EKIP– Expert Club for Economics and Politics A Different Opinion
Recently, there has been much talk about the decline of the US dollar as the world's reserve currency and the Chinese yuan as its possible replacement.
Recently, there has been much talk about the decline of the US dollar as the world's reserve currency and the Chinese yuan as its possible replacement. The main arguments in support of this hypothesis are the remarkable economic growth of the Chinese economy over the past thirty years and the increasing role that the country plays in world trade. China is already the second largest economy in the world (measured by the country's gross domestic product), the largest (by volume) exporter of goods and services and the second largest importer. These statistics make the Chinese currency one of the main contenders for the most used unit of account in world trade in the future. However, what are the conditions for this and when can we expect a possible rocking between the dollar and the yuan?
What does history show?
Different currencies have had the status of world reserve currency at different periods of human development. In the fifth century BC, this role was played by the Greek silver drachma. Then, with the expansion of the Roman Empire, the Roman denarius replaced the drachma. The Arab, Dutch and British currencies followed. The latter was a world reserve currency until the beginning of World War I, after which it gradually began to lose this status to the US dollar, which is the most widely used unit of account to this day. This brief history of world reserve currencies shows us that the main factors for their dominance are the size of the issuing economy and the volume of trade it carries out. By these criteria, perhaps in the not too distant future, China will surpass the US, but is this enough for the yuan to become a world reserve currency?
Conditions for acquiring the status of a world reserve currency
In addition to the size of the economy, there are several conditions that must be met for a unit of account to be liberalized [1] and gain global reserve currency status. The conditions are as follows:
1. Low inflation and exchange rate stability
In recent months, China’s ruling party has managed to rein in inflation, with inflation falling to 3.2% year-on-year in February. As for the exchange rate, the yuan is quasi-fixed to the dollar, with the last 10 years seeing a slight appreciation from just over 8 yuan to the dollar in 2002 to 6.3 yuan to the dollar today. If China has the ambitions to liberalize its currency, then the country must let the exchange rate move freely against other currencies. China is currently artificially manipulating the yuan’s exchange rate to prevent the currency from appreciating too much, which would hurt the country’s exports.
2. Efficient and highly liquid capital markets, including a well-developed bond market
The Chinese economy lags behind in this criterion. One of the main reasons is the capital restrictions that the government has imposed on the inflow of foreign capital, as well as the impossibility of freely exchanging the Chinese currency. However, there have been some improvements in this area in recent years. In 2007, the Chinese government allowed financial institutions to issue yuan-denominated bonds in Hong Kong. Before this important step, in 2004, Hong Kong banks were allowed to accept yuan-denominated deposits. The third important step towards yuan liberalization was taken in 2009, when 365 Chinese enterprises began to trade directly in yuan with many of their trading partners (Hong Kong, Taiwan, Macau and the ten countries of the Association of Southeast Asian Nations). Subsequently, China concluded such agreements with Japan, Brazil, Russia, India, South Africa, the UAE, Australia, etc. In 2010 China's central bank signed an agreement with Hong Kong on the free movement of yuan between private and corporate accounts in the country. The agreement solidified Hong Kong's position as an offshore center for yuan trading.
The liberalization of the yuan continues through the creation of a number of instruments denominated in this currency – trade financing, remittances, deposits, interbank lending, insurance, repo transactions, futures transactions, etc. The creation and development of all these instruments led to a large increase in the volume of yuan circulating in the financial system in Hong Kong.
3. Political stability and rule of law
China will have to make serious efforts in this area. News of protests against the government in the country often remains hidden from the world media. State censorship and weak protection of property rights and freedom of speech are some of the main problems in China that need to be addressed.
4. Interest rates determined on a market basis
This is also one of the conditions under which the Chinese state is failing. The country's markets must be liberalized, enterprises privatized, and the state gradually begins to withdraw from its leading role in the economy. China's transition to a market economy will take time, but this is one of the necessary conditions that the government in the country must fulfill if they want the yuan to take a leading role in world trade.
Despite the remarkable economic upswing of the economy over the past 3 decades, China has a long way to go in its quest to fully liberalize the yuan so that it can acquire the status of a global reserve currency. Over the past decade, the US dollar has lost a significant share of countries' foreign exchange reserves, mainly at the expense of the euro (see Chart 1). Without a doubt, the battle for the top position will take on another dimension when the Chinese yuan is liberalized. This depends largely on both the political will of the Chinese Communist Party and China's ability to prevent a sharp slowdown in its growth, which is often discussed in the economic and financial media.
Chart 1 : Distribution of foreign exchange reserves (1995 – 2011)
Sources:
[1] Curry, Jennifer. Renminbi Internationalization: Background and Milestones. Accessed at: http://blogs.cfainstitute.org/investor/2012/02/27/renminbi-internationalization-background-and-milestones/.
[2] Papaioannou, E. & R. Portes (2008). Costs and Benefits of Running an International Currency. European Economy. Economic Papers 348.
[3] Yuan as a reserve currency. Deutsche Bank Research. July 16, 2010.
[1] The liberalization of the yuan is characterized by the free movement of yuan in and out of China. The ability of economic agents outside China to use yuan implies the use of the currency for payments, investments, and foreign exchange reserves.
Meto, I think China has at least one "hard landing" until it makes the necessary structural changes for its currency to be considered safe enough. I've heard that the amount of "bad debts" in the Chinese economy is reaching alarming levels, and property prices may have already peaked.
So, in my opinion, there is a period of cleaning up the misallocation of capital invested in the economy, and what is interesting is what role the state will play in the process. Unfortunately, we do not have much information about what is happening in China, as you say, and we will mainly wait for the GDP data to understand what is exactly happening there. By the way, 8.1% for the first quarter, which in my opinion at least, is not as bad as it is being made out to be.
Just to add a little historical background. In my opinion, China resembles the USSR in some ways in the 1920s and 1930s. And back then, people were amazed at the rapid development of the huge backward country, but things were not so rosy at all. What matters in the end is how efficiently capital is invested in the economy, something that all socialist economies, in my opinion, have difficulty with, and progressively with the development of their economy.
Kosyo,
I completely agree with you. I also think that there will be a hard winter, accompanied by a slowdown in economic growth to 3-4%. By the way, GDP growth for the first quarter, compared to the previous one, is 1.8%, which on an annual basis makes 7.4%. It will be interesting to see how GDP growth will develop in the coming quarters of the year, but considering the huge construction bubble in the country (which contributes to a large part of the growth in recent years) I expect things to only get worse.
Here is an interesting analysis with 12 predictions for China provided by Michael Pettis, known for his bearish views on the Chinese economy.
http://globaleconomicanalysis.blogspot.co.uk/2012/04/12-predictions-by-michael-pettis-on.html
One question keeps running through my mind, "Since in both China and Japan the state has a serious influence in economic life, to what extent will China repeat the rise and subsequent prolonged stagnation of the Japanese economy?"