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April 27, 2015
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INTRODUCTION TOM ORLIK, BLOOMBERG ECONOMIST
April 27, 2015 Bloomberg Brief Economics Asia 2
INTRODUCTION TOM ORLIK, BLOOMBERG ECONOMIST
China's Yuan and AIIB Wins Symbolic, Not Yet Substantive China is riding high with its leadership
of a new development institution andenhanced international standing for theyuan. The hard work is still to come.
The past few weeks have been positivefor China's position in the internationalfinancial system. The Asian InfrastructureInvestment Bank has attracted 57prospective founding members.Subscribed capital of $100 billion — if theaspiration is achieved — will give it alending capacity comparable with that ofthe Asian Development Bank.
At the International Monetary Fund'sspring meetings in Washington D.C., theyuan moved a step closer to reservecurrency status. Managing directorChristine Lagarde said China's financialreforms were "very positive steps" towardincluding the currency in the SDR basket.The Fund also edged toward removing itslong-standing assessment of the yuan asundervalued.
China has played its cards effectively.In terms of international payments, theyuan is not in the top ranks of globalcurrencies. China's capital accountremains controlled, which means it's astretch to describe the currency as "freelyusable" — a requirement for inclusion inthe SDR basket.
That means expectations and politicsare playing a critical role in the SDRdecision. Expectations are driven byChina's continued rise, with potential torival the U.S. as the world's largesteconomy in the next decade. The launchof the AIIB will help shift the substanceand the politics. AIIB loans might helppush the yuan as an internationalcurrency. If China does not get a biggervoice in the IMF, its leaders can focus ontheir own institutions.
So far, so good. The challenge forChina is that moving from symbolic tosubstantial victories will be tough to do.The yuan's admission into the SDRbasket would legitimize its use as a
reserve currency. Even so, barriers to itswidespread adoption remain formidable.
Most obviously, more widespreadinternational use of the yuan requiresaccelerated opening of China's capitalaccount. So far, the total quota for foreignparticipation in its financial markets addsup to about $170 billion. That's equal tojust 1.5 percent of global foreignexchange reserves.
Capital account opening looks like ahigh-risk strategy. Outstanding credit hasswelled to more than 200 percent of GDPin 2015, from about 125 percent in 2008.A critical reason for confidence thattempestuous credit growth won't trigger acrisis is that a controlled capital accountmeans borrowing is domestic anddeposits are captive. A significantopening to cross-border flows wouldchange that equation.
As for the AIIB, China's expertise ininfrastructure development and deeppockets are a formidable combination.Even so, development loans by definitiongo to projects that are high risk and low
return. As the World Bank and AsianDevelopment Bank have found, thoseprojects are difficult to manage. Startingfrom scratch, with rules still to be writtenand zero institutional knowledge, won'tmake it any easier for the AIIB.
In the background are concerns aboutChina's growth. Bloomberg Economicsbelieves that with far-reaching reforms,the economy could end the decade withgrowth still around 6 percent. That is not auniversal view. Some analysts believeChina is set to collapse under the weightof overcapacity and indebtedness. AsJapan discovered in the 1990s, whengrowth ends, global influence goes with it.
The U.S. overtook the U.K. as theworld's main economic engine at the endof the 19th century. It wasn't until thecreation of the Bretton Woods systemafter World War II that it emerged as themain power in the International MonetaryFund, with the dollar anchoring the globalfinancial system. China's symbolic risehas been breathtaking. It may be a whilebefore its substantial position catches up.
CONTRIBUTORS
For U.S., Economic Strength Came Before Dollar Dominance
April 27, 2015 Bloomberg Brief Economics Asia 3
CONTRIBUTORS is Bloomberg's chief Asia economist, based in Beijing. HeTom Orlik
was previously chief China economics correspondent for The WallStreet Journal, China economist for Stone & McCarthy ResearchAssociates and a policy analyst at the British Treasury. He is theauthor of Understanding China's Economic Indicators.
Tamara Henderson is a Ph.D economist with buy- as well assell-side experience, covering G-3 economies and the emergingmarkets over a span of 25 years. She has focused on FX and ratesstrategy over the past 12 years and has accumulated a strong trackrecord for her trade ideas. Previously, she was an economist with theInternational Monetary Fund. Tamara is a CFA charterholder and theauthor of 'Fixed Income Strategy: A Practitioner's Guide to Riding theCurve,' published by Wiley.
