Following the increasingly robust recovery of the US economy, the US Federal Reserve is to conclude the third round of quantitative easing and raise the interest rate. This news caused exchange markets around the world to go south.
The Japanese yen fell against the US dollar by 1.2 percent two days in a row, while the euro fell by almost 1 percentage point. The Chinese yuan was less affected, but was not entirely invulnerable, falling by 0.03 percent.
This shows that the US dollar remains the most influential currency, and that all other currencies are restricted by its behavior to some degree. It is still a little early, then, to speak of the yuan challenging the US dollar.
Since the Chinese government started actively pushing for the internationalization of the yuan, the process has accelerated. As of the end of last month, China has signed bilateral swap agreements with 25 countries and regions, with 2.8 trillion yuan (US$456 billion) in foreign exchange reserves.
At the same time, the yuan can now be used as a clearing currency beyond Asia for the first time, including with its adoption in Europe: Many financial centers around the world, including Hong Kong, Tokyo and London, now offer yuan-denominated business services.
While the yuan is becoming more important, it is still not ready to be used as an anchor currency. According to calculations by us and Jason Yeh (葉家興), an associate professor of finance at the Chinese University of Hong Kong, the yuan currently ranks as the fifth international currency in terms of importance, with only the US dollar, the euro, the British pound and the yen ranking higher.
Last year, 3.1 percent of the world’s transactions were done in yuan. This internationalization index not only lags behind the pound and the yen at 10.8 percent and 10.2 percent respectively, it also trails far behind the US dollar, by 54.3 percent, and the euro, by 44.9 percent. These figures show that the US dollar and the euro are the predominant international currencies, widely applied in international transactions and investment, and used for foreign exchange reserves globally. The internationalization of the yuan is still in its infancy.
Nevertheless, with the prodigious increase of China’s financial clout, the potential is unmistakably there for the yuan to become an international currency. Between 2000 and last year, the yuan’s internationalization prospect index rose 4 percentage points, second only to the 6 percentage point increase of the euro in that same period, at a time when the other main currencies were exhibiting slight declines in their internationalization prospect index. That said, in the short term at least, it is unlikely that the yuan will catch up with the US dollar or the euro on the index. Last year, it stood at 14.8 percent compared with the US dollar and the euro at 36.4 percent and 37.3 percent respectively.
In addition to the rapid rise of Beijing’s international economic influence, the speed of the yuan’s internationalization depends on how much China’s national capital account is deregulated. According to World Economic Forum statistics, the capital accounts of the issuing nations of all of the world’s major international currencies are completely deregulated, whereas China’s, by contrast, is almost entirely controlled. Of course, Beijing is well aware that if it is to succeed in internationalizing its currency, it will have to completely deregulate its capital account.
However, there are risks, not least due to the shadow banking system, local government debt, and the housing and property bubble. These risks, if controls on the capital account are suddenly deregulated, could result in considerable capital flight, which could precipitate a financial crisis that China would find difficult to handle. For this reason, the liberalization of the yuan capital account might be put on the back burner for the time being.
With China’s economic rise, the yuan will eventually be on a par with its peers. However, the continued existence of controls on China’s national capital account and the well-established convention within the international community of using the US dollar and euro will slow down the rate at which its currency internationalization will happen. That is, until China deregulates its capital account, the US dollar and euro will continue to dominate the international currency system and the yuan will find it difficult to shake off the influence of the US dollar.
Tung Chen-yuan is a professor at the Graduate Institute of Development Studies at National Chengchi University. Wang Guo-chen is a doctoral student at the institute.
Translated by Paul Cooper
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