Chinawants its currency, theyuan, to replace theU.S. dollaras theworld's global currency. That would give it more control over its economy.
As China's economic might grows, it's taking steps to make that happen. Could we see a switch from a greenback- to a redback-dominated world? If so, how and when would that happen? What would be the consequences?
Key Takeaways
- Currently the U.S. dollar is the world's global currency, which affords the United States economic and political advantage.
- Before the yuan can become a global currency, it must first become a reserve currency held by central banks around the world.
- Among the benefits China would enjoy are lower trade costs, greater demand for the yuan worldwide, and less concern about the value of the U.S. dollar in relation to the yuan.
What Must Happen First
China is working hard to make the yuan the next global currency. Although presently a reserve currency, the yuan can’t upstage the U.S. dollar without several important scenarios taking place first, including:
- Central banks around the world choose to keep a total of at least $700 billion worth of yuan in foreign exchange reserves
- The People's Bank of China (PBOC) allows free trade of the yuan and relaxes its peg to the U.S. dollar
- The PBOC becomes straightforward about its future intentions with the yuan
- China’s financial markets turn transparent
- Chinese monetary policies are perceived as stable
- The yuan acquires the U.S. dollar’s reputation of stability, which is backed by the enormity and liquidity of U.S. Treasurys
How China Benefits from the Yuan as a Reserve Currency
Before the yuan can become a global currency, it must first be successful as areserve currency. A reserve currency is one that is held in large amounts by governments and institutions as a supplement to national currencies.
Once the yuan is successfully established as a reserve currency, it would give China the following benefits:
- More international contracts could be priced in yuan, which would meanChina would not have to worry so much about the dollar's value.
- All central banks would have to hold yuan as part of theirforeign exchange reserves, which would place the yuan in higher demand and lower interest rates for bonds denominated in yuan.
- Chinese exporters would have lower borrowing costs.
- China would have more economic clout in relation tothe United States.
- It would support President Jinping'seconomic reforms.
How the Yuan Is Becoming a Reserve Currency
On Dec. 1, 2015, the International Monetary Fund (IMF)announced that it awarded the yuanstatus as a reserve currency. The IMF added the yuan to its Special Drawing Right basket on Oct. 1, 2016. This basket currently includes theeuro, Japanese yen, British pound, and U.S. dollar.
Why did the IMF make this decision? China’s leaders want toimprove thestandard of livingand increase its economic output. The Chinese have pegged the yuan to the U.S. dollar but via an adjustable peg, or “managed peg.”
This floating peg has generally been on a downward trend since 2015,implying that the yuan has been steadily devaluing against the dollar, thus making Chinese exports relatively more competitive against dollar prices around the world. That allowed China's economic growth to soar thanks to low-cost exports to the United States.
As a result,China's share ofinternational tradeandgross domestic productgrew to around 10%. This has been a source of trade friction between China and the U.S.
Note
As international trade grew, so did the yuan's popularity. In August 2015, it became the fourth most-used currency in the world. It rose from 12th position in just three years. It surpassed the Japaneseyen, the Canadian dollar, and the Australian dollar.
Central banks should increase theirforeign exchange reserves of yuanto provide funds for that level of trade. Central banks alone should purchase about $700 billion worth of yuan. But banks never purchased all theeurosthey should have, even when theEuropean Unionwas theworld's largest economy. Most international transactions are still done in U.S. dollars, even though its trade has dropped.
The IMF requires China to liberalize its capital markets. It should allow the yuan to be freely traded on foreign exchange markets. That allows central banks to hold it as a reserve currency.For that to happen, China's central bank must relax the yuan's peg to the dollar.
China must have clearer communications about itsfuture actions regarding the yuan. That's what the Federal Reserve does for the dollar at each of its eight Federal Open Market Committee (FOMC) meetings.
Note
In August 2015, the PBOC relaxed theyuan to dollarconversion rate.
Instead of a fixed exchange rate, the PBOC wouldset the yuan's value to its closing value on the previous day. Instead of rising, as many expected, the yuan fell 3%over the next two days.
The PBOC stabilized the rate. It now has the freedom to allow the yuan to be a stronger tool in monetary policy. The drop also silenced critics of China's reforms, many of whom were members of theU.S. Congress.
In December 2015, the Bank announced it would begin to shift the dollar peg to a basket of currencies. That basket includes the dollar, euro, yen, and 10 other currencies.
The Yuan Is Slowly Being Traded in Foreign Markets
Chinese leaders are beginning tomake it easier to trade the yuan in foreign exchange markets.To do this risks more open financial and political systems. On March 23, 2015, China backed the Renminbi Trading Hub for the Americas. The renminbi is the name of China's currency system (yuan is the name of each individual unit of currency). Thatmakes it easier for North American companies to conduct yuan transactions in Canadian banks. China opened up similar trading hubs in Singapore and London.
Former New York City Mayor Michael Bloomberg is Chair of the Working Group on U.S. RMB Trading and Clearing. It iscreating a renminbi trading center in the United States. The group includes former U.S. Treasury Secretaries Hank Paulson and Timothy Geithner. Such a center would lower costs for U.S. companies trading with China. It would also allow U.S. financial companies to offer yuan-denominated hedges and other derivatives.
On June 8, 2016, Chinagranted the United States a quota of 250 billion yuan, the equivalent of $38 billion, under China's Renminbi Qualified Foreign Institutional Investor program.
Can the Yuan Replace the Dollar?
The level of trade is not the only reason the U.S. dollar is the world's reserve currency. The strength of the U.S. economy instills trust. Most important are the transparency of U.S. financial markets and the stability of itsmonetary policy.
On the other hand, Stuart Oakley, managing director of Nomura, pointedout in a 2013 article that China owns $4 trillion to $5 trillion of unallocated central bank reserves and these could be in yuan. As more bilateral swap linesare set up and China moves further down its path of capital market liberalization, central banks' appetite to own this currency will grow.
Could China's ambition to make the yuan the world's currency lead to a dollar collapse? Probably not. Instead, it will be a long, slow process that results in a dollar decline, not a collapse.