Fielding Chen is an economist for Bloomberg based in Hong Kong.He was previously a senior economist for Asia at Banco BilbaoVizcaya Argentaria. He holds a Ph.D in economics from GeorgiaState University and a master's degree in finance from XiamenUniversity. Chen is a published author and was an instructor atChinese University of Hong Kong Business School.
is a senior fellow with the John L. Thornton ChinaDavid Dollar Center at Brookings and an expert on the Chinese economy. From2009 to 2013, he was the U.S. Treasury Department's economic andfinancial emissary to China. Previously, he worked at the World Bankfor more than 20 years, including serving as country director forChina and Mongolia.
GETTING INTO THE SDR BASKET Chances are good that China’scurrency will be included in the IMF’snew Special Drawing Rights basket inJanuary.Page 4.
CHARTING THE YUAN'S RISEWhile use of the yuan in globaltransactions continues to rise, barriersremain to more rapid progress.Page 5.
YUAN TRADING RULESBacktesting analysis yields the tradingrules that top returns for the offshoreyuan in the past three years.Page 7.
LESSONS FROM EXPERIENCEThe AIIB can learn from theexperiences of the World Bank, saysDavid Dollar.Page 8.
PAVING THE WAY FOR ASIAGROWTHImproving infrastructure and boostinggrowth are among the potentialbenefits from AIIB investment.Page 9.
TIMELINEBloomberg Economics tracks adecade of the yuan's majormilestones.Page 10.
CONTENTS
YUAN IN THE SDR BASKET TAMARA HENDERSON, BLOOMBERG ECONOMIST
April 27, 2015 Bloomberg Brief Economics Asia 4
YUAN IN THE SDR BASKET TAMARA HENDERSON, BLOOMBERG ECONOMIST
Achieving SDR Status for 2016: China May Get the Yuan Into the IMF's BasketThere is a real chance that remaining
hurdles for the Chinese yuan can becleared before the International MonetaryFund's new SDR basket is implementedon Jan. 1. IMF Managing DirectorChristine Lagarde signaled last monththere was still a lot of ground to cover.The issue is whether CNY has becomesufficiently usable in the five years sincethe last formal review of the organization'sSpecial Drawing Rights.
The SDR is an international reserveasset created by the IMF. SDR value isbased on a basket of selected currenciesdetermined by the Fund to be "freelyusable." These currencies are currentlythe U.S. dollar, euro, yen and pound.
During the last review of the SDRbasket in 2010, the IMF rejected the yuanbecause the currency was not "freelyusable." The political backdrop was alsoagainst China. CNY trade settlementvolumes were low and very one-sided,putting further upward pressure on thecountry's already enormous internationalreserves. IMF staff considered the yuansubstantially undervalued and the realeffective exchange rate was depreciating.
Today, the yuan is much more usable(see trends mapped out in Charting the
) and IMF politics are moreYuansupportive. In particular, more than 30central banks are believed to havealready begun reserve diversification intoyuan. China also widened the yuan'strading band and CNY valuation hasimproved. The Fund's most recent ArticleIV assessment in 2014 noted the yuanhad appreciated in real effective termsconsistent with underlying fundamentals,though not enough to eliminate what wascharacterized as a more "moderateundervaluation" between 5 percent and10 percent.
The yuan need not become fullyconvertible to satisfy the Fund's SDRrequirement that a currency be "freelyusable." According to the Articles ofAgreement of the IMF (Article XXX), theyuan need only be "widely used to makepayments for international transactions"and "widely traded in the principalexchange markets."
The IMF also has some wiggle room inits assessment of usability. The Fund'sExecutive Board said in 2010 thatindicators should not be used"mechanistically" and that "ultimately, the
determination of free usability would needto rely importantly on judgment, framedby the definition of freely usable currencyset out in the Articles of Agreement."
The issue is no longer the yuanwhetheris an international reserve currency, butthe to which it is a major player.extentOne indicator of progress: the notionalvalue of onshore yuan options contractscleared by the Depository Trust andClearing Corporation from week to weekusually rivals those for the yen.
