How the Yuan Could Become a Global Currency

China wants its currency, the yuan, to replace the U.S. dollar as the world's global currency. That would give it more control over its economy.

As China's economic might grows, it's taking steps to make that happen. Could we see a switch from a greenback- to a redback-dominated world? If so, how and when would that happen? What would be the consequences?

What Must Happen First

China is working hard to make the yuan the next global currency. Although presently a reserve currency, the yuan can’t upstage the U.S. dollar without several important scenarios taking place first, including:

• Central banks around the world choose to keep a total of at least $700 billion worth of yuan in foreign exchange reserves
• The People's Bank of China (PBOC) allows free trade of the yuan and relaxes its peg to the U.S. dollar
• The PBOC becomes straightforward about its future intentions with the yuan
• China’s financial markets turn transparent
• Chinese monetary policies are perceived as stable
• The yuan acquires the U.S. dollar’s reputation of stability, which is backed by the enormity and liquidity of U.S. Treasurys

How China Benefits from the Yuan as a Reserve Currency

Before the yuan can become a global currency, it must first be successful as a reserve currency. A reserve currency is one that is held in large amounts by governments and institutions as a supplement to national currencies.

Once the yuan is successfully established as a reserve currency, it would give China the following benefits:

• More international contracts could be priced in yuan, which would mean China would not have to worry so much about the dollar's value.
• All central banks would have to hold yuan as part of their foreign exchange reserves, which would place the yuan in higher demand and lower interest rates for bonds denominated in yuan.
• Chinese exporters would have lower borrowing costs.
• China would have more economic clout in relation to the United States.
• It would support President Jinping's economic reforms.

How the Yuan Is Becoming a Reserve Currency 

On Dec. 1, 2015, the International Monetary Fund (IMF) announced that it awarded the yuan status as a reserve currency. The IMF added the yuan to its Special Drawing Right basket on Oct. 1, 2016. This basket currently includes the euro, Japanese yen, British pound, and U.S. dollar. 

Why did the IMF make this decision? China’s leaders want to improve the standard of living and increase its economic output. The Chinese have pegged the yuan to the U.S. dollar but via an adjustable peg, or “managed peg.”

This floating peg has generally been on a downward trend since 2015, implying that the yuan has been steadily devaluing against the dollar, thus making Chinese exports relatively more competitive against dollar prices around the world. That allowed China's economic growth to soar thanks to low-cost exports to the United States.

As a result, China's share of international trade and gross domestic product grew to around 10%. This has been a source of trade friction between China and the U.S.

Central banks should increase their foreign exchange reserves of yuan to provide funds for that level of trade. Central banks alone should purchase about $700 billion worth of yuan. But banks never purchased all the euros they should have, even when the European Union was the world's largest economy. Most international transactions are still done in U.S. dollars, even though its trade has dropped. 

The IMF requires China to liberalize its capital markets. It should allow the yuan to be freely traded on foreign exchange markets. That allows central banks to hold it as a reserve currency. For that to happen, China's central bank must relax the yuan's peg to the dollar.

China must have clearer communications about its future actions regarding the yuan. That's what the Federal Reserve does for the dollar at each of its eight Federal Open Market Committee (FOMC) meetings.

Instead of a fixed exchange rate, the PBOC would set the yuan's value to its closing value on the previous day. Instead of rising, as many expected, the yuan fell 3% over the next two days.

The PBOC stabilized the rate. It now has the freedom to allow the yuan to be a stronger tool in monetary policy. The drop also silenced critics of China's reforms, many of whom were members of the U.S. Congress.

In December 2015, the Bank announced it would begin to shift the dollar peg to a basket of currencies. That basket includes the dollar, euro, yen, and 10 other currencies.

The Yuan Is Slowly Being Traded in Foreign Markets

Chinese leaders are beginning to make it easier to trade the yuan in foreign exchange markets. To do this risks more open financial and political systems. On March 23, 2015, China backed the Renminbi Trading Hub for the Americas. The renminbi is the name of China's currency system (yuan is the name of each individual unit of currency). That makes it easier for North American companies to conduct yuan transactions in Canadian banks. China opened up similar trading hubs in Singapore and London.

Former New York City Mayor Michael Bloomberg is Chair of the Working Group on U.S. RMB Trading and Clearing. It is creating a renminbi trading center in the United States. The group includes former U.S. Treasury Secretaries Hank Paulson and Timothy Geithner. Such a center would lower costs for U.S. companies trading with China. It would also allow U.S. financial companies to offer yuan-denominated hedges and other derivatives.

On June 8, 2016, China granted the United States a quota of 250 billion yuan, the equivalent of $38 billion, under China's Renminbi Qualified Foreign Institutional Investor program.

Can the Yuan Replace the Dollar?

The level of trade is not the only reason the U.S. dollar is the world's reserve currency. The strength of the U.S. economy instills trust. Most important are the transparency of U.S. financial markets and the stability of its monetary policy. 

On the other hand, Stuart Oakley, managing director of Nomura, pointed out in a 2013 article that China owns $4 trillion to $5 trillion of unallocated central bank reserves and these could be in yuan. As more bilateral swap lines are set up and China moves further down its path of capital market liberalization, central banks' appetite to own this currency will grow.

Could China's ambition to make the yuan the world's currency lead to a dollar collapse? Probably not. Instead, it will be a long, slow process that results in a dollar decline, not a collapse.