Why China’s yuan still has work to do to oust US dollar as world’s reserve currency

If Beijing wants to win wider confidence in the yuan, it has a major hearts and mind campaign on its hands to shore up its currency’s appeal
The crackdown on China’s hi-tech sector will not help in the short term but, with market-friendly policies in place, the yuan’s future looks bright

David Brown

Published: 2:30pm, 16 Aug, 2021

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It was never supposed to be a race to the top, but the matter of which currency gets to dominate world financial markets has been the subject of hot debate for years.

The US dollar’s position as the world’s premier reserve currency has been in decline. However, which currency gets to kick the dollar from the top slot in the future, if ever, is still a matter of divided opinion.

The much-anticipated challenge from the euro has never really materialised since its inception in 1999. Cryptocurrencies are being touted as a possible successor in the long term, but they have yet to pass the credibility test with global policymakers and markets.

And, China’s yuan still has a long way to go before it wins wider appeal as a reserve currency. As a result, the dollar’s dominance looks safe for the time being.

So, what status must a reserve currency achieve to win worldwide approval with governments, central banks and investors? It must be recognised as a universal medium of exchange, be highly convertible, free from untoward government manipulation, offer a safe store of wealth, and have a good track record.

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The dollar has easily fitted the bill since free-floating exchange rates came into being after the breakdown of the Breton Woods fixed exchange rate system in 1973. Its share of global currency reserve holdings peaked at around 85 per cent in the early 1970s, gradually declining to a 25-year low of 60 per cent in the first quarter this year.

But it is jumping the gun to say the dollar’s days are numbered. It remains the foremost currency of choice for most asset managers and investors when global financial stability is at stake and safe-haven bolt-holes are in high demand. In times of strife, the dollar comes into its own.

So why is China’s yuan struggling to make better headway as a favoured reserve currency, currently only accounting for a meagre 2.5 per cent of global foreign exchange reserve holdings?

After all, China is the second-largest economy in the world, it is the powerhouse of global manufacturing and has impeccably strong country risk fundamentals. The yuan has considerable backing from China’s vast foreign exchange reserves, which were worth US$3.2 trillion in July.

China is the world’s biggest exporter and is building stronger global trade links through the Belt and Road Initiative. The yuan is one of the world’s most actively traded currencies, ranked eighth in the Bank for International Settlements’ latest survey of global foreign exchange turnover. These are all powerful positives for the currency.

Liquidity conditions are improving and China’s economic fundamentals are sound. Beijing is working hard to open its domestic markets to international investors.

Yet, five years on from the yuan being granted official reserve currency status, progress has been slow. Global central bank holdings of the yuan have only risen from 1 per cent at the end of 2016 to 2.5 per cent in the first quarter of this year.

Beijing might be on a long-term mission to boost market share, but it needs to work quickly to broaden the yuan’s appeal to avoid losing out to other major currencies such as the euro, Japanese yen, British pound and the Canadian and Australian dollars.

If Beijing wants to win wider confidence in the yuan, it has a major hearts and mind campaign on its hands. It needs to adopt a more liberal, hands-off approach, allowing the yuan to float freely in the foreign exchange markets without restriction.

China’s new dual circulation strategy, which prioritises faster domestic expansion over export-led growth, should allow more leeway for the government to be relaxed about the yuan’s competitive strength in the foreign exchange markets.

At the moment, Beijing is getting the best of both worlds. Export growth is racing away at 19.3 per cent year on year in July, despite the yuan’s relative strength against the dollar at 6.48.

It would be a different matter if exports were flagging and Beijing started urging a return to 7 yuan per dollar to boost growth. Investors would flinch at the merest hint of market interference.

In the longer term, Beijing has its work cut out to build up the yuan’s credibility and boost investor confidence. The recent crackdown on China’s hi-tech sector will not help in the short term but, with the right market-friendly policies in place, the yuan’s future looks bright.

David Brown is the chief executive of New View Economics