At the same time, the yuan is not thereyet in terms of daily turnover in thecurrency markets. Yuan turnover is 2.2percent of the total compared with 2.5percent for the Mexican peso, 4.6 percentfor the Canadian dollar, 5.2 percent forthe Swiss franc, 8.6 percent for theAustralian dollar and 11.8 percent for theBritish pound, according to the latest BISsurvey for 2013. The difference here isrelated to currency convertibility, which iscritical for the high-frequency trading thatChina has so far steered clear of. Still,China's share of SWIFT transactions issimilarly small, albeit quickly rising.
There is nevertheless a good chancethe yuan will be included in the SDRbasket from January 2016 as politicalpragmatism trumps economic detail. Asthe world's second largest economy, andwith growth robust as many developedcountries remain stagnant, China nowhas greater heft in international decisionmaking. Since China's economic power is
only likely to grow, the granting of SDRstatus at this stage would be an importantgesture of goodwill. On the inclusion ofthe yuan in the SDR basket, Lagarde saidlast month "timing is something that wewill be discussing amongst ourselves."The comment is revealing — there wouldbe nothing to finesse if this were purely amechanical decision based on SWIFTtransactions and FX turnover.
The formal SDR review is not untilOctober. That allows time for China topush ahead with further reforms.Increased access for internationalinvestors to the mainland's bond andequity markets would bolster the yuan'sclaim to be "freely usable."
In the meantime, the Fund mayacknowledge the yuan's use as a reservecurrency by separately identifying CNYforeign reserves in its CurrencyComposition of Official Foreign ExchangeReserves report. COFER currently lumpsthe yuan into the group, "OtherCurrencies," which accounts for 3 percentof allocated reserve holdings. Thiscompares with 4 percent shares for theseparately identified yen and pound, 2percent shares for the Australian andCanadian dollars, and a 0.3 percent sharefor the Swiss franc.
The Fund could also adopt a morecongenial tone in the IMF's Article IVassessment for China due this year.These could all be signals of CNY's shiftto SDR status in January.
CHARTING THE YUAN TOM ORLIK AND FIELDING CHEN, BLOOMBERG ECONOMISTS
Yuan the Seventh Most Used World Payments Currency
April 27, 2015 Bloomberg Brief Economics Asia 5
CHARTING THE YUAN TOM ORLIK AND FIELDING CHEN, BLOOMBERG ECONOMISTS
Rise of the Yuan as an International CurrencyUse of China’s currency in trade and
foreign exchange transactions continuesto rise. Limited foreign access to themainland’s markets remains a barrier tomore rapid progress.
As the world’s largest exporter, China hasa natural advantage when it comes toraising the importance of the yuan intrade settlement. The data shows 1.65trillion yuan of China’s imports andexports were settled in yuan in the firstquarter, unchanged from the same perioda year earlier. That’s equal to about 30percent of total trade.
China’s share of total paymentsprocessed on the Swift network continuesto edge up. As of February 2015, theyuan made up 1.8 percent of totalpayments, up from 1.4 percent a yearago. The yuan is the seventh most usedglobal currency, fractionally behind theCanadian dollar and the Swiss franc.
The Bank for International Settlementsdata on FX market turnover provides amore comprehensive read on the yuan’sglobal position. Unfortunately, the BISreview is carried out only once everythree years. The latest data, from 2013,shows the yuan in ninth place with 2.2percent of global turnover. Based on theSwift payments data, its ranking has likelyimproved a little since then.
Bid-ask spreads in currency marketsprovide a more high-frequency reading onthe yuan’s relative position. A tightbid-ask spread suggests strong liquidityand trading activity. On that basis, theyuan’s position remains some way off thatof the euro, yen and sterling. Bid-askspreads so far in 2015 have averaged0.03 percent and 0.05 percent in theonshore and offshore yuan markets,respectively, compared with 0.01 percentfor the euro, yen and sterling.
Trade Settlement
Global Payments
BIS FX Transactions
Bid-Ask Spreads
Continued on next page…
Growing Importance in Trade Settlements, Global Payments
BIS Data Shows Yuan in Ninth Place in Global FX Market
Yuan's Bid-Ask Spreads Still Wider Than Rivals'
April 27, 2015 Bloomberg Brief Economics Asia 6
Continued from previous page...
