As the world's second largest economy, China's challenge to America’s dominance includes a push to set the yuan, officially called the renminbi (RMB), on a similar footing to the U.S. dollar (USD) as the world’s reserve currency. Whether the Chinese currency will ever reach the international prestige that the greenback now holds is a matter of speculation. The dollar has been the world's de facto reserve currency since displacing the British pound sterling around the middle of the last century.
China's yuan is likely to be granted inclusion by the International Monetary Fund (IMF) into its special drawing rights (SDR) basket of reserve currencies that include the U.S. dollar, euro, pound and yen. But even if and when the yuan is included, it will still have a very long way to go to rival the dollar’s preeminence as the international reserve currency of choice.
Recent events, including a sudden 2% devaluation of the yuan and the Chinese government's intervention in its plummeting stock market both signal that the yuan will not be challenging the dollar’s dominance any time soon.
Criteria for SDR Inclusion
The two primary criteria for inclusion in the SDR basket are that issuing countries of basket currencies possess the greatest value of exports over a five-year period and that their currencies are freely usable. The first ensures that only the currencies of countries that play a dominant role in the global economy qualify for inclusion, while the second requirement ensures that only currencies widely traded and used for international payments will be included.
While China’s significant place in international trade meets the first criteria. But whether or not the yuan meets the second criterion is less clear. Some argue that China’s exchange-rate interventions violate this second criteria. But the Deputy of the IMF’s Strategy, Policy, and Review Department has publicly stated that that the IMF's free-usability concept is “distinct from whether a currency is either freely floating or fully convertible.” For this reason, China’s management of the value of the yuan doesn’t exclude it from the IMF’s SDR reserve currency considerations.
China’s Recent Interventions
Due to weaker-than-expected economic growth, The People's Bank of China recently devalued the yuan by almost 2% relative to the U.S. dollar for two consecutive days. Some argued the move was an act of currency manipulation by the Chinese central bank to boost exports. Regardless, the move may actually help the yuan gain acceptance into the SDR currency basket. The currency has been loosely pegged to the dollar for a number of years, and the latest devaluation is actually more consistent with a market-determined valuation. In fact, the devaluation was welcomed by the IMF, which made it clear that it would have no direct impact on China’s goal of earning reserve currency status.
Nonetheless, other concerns center on the Chinese government's recent intervention to halt a nearly $4 trillion stock market rout. IMF Managing Director Christine Lagarde indicated that the intervention did not disqualify the yuan from inclusion, but she did say that the IMF still needs to do significant amount of work before arriving at a final decision. After the stock-market intervention, that decision may be postponed another nine months, until September 2016. Lagarde has also publicly stated that the real question is when the Chinese currency will be included, rather than whether it will.
SDR Inclusion and International Reserve Status
China’s inclusion into the SDR basket will bring a number of benefits, stabilizing the currency and relieving pressure on policymakers to suppress domestic demand that its banks keep a sufficient level of foreign currency reserves on hand.
For China, the yuan's reserve status holds a high symbolic value, but being included in the SDR basket does not bring it that much closer supplanting the dollar as the the de facto international reserve currency. Non-dollar currencies in the SDR currently comprise only 2% of the total reserves of central banks around the world.
To make the yuan a real competitor with the U.S. dollar, China will need to make a number of significant changes. America has partly gained its dominance through its extensive, open and credible financial markets. China still needs to prove that it is capable of providing a stable and transparent environment for similar financial markets to flourish. And its recent market interventions reveal that the country still has a long way to go to develop the kind of financial markets that will support the yuan as a reserve currency.
The Bottom Line
China will likely earn the IMF’s official stamp of approval as an international reserve currency in the next year, joining the U.S. dollar, euro, pound and yen. But that will not necessarily give it equivalent status with those other currencies, especially the dollar. International desirability of a fiat currency depends on the perceived strength and credibility of the issuing nation’s government and financial markets. China’s recent stock market intervention hurt that credibility, delaying the ascension of the yuan as a true competitor with the U.S. dollar as the world’s preeminent reserve currency.
