The International Monetary Fund’s (IMF) decision in December 2015 to add China’s renminbi (RMB) to its basket of elite ‘special drawing rights’ (SDR) currencies came as a surprise to many. It was a step into the unknown, marking the first new addition to the basket in 15 years, and the inaugural inclusion of an emerging-world currency. US dollars and euros still dominate the basket, but the RMB went straight in at number three, with a weighting of just under 11%, ahead of the Japanese yen and British pound.

For China’s political leaders, the move to expand the SDR, which came into effect on 1 October 2016, was seen as long overdue. Beijing had fought hard for greater influence within the IMF and the World Bank. When it failed, its reaction was to set up its own multilateral financial institution, the Asian Infrastructure Investment Bank, which opened for business in January 2016, having been initially proposed in 2009. By doing this, Beijing has boosted its chances of drawing Asia further into its orbit, and of making the RMB the de facto regional currency, vying with and even replacing the dollar – though this still remains a distant prospect. 

The IMF, which reviews the composition of the SDR – less a currency than the IMF’s internal monetary unit – every five years, with the next review due in 2020, justified its decision by pointing to China’s rapid rise from economic backwater to the world’s leading exporter, adding that, in its view, the yuan was globally ‘freely usable’. IMF managing director Christine Lagarde hailed “an important milestone in the integration of the Chinese economy into the global financial system”.
Some still scepticalYet not everyone was convinced. To many, the yuan had hit a high-water mark in 2014. Since then, Beijing has twice devalued its currency, and suffered a nasty stock market crash. China’s central bank then spent the final months of 2016 desperately trying to weaken the yuan (in order to make its exports cheaper to buy), only to have to slow the pace of depreciation by diluting the dollar’s role in a basket of currencies used to set the RMB’s daily rate.

Worse, the currency has slipped sharply in terms of its global use. According to data from Swift, use of the yuan in global trade finance has almost halved, to 4.61% at end-November 2016, from 8.66% three years ago. And the market for debt priced in RMB is shrinking, not expanding. Just three Chinese firms priced yuan bonds offshore in the first nine months of 2016, against 73 two years ago, according to data from Dealogic.

To some extent, the RMB is a victim of both China’s success, and confusion about Beijing’s long-term ambitions. A sharp rise in global yuan holdings in the early 2010s were, believes Mark Williams, chief Asia economist at Capital Economics, driven by “hyperbolic expectations of the RMB rapidly becoming an international reserve currency. But that was based on investors looking to profit from the RMB’s appreciation, and once that process stopped, no one wanted to hold yuan any more”.
Counterintuitive ambitionsIn recent years, Beijing has tried to open the capital account while controlling its currency. Those ambitions are naturally counterintuitive, and the tension within that process has been building for some time. It has resolved that problem by making a simple trade-off: slowing the process of capital account liberalisation, in exchange for controlling its currency – a decision that has undermined global use of the yuan at all levels. But that process will reverse again, says Mark, once the market stops seeing the yuan as a one-way bet on appreciation.

In this climate, the big and so-far-unanswered question is whether China can transform the RMB from a middling power into a bona fide reserve currency, able to compete with, and perhaps in time supercede, the dollar. To meet this ambition, observers say three conditions need to be met.
4.61%
The use of the yuan in global trade finance at end-November 2016, down from 8.66% three years ago
First, the currency’s sovereign needs to run a big economy compared to others. China ticked this box long ago. Second, that economy needs to be stable. Beijing has largely met this criterion, though it needs to diversify its economic mix – toward consumption- and services-led growth – to avoid a Japan-style stagnation over the next decade. (The yen was on course to become an influential global currency until the bursting of a huge asset and real estate bubble in the 1990s.)

