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Yuan’s potential to become the new global reserve

Published : Wednesday, 17 August, 2022 at 12:00 AM  Count : 661

Taking into account inflation Currently, China has the largest economy in the world. When it comes to international trade, it outdoes both the US and EU together. However, China's economic growth will be constrained, and its influence may be even more so, because its currency is not the world reserve.

The American dollar has been doing very well recently, and a lot of that is due to the world's being in an uncertain economic situation. Fears about inflation and recession are causing individuals and institutions with lots of money to look for safe places to keep their wealth until this whole thing blows over. And it's safer to keep it in the world's default medium of exchange.

Being the world's reserve currency has a lot of advantages beyond just bragging rights. Whether they publicly admit it or not, China would love for their currency to be treated the same way in the global economy, and they are doing their best to get it there.

The US dollar has obviously not always been the world's reserve currency. Before the US dollar, the British pound was the world's reserve through the colonial era of global trade. However, towards the end of the Second World War, 44 countries sat down and laid out a plan for an efficient system of global trade and finance. This agreement, called the "Bretton Woods" system, pegged the price of the American dollar to a set amount of gold. The currencies of all other participating nations were then pegged to the dollar. This allowed countries to keep American dollars in reserve instead of physical gold.

The US dollar is historically very stable. It is widely recognized and there is enough in international circulation for it to be useful for trade. It also has a fair value, which is determined by the international market. Fair value, wide circulation, stability, and wide acceptance are the four ingredients that any currency would need to become the world's reserve. Despite the fall of the Bretton Woods system in 1970s, the US dollar is still the world's reserve currency as it has all those characteristics.

Currently, the Chinese yuan, or renminbi, is the third most common currency reserve after the euro and, of course, the US dollar. The greatest tool that China has to push its currency onto the world stage is simply trade. For small-time trades the importer normally pays the exporter in their local currency. Larger operations can go either way, and normally the settlement currency is something that is agreed upon in the purchase agreement contracts. On the scale of global commodity transfers, though, it is simply easier to use a trustworthy third party, which is almost always the American dollar. Sometimes the dollar is referred to as "Petrodollars" because almost all international oil sales are done using American dollars. This means big oil-exporting countries naturally build up large reserves of this currency.

The best way to build up these reserves is by trading and China does a lot of trade. It is by far the largest manufacturer of goods in the world and it sells those goods to basically everyone. All of these exports and imports present an opportunity for China to request that trade be done using its currency. They are also taking a more direct approach with their neighbors. The Belt and Road initiative has been a major infrastructure project undertaken by the Chinese government to provide trade infrastructure to developing nations in their region.

Last month, Brazil, Russia, India, China, and South Africa, the so-called BRICS economies, met up to discuss their ongoing trade relationships, mostly in the context of western sanctions being placed on Russia. These are all very powerful economies and trade between them is up 38% this year due to sections of the West. China is benefiting from this in more ways than just getting cheap oil from Russia. It is pushing the trading block to adopt the RMB as the de facto medium of exchange.

Western sanctions, particularly those that cut off Russian reserves of American dollars, have also made a few governments around the world a bit. For economies that are very politically, culturally, and economically close to America, like Canada, Australia, and most of Western Europe, this probably isn't a huge deal. Because they are extremely unlikely to be sanctioned by the US. But for countries that don't have such strong ties, these sanctions are acting as a bit of a wake-up call to say that it's probably worth diversifying the emergency reserves to include some currencies that can't be cut off by.

As far as hedges against the risk have been sanctioned by America, the Chinese yuan is about as good as it gets. It's a currency that can be used to make direct purchases from the largest exporting nation in the world, and the Ukrainian invasion has shown that the Chinese government is happy to do business with economies that have been shunned by the west.

The RMB's global use is certainly on the rise, as is to be expected given China's economic growth over the past three decades. But holding a reserve currency is in many ways like holding shares in the currency issuing country. You want to be sure it's run well; it's run sustainably and that management won't do anything silly.

China's currency just has a lot of problems that make it unpalatable in the eyes of many institutions. There are just direct limitations on how it can be used. Chinese citizens are not allowed to transfer more than the equivalent of $50,000 USD worth of currency out of China every year. This demonstrates two things. One is that China thinks it's necessary to effectively imprison the wealth of its people on shore to stop them from starting businesses and lives overseas, and two, it shows that even China itself is so uncomfortable with the true value of its own currency that it writes laws in US dollars.

As for protections against sanctions, well, China isn't really a viable alternative. It has a much worse reputation for unnecessarily punitive economic actions. The US sanctioned Russia because it started a war of aggression with another foreign nation. China sanctioned Australia because it wanted to conduct an investigation into the cause of the Coronavirus to prevent another outbreak.

Foreign currency reserves are subject to the whims of the governments that issue them, but some governments are just inherently more stable than others, and it's not like there are only two options either. Most central banks are now stocking up on a range of currencies to keep in reserve. For now, at least, concerns over extended lockdowns, trade wars, debt crises, housing bubbles and government infighting are hurting the case for the RMB global reserve far more than any opportunistic gains or heavy-handed trade deals are doing to help it.
The writer is a contributor















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