Will a rising yuan topple the dollar?

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#1
Will a rising yuan topple the dollar?

Fiona ChanThe Straits TimesThursday, Apr 17, 2014

Much has been written about whether China's yuan will ever join the lofty ranks of the world's reserve currencies, but central banks now appear to be settling that point on their own.

Over 40 of them - including Singapore's - have been investing in the yuan and more will soon join them, as observed by Standard Chartered's Singapore-based global head of central banks and sovereign wealth funds last week.

"The (yuan) has effectively already become a de facto reserve currency because so many central banks have already invested in it," Mr Jukka Pihlman told the South China Morning Post.

His remarks, following China's recent moves to liberalise its unit, have reignited a debate about whether the yuan will eventually succeed the greenback as the world's main reserve currency.

Such a momentous shift - the yuan would be only the fourth currency since the 1800s to hold the role of leading reserve currency, after the French franc, British pound and US dollar - would give China immense influence in the global monetary system to match its economic weight.

It might also be disastrous for the heavily indebted US economy, which relies on the dollar's role as the main reserve currency to borrow at super-low costs.

Mr Pihlman himself did not state that the yuan will ever overtake the greenback as the No. 1 reserve currency, saying the US dollar's role as "the most dominant reserve currency" won't change in the short to medium term.

He told The Straits Times: "But the yuan is bound to gain prominence and will first challenge the British pound and Japanese yen as the third and fourth largest reserve currencies."

The euro is the second.

For a currency to be considered worthy of reserve status, its economy must be sizeable and stable enough to back the currency, and open enough to be a major trading force in the world. The currency must also be highly liquid, easily tradable, and widely available in a variety of instruments -

China is the world's second- largest economy and its biggest exporter, and holds US$1.8 trillion (S$2.3 trillion) in net foreign assets - second only to Japan. These make it the greatest challenger to the greenback for top dog status.

The United States had achieved similar standing by the end of World War I and had overtaken the British sterling as the main reserve currency by the 1920s, noted US-based economist Arvind Subramanian.

A February poll by State Street and the Economist Intelligence Unit of 200 institutional investors - half of them from China - found 53 per cent believed the yuan would surpass the US dollar as the dominant reserve currency.

Their views have good basis. Last year, the yuan overtook the euro as the second most-used currency in global trade finance, said financial services company Swift.

As of February, it was also the seventh most-used currency for global payments, noted HSBC's head of Asia currency research Paul Mackel and co-head of Asian economic research Qu Hongbin.

Yet the yuan is still not even recognised as a major reserve currency - alongside the greenback, euro, pound and yen - mainly due to restrictive currency rules.

Capital flows in and out of China are still tightly controlled, as is the exchange rate, and there are limits on how much yuan can be converted into other currencies and vice versa.

The range of yuan-denominated assets is also relatively paltry. Foreigners are not allowed to invest directly in many of them, making yuan markets fairly shallow and illiquid - especially in comparison with the US dollar's deep and thriving capital markets.

But these obstacles are falling. China is moving to ease curbs on cross-border capital flows, raise the yuan's role in offshore markets, allow foreign investors greater access to its markets, and make its exchange rate more flexible.

Meanwhile, central banks are stocking up on the yuan not just because of China's growing economic and trade heft, but in order to diversify their reserves in search of better yields, said Mr Pihlman. As more central banks invest in the yuan, even more are likely to follow suit, he added.

And RBS economist Louis Kuijs said: "Confirmation in recent years about the direction of reforms in the financial and monetary area also helps, central banks feel reasonably confident that the yuan is on track to become fully convertible in due time."

OCBC economist Tommy Xie, however, said it will be a long way before the yuan becomes a reserve currency, let alone the leading one. It has to completely open its capital account and allow the yuan to be fully convertible.

Mr Kuijs said what's needed to steer the path to reserve status is for China's growth to remain on the right track and the Chinese government to provide a full set of support policies to expand the yuan's global presence.

China's institutions, in particular, have a long way to go before reaching the level of transparency and accountability as those in the US, economists said. If the yuan is to be even a major reserve currency, China's political system, central bank and monetary policy must shed their opacity to an extent almost unthinkable now.

Will China consider these tradeoffs worth its while? Having the main reserve currency would give it the advantage of seigniorage - profits from minting money - and the ability to borrow cheaply, since there are always people willing to buy its debt.

But there are cons too: The Triffin Dilemma states that a country issuing the foremost reserve currency could have to run trade deficits in order to meet the voracious appetite for its currency, but too-large deficits may lead to a financial crisis, Mr Pihlman said.

Ultimately, there could be a global system where various reserve currencies play a nearly equal role, with trade transactions denominated in more than one unit.

"We expect the yuan's rise to make the international monetary system a multi-polar one instead of a... US dollar-focused one," said Mr Pihlman. HSBC's Mr Mackel and Mr Qu similarly tip that instead of replacing the dollar, the yuan will join "a multiple reserve currency system in which the US dollar, the euro and the yuan all play their part".

That, perhaps, would be a truly modern monetary system that can help achieve more stability than the world has recently seen.

- See more at: http://business.asiaone.com/news/will-ri...7hCpb.dpuf
Research, research and research - Please do your own due diligence (DYODD) before you invest - Any reliance on my analysis is SOLELY at your own risk.
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#2
Reserve currency is not a given. It is market choice.

When you are the largest trade nation in the world, it is likely that your currency is held by many institutions around the world.

Whether the world recognizes it or not, the yuan is an important currency to the world.
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