Third, it needs the backing of a supportive state, a factor key to the rise of every global reserve currency through history, from the Roman aureus through to the American greenback. The People’s Bank of China (PBoC) has established currency-swap agreements with its peers, while supporting the use of the RMB overseas. So again – tick.
A long way offBut much remains to be done. Many analysts are unsure whether Beijing is yet ready or willing to shoulder the burden of global financial management. “The yuan is still a long way off replacing the euro or US dollar as a major transactional currency,” says Ben Simpfendorfer, founder and managing director of China-focused consultancy Silk Road Associates. “China would like a fully liberalised currency, but it doesn’t want to lose its ability to control the inflow and outflow of capital. At the moment, stable capital flows are the government’s priority, so full liberalisation may temporarily have shifted to the back burner.” Recent history also teaches China’s political leaders that a currency can become influential and widely disbursed without needing to be a power-packed global tender. In 1989, the year before German reunification, the Deutsche Mark (DM) accounted for around 20% of all global monetary reserves, reflecting its popularity, primarily among European sovereigns, as a counterweight to the dollar. 

The yuan is also, despite the IMF’s bullish claims, still very far from being considered a ‘freely usable’ currency, widely traded in the principle exchange markets. According to Swift, most payments processed between China and the Middle East are still settled in US dollars, using American clearing banks. And in terms of turnover on the foreign exchange markets, the RMB is only the eighth most widely traded currency, below the Canadian dollar and the Swiss franc.
The yuan’s idiosyncrasiesThen there are the yuan’s inimitable qualities, shared by no one else. China’s current account is opening, but only very slowly, with the flow of capital entering and leaving the country still carefully controlled. In 2015, PBoC governor Zhou Xiaochuan warned that China would continue to “adopt a concept of managed convertibility” when it came to its capital account.

Foreign funds still have to apply for quotas before buying onshore securities. This limits the RMB’s global use and relevance as an investment tool. After all, if foreign investors want to buy assets priced in yuan, they want reassurance that those assets are priced properly, and can be easily converted into their own currency. China’s bond market is reckoned to be less than 2% owned by foreign investors, a figure low by any measure.

China’s government is also notoriously opaque, and often surprises global markets with poorly-telegraphed decisions – 2015’s currency devaluations being a case in point. Often forgotten too is that the RMB is in effect two currencies, one offshore and liquid, the other onshore and (at least for most global investors) illiquid. Finally, China lacks deep, open, transparent and well-regulated capital markets, viewed as vital to the creation of a genuine global investment currency. Time and again, Beijing has pledged to overhaul everything from the IPO registration process to the securities regulator itself, only to backtrack.
What Beijing wantsOne final question here is that of China’s long-term ambitions. Does it want a fully internationalised yuan – and if so, when will it allow the RMB to float free and unfettered? (The PBoC currently fixes the yuan on a daily basis against a basket of currencies dominated by the dollar, and lets it move 2% either way.) 

Will Beijing be willing to cede some control over the yuan, as the US has with the greenback, in exchange for the bragging rights that come with a reserve currency? “China wants the yuan to become a global reserve currency, but it doesn’t want to cede control of domestic financial conditions to foreign investors,” says Capital Economics’ Mark. “There is no deal to be made there. A globalised yuan is not going to happen until China becomes more confident with the idea that domestic financial conditions are determined by global, not local, events. The RMB has no chance of becoming a global currency, even with the Japanese yen or sterling, any time in the next decade.”

After two tough years dealing with the yuan’s growing pains, China now faces a third. The yuan weakened faster than expected in the final months of 2016, undermined by a surging dollar, causing the outflow of capital from the mainland to accelerate. The RMB hit an eight-year low against the dollar in December 2016, prompting US hedge fund manager Kyle Bass to tip China’s currency to fall 30% in value against the greenback. Buying dollars against yuan is a recommended trade of Goldman Sachs, along with bets against sterling and the euro.

Whether these headwinds will strengthen or weaken China’s desire to create a truly global currency remains to be seen. Other sovereigns, notably Russia and India, both of which are keen to see their currencies flourish on the world stage, are eyeing events with interest. So too is the IMF, whose decision to include the yuan in its elite basket of special drawing rights will either come to prove impressively prescient, or remarkably ill-timed.

Elliot Wilson is a business and finance writer, specialising in markets including China, India, Russia and Africa. He has worked as a journalist in Beijing, Mumbai, London and Hong Kong, writing about the future of emerging markets.