will chinese yuan become the next reserve currency chandrashekar 2 1

8/3/2019 Will Chinese Yuan Become the Next Reserve Currency Chandrashekar 2 1

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CRISIL YOUNG THOUGHT LEADER, 2010

_____________________________________________________________________

WILL CHINESE YUAN BECOME THENEXT RESERVE CURRENCY?

_________________________________________

DISSERTATION POSTGRADUATE CATEGORY

BY

B.CHANDRASHEKAR

MBA (2009-2011)DEPARTMENT OF MANAGEMENT STUDIES,

ANNA UNIVERSITY, CHENNAI

WORD COUNT: 2496PAGES: 10

(Excluding Cover Page, Index, References and Bibliography)


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INDEX

EXECUTIVE SUMMARY 3

1. INTRODUCTION 42. HOW DOLLAR BECAME A RESERVE CURRENCY? 43. RESERVE CURRENCY FACTORS 4

3.1 SIZE OF THE ECONOMY AND TRADE 43.2

FINANCIAL MARKETS 7

3.3 CONVERTIBILITY OF THE CURRENCY 83.4 RULE OF LAW 83.5 GEO-POLITICAL STRENGTH 93.6 NETWORK EXTERNALITIES 9

4. CURRENCY SWAP AGREEMENTS 95. SOME CONCERNS ON THE GROWTH OF CHINA 106. CURRENT STATUS OF RESERVES 117. CONCLUSION 12REFERENCES 13

BIBLIOGRAPHY 13

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EXECUTIVE SUMMARY:

Due to the recent financial crisis, the strength of the dollar and its status as the reserve

currency are in question mark. China being the fastest growing economy and with

increase in its share of trade, the focus is on yuan today. This paper starts with a brief

historical look at how dollar became a reserve currency. Then the important factors

that act as a prerequisite for a currency to attain reserve status are analysed

individually. The size of the economy, trade, current account balance, government

debt etc of China is compared with that of the US. Also the factors like openness of

financial market, currency convertibility, rule of law, geo-political strength and

network externalities are studied. The conclusion is drawn for each and every factor,indicating whether the yuan fits the bill or not. The steps being taken by China,

importantly the currency swap agreements with its trade partners are highlighted and

the current reserves holding pattern is graphed. Though China is growing rapidly,

some concerns on whether it can sustain its growth in the future too are discussed. In

the end, considering all factors, it is concluded that China has to take some drastic

policy changes in the areas of capital account convertibility, opening financial

markets, improving rule of law etc. to be treated as a worthwhile competitor to dollar.

Even if it meets all prerequisites, factors like network externality and geo-political

strength being tilted in favour of dollar, and possible pace of policy changes, it is

concluded that yuan can become an important currency but cannot surpass dollar in

the near future.

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1. INTRODUCTION:

US dollar has been the reserve currency for many years due to its stable economy.

Owing to the recent global financial meltdown, this has been challenged. Global

leaders have started stressing the importance to find an alternative to dollar. After theadvent of euro, it contributed to most of the international transactions, only next to the

dollar. But due to the raising concerns in euro zone especially in countries like

Greece, Portugal, Italy, Spain and Ireland which are in deep financial distress, the

focus is now being shifted towards yuan. China is poised to grow rapidly as it has

been doing for last three decades and it has emerged as an economic power that has a

large contribution to the international trade. Will yuan become the next reserve

currency challenging dollar? Is China ready?

2. HOW DOLLAR BECAME A RESERVE CURRENCY?

Post World War II, the Bretton Woods system gave rise to the pegging of dollar to the

gold. All other currencies were pegged to the dollar. But this system collapsed after

President Richard Nixon, in 1971 announced that the dollar would no longer be

pegged to gold. This came as a shock, but still dollar continued to rule the world,

because the world at that time had no other alternative and oil trade was basically

carried out on dollar terms which kept the demand for dollar intact. Network

externality also played a part in sustaining the hegemony of dollar.

3. RESERVE CURRENCY FACTORS:

A reserve currency should play the following roles:

Store of value Medium of exchange Unit of accounting

There are various factors that determine whether a currency can be a reserve currency

or not. Some of them are quantitative while some are qualitative.

3.1 SIZE OF THE ECONOMY AND TRADE:

4

China has surpassed Japan in second quarter, 2010 (Q II nominal GDP figures: China

- $1.337 trillion, Japan - $1.288 trillion) to become the second largest economy. China


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has been growing at an astounding rate, the fastest growing economy in the world and

expected to surpass US around 2027 [1].

Chart 1 - GDP in current prices

0

2

4

6

8

10

12

14

16

2001 2002 2003 2004 2005 2006 2007 2008 2009

Year

TrillionsofUS$

China

US

Source: IMF

When we look at the trade data, the chances for Chinese yuan look brighter.

