Amid considerable doom and gloom in China’s economy, President Xi Jinping has at least one 2023 milestone to celebrate: a near-doubling of the yuan’s role in global payments.
The yuan’s 3.6% share might not sound too impressive considering the US still commands 47% of payments. But the rate of increase from 1.9% over the last 11 months since January is sure to catch Washington’s attention.
The key now, of course, is for Xi’s team to lean into the trend by accelerating financial reform efforts. Hastening it depends on Xi’s ability to earn investors’ trust.
Developed economies have something in common: They build credible and trusted financial systems before trillions of dollars of overseas capital arrive. They methodically increase transparency, prod companies to strengthen governance, devise reliable surveillance mechanisms, develop an independent credit-rating system and erect a robust market infrastructure before the world shows up.
As 2024 approaches, investors will be paying closer attention than ever to whether Xi’s reformers can keep up with the yuan’s rise.
This week, China’s Central Economic Work Conference convened in Beijing to plot the next steps for Asia’s biggest economy. Xi’s Communist Party vowed to boost domestic demand, tackle the real-estate crisis and accelerate the development of strategic sectors to raise China’s competitive game.
“China’s economy has achieved a recovery, with solid progress made in high-quality development in 2023,” party leaders said, according to state-owned Xinhua. “China still has to overcome some difficulties and challenges to further revive the economy.”
And to continue building on the yuan’s increasing popularity. The yuan’s international profile is growing at a moment when questions about the US dollar’s dominance are surging. Concerns hit a fever pitch in mid-November when Moody’s Investors Service threatened to deprive the US of its last AAA credit rating.
US fiscal policy
That news dropped soon after America’s national debt topped $33 trillion. Moody’s also cited political dysfunction amid Washington lawmakers playing politics with the nation’s basic functioning.
“Fiscal policymaking is less robust in the US than in many AAA-rated peers, and another shutdown would be further evidence of this weakness,” Moody’s analysts argue.
“After having negotiated a contentious bipartisan debt-limit deal in June, US Congress is yet again renewing internal party disagreements that threaten a government shutdown and clearly reflect the political hurdles to US fiscal policymaking.”
Such political brinkmanship risks doing additional damage to the dollar. So is the collateral damage from 11 Federal Reserve interest-rate increases in 18 months. And fallout from President Joe Biden using the dollar as leverage in efforts to punish Russia over its Ukraine invasion.
But this milestone is the payoff for Xi’s policy of internationalizing the yuan.
The effort began gaining traction in 2016, when the governor of the People’s Bank of China at the time, Zhou Xiaochuan, secured a place for the yuan in the International Monetary Fund’s “special drawing rights” program. It marked the yuan’s inclusion in the IMF’s exclusive club of reserve currencies, joining the dollar, euro, yen and pound sterling.
In the years since, Xi’s team steadily increased and broadened the channels for foreign investors to access mainland China stock and bond markets. Mainland stocks were added to the MSCI index, while government bonds were included in the FTSE Russell benchmark.
That, and moves to increase financial transparency, boosted global demand for the yuan. More recently, Beijing’s tolerance of stronger yuan has given Xi’s Ministry of Finance some street cred in market circles as the yen plunged.
This year, the yuan overtook the euro to become the world’s second-most-utilized currency in global trade, according to data from the Society for Worldwide Interbank Financial Telecommunication, or SWIFT. As of September, the yuan’s share of SWIFT payments hit 5.8%.
Yet as 2024 beckons, Xi’s party stands at something of a fork in the road. Accelerating yuan use in global trade and finance requires a clear and bold commitment to structural reforms.
Priorities include pivoting toward full yuan convertibility, increasing local-market liquidity and the availability of heading tools, modernizing a giant and opaque state sector and internationalizing a rudimentary credit-rating system that obscures risk and enables the chronic misallocation of capital.
Slowing growth
Xi and Premier Li Qiang also must get a handle on regional governments, namely, containing risks in the local government financing vehicles (LGFV) space. Even as China’s property crisis festers, Beijing needs to head off a reckoning involving roughly $9 trillion of off-balance-sheet municipal debt.
That’s easier said than done as China grows the slowest in 30 years and deflationary pressures mount. So far, Xi and Li have tried to do so without major public bailouts that might squander progress reducing financial leverage across sectors. Weak consumer prices and talk of “Japanification,” though, have economists betting on a more strenuous response.
Deflation could work at cross-purposes with Xi’s hopes of increasing global demand for the yuan. Chinese consumer prices fell 0.5% in November from a year ago, the worst decline since the height of the Covid-19 pandemic.
“The lingering softness in core CPI suggests domestic consumer-demand conditions may have remained weak,” write JPMorgan analysts in a recent report. Economists at Goldman Sachs argue that “weak” prices are “likely reflecting sluggish domestic economic momentum in the near term.”
Again, not the way Xi’s inner circle hoped to close out the year.