CHARTING THE YUAN…
The People’s Bank of China continues tocome up with ingenious workarounds topromote yuan internationalization withoutcapital-account opening. Rapid growth ofthe dim sum bond market meansinternational investors don’t need to bringfunds into China to buy yuan assets.Offshore yuan bond issuance rocketed to270 billion yuan in 2014, up 153 percentfrom 107 billion yuan in 2013. Issuancehas slowed this year as offshore yuanrates have risen and access to themainland market increased.
Swap agreements totaling 3.5 trillion yuanhave now been signed between thePBOC and more than 30 other centralbanks. Currency swaps can be used bytrade partners to cushion against abalance of payment crisis. As such, theyreduce other central banks’ need fordollars and mean the yuan is alreadyplaying a role as a de facto reservecurrency.
The start of Mutual Market Accessbetween Shanghai and Hong Kong equitymarkets last year represented a steptoward market opening. So far, itsreception has been lukewarm, with morethan 50 percent of the inbound quota and70 percent of the outbound still unused.
Despite its progress, the scope for theyuan to emerge as a reserve currencyremains limited by controls on access tothe mainland markets. Adding up thequotas under the Qualified ForeignInstitutional Investor, Renminbi QualifiedForeign Institutional Investor and MutualMarket Access schemes, foreigners canbring a total of about $170 billion intoChina’s markets. By way of comparison,global FX reserves are about $11.6trillion.
Dim Sum Bond Issuance
Bilateral Agreements
Hong Kong-ShanghaiExchange
QFII and RQFII
TRADING RULES TAMARA HENDERSON, BLOOMBERG ECONOMIST
Investors Still Hungry for Dim Sum Bonds
Currency Swap Agreements Swell to 3.5 Trillion Yuan
Quotas Limit Yuan's Progress as a Reserve Currency
April 27, 2015 Bloomberg Brief Economics Asia 7
TRADING RULES TAMARA HENDERSON, BLOOMBERG ECONOMIST
Moving Average Rules Top Yuan Returns Since China's Trading Band WideningMoving average rules have been
generating more and more consistentreturns for the onshore and offshoreChinese yuan during the past three years.The outperformance coincides with thewidening of the daily trading band fromplus or minus 0.5 percent of China's dailycentral parity rate against the U.S. dollarto 1 percent in April 2012 and 2 percent inMarch 2014. The AccumulationDistribution Oscillator and Ichimokusignals also performed well within thegroup of strategies included inBloomberg’s back-testing function
.{BTST<GO>}Since the yuan trading band has been
plus or minus 2 percent of the daily fixing,the Accumulation Distribution Oscillatorhas earned the highest return forCNHUSD, 4.1 percent. The SimpleMoving Average rule was the top strategyfor CNYUSD, earning 3 percent.
SMA has been one of the top threeperforming rules for both currency pairssince April 2012. SMA has earned 1.9percent for CNHUSD and 3 percent forCNYUSD during the latest period, withthe band at plus or minus 2 percent —compared with losses for the Buy & Holdrule. SMA earned 6.2 percent forCNHUSD and CNYUSD when the tradingband was 1 percent either side of parity,compared with earnings of 2.4 percentand 2.5 percent, respectively, for Buy &Hold.
Weighted MA, Triangular MA andExponential MA rules have outperformedBuy & Hold strategies by a margin of atleast 1.4 percentage points since April2012.
Between August 2010 and April 15,2012, when the trading band was plus orminus 0.5 percent, Buy & Holdoutperformed. Rules that earned profitsfor the offshore yuan often generatedlosses for the onshore yuan, and viceversa. Since April 2012, winning rules forthe offshore yuan have also tended to beprofitable for the onshore yuan.
Moving average rules can be moreeffective in established trends, whileoscillators are designed to signal turningpoints. Oscillators might send falsesignals in a moving market, whiletrend-following indicators mayunderperform in a stable market.