Table 1: Trade Data

Merchandise Trade (2009) China US

Rank in world trade (exports) 1 3

Rank in world trade (imports) 2 1

Share in world total exports 9.62% 8.45%

Share in world total imports 7.93% 12.66%Trade per capita (US$, 2007-2009) 1921 12728

Trade to GDP ratio (2007-2009) 58.6 27.3

Source: WTO

Table 2: Major Trade Partners of China

Exports % of overall exports Imports % of overall imports

EU (27) 19.70% Japan 13.00%

US 18.40% EU (27) 12.70%

Hong Kong 13.80% Republic of Korea 10.20%

Source: WTO

5

China is the second largest exporter to the US, next to EU. The pattern is clear that the

China is catching up with the US and has a good chance that it will surpass the US in

the coming years.


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Chart 2 - Total Merchandise Trade

0

500

1000

1500

20002500

3000

3500

4000

2001 2002 2003 2004 2005 2006 2007 2008 2009

Year

US$billio

ns

China

US

Source: WTO

Apart from GDP and trade, it is worthwhile to compare other economic indicators like

general government gross debt, current account balance etc.

Table 3: Gross Debt and Current Account Balance

Indicator (2009) China US

General government gross debt, US$ (billions)

As % of GDP

926.88

18.595

11896.59

84.259

Current Account Balance, US$ (billions)

As % of GDP

297.1

5.96

-378.434

-2.68

Source: IMF

Chart 3 - General Government Debt

0

10

20

30

40

50

60

70

80

90

2001 2002 2003 2004 2005 2006 2007 2008 2009

Year

Debtas%o

fGDP

China

US

Source: IMF

6

The US debt position is very high compared to China and the current account balance

is negative for the US. China is a net exporter, while the US is a net importer. All

these indicators point to a very weak US economy and add to the chances in favour of

yuan.


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Chart 4 - Current Account Balance

-1000

-800

-600

-400

-200

0

200

400

600

2001 2002 2003 2004 2005 2006 2007 2008 2009

Year

US$billion

s

China

US

Source: IMF

3.2 FINANCIAL MARKETS:

The index of capital account liberalization first generated by Chinn and Ito (2008) is

used to measure the degree of openness to global financial markets [2].

The Chinn-Ito index (KAOPEN) is an index measuring a countrys degree of capital

account openness. The index was initially introduced by Chinn and Ito, Journal of

Development Economics, 2006.

China is ranked 113 in the total of 182 countries for the period 1984 to 2008.

Table 4: KAOPEN index for major economies

Table 5: Summary of Chinn & Ito KAOPEN index

Summary Statistics: Minimum Mean Median Maximum Standard

Deviation

Full Sample -1.83 0.00 -0.60 2.50 1.52

Industrialized Countries -1.83 1.23 1.70 2.50 1.40

Developing Countries -1.83 -0.22 -1.14 2.50 1.43

Emerging Markets -1.83 -0.22 -0.87 2.50 1.43

7

Country KAOPEN Rank

China -1.14 113

France 1.45 67

Germany 2.50 1

Japan 2.50 1

UK 2.50 1

US 2.23 57


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China does very poorly when it comes to open financial markets. When we compare

with US, Japan or other Euro countries, it lags far behind. It is well below the mean

values for developing countries and emerging markets.

From the illustrations below (Charts 5&6), it is clear that the daily foreign exchange

turnover in China is midget compared to the UK or the US. To add to this, there is no

deep domestic bond market in China. This is because of two factors: the government

has leaned on banks to assist in lending and has used direct quantity and price controls

in the conduct of monetary policy [3].

Chart 5 - Currency Distribution of Global Foreign

Exchange Market Turnover - % of Shares of

Average Daily Turnover in April 2010

84.9

39.1

1912.9

0.30

20

40

60

80

100

US dollar Euro Yen Sterling Yuan

Percentag

e

Source: BIS

(As tw o currencies involved in each transaction, sum total of all currencies will be 200%)

Chart 6 - Global Foreign Exchange Market

Turnover Daily Averages in April 2010

0.43 2.1

4.76.2

36.7

17.9

0

5

10

15

20

25

30

35

40

China France Germany Hong

Kong

Japan UK US

Percentage

Source: BIS

There has to be some drastic improvement in these areas to make yuan a worthwhile

contender for reserve currency.

3.3 CONVERTIBILITY OF CURRENCY:

The yuan is not convertible and there are tight capital controls. Central banks would

not be interested in holding a large amount of a currency if they would not be able to

sell it or trade it without any limits. Thus, if at all China wants yuan to give

competition to the dollar and aims to make it a reserve currency; it has to make yuan

convertible. An Asian Development Bank study points out that in the future, the

yuans share will be insignificant despite the significant share of China in world GDP

if it fails to make yuan convertible [4].

