Five reasons yuan is no threat to dollar as reserve currency
If I had US$100 billion for every time someone has told me that the yuan is going to displace the US dollar as the world's foremost reserve currency, I reckon I'd have almost as much in foreign reserves as China.
Yet I remain sceptical. For the yuan to become a major reserve currency, China will first have to fulfil several important conditions.
According to a new paper by economists Professor Eswar Prasad and Professor Lei Ye of Cornell University in the US, China's economy must first be big. Second, it must be open, especially to capital flows. Third, it must have a flexible exchange rate. Fourth, it must have broad, deep and liquid financial markets. And finally, China must follow economic policies that inspire confidence in the rest of the world.
Obviously, China already meets the first criterion. It's economy is not only big, it's the second biggest in the world, accounting for around 10 per cent of the planet's gross domestic product and 25 per cent of its economic growth.
China is also increasingly open. Last year its imports and exports of goods and services made up around 10 per cent of all global trade.
What's more, as the first chart shows, the proportion of China's trade being paid for in yuan has risen rapidly, reaching 10 per cent last year.
China is also opening up to cross-border capital flows. Although Beijing retains many restrictions, over the last five years the value of China's foreign assets and liabilities has doubled to more than US$6 trillion.
However, as the second chart shows, that's tiny by the standards of the US, or even Britain. China's gross external position is now roughly the same size as that of Switzerland, whose currency the franc, according to the International Monetary Fund, makes up only about 0.1 per cent of the world's foreign reserves. Clearly China still has a long way to go on opening up to capital flows.
Next, Beijing will have to allow exchange-rate flexibility. Here too, China has a long way to go. At the moment the yuan's exchange rate is tightly managed in order to protect the county's exporters from volatility. Although the currency has been allowed to strengthen against the US dollar in recent years, in trade-weighted terms Beijing has actually kept it so steady that at the end of last year the yuan was no stronger than at the end of 2008.
Then, before the yuan can get accepted as a reserve currency, China will have to develop deep and liquid domestic debt markets so that foreign central banks can have yuan assets to hold. Here China is badly behind. In 2010, China's bond market was just one-fifth the size of the US market, and only one-fiftieth as liquid. Developing a market near the size and sophistication of the ones in the US or Europe will take many years, possibly decades.
Next, Beijing will have to persuade the rest of the world that it is pursuing responsible economic policies.
That might not sound hard, given that China is growing strongly and other major economies are accused of recklessly printing money. But the truth is that because of Beijing's all-out stimulus efforts, over the last few years the ratio of money supply to GDP has shot up far faster in China than in either the US or the euro zone. The rest of the world will want to see that excess wound in before it is comfortable holding large amounts of yuan assets.
So for the time being, China only fulfils one of the five conditions required of the issuers of major reserve currencies: sheer size.
But even if China meets the other four criteria, there is another reason why the yuan will not displace the US dollar as the world's leading reserve currency: sheer arithmetic.
At the moment, China holds around 30 per cent of all the world's foreign reserves, and China has to hold those reserves in foreign currencies, which for practical purposes means the US dollar and the euro.
That means if China were to hold its reserves half in US dollars and half in euros, Europe to hold half US dollars and half yuan, and the US to hold half euros and half yuan, with the rest of the world holding US dollars, euros and yuan equally, then the sheer size of China's reserves would ensure the US dollar remained the dominant currency by a considerable margin, with the euro second and the yuan a distant third.
So unless China runs down its own foreign reserves by running massive trade deficits over the coming years, the US dollar will remain the world's reserve currency of choice for the foreseeable future.