The Yuan as Reserve Currency?

Reform of the architecture of the international financial system will be crucial in the near future. The economic shifts that have been taking place, most notably regarding emerging economies have not yet been recognized in terms of financial architecture. China sits on the worlds' largest stock of reserves and Russia is now third. Capital flows now not from the rich to the poor countries but from the emerging market economies to the industrialized ones. The financial system has to accommodate these flows and reforms are needed to facilitate the process. This is one important research item for our new center, CRIFES.

There has been some talk of the yuan replacing the dollar as a reserve currency. This is partly motivated by politics, and partly by the desire for the Chinese to diversify their dollar holdings. As Sebastian Mallaby describes it:

China's other approach is to promote the global use of its own currency. Its central bank has offered yuan to Indonesia and Argentina in return for rupiah and pesos. It hopes more trade will be denominated in yuan. Its contribution to the new IMF-like East Asian reserve fund may one day mean that a crisis-prone country in the region borrows partly in yuan.

All this is intended to buy China's currency some respectability. But as an escape from China's dollar trap, it is laughable. The idea is that once the yuan goes international, foreigners may be willing to borrow in it. That way, China can keep running a trade surplus and exporting capital, but instead of accumulating bonds denominated in dollars it would be able to accumulate bonds denominated in yuan.

Mallaby notes that for this to work all the currency risk would be shifted to China's debtors. Why would they be willing to accept the currency risk? This is not negligible given that most consider China's currency to be undervalued. So a debtor would be faced with a non-negligible risk of their debts appreciating with the yuan.

This suggests a more fundamental problem. How can the yuan become a reserve currency when investors believe that its value is determined by domestic political concerns? The cost of being a reserve currency is that, at least to some extent, domestic concerns are subordinated to international ones. When the US failed on this score in the late 1960's it brought the Bretton Woods system down, though not the dollar's status. While the US is not perfect, the value of the dollar primarily depends on fundamentals, not central bank policy.

As long as China manipulates it currency, or is perceived to do so, it will be impossible for it to become widely held as an international store of value. Nor do China's capital controls help.