Chinese Yuan (Renminbi) as World’s Next Reserve Currency?
Posted in Finance Articles, Total Reads: 3148
, Published on 13 December 2012
A reserve currency is like an international pricing currency that is held in major quantities by most of the governments to pay off their debt obligations. Most governments like to buy foreign currency is to reduce the risk of exchange rate and therefore they don’t have to exchange the currency to pay for common commodities like Oil and gold. Foreign currency reserves create a hedge against weaker currencies when institutions and government keep them in bulk.
The current economic condition of most western countries is not good because of the global recession that started in 2008. Countries such as the USA, UK and other European nations owe money in billions to other nations. Because of the recent economic turmoil the strength of US dollar and significance are doubtful. After the US dollar, the Chinese Yuan has been on the focus because China being the second largest economy in the world.
After the Second World War, the US dollar has been the prominent reserve currencies that most governments have been using to pay off their obligations. The reason behind the US dollar to be significant is because the US engaged in foreign trade after 1945. China on the other side entered into foreign trade after joining WTO in 2001. So it is clear that the US has been dominating because they took the trade advantage by early entrants into foreign trade.
(Source : Wealth Daily, 2009)
The above graph shows that US dollars significance as a prominent reserve currency is decreasing in the world market. This also means that the market value for the US dollar would be reducing in the next few years.
The US economy was stable until late 2008 when the global recession started. Because of the deepening financial distress and shrinking GDP in most of the western nations including Europe, the focus has been shifting from US to China which is poised to overtake the US as the world’s biggest economy in few years from now.
In this section this article discusses on some of the factors that forms the base for Yuan as a reserve currency.
1. Stability in the exchange rate
China keeps the value of Yuan relatively low so that most of the American and European companies will buy goods from them. In other words, Chinese government has complete control over its Yuan. This is the reason why US is China’s biggest exporter.
Until 2008, Chinese Yuan was pegged to the US dollar. After 2008 following the pressure by US authorities and allies, the Chinese government decided to make Yuan a floating currency and it continues not being pegged with dollar or any currency. Since then the Yuan have started to appreciate with respect to the US dollar.
If China allows a flexible exchange rate for the Yuan like what is has today with respect to other currency then this key factor will drive the Yuan in becoming a reserve currency over the next few years.
2. Financial markets
China used to give limited access to foreign companies investing in the country’s bond market. This was the biggest bottleneck for the Yuan to emerge as a global currency. But recently in June 2012, China opened up the biggest financial market encouraging more companies to invest. This means that China has been changing the system in markets and they can now bid to make the Yuan a global currency.
3. Political stability
Although China has been politically stable under the communist 1 party rule, there are many lags in most of the Chinese laws. This might prevent a lot of investors from investing in the country.
Another concern for the Yuan in becoming a global currency is the support of emerging nations especially BRICS. Chinese Yuan can only become a global reserve currency if emerging nations like India, Brazil and Russia are willing to buy majority of foreign reserves in Yuan.
Diplomatic relations with western powers will also play an important role in popularizing the Yuan. The current cold war tensions between the US and China needs to be eased away. Diplomatic relations from emerging powers like India and Russia has not been good with Beijing. This would be another factor for the Yuan to be a reserve currency in the future.
Motivation to become a reserve currency
There are many reasons why Yuan has to be considered for the next reserve currency. First and foremost, the Chinese exports to the world market have increased in contrast with the US.
China has become a net exporter whereas the US is a net importer. Even till date most of the American companies buy goods from China and sell them in the US because they are relatively priced much lower than anywhere else. Moreover the debt position of the US is much higher due to the global recession.
As a minor step recently taken to surpass the US dollar, China has setup currency swap with some of its partners like Hong Kong. China trades freely in Hong Kong because they have created a Chinese Yuan Hong Kong account.
As mentioned earlier that US had entered into world trade after the Second World War and they had reaped the advantage following the increase in demand for dollar. In the same way if Yuan becomes a global currency China can reap the benefits as the US enjoyed in 1900s post World War 2. After the Second World War the US was once the largest creditor nation in the world.
Moreover after the Second World War countries like US and UK had colonized some countries thereby promoting trade. So again this was another advantage they enjoyed in that period. But as of now China seems to emerge as a global power. Hence this factor should also help in the Chinese Yuan to rise as a global currency.
Hindrances in becoming a reserve currency
One of the key things which will happen if the Yuan starts to rise is that most of the American companies that buy goods from China will rethink and definitely feel the heat in continuing to do so. They may even end up buying ‘cheaper’ goods from China. The reason they buy goods is because of inexpensive labor in the country. This means that a stronger Yuan would even force American companies to look for other alternatives rather than buying goods. The Chinese communist government wouldn’t let this happen for a stronger Yuan as this would result in loses for the Chinese economy.
It is inevitable that the Yuan will become the next world reserve currency in the coming years. By the volume of trade that China is currently doing with other nations it is also clear that China would play a vital role in global affairs being the world’s biggest economy.
Most of the factors like the current economic growth, opening of bond market to western companies are favoring the growth of Chinese Yuan. Prior to the opening up of the bond market by the Chinese government there was a big question mark whether the Yuan could replace the dominant US dollar in the next few years. Although the bond market has been opened to foreign companies, China still needs to amend few other laws to have more foreign participation in various sectors. Opening up markets is not the only factor but it must also allow its citizens money to move out of the country. Only these factors can help in setting the Yuan as a reserve currency.
This article has been authored by Sanal Nair fromUniversity of Wales in Singapore.
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