4th October 2016
Jan Dehn, head of research at Ashmore, explores the significance of the recent inclusion of China’s currency in the IMF’s SDR basket. As the first EM currency to achieve this global reserve currency status, he looks at where China is headed in the long term and predicts that China’s per capita GDP will catch up with US per capita GDP sometime between year 2040 and 2051.
Renminbi becomes a global reserve currency
Make a note of the date 1st October 2016 as the day China’s currency, the RMB, became the first Emerging Markets (EM) currency to attain global reserve currency status. In years to come it will also be seen as the day the RMB embarked on its long journey to become the world’s pre-eminent global reserve currency. The IMF included the RMB in its SDR basket with a weight of 10.9%. The basket weights of EUR and GBP were reduced to make room for RMB, while the USD and JPY broadly maintained their weights. The UK has already benefited significantly from its gesture to China by securing material Chinese investment in the Hinkley nuclear power plant.
The RMB’s inclusion in the SDR is particularly important for central banks, which now have access to a reserve currency, whose integrity is not undermined by QE and where the government in question pays positive nominal and real yields on its bonds. This makes the RMB unique among the SDR currencies. SDR inclusion is only the beginning for the RMB’s journey, however. The real significance of RMB’s SDR inclusion will only become fully apparent as China’s growing economic importance becomes more widely accepted. Size matters in global finance. In particular, financial markets prefer to benchmark themselves against the largest and most liquid markets. This is why, for example, the US Treasury market and the US dollar rapidly replaced the UK Gilt and Pound Sterling as global benchmarks for fixed income and currencies in the interwar years, where the US economy dramatically outpaced the UK economy.
China’s growth will eclipse US growth for decades to come
China is now in the process of pulling a similar trick on the US. Chinese growth is likely to eclipse US growth for several decades to come for a number of reasons. It is important that China is reforming, while US productivity is declining sharply, but China also starts out with a much lower level of per capita income and a much higher savings rate. Higher savings means that China’s investment rates and hence her growth rates will be structurally higher, while a lower starting level of per capita income will ensure that the basic forces of economic convergence continue to propel China forward at much greater speed than the very mature US economy.
Realistically, China’s per capita GDP will catch up with US per capita GDP sometime between year 2040 and year 2051. This is significant, because China’s population is more than four times larger than that of the US. Hence, when the two countries have the same per capita income the Chinese economy will in fact be more than four times larger than the US economy.
Clearly, these types of long-term projections always depend on the underlying assumptions. Early catch up (i.e. in 2040) would require that both China and the US economy continue to grow at the same per capita growth rates since 1980 (Scenario 1). In reality, however, both countries have been growing at progressively slower rates over the last few decades. It is arguably more realistic to assume that both countries’ growth rates will continue to decelerate at the current pace. Even so, China will catch up with US living standards just five years later, i.e. by 2045 (Scenario 2). What if these assumptions are also too optimistic? Suppose that China grows only 5% per year and the US only 1% per year. In that scenario, China will still catch up with US living standards by 2050 (Scenario 3). Finally, just as a sense check, if China grows at the IMF’s expected medium-term growth rate projections, then catch up will happen by 2051, i.e. not materially out of line with the bearish growth scenario.
The conclusions from these scenario analyses should be clear: China’s rise to global economic pre-eminence is a near-mathematical certainty. As China continues to gain clout her government bond and currency markets will catch and then overtake US markets eventually to emerge as the most dominant reference markets for global investors. US markets will remain very large and very important, but second to China’s. Europe’s markets will become marginalised in the global context, unless European countries come together in a political and economic union with a single centralised government with unified fiscal and monetary policies, a prospect that is currently receding due to rising nationalistic fervour.
Chinese index inclusion is only a matter of time
China’s domestic investors are far more in tune with the bullish outlook for China than most investors outside of the country. One reason for this imbalance may be that global investors are still hampered by the continuing failure of index providers to include China’s onshore markets in their main equity and fixed income benchmarks. However, we think inclusion is only a question of time and RMB inclusion in the SDR should increase the odds of index inclusion within the next twelve months.
Why has China pushed so hard to get its currency into the SDR?
China correctly takes the view that its investment and export-led growth model is now past its sell-by date. This growth model hinged on the existence of debt fuelled consumption in the West and the ability to weaken the RMB versus Western currencies. Debt fuelled demand is now far less likely and QE policies will ultimately weaken Western currencies, so China must turn to other growth engines. Fortunately, with a savings rate of 50% China has a bright future ahead as a consumption-led economy.
China’s trajectory: from export-led growth to consumption-led growth
The challenges associated with transitioning from an export/investment growth model to a consumption-led growth model are considerable, though temporary. Deep reform is required. For example, higher consumption will eventually erode China’s large current account surplus, so China will eventually need to finance imports by importing capital. This is precisely why China is liberalising its capital account. Joining the SDR is part of this effort, because reserve currencies tend to be more stable than non-reserve currencies, which is clearly a desirable quality if you have to rely more on external financing.
However, nearly all other sectors of the Chinese economy also require reform as the country turns to consumption-led growth. Importantly, China has to develop new, effective means of controlling consumption in order to have overall control of the aggregate demand. This is why the government has set in motion a raft of measures to improve the transmission mechanism for monetary policy, including liberalising interest rates and converting non-tradable bank loans into municipal bonds as part of efforts to building a liquid domestic bond market. Domestic savings institutions are pivotal here – there will be ongoing restructuring of the financial sector, including the creation of a large mutual fund industry as well as better insurance and pension systems. As these building blocks of China’s domestic capital market are put in place, China will gradually dismantle access quotas and other controls on cross-border flows.
A third plank of China’s ongoing reforms take aim at raising domestic productivity. Here too the rationale is logical: China can only increase domestic demand – consumption – without sacrificing macroeconomic stability provided it also increases domestic supply, i.e. raises productivity. The productivity enhancing measures are many, but the most prominent ones include modernising state-owned enterprises, liberalising prices, expanding the Judiciary to give better protection for intellectual property rights, broadening the rule of law and use of contracts, implementing environmental protection measures, etc.
Global investors are not paying enough attention to – and perhaps not fully understanding – the seriousness and profundity of China’s economic reform efforts. While reforms create a great deal of uncertainty, which in turn results in postponement of consumption and investment decisions – and hence slows the rate of economic growth – it is critical to bear in mind that the reforms also hold the key to high sustained growth in China for decades to come, especially when the full ramifications of myopic policies in the West become evident.