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5 Benefits Of The Yuan As A Reserve Currency

 

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maxxelli

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Despite its devaluation over the past six months, the Chinese remminbi is still on the rise. Since 2008, China has signed 32 local-currency swap agreements with central banks inside and outside of Asia, which have slowly but deliberately been promoting the yuan in the region to increase its usage in international payment settlements.



To find out to what extent China has become the dominant or leading currency in Southeast Asia it is important to first understand what gives a currency the status of an international currency.


For a currency to become an international currency, it has to fulfill the three classical roles of money in general which are: Unit of account, medium of exchange, and store of value. In an international sense this can be distinguished into two sectors, the private sector and the official sector.


  1. As a unit of account, money provides a common measure of the value of goods and services being exchanged. In the private sector, product import and export between two countries could be invoiced in the currency of a third country – for example when an Indonesian company uses the US dollar to pay for products from Vietnam. In the official sector, having your currency pegged by other countries or used in a currency basket of foreign central banks would be a dimension of an international currency. One of the most prestigious baskets to be included in is the “Special Drawing Rights” of the International Monetary Fund. When a country in crisis wants to take out a loan from the International Monetary Fund it does so in Special Drawing Rights. Special Drawing Rights are not a currency and thus hold no value for the private sector, they represent a claim to currency held by International Monetary Fund member countries for which they may be exchanged. They can only be exchanged for euros, Japanese yen, pounds sterling or US dollars. “Holders of SPECIAL DRAWING RIGHTS’s can only obtain these currencies in exchange for their Special Drawing Rights in two ways: first, through the arrangement of voluntary exchanges between members; and second, by the International Monetary Fund designating members with strong external positions to purchase Special Drawing Rights from members with weak external positions”. If a currency is used to denominate securities that are marketed abroad, such as US treasury bonds, it is also being used as a unit of account. Government bonds are considered risk-free bonds because the government can raise taxes or increase the money supply in order to redeem the bonds when they mature. However, emerging economies often have difficulties marketing domestically denominated bonds abroad because investors fear possible devaluations of the currency thus bonds can be issued in a foreign currency, these are referred to as sovereign bonds.



  2. As a medium of exchange, currency is used in the private sector for trade and financial transactions. In the official sector an international currency is one that is used abroad, hand-to-hand, and is used in government financial transactions such as central bank swaps. There are generally two types of swap arrangements: “one in normal times when needs are anticipated, and another in crisis times when ad hoc arrangements are required”. The bilateral swap arrangements that China made with six members of the ASEAN+3 as a result of the agreements made in the Chiang Mai Initiative (it is a multilateral currency swap arrangement among ten members of the Association of Southeast Asian Nations (ASEAN), the People’s Republic of China (including Hong Kong), Japan and South Korea. Its draws from a foreign exchange reserve pool worth US$ 120 billion and was launched on 24 March 2010) are an example of the former. In three cases China provided US dollars in exchange for the local currencies of Thailand, Malaysia and Indonesia and in the other three cases China provided renminbi in exchange for the local currencies of Japan, the Philippines and South Korea. A bilateral swap during a crisis occurred in 2007 when the US Federal Reserve provided dollars to the G10 countries as well as South Korea, Mexico, Singapore and Brazil.



  1. For the official sector, an international currency acts as a store of value when that currency is kept in store in the foreign reserves of a foreign country. The most common foreign reserve is the US dollar followed by the other three official Special Drawing Rights currencies, the euro, the pound and the yen.




What is the expected result for China in the short and long term


In 2013, the RMB was the 8th most traded currency in the world and the 7th most traded in early 2014. By the end of 2014, RMB was ranked 5th as the most traded currency according to SWIFT’s report, clocking at at 2.2% of SWIFT payment behind JPY (2.7%), GBP (7.9%), EUR (28.3%) and USD (44.6%). Currently (October 2015) the RMB is the second most used currency in trade financing, and ninth in forex trading.





In order for China to realize capital account convertibility for the renminbi it will need to adopt a true free floating exchange rate regime. China did so partly to meet the I.M.F.’s rule that a currency must be “freely usable” before it could be included in this benchmark. China has already indicated its wishes to internationalize the renminbi, and has clearly been pushing usage of the renminbi through swap agreements with both regional and extra-regional central banks. As a result, it is reasonable to assume that until full convertibility of the renminbi is accomplished, it will continue to appreciate. This steady and anticipated appreciation for the foreseeable future makes it a reliable investment.


The I.M.F. decision will help pave the way for broader use of the renminbi in trade and finance, securing China’s standing as a global economic power. But it also introduces new uncertainty into China’s economy and financial system, as the country was forced to relax many currency controls to meet the I.M.F. requirements. The changes could inject volatility into the Chinese economy, since large flows of money surge into the country and recede based on its prospects. This could make it difficult for China to maintain its record of strong, steady growth, especially at a time when its economy is already slowing. Many central banks follow this benchmark in building their reserves, so countries could start holding more renminbi as a result. China will also gain more influence in international bailouts denominated in the fund’s accounting unit, like Greece’s debt deal.




The benefits that Southeast Asia stands to gain if the renminbi where to become the leading international currency of the region instead of the dollar are based on the expected future outcomes of the current reforms in China’s financial and economic policies. China is doing something that has never been attempted before, creating a potentially market based financial sector that is subjugated to control from a single political party. Due to these unique circumstances there is no literature to fall back on to examine similar historical cases and how they worked out.


About The Author

Maxxelli Group is a foreign-owned consulting firm, operating primarily throughout second tier China. They offer destination services for expats and consulting for foreign direct investment, as well as provide information and advice for expats living in China via their two blogs, Maxxelli Insights and Maxxelli Blog.





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