very large or liquid: the former is evidence of the
countrys fiscal discipline. As for the latter, the increasing scale of swap lines suggests
that there already exists a mechanism to convert yuan assets of central banks into
other currencies: this does not necessarily need removal of all restriction on private
capital flows or a market-determined exchange rate.
Unlike Prasad, other economists are far more bullish on the subject. Arvind
Subramanian has argued in his Eclipse: Living in the Shadow of Chinas Economic
Dominance that Chinas dominance could be more imminent, broader and larger than
currently imagined. Even if Chinas growth slows down to 6% pa, by 2030, its GDP in
PPP terms, would be double that of the US. CNY could become one of the reserve
currencies well before that. To quote from Martin Jacques book, in the 21st century,

Chinas impact on the world will be as great as that of the United States over the last
century, probably far greater.
Reserve currency states for the yuan will add to the attraction of the Chinese model,
which worries Fukuyama. And the current hegemon will not really like that to happen.
But its own economic sanctions may persuade more and more countries to adopt the
yuan. It is worth recalling that it was the cold war and the USs interest equalisation tax
that gave birth to the offshore dollar market: the law of unintended consequences has
not been repealed, at least so far!