How China's Yuan Can Become a Global Currency

Despite the strength of China's economy, the yuan lacks the foremost prerequisite for a global currency: free and full convertibility

By Friedrich Wu

With the rapid economic ascent of China, the explosion of the global crisis, and the discrediting of the U.S. and European financial models, there has been growing speculation on the future role of China's currency, the yuan. Recent new policy initiatives adopted by Beijing toward its own currency and statements by senior officials of the People's Bank of China (PBOC) (who have recently become increasingly vocal in world forums on the need of economies to rely less on the U.S. dollar as a reserve currency and for trade settlement) have fueled the debate further.

What does it mean for a currency to be global? To gain international stature, there must be strong demand by world traders, investors, and central bankers for the currency as a medium of exchange for foreign trade settlement, a unit of account for denominating international financial transactions, and a store of value for central banks' foreign exchange reserves. Economists generally agree there are three pillars for the internationalization of a currency: the size of the country's economy and its trade volume; the breadth, depth, and liquidity of its capital markets; and the stability and convertibility of its currency.

China certainly meets some of those criteria. In terms of economic strength, China's breakneck growth rate since the beginning of the 21st century has helped the country surpass Germany and become the world's third-largest economy. Only the U.S. and Japan are larger. Goldman Sachs (GS) has projected that China will overtake the U.S. to become the world's largest economy by 2027, should China manage to continue to grow at its current rate.

Population Still in Penury

However, a large gross domestic product is not necessarily equal to a wealthy or healthy economy. Despite its No. 3 world ranking in absolute economic size, China remains far behind the other leading economies in average per capita income level. In the long run, even though China's GDP per capita is projected to surge exponentially, to $49,650, by 2050, up from $2,430 in 2007, it will still lag far behind that of the U.S. ($91,683) and many other developed and emerging economies, according to Goldman Sachs.

Furthermore, despite optimistic projections of China's future growth potential, its economy is still beset by numerous imbalances and risks in the medium term. These include, among other problems, persistent and widening regional economic disparities and rural-urban income inequality, rising social unrest and inter-ethnic conflicts, rampant corruption, and serious environmental degradation. An eruption of any one of these, or a combination of several "fault lines," could put a sharp brake on the ascent of the Chinese economy and concomitantly propel the yuan onto an inordinately volatile trajectory.

In terms of trade volume as a share of the world total, China's ratio was 5.1% in 2007, having already overtaken Japan and Britain in 2004. In the first half of 2009, the World Trade Organization reported that China had surpassed Germany to become second only to the U.S. among the world's largest exporting nations.

Accompanying the surging foreign trade is the expanding trade settlement by the yuan, which has already evolved into a major currency for cross-border trade settlement with neighboring countries such as Cambodia, Mongolia, Russia, and Vietnam. At the end of 2008, the Chinese government announced pilot programs allowing Guangdong province in southern China and the Yangtze River Delta in the eastern part of the country to use the yuan to settle trade deals with Hong Kong and Macao. A similar arrangement is under consideration to allow southern Guangxi and Yunnan provinces to use the yuan to settle trade accounts with select member-countries of the Association of Southeast Asian Nations (ASEAN).

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