WILL CHINESE YUAN BECOME WORLD CURRENCY?

Swati MondalAnkur Shrivastava

Pavanprit SinghVipul Munot

Rohini Khabade

INTRODUCTION China’s economy is the 2nd largest in the world

Of the currencies of the world’s six largest economies, China’s

Renminbi or Chinese Yuan is the only one without reserve

currency status.

Economy has neither a flexible exchange rate nor an open capital

account.

Three aspects of the RMB’s role in IMS:

a. Currency Internationalization

b. Currency Convertibility

c. Principal Reverse Currency Status

Internationalization: its use in denominating and

settling cross-border trade and financial transactions,

that is, its use as an international medium of exchange.

Capital account convertibility: the country’s level of

restrictions on inflows and outflows of financial capital.

A fully open capital account has no restrictions.

Reserve currency: whether the renminbi is held by

foreign central banks as protection against balance of

payments crises.

INTERNATIONALIZATION China is promoting the international use of its currency by:

a. Permitting the settlement of trade transactions with the

Renminbi.

b. Easing restrictions on cross-border remittances of the

Renminbi for settlement.

c. Allowing the issuance of Renminbi-denominated bonds in Hong

Kong and by foreigners in the Mainland.

d. Permitting selected banks to offer offshore Renminbi deposit

accounts.

e. Setting up local currency bilateral swap lines with other central

banks.

CRITICAL FACTORS THAT UNDERPIN A RESERVE CURRENCY

Economic size

Open capital account

Flexible exchange rate

Financial market development

Macroeconomic policies

Economic Size: China now accounts for:a. 10% of the world gross domestic product (15% by PPP rather than market

exchange rates)b. Nearly 9% of the foreign direct investmentc. > 10% of the world trade

o Open Capital Account:China is gradually and selectively easing restrictions on both inflows and outflows.

a. The limit of foreign exchange purchases by residents for remittance abroad for personal reasons was increased to $50000 a year.

b. More recently, the government has been encouraging outflows by institutional investors (e.g., pension funds and insurance companies) and corporations.

c. Controls on inflows are also being gradually eased, although with many restrictions still in place.

d. The upper limit on portfolio investments by individual Qualified Foreign Institutional Investors has been raised but still remains at a modest $1 billion, and the period for which these investments are “locked up” has been reduced.

Flexible Exchange rate:a. Reserve currencies generally trade freely, and their external value is

market determined. b.China follows a quasi-pegged exchange rate and manages capital

control.

Financial market Development:

a. China has relatively shallow and underdeveloped government and corporate bond markets.

b. Inorder to establish Yuan as a reserve currency it also has to strengthen its foreign exchange and derivatives market.

Macro-economic policies:

a. Investors in a country’s sovereign assets must have faith in its commitment to low inflation and sustainable levels of public debt.

b. China has a lower ratio of explicit public debt to GDP than most major reserve currency economies and has maintained moderate inflation in recent years.

EVALUATING CHINA’S GLOBAL CURRENCY STATUS

Financial market development in the home country is one of the key determinants of a currency’s international status.

The relevant aspects of financial market development are the following:

a.Breadth: the availability of a broad range of financial instruments, including markets for hedging risk;

b.Depth: a large volume of financial instruments in specific markets;

c.Liquidity: a high level of turnover (trading volume). China falls short on many key dimensions of financial market

development, and its steps to aggressively promote its currency’s international role are likely to be impeded over the medium term by the weaknesses of its financial system.

China’s financial system remains bank-dominated, with the state directly controlling most of the banking system.

REASONS WHY YUAN WON’T REPLACE DOLLAR’S:

Money Talk is not enough: Dollar’s holds 62% of the world’s aggregated reserve

currency. Most of the central banks in other countries hold a lot of dollars for the capital market.

Government Transparency: The lack of transparency will be the main drawback

against the Yuan. Stability is the biggest factor why countries gravitate to the dollar, which has not been devalued ever.

The Yuan, on the other hand, is tightly controlled by China, even as Western countries led by the US call for more liberalization of the Yuan.

REASONS WHY YUAN WON’T REPLACE DOLLAR’S

Friendly pressure: The Yuan is already being traded directly between China and

two other countries: Australia and Japan. That means, both countries do not need US dollars to trade with China.

Does it mean the Yuan is gradually encroaching into the dollar reserves of other countries? Yes and no. The encroaching only goes as far as the bilateral trade between China and that other country.

In world trade, the US will exert friendly pressure to maintain the dollar as the exchange currency, and the rest of the world other than perhaps North Korea, Iran, and China will not likely mind.

CONCLUSION