Is China paving the way for the yuan to become the world’s next reserve currency? At the beginning of this month its central bank announced that it was for the first time using its own currency rather than dollars to buy IMF bonds. China agreed to buy $50 billion-equivalent of the Fund’s special drawing rights as part of the official sector’s fight against the international financial crisis. China’s loan is part of a $500 billion emergency pool of funds the IMF is making available to troubled countries through the issuance of SDRs, a currency basket comprising dollars, euros, yen and sterling.
China’s purchase could be interpreted as an accounting move in that the IMF could sell the yuan back to China for dollars, allowing the central bank to diversify its reserves. More likely, however, it is part of a ploy by the Chinese authorities for the yuan to gradually challenge the dollar’s authority as the world’s main reserve currency.
One reason why the Chinese paid for the SDRs in its own currency could be for the Fund to lend the yuan to a creditor nation, which could then use the money to buy goods from China, thereby promoting the use of the yuan for trade and settlement purposes. The IMF could buy assets too from other countries using yuan or even issue loans in the currency.
China has already elevated the importance of the yuan in the international financial system through swap deals in Latin America. It will soon do so in Russia too. It has also agreed to lend the currency to South Korea, Indonesia and Malaysia, and is about to offer yuan-denominated bonds to offshore investors for the first time. The amount issued will be Rmb6 billion ($879 million).
While the yuan might not become part of the G7 central banks’ foreign-currency reserves for some time, it might play a role in emerging markets, especially given China’s growing importance as their trade partner.
Sceptics will point out that the yuan is not fully convertible and that until it floats freely it cannot become a reserve currency. But a recent piece by Ousmene Mandeng of Ashmore Investment Management argues that a closed capital account need not be a detriment. He points out that the rise of the Deutschmark and the yen occurred as both countries maintained capital controls, although they were relaxed sufficiently to allow the official sector to accumulate reserve assets. He adds that an undermining of the hegemony of a currency in the international financial system is more common than many people think – again highlighting the rise of the Deutschmark and yen in the 1970s as evidence of central banks being flexible in their reserves accumulation.
With nearly two-thirds of China’s $2 trillion of foreign-currency reserves in dollars it is not in its interests to destabilize the US currency. The dollar is not about to lose its primacy soon, although China is preparing for such an eventuality by buying hard assets, such as gold, metals and oil and their producers, as a hedge against a possible collapse of the currency. The yuan’s march towards international recognition is just a matter of time.
