Four reasons the yuan will struggle to gain acceptance | South China Morning Post
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  • Jan 22, 2015
  • Updated: 6:45pm
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PUBLISHED : Thursday, 06 February, 2014, 4:24am
UPDATED : Thursday, 06 February, 2014, 4:24am

Four reasons the yuan will struggle to gain acceptance

Open and well-regulated markets, transparent governance and solid banking system needed for Chinese currency’s rise to dominance

Talk to financiers in Hong Kong and you will get the impression that it is the manifest destiny of China's yuan to displace the US dollar as the world's dominant currency, probably within the next decade or two.

You can see why they think so. The fast growth of China's economy, its ascent as a trading power, the rapid spread of the yuan as a trade currency and Beijing's programme of financial liberalisation all appear to support their belief.

Factor in America's monstrous deficits and intractable budget disputes, and it seems as if the yuan's rise to pre-eminence as the world's currency of choice for international trade and investment can only be a matter of time.

Yet a look at the economic history books advises caution. Over the past 50 years, other currencies - including the deutschemark, its successor the euro, and the Japanese yen - had been tipped to steal the dollar's crown.

All failed. And the obstacles the yuan will have to overcome to unseat the dollar are just as formidable as those that defeated the three earlier pretenders.

In the 1970s, many saw the deutschemark as a competitor to the dollar. Germany's economy was growing quickly, and by the early 1980s, it had captured a 10 per cent share of global commerce, roughly the same as China today.

The mark was widely adopted as a currency for invoicing and settling international trade, even among third parties. Other countries chose to anchor their exchange rate to Germany's, and the mark found a prominent place in central bank portfolios of foreign reserves.

Yet despite these advantages, the mark's progress stalled. Part of the problem was that although Germany's trade prowess was undoubted, its financial markets could not come close to matching the breadth and depth of America's.

As a result, the mark never gained critical mass as an investment currency. Without deep and sophisticated financial markets, it stood no chance of toppling the dollar.

It looked as if things might change with the introduction in 1999 of the euro. International issues of euro-denominated debt took off, and the new currency quickly gained ground in both trade settlement and reserve portfolios.

Again the advance petered out. Although the euro achieved acceptance around Europe's periphery, it remains only a regional currency. Further afield, it is barely used.

The trouble was the weakness of European governance. It took only a few years following the euro's introduction for both Germany and France to breach the deficit limits imposed by the Growth and Stability Pact that was supposed to underpin the new currency's credibility.

Today, as much of the continent grapples with a debt crisis of the euro zone's 18 members, only Finland and Luxembourg can claim to have kept their obligations on financial discipline. As a result, international trust in the euro has been fatally wounded.

Then there was the yen. In the 1980s, the rise of Japan's currency seemed assured.

Japan had already become a trade superpower. Its banks were the world's largest. And as Tokyo dismantled its capital controls and encouraged the development of its financial markets, the yen captured close to a 30 per cent share of global currency transactions.

It didn't last. Financial liberalisation inflated Japan's bubble economy, leading to a bust and a crippling balance sheet recession. The yen's slice of global markets fell by a third, its share of official reserves by half.

Each of these episodes has lessons for China today. To get its currency generally accepted around the world, a country needs more than a widespread international trade network.

It must have deep, sophisticated and well regulated capital markets, which are freely open to foreign participants.

It must have a credible and transparent governance structure, with policymakers that can demonstrate a track record of successful financial management.

And it must have a strong and stable banking system, and solid economic prospects.

China looks shaky on all three counts. Its capital markets are underdeveloped and closed to outsiders. Its government is a black box. And with debt levels ballooning, its banking system and economy are looking increasingly fragile.

Of course, the credibility of the US government and the solidity of the US financial system have taken severe knocks in recent years.

But the US government isn't trying to get the dollar accepted by the rest of the world. It already has been.

And that's the final point. Even if China successfully meets all the other criteria, the yuan will still have to overcome the enormous inertia that favours the dollar as the world's leading currency.

History teaches us that the yuan's destiny is anything but manifest.

tom.holland@scmp.com

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