LESSONS FROM EXPERIENCE GUEST COMMENTARY BY DAVID DOLLAR, BROOKINGS INSTITUTION
Performance During Band Width of +/- 2 Percent
Performance During Band Width of +/- 1 Percent
Performance During Band Width of +/- 0.5 Percent
April 27, 2015 Bloomberg Brief Economics Asia 8
LESSONS FROM EXPERIENCE GUEST COMMENTARY BY DAVID DOLLAR, BROOKINGS INSTITUTION
Lessons for the AIIB From the Experience of the World BankTo understand the impetus for
launching the Asian InfrastructureInvestment Bank, look no further thanChina’s concern that the governancestructure of existing international financialinstitutions was evolving too slowly. Animportant agreement to increase theresources of the International MonetaryFund and to raise the voting shares offast-growing emerging markets, ratified byother nations, has been stalled in the U.S.Congress. It is ironic that one of China’sfrustrations with the U.S.-dominatedinstitutions is that China sees a need formore resources and is willing tocontribute, whereas the different parts ofthe U.S. government cannot agree to thisexpansion.
China’s frustration is not just about thesize of the institutions and its weightwithin them. In the case of the WorldBank, China has argued for years formore focus on infrastructure and growth.
Several years ago, Ernesto Zedillo,former President of Mexico, chaired a“High-Level Commission onModernization of World Bank GroupGovernance.” This was a serious effort bya distinguished international committee,including Zhou Xiaochuan from China andother emerging market heavyweights.The Zedillo report is quite critical of thecurrent World Bank arrangement of aresident board that approves all loans.The resident board is both a largefinancial cost to the bank ($70 million peryear) and an extra layer of managementthat slows down project preparation andmakes the bank less efficient. Slownessof project preparation is one of the maincriticisms of clients concerning the poorperformance of the multilateraldevelopment banks.
The Chinese officials charged withdeveloping AIIB are looking at the Zedilloreport for ideas. It is likely that the bankwill have a non-resident board that meetsperiodically in Beijing and also by
videoconference. Given the newness ofthe bank, a likely compromise among thecountries that have signed up is that theboard will approve many of the initialprojects and eventually delegate moredecision-making to management.
The Zedillo report recognizes theimportance of environmental and socialsafeguards but argues that the WorldBank has become so risk averse that theimplementation of these policies imposesan unnecessary burden on borrowingcountries. In practice, developingcountries have moved away from usingthe existing multilateral development
"The idea that AIIBprojects would help
absorb China’sover-capacity problem
does not make anysense at all."
banks to finance infrastructure becausethey are so slow and bureaucratic. Theenthusiastic response of developingcountries in Asia to the AIIB conceptreflects their sympathy with the idea thata bank can have good safeguards andstill be quicker and more efficient than theexisting banks.
Some of the Western commentary onAIIB expresses a fear that China will usethe bank for narrow political or economicends. Now that a diverse group of nearly60 countries have signed up, it would bedifficult for China to use the bank tofinance projects in favored countries overthe exclusion of other members.
The idea that AIIB projects would helpabsorb China’s over-capacity problemdoes not make sense. If the bank is verysuccessful, then in five years it might lend$20 billion per year, on a scale with theWorld Bank’s International Bank forReconstruction and Development lending.In the steel sector alone, China wouldneed $60 billion per year of extra demandto absorb excess capacity. Add in excesscapacity in cement, heavy machinery andother sectors — the point is that the bankis just way too small to make any dent inthe excess capacity problem, even ifChina were the sole supplier for theseprojects, which it won’t be.
The initial success of AIIB is adiplomatic victory for China. The U.S.diplomatic response has not been adroit,playing into the narrative of U.S. declinein the Asia-Pacific. But that perceptioncould change quickly. Infrastructure is the“hardware” of economic integration, whichis certainly necessary. But tradeagreements such as the Trans-PacificPartnership are the “software.” If the U.S.and its partners can negotiate andimplement this agreement for deeperintegration, that will provide a large boostfor the members and reestablish U.S.importance to the Asia-Pacific economy.