3.4 RULE OF LAW:

Though there are various indicators to measure the rule of law in a country, here we

use the strength of legal rights index. This index measures the degree to which

collateral and bankruptcy laws protect the rights of borrowers and lenders and thus

facilitate lending. The index ranges from 0 to 10, with higher scores indicating that

these laws are better designed to expand access to credit.

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Table 6: Strength of legal rights index for major economies:

Country 2005 2006 2007 2008 2009

China 4 4 4 6 6

France 4 6 7 7 7

Germany 8 8 8 7 7

Japan 7 7 7 7 7

UK 9 9 9 9 9

US 8 8 8 8 8

World 5 5 5 5 5

Source: World Bank

Though there is political stability in China, the rule of law index indicates that the

foreigners may be unwilling to invest there as it scores poorly in comparison with the

US or other Euro countries. In this area, China has a long way to go.

3.5 GEO-POLITICAL STRENGTH:

Post world war, the US enjoyed the advantage of being a superpower when the world

became populated with dollar. So was the case with pound sterling and the UK, when

it colonized countries and promoted trade. We do not see a similar situation now, nor

can we expect in the near future.

3.6 NETWORK EXTERNALITIES:

The network externality effect is heavily tilted towards dollar. The incumbent reserve

currency will have a natural tendency to remain dominant, and it will be very difficult

for any new currency to replace the incumbent altogether. Each country is more likely

to use whatever currency is used by others. Higher will be the value of a currencywhen more people use it. There is an inertia that stops countries from switching to a

new reserve currency swiftly. So the switch will happen only gradually. This is a

reason why it took many years for dollar to replace sterling as reserve currency

though US economy surpassed Britain in 1872.

4. CURRENCY SWAP AGREEMENTS:

9

So far we have analysed each and every factor and concluded where China stands.Now let us see some measures being taken by China to popularize its currency.


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Peoples Bank of China has entered into bilateral currency swap agreements with

central banks of various countries so that they can trade using their own currencies.

Table 7: Currency Swap Agreements

Partner Amount Date

Bank of Korea 180 billion yuan / 38 trillionKRW

December 12, 2008

Monetary Authority of HongKong

200 billion yuan / 227 billionHK dollars

January 20, 2009

Bank Negara Malaysia 80 billion yuan / 40 billionMYR

February 8, 2009

National Bank of theRepublic of Belarus

20 billion yuan / 8000 billionBYR

March 11, 2009

Bank Indonesia 100 billion yuan / 175 trillion

IDR

March 23, 2009

Central Bank of Argentina 70 billion yuan / 38 billionARS

April 4, 2009

Monetary Authority ofSingapore

150 billion yuan / 30 billionSingapore dollars

July 23, 2010

Source: Peoples Bank of China

Apart from this, Chinese Central Bank Governor Zhou Xiachuan has suggested

replacing the dollar as international currency with a basket of currencies supervised

by the IMF.

5. SOME CONCERNS ON THE GROWTH OF CHINA

Though China is poised to overtake US as the largest economy around 2030, there are

various concerns being raised against China. The question is whether China will get

old before it gets rich due to increasing longevity and one child policy being followed

for years. Per-capita GDP even with most optimistic scenario will be very less

compared to that of the US, Japan or Germany in 2030 [5].

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Many studies suggest China to overtake the US in coming decades, but a word of

caution was raised by Paul Krugman [6]. Krugmans argument was that these kinds of

predictions were bound to fail because they ignored the intangible forces: the

multipliers of innovation, technology and competitive efficiency. When the World

Bank estimated in early 90s, that by 2010, Chinese economy would be a third larger

than that of the US, Krugman rightly concluded that this prediction would fail. Still

Chinese economy continues to be less than 40% of the US.


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7. CONCLUSION:

There is no doubt that China is going to be an important country in world economy in

the coming years. If all the concerns about the Chinese economy pointed out above

are answered by careful macroeconomic policies, there is a good chance that Chinawill surpass the US before 2030. Though some prerequisites like size of the economy,

trade etc are tilted in favor of yuan, unless issues in relation to the openness of

financial markets, domestic bond market and convertibility are addressed, it will be

difficult for yuan to give competition to dollar. The pace with which China will carry

out these reforms is a question mark. Apart from that, geo-political strength and

network externalities are equally important factors working against the chances of

yuan. Chinas major trading partners (Table 2) are EU, the US, Japan etc, which are

unlikely to use yuan. Since diplomatic and military factors are also important, oil

exporters will think twice to give up dollar because of their ties with the US.

Yuan cannot completely replace or surpass dollar or even euro in terms of percentage

holdings. If China moves to capital account convertibility, opens up the financial

markets more, creates a deep domestic bond market, improves the rule of law and

finally, maintains the high growth path in the coming decades, we can expect the

future to be tripolar (dollar, euro and yuan) with yuan occupying an important

position. Right now, yuan is far from ready.

