Yuan for the Money, Two for the Show

13 February 2013 | Philip Ammerman

The Economist ran the latest of a series of interesting article on the increasing convertibility of the Chinese Yuan (“Yuan for the money”) in its February 9th, 2013 edition. According to The Economist:

In the last three months of 2012 the amount of trade settled in China’s currency reached almost 900 billion yuan ($145 billion), or 14% of China’s trade, up from almost nothing three years earlier. China accounts for about 15% of the world’s money supply.

Although the yuan accounts for a small currency share compared to the US dollar, Euro, Yen and British pound, the trajectory of future growth can readily be assumed.

Bloomberg ran an article on the growth of Chinese trade and the fact that in total imports and exports, China surpassed the United States to become the world’s largest trading nation (China Eclipses U.S. as Biggest Trading Nation, February 10th, 2013).

“U.S. exports and imports of goods last year totalled $3.82 trillion, the U.S. Commerce Department said last week. China’s customs administration reported last month that the country’s trade in goods in 2012 amounted to $3.87 trillion. ... China’s growing influence in global commerce threatens to disrupt regional trading blocs as it becomes the most important commercial partner for some countries.”

The trade numbers are interesting for their impact on GDP. US GDP is just over $ 15 trillion, while China’s GDP is slightly less than half of this at $ 7 trillion. But remember that GDP is defined as the sum of:

GDP = private consumption + gross investment + government spending + net exports (exports – imports)

This raises a number of questions as to what happens to headline GDP and other factors in the “China model” if more transactions are denominated in yuan.

Chinese GDP is a complex and often opaque creature, but a very large part of it is due to structure issues and government control.

Chinese manufacture, despite its volume, retains a relatively low share of value in China. See for instance the share of value captured by Apple’s manufacturing operations in China. This results in lower relative net exports, and in turn feeds into lower private consumption due to low wages and dividends in China.

Low wage costs and a high labour supply. The Chinese growth model has been on attracting FDI to assure export-led growth, initially using low cost labours supply as a competitive advantage. This is beginning to change, as the Foxconn strikes and other data indicate. Should this continue, it will increase the net export and private consumption components of GDP.

Overinvestment in key manufacturing sectors, driven by the Chinese government’s stimulus spending focussing on export-led growth (but also domestic real estate). See for instance the glut in solar panel production. This depresses the net export component of GDP but raises gross investment. It is interesting that since much of the credit is from government-sponsored financial entities which are recycling hard currency earnings (via credit guarantees and credit lines from the central bank), government debt remains relatively low.

The availability of these hard currency reserves is precisely a result of exchange rate controls. It will therefore be interesting to see what effect denominating a higher volume of trade in yuan will have on China’s forex reserves, which numbered over $ 3 trillion in 2012.

This last point also inevitably concerns the US dollar. Besides the obvious issues of how the USD will continue as the reserve currency and the value of the USD, there is another question as to how much longer China will continue to invest in US Treasuries, both as a hedge against devaluation as well as a political lever.

Will yuan-denominated transactions incur lower transaction costs? Theoretically, yes, although if we measure total transaction costs, including potentially higher yuan inflation rates, regional currency valuation issues, and the costs of converting yuan holdings to parent currencies when repatriating or declaring annual profits or dividends, this is not a foregone conclusion if set over a 5-year time period. On the other hand, if we assume a well-managed currency and an appreciating yuan, the conversion effect will provide a significant upside to such transactions.

This last point notwithstanding, we anticipate a major growth in yuan transactions over the next five years. The momentum pointing to this is undeniable, and is magnified by semi-governmental investments in African infrastructure projects or commodity trading.

This will inevitably lead to a struggle to manage the yuan’s appreciation by the Chinese central bank, which already finds itself having to manage a short-term Japanese yen and a longer-term US dollar devaluation. It is no coincidence that China is doubling down on gold purchases.

An increase in yuan transactions is a clever short-term method of taking some of the pressure off the rising Chinese currency. Yet this pressure is only likely to accelerate, both given national policy among key trading partners (Japan and the US in particular) as well as the likely demand for yuan transactions among companies, semi-governmental organisations, and private citizens and small entrepreneurs.

The next step will almost certainly be a move to denominate oil and commodity prices in yuan, which would lead to a real issue in the future of the US dollar. And while an appreciating yuan will flatter USD-denominated GDP, the current structural imbalances in an over-supplied, mercantilist model remain to be resolved.

Philip Ammerman