A reserve currency constitutes a currency that is held by other countries as part of foreign exchange reserves, and typically will also be the currency used for the pricing of global commodities.
There are two central advantages offered to a country which issues the currency that is used by the rest of the world as a reserve currency. The first of these is that if global commodities have been priced using the global reserve currencies, then the issuing country does not have to pay transaction fees for currency conversion. This is recognised as being a relatively minor advantage. The second advantage is that the issuing country will generally be able to borrow money at a more favourable rate, due to the fact that there will always be a guaranteed market for that currency. Reisen (2009) identifies that the this additional demand for money creates seigniorage revenues; and that as a result the US Fed claimed $43 billion in net interest. The Economist equates this to an interest-free loan by the public to the central bank (Economist 2009). If the Renminbi was accepted as a reserve currency, China would benefit from these elements instead.
A further advantage for China would be a greater guarantee of strength in China’s financial reserves. LeVine (2009) identifies that Beijing holds $2 trillion in dollar assets, but that the weakening of Treasuries and the dollar could result in significant losses by China. Conversely though, if the dollar was rejected by China and the world as a reserve currency, then this action would guarantee that the value of these reserves would fall in the short term. This latter obstacle is not necessarily insurmountable though. LeVine (2009) identifies that if reserves are shifted slowly from long-term Treasuries to short-term US bonds, the move from the dollar would be more palatable – though this clearly indicates that any move to an alternative reserve currency would be slow.
There are also significant doubts about the viability of introducing the Renminbi as the world’s reserve currency, with critics arguing that even if China did push to forward the Renminbi as a reserve, it would not be accepted. The first obstacle to the introduction of the Renminbi would be that the US dollar has become significantly entrenched in its role as reserve. It is identified that sixty-four percent of the world’s official foreign exchange reserves are currently held in US dollars; roughly 88% of daily foreign exchange trades involve US dollars (Humpage, 2009). However, doubt has been expressed by governments and critics regarding the strength of the dollar, and in particular they are concerned about the concept of inflation as a result of the US’s policy of quantitative easing during the recent economic crisis (Reisen, 2009). This may mean that the markets are more receptive to change than might have been previously envisioned.
The second major obstacle would be the need for the Renminbi to become a convertible currency that could be traded globally, and thus subject to market forces. This would require a significant shift in the structure of China’s financial markets, requiring them to relinquish a great deal of control that is currently held centrally by the Chinese government – lowering financial trade barriers and allow access by foreign investors to the domestic securities markets. Commentators such as LeVine believe that this is an unrealistic expectation of a country which maintains fierce control over its markets. However, more recently there have been indications that the Chinese government are making attempts to reduce reliance on the dollar, and potentially make the Renminbi freely convertible within the next few years. It is clear that other Central Banks will not hold any large sum of currency which is subject to restrictions in trade and sale.
As a further issue, there is the question of whether foreign investors would ever be able to place trust in a country – its politics and economy – that is yet to achieve a model of free markets to parallel that of Western countries, and is still somewhat entrenched in state-dominated control and credit-allocation, and is not unfamiliar with deceptive and secretive modes of operation. However, Reisen (2009) argues that if historical parallels are used a comparison, with the example of the last switch from the British Pound to the Dollar, the change is inevitable, due to the switch in net debtor/creditor positions. Trust will fall into second place in consideration against economic drive, so long as the conditions outlined above (such as convertibility) are met.
Through analysis of the various issues surrounding the Renminbi as a future reserve currency, it can be said that its status remains uncertain. However, it is apparent that previous absolute assertions of its inability to constitute the new reserve currency have been eroded, and there are increasing (though still tentative) predictions of it toppling the dollar at some point within the next 50 years.
1. Reisen (2009) Shifting US Wealth: Is the US dollar empire falling?, VoxEU.org, 20th June
2. LeVine (2009) China's Yuan: The Next Reserve Currency?, Bloomberg, May 26th
3. The Economist (2009) The Hedge Fund of Foggy Bottom, The Economist, 30 April
4. Humpage, (2009), Will special drawing rights supplant the dollar?, VoxEU.org, 8 May.
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