“China’s deflation problem could be a welcome disinflationary restraint for the West,” says economist Albert Edwards at Société Générale.
Edwards adds that “the fly in the ointment might well be that, if a US hard landing is imminent – reflected in weak money supply Société Générale and triggers a collapse in US domestic inflation anyway, importing an extra slug of Chinese deflation would then be extremely unwelcome and throw the Fed into a tizzy. Mind you, at least US bond investors would be delighted.”
Strategist Thierry Wizman at Macquarie Bank notes that “the longer that China fails to show that it can recover, the likelier that inflation expectations will decline in the West, as fears that China can export its deflation to the rest of the world through international trade will gain ground.”
This is hardly a narrative that a government hoping to increase the use of its currency wants.
There’s optimism, of course, that efforts by Xi and Li to boost fiscal stimulus and targeted PBOC action could turn the tide. At the same time, a 0.5% year-over-year increase in exports suggests steady external demand for Chinese goods.
Yet even here, caveats abound. Though overseas shipments might benefit from a “global upswing” in demand, economists at Nomura Holdings Inc. write that it’s “still too early to call the bottom.” The bigger picture, Nomura argues, is that “there might yet be another economic dip in spring 2024 due to a worsening property sector.”
Last week, Xi admitted that China’s economic recovery is “still at a critical stage” amid sluggish domestic demand and the drag from a staggering property sector.
According to state media, Xi delivered the comments at a meeting of the Politburo, China’s top decision-making body. There, Xi reportedly said “the development situation facing the country is complex, with increasing adverse factors in the international political and economic environment” and called for growth-stabilizing measures.
Importantly, Xi stressed that “it’s necessary to focus on accelerating the construction of a modern industrial system, expand domestic demand, (and) prevent and defuse risks.” This, he said, includes achieving greater “self-reliance” in key science and technology sectors, and moves to “accelerate the construction of a new development layout.”
The clock is ticking, though. This month, Moody’s downgraded the outlook for Beijing’s credit to “negative” from “stable,” highlighting “broad downside risks to China’s fiscal, economic and institutional strength.”
Though Xi’s Finance Ministry was “disappointed with Moody’s decision” and stressed that such worries are “unnecessary,” such headlines are the last thing Xi wants as investors plot 2024 capital-allocation plans.
Along with local-government debt levels, Moody’s fears troubles are deepening in the default-plagued property sector. Property, says Ting Lu, chief China economist at Nomura, remains “the single largest drag affecting China’s economy.”
He adds that “despite the multitude of stimulus measures announced recently,” real estate is a clear and present danger.
Zhiwei Zhang, president and chief economist at Pinpoint Asset Management, speaks for many when he says “it’s unclear if exports can contribute as a growth pillar into next year.”
Getting reforms back on track
The good news is a late-2023 pivot back to structural reforms that moved to the back-burner amid the pandemic. At this week’s Central Economic Work Conference, Xi’s party pledged to defuse property-sector risks and to get a handle on debts plaguing both local government and medium-sized financial institutions.
Priorities include a renewed push to build affordable housing, address record youth unemployment, support for private enterprises, catalyze greater innovation in science and technology, strengthen domestic supply chains, accelerate China’s transformation toward a greener economy and develop the digital space, including artificial intelligence.
Other vital initiatives include boosting China’s declining fertility rates and the population ages.
“It’s an ambitious document heavy on aspiration and light on details,” observes Bill Bishop, longtime China-watcher and author of the Sinocism newsletter. “I think you can find reasons to start feeling more constructive on the [Chinese] economy, but still lots of reasons to be skeptical.”
Bishop notes that the “main issues are insufficient effective demand, overcapacity in some industries, weak social expectations, and still numerous risks and hidden dangers. There are bottlenecks in the domestic big cycle, and the complexity, severity, and uncertainty of the external environment are increasing. It is necessary to enhance the awareness of potential dangers and effectively address and resolve these issues.”
On the whole, Bishop says, “the favorable conditions facing China’s development outweigh the unfavorable factors. The basic trend of economic recovery and long-term improvement has not changed, and it is important to strengthen confidence and resolve.”
All this will benefit Xi’s yuan internationalization push. So are US policies, both in terms of fiscal mismanagement and global sanctions. Biden’s sanctions regime versus Russia played into Beijing’s hands as governments around the globe buzzed about a “weaponized” dollar.
The measures spurred China to step up its campaign to eclipse the dollar and other Group of Seven currencies. The past year saw Xi’s efforts to prod nations to use the yuan in trade make progress. Xi’s Cross-Border Interbank Payment System is gaining traction. And the Belt and Road Initiative has acted as something of an accelerant for cross-border use of the yuan.
Now, the onus is on Xi and Li to step up the reform process to increase the yuan’s appeal in global markets. Discussions at this week’s China’s Central Economic Work Conference show Beijing knows what’s needed to stabilize the economy and show the dollar who’s boss. Implementation has been more vital to China’s trajectory.