Shanghai Daily——A tradable yuan can weaken the dominant dollar

Author : Arne Jon Isachsen

BI Norwegian Business School

Previously he has taught BI-Fudan MBA Program　

If China’s trade with other countries was done using yuan instead of US dollars, the Chinese dependency of the US in this matter would disappear.　

While more than 90 per cent of imports to USA is invoiced in dollars (and an even larger part of exports), only a fraction of China’s trade is invoiced in yuan. In order to increase this share, China has the last couple of years made arrangements with a number of countries on exchange-agreements of currencies. The purpose is to facilitate the use of yuan as a currency for invoicing and settlement.

But what should the countries that accumulate a surplus in Chinese yuan do with this surplus? Leave it as a foreign currency reserve in the central bank? That would presuppose that the Chinese government opens for investing the funds into financial assets in China. If a gradual appreciation of the Chinese currency takes place, such reserves would give a good return. In addition there will be a diversification premium.　

But as long as the yuan is not fully convertible, the availability of financial assets remains quite limited. This makes the yuan less suitable as a reserve currency in other countries’ central banks.　

In March 2009 the Head of the People’s Bank of China openly shared his thoughts concerning the need for a reform of the international monetary system. He maintains that Special Drawing Rights (SDR), which is a drawing right that the International Monetary Fund (IMF) at irregular intervals grants their member countries, should replace part of the international role of the US dollar. The value of SDR is calculated on the basis of a basket consisting of four currencies; US dollars, Euro, Japanese yen and British pounds. Currently, SDR stands for seven per cent of the world’s total currency reserves.

SDR is almost never used in private transactions. Therefore it lacks liquidity. When SDR is used as settlement in transactions between countries it first has to be converted into a currency. Or as professor Charles Wyplosz puts it: ”SDR can be seen as a store of value waiting to be converted into dollars to be used as a medium of exchange.”　

The US dollar did not assume its role as the leading international currency by way of deliberate international decisions. Just as little as one can decide that Esperanto should replace English as the leading international language, can one decide that Chinese yuan, or Special Drawing Rights in the IMF for that matter, shall replace the US dollar as the leading international currency. One might wish for it. But that does not make it come true.　

If the dollar shall be dethroned from its position as the leading world currency it has to be through the emergence of better alternatives. Over time the Euro might play a larger part. And gradually also the Chinese yuan.　

However, it will most likely be one decade or two before the dollar’s leading position becomes threatened.　

One thing that may weaken the role of the dollar, though, is a persistently high American inflation rate. If such an inflation is mixed with relatively low American interest rates, central banks which sits on dollar reserves, like the People’s Bank of China (PBOC), will end up with decreased purchase power over time. For USA, on the other hand, inflation might be an appropriate means to reduce the real value of its national debt. Since other countries own a lot of this debt, it is a ”cheap” way for the Americans of dealing with their national financial problem. The scheme of Ben Bernanke, the Head of Federal Reserve, adding dollar liquidity to the market by buying back 600 billion dollars worth of American government bonds during the first eight months of 2011, facilitates an increasing American inflation.