China — the second largest economy after the United States — would see the inclusion of the yuan as a major symbolic win in the international financial and economic community. More importantly, China has operationalised new multilateral institutions like the Asian Infrastructure Investment Bank (AIIB) and the BRICS-led New Development Bank (NDB). Coupled with these institutional developments, including the yuan in the SDR reserve currency basket means that the yuan is likely to make significant inroads as an open tradable currency for emerging economies.
Both at a regional and global level, a rift between countries that prefer the US dollar versus those that prefer the yuan is quite likely on the cards. But the People’s Bank of China is likely to be careful in handling the yuan. It will maintain a stable float by building trust with major economic players that may prefer the yuan over the dollar. After all, more than a quarter of the world’s foreign investment (in terms of capital flows and trade exchanges) involves China.
Since the beginning of the Bretton Woods period in the 1940s, the dollar has been the dominant currency. The United States Federal Reserve manages and prints it to keep a fluid foreign exchange market. One of the major reasons that the United States accrued a large government debt is because it managed its local currency as a reserve currency. This operational flexibility allowed the US Federal Reserve to exercise unrestrained control in printing the dollar, as is well explained through the Triffin Dilemma.
In the last 10 years, particularly since the global financial crisis, the dollar seems to have lost its advantage. The dollar’s value saw sharp fluctuations with a sizeable appreciation and depreciation during the 2007–2010 period that negatively impacted growth. But since 2010 there has been a general appreciation of the dollar. This has been largely due to effective monetary policies that supported better exchange rate management by the US Federal Reserve.
But the dollar has still managed to sustain trust among most developing economies as alternative currencies (such as the euro) are also performing poorly. Until recently, China was also content to accumulate dollars and buy US government bonds through its earnings from exports.
Including the yuan in the SDR basket is also likely to help China restructure its economy as it grapples with a manufacturing slowdown and attempts a shift towards the service sector. China’s international credit rating and credibility will significantly improve, which will only help its case in pushing for more inwards and outward foreign investment as the largest stakeholder in the AIIB and the NDB.
The Chinese yuan has been included in the SDR basket with a weight of 10.92 per cent — higher than both the Japanese yen and the pound sterling. This is a good start for the yuan in building more trust as an open tradeable currency among emerging global economic players. During the last rebalancing of currency weights in 2010, the dollar accounted for 41.9 per cent, the euro 37.4 per cent, the pound 11.3 per cent and the yen 9.4 per cent.
The US Federal Reserve will likely react to the yuan’s internationalisation by raising domestic interest rates, which will raise the value of the dollar over time. Those investing in the dollar are likely to get higher returns, but companies that have borrowed in US dollars will face higher debt costs.
Whatever may be the case, it is safe to surmise that with the rise of the yuan as a freely usable reserve currency comes the beginning of the end of the era of dollarisation. Countries will be less willing in the future to align their currencies with the US dollar as a means to achieving economic prosperity and financial integration.
Deepanshu Mohan is an assistant professor of economics and the assistant director at the Centre on International Economic Studies, OP Jindal Global University.
While the Yuan will have an increasing role in international exchanges and as a reserve currency when its inclusion in the SDR takes effects, the initial effects may be relatively small and it will take at least a decade and possibly two before the Yuan to have the possibility to have an equal role as the US dollar. Likewise, the weight of Yuan in the SDR will take the same length to have the prospect of an equal weight as the US dollar.
Of course, it will obviously depend on how China will handle its currency. Will China allow its Yuan as free as the US dollar?
It is said that “A foreign currency is traditionally held as a country’s official reserves because of its global importance as a medium of exchange and its inherent stability”.
This cannot be said of the US dollar because at Bretton Woods in July 1944, the US dollar, which replaced the pound sterling as the world reserve currency, was backed by gold at US$35 per oz of gold.
To fund the 10 year, expensive Vietnam War the US Fed printed more dollars that the US had gold in Ft Knox to back them up.
There was a run on gold, started by a cynical President Charles De Gaulle of France.
On 15 August 1971, President Nixon closed the gold windows and today the gold price is US$1073. Therefore, since then the US dollar has depreciated by nearly 3000%.
Now the US dollar is backed by nothing but a mixture of thin air and cruise missiles. Both Saddam and Gaddafi were deposed off summarily when they refused to accept it as the Petrodollar.
But for any currency to remain relevant for the longer term as a world reserve currency it must maintain its stability and to do it has to be backed by preciousl metals, like gold and/or silver.
In his speech in March 2009, the Governor of the People’s Bank of China Zhou Xiaochuan noted that there is a need to create a super-sovereign currency whose value does not depend on any particular country’s economic fortunes.
Though he did not mention that the RMB was meant to be the super-sovereign currency I think he intuitively knew that for the RMB to gain primacy it has to be backed by precious metals, otherwise it will just be another fiat currency.
China today has about 1.650 tons of central bank gold and an unknown amount of gold privately held. The amount of silver is also unknown, though in the past China’s currency was based on tael silver.
In the last 30 years China may have produced at least an average of 300 tons of gold a year (not sold outside of China), which equate to another 9,000 tons. The grand total of known gold is approx 10,065 tons vs about 8100 tons in the USA (if any).
If China buys more gold/silver at these current low prices with say a big portion of her US$3.44 trillion of foreign reserves, then China will have, by far, the most amount of gold/silver in the world, enough to back the RMB for a very long time.
And if the RMB is backed by gold/silver, then the RMB will be the new super-sovereign currency, replacing the US dollar as the world reserve currency (WRC). When will this happen? The jury is till out.
Previously, the Western WRCs were first, the Portuguese escudo, followed by the Spanish peso, then by the Dutch gilder, then by the French franc and the pound sterling, following the Rise and Fall of Western Empires.
Today, the rising power is China while the sun is setting on the US military empire.
Lots of hype, supported by misunderstandings. The international use of a currency is determined by private transactors — not by ‘cruise missiles and thin air’ — folks who decide based on their own interest of holding monetary balances for payments in their own currency or that of another country. And when it comes to ‘transactions among consenting adults’ the dollar is by far the best game in town and will not be challenged by a country’s currency where free use is restricted and property rights have a precarious history. Central banks have a bit more leeway in denominating their assets but when everything is said and done they will hold the bulk of their assets in the currency which private businesses decide to keep their liquid balances, as they need those assets for supporting the value of their own monetary assets. We will see real RMB internationalization when trade and investment transactions, say between Singpore and Indonesia will be settled in Yuan rather than USD!
It is no secret that China wishes to become first among equals as a superpower. As part of this strategy, it is not unrealistic to assume that China’s endgame will be to knock the U.S. dollar off its perch as the International Reserve Currency.