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REFERENCES:

[1]BRICs and Beyond, Goldman Sachs Global Economics Group, 2007.[2] Ito, Hiro and Chinn, Menzie. Notes on the Chinn-Ito Financial Openness Index,2008 Update, August 5, 2010.

[3] Bonding the BRICs: The Ascent of Chinas Debt Capital Market, Chapter Fifteen,BRICs and Beyond, Goldman Sachs Global Economics Group, 2007.[4] Lee, Jong-Wha, Asian Development Bank. Will the Renminbi Emerge as an

International Reserve Currency? June 2010.[5] Will China Grow Old Before Getting Rich? Chapter Three, BRICs and Beyond,Goldman Sachs Global Economics Group, 2007.[6] Krugman, Paul. The Myth of Asias Miracle, Foreign Affairs;November/December 1994.[7] Rajan, G.Raghuram. Fault Lines, How Hidden Fractures Still Threaten the WorldEconomy, pages 217-221, Collins Business, 2010.

BIBLIOGRAPHY:

JOURNALS, PAPERS AND REPORTS:

1) Chinn, Menzie and Frenkel, Jeffrey. Why the Euro Will Rival the Dollar.International Finance 11:1, 2008.

2) Deutsche Bank Research, Yuan as a reserve currency, Likely prospects & possibleimplications, July 16, 2010.

3) Papaioannou, Elias and Portes, Richard. Costs and benefits of running aninternational currency. European Economy, Economic Papers 348, November2008.

BOOKS:1) Bahl, Raghav. Superpower? The Amazing Race between Chinas Hare and Indias

Tortoise. Penguin Allen Lane, 2010.2) Ferguson, Niall. The Ascent of Money, A Financial History of the World. Penguin

Books, 2009.

WEBSITES:

http://www.imf.org/external/data.htmhttp://www.wto.org/http://data.worldbank.org/

http://www.bis.org/publ/rpfx10.pdfhttp://www2.goldmansachs.com/ideas/brics/index.htmlhttp://www.pbc.gov.cn/publish/english/963/index.htmlhttp://web.pdx.edu/~ito/Chinn-Ito_website.htmNEWSPAPERS, MAGAZINES AND OTHER ARTICLES:1) China takes a small step away from the dollar TIME. Retrieved from:http://www.time.com/time/business/article/0,8599,1889587,00.html2) China's Yuan: The Next Reserve Currency? BusinessWeek. Retrieved from:http://www.businessweek.com/globalbiz/content/may2009/gb20090522_665312.htm3) Chandy, Jacob. The Hindu Business Line: End of dollars hegemony? March 31,

2009. Retrieved from:

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http://www.blonnet.com/2009/03/31/stories/2009033150070800.htm
http://www.imf.org/external/data.htmhttp://www.wto.org/http://data.worldbank.org/http://www.bis.org/publ/rpfx10.pdfhttp://www2.goldmansachs.com/ideas/brics/index.htmlhttp://www.pbc.gov.cn/publish/english/963/index.htmlhttp://web.pdx.edu/~ito/Chinn-Ito_website.htmhttp://www.time.com/time/business/article/0,8599,1889587,00.htmlhttp://www.businessweek.com/globalbiz/content/may2009/gb20090522_665312.htmhttp://www.blonnet.com/2009/03/31/stories/2009033150070800.htmhttp://www.blonnet.com/2009/03/31/stories/2009033150070800.htmhttp://www.businessweek.com/globalbiz/content/may2009/gb20090522_665312.htmhttp://www.time.com/time/business/article/0,8599,1889587,00.htmlhttp://web.pdx.edu/~ito/Chinn-Ito_website.htmhttp://www.pbc.gov.cn/publish/english/963/index.htmlhttp://www2.goldmansachs.com/ideas/brics/index.htmlhttp://www.bis.org/publ/rpfx10.pdfhttp://data.worldbank.org/http://www.wto.org/http://www.imf.org/external/data.htm


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4) Dhuddu, Adhvith. The Hindu Business Line: Perilous state of the dollar. May 19,2009. Retrieved from:http://www.blonnet.com/2009/05/19/stories/2009051950050900.htm5) Foroohar, Rana.Everything You Know About China Is Wrong. Newsweek, October17, 2009.

6) Gurumurthy S. The Hindu Business Line: What is the alternative to the dollar?April 22, 2010. Retrieved from:http://www.thehindubusinessline.com/2010/04/22/stories/2010042250220800.htm7) Venkitaraman S. The Hindu Business Line: China proposes to dethrone the dollar.April 6, 2009. Retrieved from:http://www.blonnet.com/2009/04/06/stories/2009040650170800.htm8) Yuan starts on long slog to reserve currency status | Reuters. Retrieved from:

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http://www.reuters.com/article/idUSTRE5650W720090706
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