THE RISE OF THE YUAN

Days before world leaders met in London to address the global economic crisis, China’scentral bank proposed replacing the US dollar as the world international currency with a new “super-sovereign reserve currency” under the surveillance of the International Monetary Fund. Followingthe 1971 “Nixon Shock” when President Nixon unilaterally ended the Bretton Woods fixed exchangerate system, the US dollar has maintained its special status as the world reserve currency. Since theUS dollar is perceived to have the lowest default risk among all the currencies of the world,governments and corporations demand US dollars as the standard store of cash and liquidity to usein times of crisis.

However, what if the leading global currency is under threat? Currently, there is no nationalcurrency that is an attractive alternative. China is in a precarious position as the largest holder of USfinancial assets with over $2 trillion of foreign exchange reserves, about half in US Treasury bondsand other government-backed debt. Therefore, the Chinese fear a weakened US dollar because itwill erode the value of Chinese investments.

If the status quo continues, the fiscal and monetary policies of the US government willgenerate inflationary pressure that may weigh down the value of the US dollar. As a result, Chineseinvestments will lose their value commensurate to the US dollar’s devaluation. The Obamaadministration is currently overseeing multiple government bailouts, stimulus spending, two foreignwars, and a potential overhaul of domestic programs. The only means of financing theseexpenditures is through borrowing. Now that the Chinese are diverting their savings towarddomestic consumption and investment, the US will have greater difficulties servicing our deficit. Infact, the gravest risk is the monetization of debt—the Federal Reserve has purchased US Treasurybonds in an effort to further reduce the cost of credit.

If the Chinese decide to transfer their foreign exchange reserves from US dollars to a basketof currencies, the outcome may be worse. The massive transfer would prompt other countries tolose confidence and to pursue the same policy. This wide-scale shift would create volatility in theglobal currency markets, negatively affect the US financial markets, and most importantly, will alsoweaken the US dollar.Given this context, Governor Zhou Xiaochuan of the People’s Bank of China, along with Premier Wen Jiabo have cautiously articulated their distress about China’s substantial holdings of US debt andtheir underlying fear of volatile global currency markets. Since there is no attractive alternative atthis time, Zhou has evoked the creation of an international reserve currency “that is disconnectedfrom individual nations and is able to remain stable in the long run.”

But nevertheless, China is currently globalizing the yuan and promoting its influenceoverseas, which may reflect ambitions to eventually supplant the US dollar as the world reservecurrency in the long-term. China has brokered deals with six countries, including South Korea,Malaysia, and Argentina for a currency swap arrangement to facilitate trade transactions. If thesedeals are repeated with other countries, the Chinese can effectively create a trading network thatwill use yuan and thereby bypass the US dollar. In addition, the Chinese are encouraging loans andinvestments to be made in yuan in order to spread its influence abroad; and even Chinese touristscontribute to this trend when they carry pocketbooks of yuan to their travel destinations.Both Western and Chinese analysts are predicting that the yuan will become the dominant reservecurrency by 2020. Tim Condon, the chief Asian economist for ING, agrees with this forecast, “That’sa reasonable time table…I see undesirable risk against the dollar and appreciation pressure on theChinese yuan.”

 Today, hip hop rappers in music videos fan out Euros as a sign of success, but one day wemay all have to bow down to the “All Mighty Yuan.”