Is the Chinese yuan going to replace the US dollar?

It is no secret that the Chinese are aiming at making the Chinese yuan (also called Renminbi or RMB for short) an international trading currency.

As of mid-January, Chinese companies have been allowed to use the RMB to pay for investments outside the country. It has also become much easier for firms to use the RMB to settle cross-border transactions – just a year ago, the number of companies allowed to do this was around 350, which has now risen to nearly 70,000. For the first time ever, foreign investors are being allowed to invest in China using RMB.

All necessary steps that come as no surprise, according to Joerg Kraemer, head economist at the Commerzbank.

China has been taking small steps for several years, he says: "It has already introduced the RMB as the currency for trading with ASEAN states. And now it’s possible to hold accounts in RMB outside of China. Companies are also already issuing corporate bonds outside of China."

Kraemer says, however, that the yuan still has a long way to go before it can become an international currency. The RMB is not a freely convertible currency, but it will have to become one in order to become a global currency. However, that is not expected to happen before the end of 2012.

Competition

So why does China want to internationalize its money? Doris Fischer from the German Development Institute says that first and foremost it will give China an economic advantage.

"Secondly, it is of course symbolic if the yuan belongs to the world's reserve currencies. And China’s point of reference is always the US because it is the only superpower it wants to compare itself to. It also has a lot to do with prestige and international standing as well as potential influence."

A global RMB would create a number of changes. Experts assume that many Asian countries would peg their currencies to the RMB instead of to the US dollar. That would create a new world currency system, which would create new markets. It would also make it easier to invest in China, allowing foreigners to buy Chinese shares.

A wave of change would also be expected for the banks, which would create new products for their customers trading in RMB.

Even in the West, people would then be able to hold accounts in RMBs. "Customers would be in a better position to protect themselves from fluctuations in the RMB-euro exchange rate," says Kraemer.

What about the US dollar?

China certainly would benefit from currency changes allowing it its own monetary policies, as it is currently facing an overheated economy with large growth rates and soaring inflation. But what would it mean for the world’s current main reserve currency?

Nicholas Lardi from the Peterson Institute for International Economics believes that in the short and medium run, the plans will make very little difference. That is because the exchange rate is still tightly controlled by the monetary authorities in China, which still intervene massively in the foreign exchange market to keep the yuan from appreciating. Lardi expects it will take a very long time before the monetary authorities let loose.

"Over the long run, however, it probably would make quite a difference because I believe ultimately if the Chinese currency is to become internationalized, it will have to become convertible in capital account transactions," he says.

Lardi believes the Chinese are unlikely to open up their currency until their exchange rate is closer to an underlying equilibrium value. If China doesn't allow the exchange rate to appreciate before opening up the capital account, they will have massive inflows of money, expecting an RMB appreciation. And that could threaten China's goal of achieving price stability.

Author: Sarah Berning
Editor: Thomas Baerthlein