The U.S. dollar is the currency of the world, but that dominance could begin to erode if China has its way. It won't happen right away, but by the end of the decade, the yuan could join the buck and the euro as one of the world's reserve, or anchor, currencies.
Nearly three of every four of our hundred-dollar bills circulate abroad. Oil, copper and almost every other internationally traded commodity is denominated in dollars. The vaults at foreign banks and governments are stuffed with greenbacks. Sixty percent of the planet's foreign-exchange reserves are made up of U.S. dollars, far more than 27% for the euro and 4% for the yen.
But with the dollar depreciating and the euro imploding, China is seizing the opportunity to encourage other countries to use its currency as a medium for trading and investments, as well as a store of value. It's a big leap forward since the yuan -- also called renminbi, which translates literally into "the people's money" -- is tightly controlled and isn't freely convertible into other currencies.
In recent years, China has stepped up an ambitious plan to increase the circulation of yuan outside the mainland and persuade trading partners to use it to invoice or settle transactions. And it is aggressively building a market for yuan-denominated debt. In the past year, McDonald's (ticker: MCD) as well as Caterpillar (CAT) and Unilever (UN) have all raised money by issuing yuan-denominated debt in Hong Kong. And that's just a start.
If all goes according to plan, the yuan could become one of the world's reserve currencies as soon as 2015 -- a daunting deadline, given the political and economic challenges of making the yuan freely convertible. Morelikely, it will become an alternate reserve to the buck and the euro around 2020 -- the target China has set for Shanghai to join New York and London as a global financial hub.
This being China, everything must happen at Beijing's pace. The yuan cannot become a credible reserve until Beijing relinquishes its rigid control of the exchange rate and allows capital to flow freely in and out of the country. Yet in the short term, China can't afford for that to happen until it has successfully implemented its five-year plan to shift its export-reliant economy toward domestic consumption and services. Allowing the currency to rise too quickly would hurt the competitiveness of its still-powerful manufacturers.
But over the long haul, internationalizing the yuan plays into Beijing's grand plan. "The last three years have made it clear to China that it can't sustain a growth model that's overly dependent on U.S. or European consumers," says Stephen Roach, non-executive chairman of Morgan Stanley Asia. "This has given China a number of imperatives, one of which is to stay the course of gradual currency appreciation and internationalization."
The yuan has gained 30% against the dollar since 2005, when China allowed it to float within a controlled range against a basket of currencies. But most strategists believe it's still undervalued by 30% against the greenback. That means each yuan might be worth more than 20 U.S. cents, instead of the 15.75 cents suggested by today's exchange rate.
The path toward a truly free-market economy is by no means straightforward. China is a monolithic culture with competing political forces. Within the country, there are fierce debates about the chasm between rich and poor and policy arguments as to how fast China should move toward liberalizing its currency. While China's economy is second only to America's, per capita GDP is just $4,382 -- 91st in the world.
LIBERALIZING THE YUAN eventually and letting it appreciate will help with two of Beijing's most pressing priorities -- controlling inflation and giving its vast middle class more buying power.
In many ways, the yuan is a modern Chinese paradox. The world's fourth-biggest country in geographic size already has the planet's biggest population, at 1.34 billion. And it has the world's second-biggest trading volume. China's gross domestic product surged to nearly $5.9 trillion last year, from $390 billion in 1990, and is projected to surpass that of the U.S. between 2025 and 2030. Yet its currency remains diminutive on the global stage. Mao Zedong, whose face adorns China's bank notes, doesn't get around nearly as much as Benjamin Franklin.
Beijing would like that to change. China's official forex reserves topped US$3.2 trillion this summer. By 2015, in Deutsche Bank's estimate, China could end up with a third of all publicly held U.S. Treasuries. In fact, China's stash of foreign reserves relative to domestic money stock is more than 10 times that of the U.S. RBS estimates that the People's Bank of China can easily print 10 times more yuan without having to accumulate any more reserves to back them up.
