A new day dawns for the Yuan

The Chinese currency, the Yuan, is now the fifth global reserve currency. Some might question why the world’s biggest trading nation and second largest economy has taken so long to get its currency in the IMF’s SDR basket.

It certainly sounds like an accolade for the Yuan, or RMB as it’s sometimes known. But in reality, what does it mean? Look at the Japanese Yen. Japan became the world’s second largest economy but the Yen never rivalled the dollar. Having a big economy or one of the global reserve currencies doesn’t seem to be enough for a country to transform the way world finance operates.

Another day for the dollar

Despite America’s major financial crisis, the Dollar continues to comprise just under two-thirds of global reserve holdings. Similarly, despite the Euro’s troubles since 2010, the Euro zone’s currency accounts for around one-fifth. That leaves the other two SDR constituents, the Yen and Sterling, which was the previous dominant reserve currency, each comprising less than 4 per cent.

The Yen, at one stage, was more important, particularly when it was the world’s second largest economy. But, it never approached the dominance of the dollar. So, the Yen is one of the most traded currencies but was not similarly held as a store of value, which is what gives the United States the ability to borrow more cheaply since global investors demand and hold dollar-denominated assets as well as not having to pay for conversion fees for purchases of commodities which are priced in the greenback, for instance. It’s what gives the United States its “exorbitant privilege,” as described by the former French finance minister, Valery Giscard d’Estaing. That’s been the defining monetary feature of the US-dominated world economic order.

The search for stability

It’s noteworthy that the euro has maintained its share of global reserves, which is higher than what the Deutsche Mark had when it was replaced in 2001 by the single currency when the SDR basket was last reconstituted. Its second place position reflects a willingness to hold euros as well the size of the euro area as the world’s third largest economy after the US and China.

For the RMB to similarly become held as a store of value, public and private investors will be looking for assurances that it is a stable currency whose value is market-determined, and that there will be greater financial openness in China. They will also want to see further reforms, given the worries over the still state-dominated banking sector that flare up from time to time. However, in one respect, the RMB has already defied convention to become a reserve currency without being freely convertible, though it is widely traded offshore and overtook the yen recently. Still, that is likely to come along with capital account liberalization as the RMB joins the SDR basket.

Investor confidence

Notably, China has recently liberalized its interest rate, which was previously controlled by ceilings and floors on the deposit and lending benchmark rates. That’s a significant step toward allowing the market to determine the cost of borrowing, which should lead to a market-determined exchange rate since interest rates are the dominant factor in valuations.

If that leads to the RMB stabilizing in value and China’s financial reforms continue in a manner that promotes investor confidence, then we may well see the day when the RMB share of global reserve holdings rivals that of the dollar. When the dollar overtook the Pound, a new world economic order took hold. If that day arrives for the RMB versus the dollar, then it’ll mark another new era.

The Chinese currency, the Yuan, is now the fifth global reserve currency. Some might question why the world’s biggest trading nation and second largest economy has taken so long to get its currency in the IMF’s SDR basket.