China pursuing AIIB and other initiativesthat do not include the U.S., while theTPP negotiations do not involve China,creates a risk of competing blocs andinstitutions. In my view, though, the mostlikely outcome is the world ends up with amore robust and inclusive set ofinstitutions. AIIB is likely to make theother development banks more effectiveand become a part of the globalarchitecture. China and other Asiancountries not now involved in TPP arelikely to join if it is successful. Bringing thehardware and the software together, theoutcome could be a more integratedAsia-Pacific economy.
PAVING THE WAY FOR ASIA'S GROWTH FIELDING CHEN, BLOOMBERG ECONOMIST
April 27, 2015 Bloomberg Brief Economics Asia 9
PAVING THE WAY FOR ASIA'S GROWTH FIELDING CHEN, BLOOMBERG ECONOMIST
China's New Development Bank Aims to Clear Underbrush From Asian Growth TrackIf it can overcome operational and
political challenges, the China-led AsianInfrastructure Investment Bank mayreduce infrastructure bottlenecks andboost developing Asia’s potential outputby more than 1 percentage point. TheAIIB is poised to emerge as Asia's biggestinvestment-focused multinationaldevelopment bank.
Though it's the world's fastest growingregion, developing Asia remains impededby rusting and inadequate transport,power and communications networks.AIIB resources will be targeted atremedying that situation. The bank willprobably launch by the end of the yearand has attracted interest from 57 nationsworldwide.
World Bank data show a big gapbetween infrastructure in Asia anddeveloped countries. Compared withIndia's 2.3 telephone lines per 100people, the U.S. has 42.2. WhileIndonesia has 1.3 fixed broadbandInternet subscribers per 100 people, theU.S. has 29.3. The least-developed Asiancountries have even bigger disparities.
Asia may need about $750 billion peryear from now until 2020 to finance projects in transportation, energy supply,water facilities and other areas, accordingto the Asian Development Bank. Abusiness taskforce reporting to the G20forecasts that a third to a fourth ofinfrastructure investment needs in thecoming 15 years may find difficulty ingetting financing.
The AIIB would be well positioned toreduce that shortfall. The bank's initialsubscribed capital will be at least $50billion and is expected to rise to $100billion. Its paid-in capital is 20 percent ofits total subscribed capital, or about $20billion. Callable capital makes up theremaining 80 percent. While the WorldBank and the Asian Development Bankhave higher subscribed capital of $233billion and $162.8 billion, respectively,they have lower paid-in capital — at $14.4billion and $8.2 billion.
What sets the AIIB apart is its focus oninfrastructure. The ADB committed about60 percent of its $21 billion in new loansin 2013 to infrastructure projects, or about$12.6 billion. Given the AIIB's sole focuson infrastructure, its capacity to makeloans toward building Asia's bridges andpower plants might be 60 percent to 70
percent greater than its Manila-basedrival's.
The result may be a boost toinfrastructure investment in non-Chinadeveloping Asia of up to 0.5 percent ofGDP a year. Long term, that may boostpotential GDP in these countries by 1 to1.5 percentage points. According to theIMF, a 1 percentage point increase in infrastructure investment as a proportionof GDP can raise annual output by 2-to-3percentage points long term.
Development finance is not easy, evenwith major resources. Developmentinstitutions must take on projects almostby definition too risky for the private
sector. The AIIB will take time to tacklequestions about governance and fundingas it ramps up to full capacity. Politicalconcerns and overlap with otherinstitutions are also barriers to rapidprogress.
Still, China's record of infrastructuredevelopment, the AIIB's ample resources,and evident investment need across theregion mean there are both motive andopportunity to make a difference. In anoptimistic scenario, the AIIB's position asa regional investment hub coulddrastically reduce Asia's infrastructureshortfalls and anchor future development.
TIMELINE TOM ORLIK, BLOOMBERG ECONOMIST, AND JENNIFER BERNSTEIN, BLOOMBERG BRIEF EDITOR
Asia’s Infrastructure Lags as % of U.S. Level
AIIB's Expected Capital Structure
April 27, 2015 Bloomberg Brief Economics Asia 10
TIMELINE TOM ORLIK, BLOOMBERG ECONOMIST, AND JENNIFER BERNSTEIN, BLOOMBERG BRIEF EDITOR
April 27, 2015 Bloomberg Brief Economics Asia 11
April 27, 2015 Bloomberg Brief Economics Asia 13
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