Our biggest creditor has grown uncomfortable with America's wanton indebtedness, not to mention the threats made during this summer's debt-ceiling debacle to default on our obligations. It's no coincidence that China has grown more vocal about its ambition to establish its own anchor currency, and president Hu Jintao has repeatedly called a dollar-dominated currency regime "a product of the past."
THE GREENBACK REMAINS the world's dominant reserve currency partly because of inertia. Our economic heft, transparent government and well-established rule of law have persuaded generations of foreigners to hold the buck as a store of value. Old habits die hard. It took decades after the U.S. economy surpassed Britain's for the buck to supplant the pound sterling as the world's "go to" money.
In recent years, however, the dollar has clung to its exalted status "not so much because of its quality, but because of its liquidity," says Axel Merk, president of Merk Investments and manager of its various currency mutual funds. "One advantage of issuing so much debt is you end up with a deep, liquid market."
Having a market that investors can easily buy in and out of has many advantages:
• Investors, banks, governments are more willing to hold your currency and bonds.
• You can practically print money to buy foreign assets, and investors essentially extend to you an interest-free loan.
• You can issue debt to finance myriad investments.
• Your financial markets end up deeper than they might be otherwise, which makes your banks more competitive.
• And, conducting overseas trade in your own currency avoids risks that come with fluctuating exchange rates, giving your companies greater bargaining power.
None of these attractions are lost on Chinese bankers and businesses, and Beijing sees plenty of room to grow. For example, just 8.6% of China's trade was settled using the yuan in the first half of this year. That's already a big jump from 0.7% in the first half of 2010, but pales compared to levels exceeding 50% for the euro zone and 80% for the U.S. Not surprisingly, China is steering trade partners toward the yuan.
China's trade is increasingly conducted with emerging markets, but the transactions are invoiced neither in the yuan nor those countries' own currencies. That will change. Smaller countries have greater incentives to appease a dominant, fast-growing trading partner, and diversify some of their reserves beyond the weakening dollar or euro.
Beijing also is tweaking tax policies, and multinational banks eager for a piece of the cross-border yuan trade have quickly launched a global clearing system. HSBC estimates, for example, that half of China's trades with emerging markets will be settled in the yuan within three to five years, up from less than 3% now.
UNLIKE JAPAN, Switzerland or the U.K., China has the economic heft and momentum to propel the yuan to reserve status. But first it will need to make the yuan convertible, create deep and liquid domestic bond markets, and improve the rule of law, says Markus Jaeger, a director of global risk analysis at Deutsche Bank.
The World in 2030
China's population will be even huger than it is now, and its gross domestic product and government-bond markets could catch up to those of America and Europe.
| U.S. (2009) | U.S. (2030) | Euro Zone(2009) | Euro Zone(2030) | China (2009) | China (2030) | |
| Population (in mil) | 309 | 369 | 321 | 289 | 1,337 | 1,462 |
| GDP (in US$ tril) | $14.3 | 35.3 | 12.5 | 23.6 | 4.9 | 39.4 |
| Merchandise Trade (in US$ tril) | $2.7 | 6.6 | 3.1 | 4.7 | 2.2 | 17.7 |
| Govt Bond Market (in US$ tril) | $9.2 | 28.3 | 8 | 18.9 | 1.4 | 19.7 |
| Rule of Law score* | 1.7 | NA | 1.7 | NA | -0.3 | ? |
| *Score using Germany as proxy Sources: Deutsche Bank Research, UN, EU, IMF, World Bank . | ||||||
Despite some improvement, the notion that law should apply fairly and efficiently to everyone is still lacking in China. And China's bond market is still small and illiquid, and its currency is controlled with an iron fist. Try emptying your pockets of loose change in any Beijing hotel to be converted into the yuan, and the poor desk clerk has to write down the serial number of each dollar exchanged; such is Beijing's currency control.
