Wednesday, August 19, 2015

Yuan Volatility Weighs on Reserve Currency Decision

The current volatility in the yuan and concerns about the stability of the Chinese economy may have affected the IMF’s reserve currency decisions. The IMF said today it will keep the current basket of reserve currencies through September 2016.

The IMF wants to add the yuan as a reserve currency, but it cannot credibly do so with the turmoil we are seeing now in the Chinese economy and currency. The IMF reviews its reserve currency allocations every five years, so if it does not add the yuan in its review this year, it is obliged to wait until its next review in 2020. The nine-month extension gives the IMF some extra leeway to add the yuan as a reserve currency without that move taking effect during an ongoing market crash or in its immediate aftermath. However, that makes a difference only if China can stabilize its economy and relax the rules surrounding yuan trading in the next three months.

It is a lot to ask. Trading restrictions are one of the first tools the Chinese central government would think of as it seeks to stabilize the economy, yet the current level of trading restrictions surrounding the yuan are already probably too restrictive to allow its use as a reserve currency. The IMF has said several times that it is important for China to loosen up on its currency so that foreign holders can have more confidence in the value of the currency they hold. The yuan is still unofficially tied to the U.S. dollar, and that is not a characteristic of a reserve currency.

Currency questions aside, it is not certain that China can right its economy in time to persuade the IMF to take action this time around. The combination of a stock market crash, policy leaning toward inflation, and an abrupt pause in manufacturing growth, all happening during a period of social turmoil and political weakness, may not give the central government the leverage it needs to right the economy so quickly. The wishful thinking seen in some recent policy decisions in China is not a favorable sign. It suggests that there is not much more that the central government can do right now.

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