China has been ambitiously planning to make its currency, the yuan, one of the global reserve currencies. Nevertheless, being an international reserve currency or even competing for dominance with the US dollar may present more challenges than expected.

Money is a sovereign good and being the dominant currency could be appealing in several ways. This year, the United States announced that they will place sanctions on top Hong Kong officials for the imposition of the National Security Law and the suppression of Hong Kong citizens. As a result, banks operating in Hong Kong suspended accounts connected to the politically exposed persons, with a few Chinese banks assessing their compliance needs. (Ironically, by doing so the banks violated the National Security Law by complying with foreign sanctions.)  A sanction from the United States in this context would freeze the bank’s assets and leave them unable to access American financial systems— acting like a death sentence for the institution. It was clear that banks opted for the lower cost option. The USD, being the world’s dominant international trading currency, allows for the American government to exert pressure over other countries via financial institutions. 

Another advantage of being the dominant currency is cheap borrowing. To avoid exchange rate volatility, importers and exporters around the world turn to dollar safe assets. Instead of using their own domestic currency to invoice and import goods; denominating goods in USD prevents sudden devaluation or appreciation of domestic currency. This increases demand for dollar safe assets and lowers interest rates, thus incentifying exporters to borrow the dollar and exporting their goods in dollars to match their debt. This illustrates that the dollar is being commonly used as a unit of account in international trading and also in loans. As a result, it is comparatively cheaper for the US Treasury to issue bonds and borrow money compared to other countries issuing bonds in their own currencies. 

China has been proactively promoting its currency in the international community. In 2016, the yuan officially gained reserve currency status as it was included in the Special Drawing Rights by the International Monetary Fund (IMF), an asset which gives member countries a claim on currencies of other IMF members. In 2018, Shanghai released the yuan denominated oil futures, which allowed importers to hedge against price risks. This year, China further opened up its financial market, which allows for foreign companies to take full ownership of life insurers, futures, and mutual fund companies. Now, major companies such as Blackrock and JP Morgan are applying to set up or take over mutual fund firms. Outside of its borders, the Belt and Road Initiative also increased the use of the yuan which permitted Chinese companies to invest in foreign countries.

Despite current trends and developments showing how the Yuan is setting up to become an international currency, there are key barriers that are holding the Yuan back from achieving its aggrandized status. One would be the dominance of the USD in international trade, which benefits exporters with cheaper borrowing costs. Another would be related to the storage of value where investors flock to safe-haven assets in economic downturn. For instance, with COVID-19 the dollar rallied in March and Treasury yields plummeted. A world currency does not solely rely on political and economic power, but also the strength of financial institutions and the rule of law. Should investors feel uneasy about their assets under Chinese governance, the yuan would not be able to compete with the euro, not to mention the dollar. Eswar Prasad, an economics professor at Cornell University, wrote in his book Gaining Currency: The Rise of the Renminbi that “Chinese leadership is pursuing financial liberalization and limited market-oriented reforms, but it has unequivocally repudiated political, legal, and institutional reforms.” Prasad argues that the yuan would therefore not acquire “safe-haven” status, meaning that the yuan would not act as a good storage of value in times of crisis. 

If China wants its currency and its markets to go international, it needs to go beyond making short-term, piecewise changes to its regulations and markets. Instead, it has been tightening controls over capital and even investment banking leadership. Previous attempts such as Special Trade Zones did not fulfill expectations in benefiting the financial sector. Additionally, with the example of oil futures aforementioned, capital controls prevent international access into these futures since they require large amounts of capital. Dominated by individual Chinese investors, Yuan futures are unlikely to be successful unless it opens up to a wider international audience. The patchy performances of past attempts could hint that further integration into international markets may require deeper, fundamental reforms such as allowing free flow of information, reforming its legal system, and letting go of controls over capital and firms (mentioned in the Third Plenum of the Party Central Committee in 2013). 

Internationalizing the Yuan presents both opportunities and costs. Increased demand in yuan would cause it to appreciate against other currencies, harming Chinese exports. Moreover, given the current benefits enjoyed by the US having the dollar as the dominant world currency, China would expect responses from the United States in securing the dollar’s status. China sees the opportunity to promote its currency internationally amid the large deficits and debt borne by the United States. However, current developments in China would indicate that it is unlikely for the Yuan to compete for the position as the world’s dominant currency.

Featured Image Source: Reuters

Disclaimer: The views published in this journal are those of the individual authors or speakers and do not necessarily reflect the position or policy of Berkeley Economic Review staff, the Undergraduate Economics Association, the UC Berkeley Economics Department and faculty,  or the University of California, Berkeley in general.

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