Don't look now, but Mao Zedong is sneaking into your wallet...

Indians are used to having currency notes with the imprint of Mahatma Gandhi in their wallets. The expectation that the pacific Mahatma could perhaps be joined there by the revolutionary leader Mao Zedong has been heightened by the breathless chatter, most recently this week, about the inevitable rise of the Chinese yuan (or renminbi) as the next global currency.

On Monday, China’s Cabinet, chaired by Premier Li Keqiang (who will visit India later this month), outlined nine key measures to deepen economic and financial sector reforms in 2013.The most ambitious of them relates to the announcement that the Chinese government would unveil an operational plan for convertibility of the renminbi under the capital account this year.

[caption id=“attachment_767565” align=“alignleft” width=“380”]  Chinese Yuan notes. Reuters.[/caption]

Predictably, the announcement has had economists and currency analysts salivating at the prospect of seeing the “redback” (as opposed to the “greenback”, the US dollar) become fully convertible in five years - and from thereon become a global reserve currency, perhaps even supplanting the US dollar over time.

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“All these (economic reform measures) show China’s new leaders’ determination to push forward financial reforms, seen as the solution to structural problems,” gushed HSBC’s chief China economist Qu Hongbin. “We are now more confident…. that the redback will likely become fully convertible within five years.”

Other economists like Nobel laureate Robert A Mundell, considered the father of the euro, have been rather more bullish on the inevitable rise of the renminbi. Mundell has argued in the past that the yuan will “likely become a reserve currency in the future, even if the government of China does nothing about it.” And if, as China has announced it will, China does eventually open its capital market by eliminating currency exchange controls, the yuan’s progress as an international currency will be assured, he has noted.

If all that happens, it would, of course be a dramatic denouement, with profound implications for currency markets, and economies around the world - and in India. Particularly in India, where the dream of full convertibility on the capital account, which animated policymakers in the mid-1990s, has been all but abandoned, such a move would contrast China’s ability to walk the talk on financial sector reforms in a way that India has failed to over the years.

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Analysts argue, even today, that “it would be premature for India to open up its capital account immediately” given that in the absence of structural reforms and exchange rate stability, the economy could be exposed to external shocks.

It suggests that India is still haunted by the ghost of the 1997 Southeast Asian currency crisis, which compelled it to put the report of the Tarapore Committee on Capital Account Convertibility of that year on the backburner. That report had recommended a three-step liberalisation process - centred around fiscal consolidation, a stronger financial system and a mandated inflation target - to be completed by 2000. More than 15 years later, we’ve faltered on all of those fronts - and a few additional ones besides.

The extraordinary walloping that the rupee took for much of last year would suggest that the appetite for any such reform proposal is very low without fixing the underlying structural weaknesses in the Indian economy.

But in equal measure, for all the chatter about the “inevitable” rise of the Chinese yuan to global reserve currency status, the reality of structural weaknesses in China’s own economy may mean that that transition for the yuan may not be accomplished quite so easily.

A new assessment by the brokerage CLSA, for instance, diagnoses that China is “addicted to debt” in order to fuel growth, and its current level of debt stands at 205 percent of GDP. More than half of that debt was piled on in just the past four years since the 2008 global financial crisis, and accounts for nearly 3 times the slower GDP growth of that period.

Just last month, for instance, a senior Chinese auditor warned that local government debt was “out of control” and could spark a bigger financial crisis than the US housing market crash of 2008.Financial Times quoted the auditor as saying that his firm had audited some local government bond issues and “found them very dangerous, so we pulled out… Most don’t have strong debt servicing abilities.” He flagged the risk that a crisis was possible, although the timing of the “explosion” was hard to predict since the debt was being rolled over ceaselessly.

Right after the 2008 financial crisis, China went ballistic with calls to replace the US dollar as the global reserve currency with special drawing rights, a basket of currencies and a unit of accounting drawn up by the IMF. But in more recent times, China has if anything been buying up more of the same US Treasuries that it said it despised - more out of compulsion than out of a love for the US dollar. And for all the chatter about the imminent death of the US dollar, commentators now acknowledge that the US dollar could become “almighty” once again.

The very structure of the Chinese economy and the political system additionally means that the incentives for the notionally Communist Party to ease up on total control over the financial system are rather low. For the Communist Party leaders to give up total control over the exchange rate management is virtually unthinkable, since it entails loss of political control. As analysts have pointed out, the foundations of the Communist Party rule rest on financial repression - wherein Chinese authorities keep rates low, and transfer trillions of yuan from Chinese households to inefficient state-owned enterprises.

Which is why a section of economic commentators are reacting with skepticism - which I have long shared ( here and here ) - to even the latest announcement of “full convertibility on the capital account in five years.” Commentator Tom Holland writes: “Forgive me if I contain my jubilation… Back in 2000, a very senior mainland official told me how Beijing would free China’s interest rates and make the yuan fully convertible in five years. He gave good reasons for his timetable… but today - 13 years later - he’s even more senior, and I gather he’s still telling people that full convertibility is five years away.”

In that sense, although China’s economy is in a vastly better place relative to India, they’re both pretty much in the same boat when it comes to now-you-see-it-now-you-don’t claims on full convertibility of their currencies.

Which is why for all the chatter about China’s “inevitable rise” as a reserve currency displacing the US dollar, that Mao-embellished currency note won’t be taking up residence alongside the Mahatma in your wallet anytime soon.