But China is speeding up the yuan's internationalization:
• In July 2009, it selected five coastal cities -- Shanghai, Guangzhou, Shenzhen, Zhuhai and Dongguan -- where trade with Hong Kong, Macau or certain Southeast Asian countries could be settled using the yuan. Less than a year later, that pilot scheme was swiftly broadened to 20 cities, and their cross-border trades with all foreign partners.
• Beijing has allowed foreign central banks, starting with Malaysia, to hold yuan reserves, and it has inked swap lines to boost bilateral trade and investments with neighbors like Singapore and Korea, and with countries as far away as Argentina, Belarus and Iceland. Following a visit by vice premier Li Keqiang to Hong Kong this summer, the Commerce Ministry has eased rules for yuan-based foreign direct investments. Beijing has also liberalized rules to allow Chinese importers to pay overseas trading partners in yuan and allow eligible exporters -- more than 67,000 at last count -- to receive payments in yuan.
• In a controlled experiment, China has established Hong Kong as an offshore hub for trading the yuan, a market denoted by the symbol "CNH," which stands literally for "Chinese yuan deliverable in Hong Kong." Having two markets for one currency -- one offshore and one onshore -- is an artificial by-product of Beijing's need to restrict the flow of yuan in and out of the mainland, but it's a step toward letting the yuan trade freely one day. Yuan deposits in Hong Kong have jumped to nearly 600 billion in June from less than 100 billion a year ago, according to the Hong Kong Monetary Authority.
• With such clamor, Chinese Vice Premier Wang Qishan held talks this September with U.K. officials about developing another offshore hub, this time in London. This could, crucially, pave the way for the yuan to be traded outside Asia business hours. How long before the yuan can be traded round the clock? "This is still not the same as making the yuan fully convertible," notes RBS strategist Woon Khien Chia. "But it's pretty much the very last step toward full convertibility."
• Beijing also is aggressively establishing Hong Kong as a market for bonds denominated in offshore yuan, which has been nicknamed the "dim sum bond market." The China Development Bank issued the first such bonds in 2007, but the market took off last year after regulatory limits were eased.
In addition to McDonald's, Caterpillar and Unilever, Volkswagen (VOW.Germany), UBS (UBS) and the World Bank have raised money by issuing debt here. The market is small but growing fast, swelling to 135 billion yuan from 55.8 billion yuan over the past 10 months, while the number of issuers jumped to 84 from 18, notes BofA Merrill Lynch, which has launched an index to track this burgeoning niche. Firms like Guggenheim, PowerShares and Van Eck quickly unleashed dim-sum-bond exchange-traded funds (bearing the respective tickers RMB, DSUM and CHLC).
What might speed up Beijing's path to currency liberalization? "More episodes like the debt-ceiling fiasco, which could cause foreigners to lose faith in our ability to put our fiscal house in order, will encourage them to look for alternatives," says Barry Eichengreen, a professor of economics and political science at the University of California Berkeley and author of Exorbitant Privilege, about the dollar and the international monetary system.
The dollar most likely will remain the dominant reserve for decades. For all our fretting, America has been a debtor nation and China a creditor for years. For foreign institutions to abandon the dollar, they must believe the U.S. will default on its debt. And most Americans still believe -- or hope -- that such a disaster can be averted, even as our congressional "super committee" gropes for ways to cut $1.2 trillion from our deficit over the next decade. Still, foreign central banks and investors are watching the squabbling on Capitol Hill with the intensity of hawks browsing for mice.
What's the price of our failure? The dollar's share of global forex reserves has shrunk by roughly one percentage point a year since the credit bubble burst in 2008, and continued erosion will eventually hurt our already diminished purchasing power. Imports -- from French brie to Korean flat-screen TVs -- will cost more.
"The U.S. government has been able to finance our deficit for less than it might cost because we manage to sell lots of Treasuries," Eichengreen adds. "But if foreigners become less willing to buy, we'll soon lose that ability." Americans may even have to starting saving more to finance our own economic growth. "Relying on the savings of foreigners willing to lend to us at favorable rates isn't going to cut it anymore," Roach says. "The Chinese have made it clear that those days are numbered."
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