For about seventy years, the U.S. dollar has been the currency of choice for central banks around the world when choosing how to allocate their foreign exchange reserves. Presently, the dollar makes up about 60 percent of global reserves. Its preeminent role as a store of value for foreign governments benefits America in a number of ways, not least of which is the ability for the U.S. government to borrow at lower rates than it would if the currency’s role were less prominent. Yet, pick up any article on the international monetary system written in the last five years and there is a good chance you will read the following refrain: The dollar’s halcyon days perched unchallenged atop the global reserve currency hierarchy may be ending.
Partially an unavoidable result of America’s relative economic decline and partially a consequence of American financial mismanagement as evidenced by the global financial crisis of 2008-2009, there is a growing chorus of experts saying that a multipolar international currency system will soon supplant the unipolar era of the dollar.
Another fad of late for global monetary system prognosticators is to peg China’s currency, the yuan (or renminbi), as the prime candidate to challenge the dollar for top currency status. Presently, very few central banks hold yuan (I have counted a total of eleven, though the list has been growing) and, those that do only keep a tiny fraction of their stock denominated in Chinese money. Still, that has not stopped some from saying the yuan can go “big time” in no time. Indeed, one recent study published by the Peterson Institute for International Economics predicted that it could become the world’s preeminent reserve currency within the next decade.
Of course, this is not the first time in history that speculators have predicted the currency of a rapidly growing, export powerhouse, East Asian economy would take on the dollar’s supremacy. In the 1970s, many observers of global monetary affairs made similar predictions about a coming “polycentric” global currency system pointing to the decline of the dollar after it lost the backing of gold earlier in the decade.
Like the yuan of today, the Japanese yen was viewed as a rising sun that could challenge the buck. Beginning around 1972, yen-denominated assets started showing up in central bank coffers and its presence expanded over the next decade. However, yen internationalization eventually stalled peaking in 1992 at only 8.2 percent of global reserves. So, does the Chinese “redback” stand a better chance at challenging the greenback today than the yen did decades ago?
Conventional wisdom holds that three broad conditions must be satisfied for a national currency to become widely used as a global reserve currency. First, the issuing country must have a substantial global economic presence, including a sizeable share of global GDP and world trade. Second, there must be international confidence in the stability of the currency’s value (which is dependent on price and political stability). Third, the currency must be convenient to use for international transactions, which is dependent on the issuing country having stable financial markets offering a broad range of instruments traded freely in large volume.
On the first point—having a sizeable international economic presence—both Japan of the 1970s and China of today score well. However, relative to one another, China’s structural economic position today is stronger than Japan’s was when the yen was first seen as a potential challenger to the dollar. China’s share of global GDP today is around 11 percent, which is actually nearly identical to Japan’s share when the yen debuted as a reserve asset. Yet, the yuan is advantaged by the fact that the America’s share of global GDP (nominal) today is lower than at any time since the dollar became the top reserve currency, dipping below 25 percent for the first time in 2008. Thus, relative to the country that issues the incumbent top currency, China is in a better spot today than Japan of four decades ago.
Currently, China’s share of global trade today is about 11 percent—considerably larger today than Japan’s 7 percent in 1972-1973. More importantly, China’s position in the global trading system relative to the U.S. is even more impressive. Early this year, the U.S. Commerce Department announced that in 2012 China had officially surpassed the U.S. as the world’s top trading state. For its part, Japan never came close to topping the U.S. in global commerce—even during its boom years in the 1980s. So, from a structural perspective, the yuan has a stronger starting position than the yen did years earlier and is clearly punching far below its weight class as a global reserve currency.
Structural positions aside, a key reason the yen failed to live up to its full potential as a reserve asset has to do with the fact that the Japanese government did little to encourage its use as such. Indeed, from the perspective of some scholars, Tokyo actively sought to hold the currency back, worried about the loss of autonomy that inevitably comes with issuing a global currency.
In particular, Japan never fully developed a market for its treasury bills—at least not one that could challenge the comparable market for U.S. Treasury notes. Treasuries are widely viewed by central banks as the appropriate instrument for foreign currency holdings as they are simultaneously liquid and entail no credit risk. More than a decade into the yen’s debut as a reserve asset, the market for Japanese treasuries was wrought with unnecessary transactions costs including taxes on selling the securities, tax withholdings on profits made, and significant restrictions on when securities’ transactions could be made.
By comparison, none of these same costs were imposed on participants in U.S. Treasury markets. Thus, despite Japan’s large and growing role in the world economy, central bankers found yen-denominated securities to be far inferior to the greenback status-quo.
So, what do we know about China today? Does it have global ambitions for the yuan? In the long run, the answer seems to be yes. China has taken steps recently to expand the yuan’s global role, particularly in international trade settlement. However, it still has a long way to go before any central bank will consider investing more than a marginal amount of its reserves in yuan.
Presently, the yuan remains an inconvertible currency and, therefore, holders of yuan know that they cannot exchange it—on demand—for any other asset (outside of China and a few relatively small offshore hubs). In short, the value of the yuan as a reserve currency will be severely limited until China can guarantee convertibility. Some reports have suggested this could be achieved as early as 2015, but that remains to be seen.
Finally, if Japan’s experience is any lesson to China, convertibility is not enough. The yen became fully convertible in 1980, but that did not catapult the currency to the top of the global currency hierarchy. China will need to develop stable, diverse, liquid, open, and deep financial markets where foreign investors—including central banks—can easily buy and sell yuan securities. Most importantly, China will need to focus on the development of a market for its treasury bills.
Structurally, the Chinese yuan is in a more advantageous position to challenge the dollar as top reserve currency than the yen was in the early-1970s. However, the Japanese story shows that more matters than size alone. For the yuan to thrive as a reserve currency, China needs to implement major financial reforms and—perhaps the most challenging part—make the market for yuan securities more attractive to central bankers than what they are accustomed to in America.
Bet your bottom dollar that is easier said than done.
Daniel McDowell is an Assistant Professor of Political Science at the Maxwell School of Syracuse University.