How the Yuan Could Become a Global Currency
China's Plan to Replace the U.S. Dollar
As China's economic might grows, it's taking steps to make that happen. A slim majority of institutional investors see it as inevitable, but don't say when. 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?
Before the yuan can become a global currency, it must first be successful as a reserve currency . That would give China the following five benefits:
- The yuan would be used to price more international contracts. China exports a lot of commodities that are traditionally priced in U.S. dollars. If they were priced in yuan, China would not have to worry so much about the dollar's value.
- All central banks would have to hold yuan as part of their foreign exchange reserves. The yuan would be in higher demand. That would lower interest rates for bonds denominated in yuan.
- Chinese exporters would have lower borrowing costs.
- China would have more economic clout in relation to the United States.
- It would support President Jinping's economic reforms. (Source: "Why China Wants the Yuan to Be a Reserve Currency," Bloomberg, March 23, 2015.)
How the Yuan Is Becoming a Reserve Currency
On November 30, 2015, the International Monetary Fund awarded the yuan status as a reserve currency. The IMF added the yuan to its Special Drawing Rights basket on October 1, 2016. This basket currently includes the euro, Japanese yen, British pound, and U.S. dollar.
Why did the IMF make this decision? China’s leaders want to improve the standard of living to avoid another revolution. The People’s Bank of China kept the yuan at a fixed exchange rate to the dollar. That allowed China's economic growth to soar thanks to low-cost exports to the United States. As a result, China's share of international trade and gross domestic product grew to around 10%.
As trade grew, so did the yuan's popularity. In August 2015, it became the fourth most-used currency in the world. It rose from 13th place in just three years. It surpassed the Japanese yen, Canadian loonie, and the Australian dollar.
Central banks should increase their foreign exchange reserves of yuan to provide funds for that level of trade. Central banks alone should purchase about $700 billion worth of yuan. But banks never purchased all the euros they should have, even when the European Union was the world'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.
On August 14, 2015, the PBOC relaxed the yuan to dollar conversion rate.
Instead of a fixed exchange rate, it would set 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 the U.S. Congress. They had warned that the yuan's value would rise as much as 30% or more. That would destroy China’s competitive advantage as an exporter.
On November 30, 2015, the PBOC informally communicated it will allow the yuan to depreciate between 3% and 5% in 2016. On December 11, 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 to make 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 another name for the yuan. That makes 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 group. It is creating a renminbi trading center in the United States. The group includes former U.S. Treasury Secretaries Hank Paulson and Tim 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 9, 2016, China granted the United States a quota of 250 billion yuan, the equivalent of $38 billion, under China's Renminbi Qualified Foreign Institutional Investor program. It appointed one Chinese and one U.S. bank to conduct RMB clearing business in the United States.
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 its monetary policy.
On the other hand, Stuart Oakley, managing director of Nomura, pointed out in a 2013 article that China owns $5 trillion of unallocated central bank reserves and these could be in yuan. As more bilateral swap lines are 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.
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 unless the following scenarios happen:
- Central banks around the world choose to keep a total of at least $700 billion worth of yuan in foreign exchange reserves.
- The 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.