Yuan's SDR inclusion all but approved by IMF; gradual depreciation now the best outcome

IMF chief Christine Lagarde has given the yuan the go-ahead for inclusion in the SDR, paving the way for the RMB to join the dollar, euro, yen, and pound sterling in the international currency elite.

Days earlier, PBOC chief Zhou Xiaochuan delivered a sobering warning of what this actually means:

“To guard against and eliminating financial risks is a severe challenge for us in the next five years,” the Governor of the People’s Bank of China wrote in an article.

While it's true that Zhou has long been a godfather of reform in the communist hierarchy, it's still remarkable how strong this language is.

With the immediate danger of market and currency collapse seemingly contained, the decidedly uphill battle to open up the Chinese financial sector to global competition can finally begin. Beijing has precious little time to waste: it has been lucky and sufficiently adroit so far, but, as ever, it has no laurels to rest on and can't afford to mess this one up, not least because its monetary decisions now rival even Washington's, i.e. the Fed's, in global implications.

The most optimistic scenario is a gradual, smoothed-out depreciation over the next five years to a level of 7 to 8 RMB to the dollar. This will buy time for the wider global economy to readjust and retool in the wake of what Goldman Sachs has dubbed the "third wave" of the global financial crisis, by retaining high levels of liquidity in the real Chinese economy to support 6 to 7 percent real GDP growth per the 13th five-year plan.

For China, the desired end state is a 10 to 20 percent lower yuan that enables her to cement her position as the linchpin of the global manufacturing supply chain via the shifting of advanced component production from Japan and South Korea and the attendant increased automation of her vast plant. The three-way FTA with Tokyo and Seoul is the centerpiece of Beijing's strategy.

As this CBS news report points out, it's too early to speak of Chinese consumers saving the global economy. Believe it or not, China still needs lots of investment in infrastructure and manufacturing capacity, largely because so much investment since the financial crisis has been wasted, and as anyone who's actually lived or worked in China can tell you, even the heavily utilized investments are often anything but optimal. If you just take the heavy industrial sector, especially in the north, you're talking tons of horribly inefficient, highly polluting excess capacity that's being shut down, consolidated, and/or recapitalized with new, i.e. greener investment. That's untold billions of dollars quarter after quarter.

All this also sheds additional light on the end of the one-child policy. A whole slew of articles, including in Financial Times and Fortune, have called it "too little, too late" in terms of the looming demographic crisis, i.e. rapid aging of the population and shrinking workforce; but the more optimistic view that I took in my own earlier post was echoed here in Forbes:

... But the government can’t explicitly or effectively make its people consume. The solution? Apparently, it’s to allow the existence of more people. That is, China is allowing married couples to have two children to increase consumption (and probably also investment). And this is going to work. ... 

So, there you have it. Need an economic stimulus plan that will actually work? Un-restrain the number of children the country can have. Wait. I guess this will only work in China. 

The declining labor force isn't the issue: the shortage of consumers is the real threat to China's economic future. Babies and young kids are excellent consumers - entire services and consumer goods sectors revolve around them well before they're old enough to contribute their own labor. So it makes perfect sense to have a mini-baby boom; it just behooves Beijing to make children less costly in real terms, by (among other things) getting its currency and monetary policy right to unleash enough liquidity that doesn't end up further inflating real estate.

In this respect, the government's nascent efforts to create a nationwide social safety net will also be crucial: young families will only spend more at present if they don't have to save so much for retirement on their own, though this whole topic of social security and healthcare is for another post.