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China’s bid against the greenback

Last week the IMF invited the Chinese yuan into the basket of foreign currencies it uses to as its unit of account known as Special Drawing Rights (SDR), joining the dollar, euro, pound and yen. This marks a significant step towards what some commentators see as an eventual bid against the dollar to become the global reserve currency, and certainly a growing commitment to let market forces play a greater role in setting its exchange rate.

Prior to extending its invitation, the IMF demanded the People’s Bank of China (PBOC) make some changes to their currency regime, most notably to tie the day’s opening exchange rate to the prior day’s close. This may seem somewhat elementary to a free floating exchange rate, but previously the day’s opening rate was in effect set at the whim of the PBOC, often creating a meaningful gap against the prior day’s close. This is the technical story behind the 2% devaluation in August, the spark that wobbled global markets, particularly in the emerging world.

Since then the Chinese have been forced to use more traditional methods to maintain the yuan’s effective tie to the dollar, namely selling dollars to buy yuan, which has seen their global reserves fall from a peak last year of $4 trillion down to $3.5 trillion today, a meaningful decrease of some 12%, fighting to keep pace with an appreciating dollar.

So where does that leave things today? It is unlikely that China will embrace a full-throttle free-float exchange rate anytime soon, and there is certainly a lot left in the tank to maintain its de facto peg against the dollar. But against that backdrop, now that the yuan is a signed up member of the IMF’s SDR, the Chinese by extension have pledged to reduce the intervention that has been propping up the yuan for so long. In short this means a weaker yuan may be on the horizon, particularly given the Fed has finally started its much discussed commitment to increase interest rates, which in turn could see further upward pressure on the dollar.

There is a long road ahead before the yuan could pose any realistic threat to the greenback’s exalted position of global reserve currency, but the prize at the end may be worth the fight; and if it means a less controlled yuan, that has got to be a long-term boost for global trade.


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