China’s yuan gains SDR weight but remains marginal in reserves due to capital controls, limited financial depth, and regulatory uncertainty. It may grow as invoice currency but not reserve currency without Western crisis or deregulation.
Yuan Reserve Currency Faces Structural Limits
In recent years, the Chinese government has intensified its efforts to promote the international role of the yuan as a reserve currency and a means of payment. The results are mixed. A genuine internationalization of the yuan would require a significant decrease in demand for the dollar and euro, perhaps amid a Western economic crisis or collapse of Western fixed-income markets.
The yuan makes up 12.3 percent of the currencies behind the International Monetary Fund’s (IMF) Special Drawing Rights (SDRs). SDRs are a unit of account based on a currency basket. They are used by the IMF to denominate its transactions. The dollar accounts for 43 percent and the euro 29 percent.
The yuan accounts for roughly 2 percent of the world’s currency reserves (the weights of the dollar and the euro are about 57 percent and 20 percent, respectively). Regarding international transactions, the weight of the yuan is less than one-tenth and one-seventh of those of the dollar and the euro, respectively.
Will the world consider the yuan more favorably in the future? The short answer is that the Chinese currency may play a bigger role as an invoice currency, but not as a reserve currency.
Currencies used for trade
Invoice currencies are the units of account in which transactions are priced. These units can be convertible or inconvertible, with a large grey area in between. Convertible monetary units are those that can be used to buy goods or currencies that are easily convertible into other goods and currencies. Inconvertible units are those that can only be used to buy goods and services from the countries in which the currency has been issued and at the conditions set by those very countries. The grey area reflects the presence of uncertainty about the extent to which a currency is accepted by the market, and is defined by three variables: volume, regulation and strength.
The volumes of trade and of financial transactions matter: The greater they are, the easier it is to find buyers and sellers for and of a given currency. Large volumes mean that operators are price takers. The price of the currency may vary depending on expectations about macroeconomic variables (for example, monetary policy or the aggregate demand for liquidity), but not on accidental, short-lived changes in operators’ demand and supply. The exchange rates of convertible currencies do not suffer from major shocks, at least in the short run.
Regulation relates to the possibility that the issuing country intentionally reduces the degree of convertibility of its currency. For example, this is the case when capital flows are restricted or when the issuing country denies its exporters freedom of contract. Of course, such a currency can still be transformed (converted) into goods or other currencies. Yet, government regulation means that those who want to sell that currency may have a hard time finding a buyer.
Strength concerns purchasing power. Buyers and sellers usually dislike uncertainty (volatility) and inflationary monetary policies. Operators can reduce uncertainty by operating in currencies that do not fall victim to governmental manipulation or by buying insurance on the forward market. Since the latter solution is expensive, a strong currency (more or less stable purchasing power) is usually preferred.
A checklist for yuan readiness to go global
China fully meets one requirement: strength, at least relative to its competitors. Over the past 10 years, the exchange rate of the yuan vis-a-vis the dollar and the euro has not changed much.
China partly meets the volume parameter. Beijing is a very important actor in world trade. Yet, no Chinese financial center seems to play a major role in the world’s financial markets. A large share of yuan-denominated financial operations is in fact linked to Chinese exports to developing countries and loans offered by the Chinese government within the Belt and Road Initiative.
The yuan fails badly on the regulatory front. Capital inflows and outflows are strictly regulated, and regulation frequently changes. In other words, operators may be willing to accept yuan-denominated contracts with a short time-horizon but are likely to refrain from using the yuan as means of payment unless they can quickly and easily exchange yuan into more reliable currencies.
Why Reserve Status Remains Elusive
Chinese agents can ask their trading counterparts to use the yuan when doing business. Beijing can ask foreign importers to buy yuan and use them to pay for Chinese exports. It can also ask foreign exporters to resort to yuan when denominating contractual agreements (prices) and accept yuan as a means of payment. However, it cannot force them to keep those yuan in their safes.
Currency manipulation plays an even bigger role when assessing the role of the yuan as a reserve currency. The political and regulatory risk is simply too high. That is why the yuan accounts for just a tiny fraction of the world’s foreign currency reserves, and most of these are in fact either the so-called “petro-yuan” or held by countries involved in the Belt and Road Initiative (including Russia). They serve as units of account used in semi-barter trade. This also explains why central banks hesitate to buy Chinese sovereign bonds.
Yuan Reserve Currency Hinges on Deregulation
China is eager to promote the yuan as an international currency. It is a matter of prestige, seigniorage (it allows you to buy goods and services in exchange for fiat money) and political leverage. It is not surprising that China has tried to encourage the global economy to use its currency. Nevertheless, these efforts have failed to produce Beijing’s desired outcomes and are unlikely to change the broad picture.
The so-called mBridge project offers an interesting digital alternative to the traditional banking networks. After all, competition is always welcome. Yet, the current financial systems are rather satisfactory. They are not flawless, but the international financial community remains uneasy with the idea of flows managed and monitored by a Chinese governmental agency. The digital euro may confront similar problems in the future.
While today’s dominant reserve currencies are far from ideal, the Chinese option is not currently a promising alternative, and change is not around the corner. Indeed, one has the impression that China’s efforts to transform the yuan into a truly international currency are just dictated by Beijing’s quest for political prestige and perhaps its ambition to transform parts of Asia into a currency area in which the line between a currency and an account unit is relatively and dangerously thin.
In short, the yuan is bound to remain a secondary international currency. Its chances to go global require that one of the following rather unlikely scenarios materialize. All involve either a marked deterioration of the reputation of China’s rival currencies − the dollar and the euro – or a significant deregula
ion by Beijing.
Scenarios
Most likely: All roads lead to China in a Western financial crisis
One scenario that sees the broad adoption of the yuan as a means for international trade and use as a reserve currency entails a major crisis for Western banks and financial networks. If panic spreads, for example if American and European bond yields keep rising and fixed-income markets suffer a major shock, investors will look elsewhere for sovereign debt and currently China is the only alternative. This is especially true if its economy is considered solid and its regulatory system no longer perceived as a corset but as a guarantee against disaster. If Chinese bonds and equity become attractive destinations for the world’s financial wealth, the role of the yuan as a trading and reserve currency would boom.
Somewhat likely: The dollar and euro lose strength while the yuan rises
A second scenario regards situations in which confidence in today’s major world currencies collapses. An extreme case is the disintegration of the euro area and of the euro itself, which would trigger a race for new reserve currencies. In a similar vein, the yuan could benefit if the euro and the dollar lost strength. Persistent and significant price inflation − say above 5 percent annually − would encourage investors and central bankers to rely on stronger currencies. The yuan could become a prime candidate, especially if it offered a more solid alternative, such as unrestricted gold convertibility. The ongoing large purchases of gold by the Chinese central bank add realism to this option.
Least likely: Significant easing of the Chinese regulatory framework
A third and critical scenario includes a drastic change in the Chinese regulatory system. The Chinese authorities may wonder whether the country really needs its stringent controls on capital flows. However, financial and currency deregulation would not create miracles overnight. It takes time to build a trustworthy reputation, especially for authoritarian regimes.