Scarcely a week passes without news about the ascendance of China’s currency, the yuan. However, China has a long way to go before its currency can rival — let alone displace — the US dollar as the dominant global reserve currency.
To be sure, China already plays a significant role in international trade and finance, with major financial centers like London and Frankfurt eagerly lining up for yuan business.
Recent speculation that China’s economy may soon be as large as the US’ has boosted this interest further, causing many to believe that the yuan will soon dominate.
Chinese authorities have launched a raft of reforms aimed at opening the economy and making it more market-oriented and have announced plans to liberalize interest and exchange rates, and continue to ease restrictions on cross-border capital flows.
All of this will strengthen the yuan’s claim to reserve-currency status.
However, China is missing one crucial ingredient: trust.
For currency dominance, China needs more than economic and military might; it requires a more credible set of public and political institutions. This is where the US shines, relatively speaking.
In the aftermath of the global financial crisis, even though the US’ financial markets nearly collapsed, its public-debt levels rose sharply and the US Federal Reserve was forced to undertake massive monetary expansion to support the economy, however the US dollar strengthened relative to most other currencies.
That is because global investors seeking a safe haven turn to US Treasury securities in times of global financial turmoil.
Foreign investors now hold more than US$5.7 trillion of these low-yielding securities, not to mention large quantities of other US dollar assets and the US dollar’s share in global foreign-exchange reserves has held steady since the crisis.
This can be explained partly because the US boasts the world’s deepest and most liquid financial markets.
However, the most important aspect of the US’ currency dominance is the institutionalized system of checks and balances that operates among the executive, legislative and judicial branches of its government.
Trust in US public institutions is rooted in the open and transparent democratic process that underpins them.
Freedom of expression and unfettered media bolster this confidence, not by highlighting the system’s strengths, but by exposing its weaknesses, which can then be addressed by responsive, rule-based mechanisms.
The US government must answer to its citizens, thus it is unlikely to resort to inflationary debt financing.
In fact, about US$4.5 trillion of US federal debt is held by domestic investors, including retirees, pension funds, financial institutions and insurance companies — groups with considerable political clout ensuring no administration would risk allowing inflation to spin out of control.
The US legal system — independent from the executive and legislative branches of government — further supports the US dollar’s global role.
While one might quibble about the complexity of US laws and regulations, it cannot be said that they are not applied relatively consistently.
This contrasts sharply with China’s single-party system, in which the level of government accountability is much lower. Official corruption, for example, has become so entrenched that Chinese President Xi Jinping (習近平) has made it a priority.
The reality is that, despite China’s economic heft and low central-government public debt, foreign investors are unlikely to trust China with large sums of money.
Capital inflows — which will undoubtedly increase in the coming years — are driven largely by investors’ interest in diversification and high yield, rather than the country’s image as a refuge from troubled financial markets elsewhere, especially given that China’s financial markets are relatively underdeveloped and beset by considerable risks.
Of course, some foreign central banks have signed currency-swap agreements with China and even hold small amounts of its currency in their reserve portfolios.
However, these actions may be less a sign of the yuan’s inevitable march toward global dominance than a low-cost bet on its likely emergence as a widely accepted international currency.
Also, countries’ desire to maintain good relations with China, owing to its rising economic power, cannot be discounted.
Depending on how soon China opens up its capital account and develops its financial markets, the yuan could become a significant reserve currency in the near future.
However, it will not contest the US dollar’s supremacy unless China’s leaders align the country’s political and legal institutions with its economic reforms.
Eswar Prasad is a professor at the Dyson School at Cornell University, a senior fellow at the Brookings Institution, and the author of The Dollar Trap.
Copyright: Project Syndicate
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