SO CHINA HAS been granted the ambition it has harboured explicitly for its currency for the best part of five years: to be included in the International Monetary Fund’s Special Drawing Rights, the basket of “elite” currencies that constitute part of numerous central banks’ foreign exchange reserves. From October 1 next year, the renminbi will stand alongside the dollar, the euro, the British pound and the Japanese yen in the synthetic IMF currency.
IMF head Christine Lagarde announced the move in an exchange with journalists that contained both tired old platitudes towards China and a curiously unconfident use of professional finance-speak.
Well, as the old saying goes, be careful what you wish for. That goes both for China and for the US-led bloc of Bretton-Woods legacy institutions of which the IMF forms arguably the most crucial core.
China has long wanted to have its cake and eat it when it comes to the renminbi. It is pathologically leery of market forces, as demonstrated by its goose-step into the tatters of the mainland stock market during last summer’s collapse. Forced buying and the arrest of suspected short-sellers and “rumour mongers” formed the basis of the country’s nuanced approach to the stock market bloodbath.
And China has always crimped central bank purchases of its currency for their own reserves, hoping instead that the plethora of swap agreements it has in place with the world’s central banks would put a lid on renminbi appreciation pressures while at the same time mollifying the decision-makers at the IMF’s SDR beauty pageant.
It seems to me that the stage has been set for much higher renminbi volatility than we have seen
THE IMF MADE it clear that the US$500bn of swap arguments China has in place were insufficient and that the country had to allow a much larger degree of market input into the appropriate exchange rate for the renminbi.
That conversation – alongside China’s vaunting SDR ambition – apparently led to last August’s shock devaluation of the renminbi. If that’s true, then the failure on the part of the Chinese authorities to communicate that action to the markets tells you a lot of what you need to know about how seriously they take the concept of free market pricing.
Unlike the US Federal Reserve, the European Central Bank or the Bank of England, which seem to spend most of their time massaging market expectations, the Chinese authorities will land you the sucker punch out of nowhere. Take careful note of that one because it’s worth rather a few basis points when making a risk calculation about investing in renminbi-denominated securities.
But to return to China’s SDR elevation, it seems to me that the stage has been set for much higher renminbi volatility than we have seen, now that the currency is more free to trade.
As the free float of renminbi in the global financial system rises, even without the full opening up of China’s capital account, an element of uncertainty has been built into the China credit proposition that was not there before. The Chinese authorities certainly have ample reserves to use to tinker with the renminbi. But as with the US dollar, and the other SDR currencies, which are backed by piles of central bank foreign exchange reserves, that input has been insufficient to alter the long-term – or, as has often been the case, the medium-term – direction of those currencies.
The Bank of Japan succeeded in damping down daily yen volatility with foreign exchange market intervention when everyone wanted that currency but could do little to stem the yen’s ruinous – for the Japanese economy – rise in the decade-odd prior to the introduction of the “Abenomics” regime.
That Abenomics was more than in part a policy realignment in response to the foreign exchange market’s hunger for the yen won’t be music to the ears of the Chinese financial authorities, where everything has hitherto been about control through centrally planned diktat rather than sensitivity to the pricing mechanism of markets.
NOW THAT CHINA IS about to have its SDR cake I wouldn’t be at all surprised to see sustained renminbi weakness emerge, perhaps precipitously. What would cause it? Appalling China GDP growth data, a worsening debt-to-GDP ratio or maybe a rapid Federal Reserve rate normalisation. Who knows, but according to a old mate of mine who’s been trading foreign exchange rather successfully for the best part of two decades in Singapore, the FX community has renminbi downside volatility in its sights.
That, of course, wouldn’t be all bad for the export-driven Chinese economy, nor would it matter much in relation to the country’s pile of domestic debt. But it would certainly be less than auspicious for the community of Chinese entities that have acquired rather a large amount of US dollar-denominated debt, principally over the past five years.
And if you need evidence that Chinese companies with a dollar liability burden are nervous about the future direction of the renminbi it’s in the rising cost of hedging dollar/renminbi that has manifested since the August devaluation. The Chinese unit was once seen as a one-way appreciation bet: now, if the derivatives markets are anything to go by, it’s the other way around.
Now that it’s in the SDR club, China has its work cut out managing a smooth transition to a free floating currency. With that in mind, I can’t help thinking of Groucho Marx’s comment that he wouldn’t want to join any club that would accept him as a member.
