How the Yuan Could Transition from a Reserve to a Global Currency

Will the Yuan Replace the Dollar as a Global Currency?

••• Photo by China Photos/Getty Images

China wants its currency, the yuan, to replace the U.S. dollar as the world's global currency. That would give it more control over its economy.

As China's economic might grows, it's taking steps to make that happen. A slim majority of , 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.

  1. 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.
  2. 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.
  3. Chinese exporters would have lower borrowing costs.
  4. China would have more economic clout in relation to the United States.
  1. 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. The IMF added the yuan to its basket on . 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 PBOCPeople’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 percent.

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. (Source: "Yuan Overtakes Yen as World's Fourth Most Used Payments Currency," Bloomberg, October 6, 2015.)

Central banks' should increase their foreign exchange reserves of yuan to provide funds for that level of trade. That means 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. That's because 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. That means it would 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.

China must have clearer communications about its  future actions regarding the yuan. That's what the Federal Reserve does at each of its eight Federal Open Market Committee meetings.

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 percent 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 the yuan's value would rise as much as 30 percent or more. That would destroy China’s competitive advantage as an exporter. (Source: "A Short Step in China's Long Advance," The New York Times, August 23, 2015)

On November 30, 2015, the PBOC informally communicated it will allow the yuan to depreciate between 3 percent to 5 percent 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 ten other currencies. (Source: "New Signal on Easing Yuan's Peg to the Dollar," The Wall Street Journal, December 12, 2015. "Yuan's New Status to Pressure Beijing," The Wall Street Journal, November 30, 2015.)

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. (Source: "Canada Aims to Boost Deals in China Currency," The Wall Street Journal,  March 23, 2015.) 

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. (Source: "Group Promotes Trading of China Currency in U.S." The Wall Street Journal, November 20, 2015.)

On June 9, 2016, China granted the United States a quota of 250 billion yuan ($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. (Source: "Working Group Releases Roadmap to Promote U.S. RMB Trading, Clearing,", June 9, 2016.)

Can the Yuan Replace the Dollar as the World's Reserve Currency?

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