There's chatter the yuan could rival the dollar as the primary global reserve currency.
China has loosened some control over its currency, but the government is unlikely to relinquish it in full.
The controls help China protect its banking system, control the flow of money in and out of its borders, and promote its exports—which keeps the currency from being more widely used globally.
Countries will ultimately do what makes the most fiscal sense—for now that means buying dollar-denominated assets.
Reports this week showed rapidly expanding China unseated Japan as the world's second largest economy at 2010's end—could number one US be next? There's already chatter China's currency, the yuan, could rival the dollar as the primary global reserve currency. But while opposition to the dollar's dominance is great, true challengers are still absent.
The Chinese government has recently taken steps to encourage the use of the yuan abroad, and coupled with China's significant global trade presence, there's no question its currency is showing up more often in finance and business transactions worldwide. The government now allows Chinese firms and foreign firms doing business in China to issue bonds denominated in yuan in Hong Kong and some cross-border trades to be settled in yuan, rather than converting in and out of dollars.
Additionally, France and the International Monetary Fund (IMF) have raised the possibility of including the yuan in the basket of currencies making up the value of Special Drawing Rights (SDRs), the IMF's international currency system. Currently, the basket includes fixed amounts of dollars, euros, pounds, and yen—with the dollar given the biggest weight. Do all these signs point to a decline in dollar dominance on the global scene?
We doubt it—and this storyline is one that gets replayed frequently (most recently in 2009). Though China has loosened some control over its currency—both in self-interest to promote its currency and under pressure from other countries to let the yuan appreciate—the government is unlikely to relinquish it in full. This means the dollar's status as reserve currency won't be upstaged by the yuan anytime soon.
First, China's currency is not so easily convertible—meaning China does not allow it to be freely converted into other currencies and traded globally like the dollar, yen, or euro. It's also heavily managed relative to the dollar at an exchange rate widely believed to greatly undervalue the yuan to the advantage of Chinese exports and to the frequent ire of other countries. China manages its currency heavily with an aim of protecting its banking system, controlling the flow of money in and out of its borders, and promoting its trade industry—which keeps the currency from being more widely used globally.
If not the yuan, can other currencies supplant the US dollar as world reserve currency? Sure, but which? As mentioned, SDRs are actually denominated in dollars and primarily backed by the US, whose currency comprises the largest weighting. Additionally, the amount of SDRs in global circulation (in the billions) does not remotely approach levels of dollars (in the trillions). There's also talk of shifting from the dollar to the euro, which is already used as reserve currency to some extent. But the European Monetary Union still has to work out some long-term issues, starkly brought out in the open most recently by PIIGS problems. And again, the US dollar market is much deeper.
Nations are free to buy reserve assets in any currency they choose and will ultimately do what makes the most fiscal sense. For now that means buying dollar-denominated assets, though they may continue to crow against dollar dominance for politically popular reasons. So watch what people do, not what they say.