How China's Yuan Can Become a Global Currency

(page 3 of 3)

These include regulators' latest announcements of plans to allow qualified foreign-invested firms to list on the Shanghai exchange next year, raise the investment limit per QFII to $1 billion from $800 million, and approve foreign banks to issue yuan-denominated corporate bonds. Likewise, in an unprecedented move, the Finance Ministry unveiled in September that in order to "promote the yuan in neighboring countries and improve the yuan's international status," it would help establish an offshore yuan bond market by starting to sell $879 million worth of yuan-denominated sovereign bonds in Hong Kong to foreign institutional and retail investors.

Despite these encouraging moves, it will take some years before China's capital markets can successfully transit to a more open and mature stage. According to the development strategies published by the CSRC in 2008, China will need roughly a decade to undergo "the drive to maturity stage" and build up well-developed capital markets. This would render full yuan internationalization unlikely before 2020.

Apart from the aforementioned "physical" factors fundamental to the internationalization of a currency, other "psychological" factors such as public confidence in the value of the currency also play a supporting role. Empirically, the stability of a currency can be gauged by its home economy's inflation rate, which for China averaged just 1.1% per annum from 1998 to 2007. A second way of assessing currency stability can be measured by the unit's exchange-rate volatility, which can be calculated as the standard deviation of daily percentage change in the exchange rate against the IMF's Special Drawing Rights (SDRs). Our calculation yields a score of 4.4 for the yuan during this period—lower than those of the dollar (4.5), euro (5.4), or yen (8.2).

However, despite its low volatility, the yuan lacks the foremost prerequisite to becoming a global currency: free and full convertibility. While the yuan became convertible for trade transactions and conditionally for foreign direct investment (FDI) in 1994, it has been largely nonconvertible for all portfolio capital transactions till now. Nevertheless, recent policy initiatives taken by the government have demonstrated the likelihood of a faster pace toward capital account convertibility. According to Guo Shuqing, former head of the State Administration of Foreign Exchange, the yuan would be convertible by 2010 for about 70% of the 43 capital transaction items under the IMF classification.

While chances are good that the yuan will evolve into a regional currency in the next few years, China is in no position to challenge the preeminent role of the U.S. dollar in the near future, despite some worries in the U.S. prompted by comments from Chinese Premier Wen Jiabao and others. In addition, out of concern for political, economic, and social stability, the Chinese government has adopted an extremely cautious approach toward financial liberalization. Therefore, it is not a sure conclusion that the government would have the political will to push forward aggressive reforms in capital markets, even though it has recently shown some interest in using the yuan for trade settlement. Furthermore, politically it is also not certain whether other countries would have the confidence to accept the yuan for various international uses, a currency issued by a country controlled by a Communist Party.

Friedrich Wun-Yuen Wu is adjunct associate professor of international political economy at the S. Rajaratnam School of International Studies of the Nanyang Technological University in Singapore. He is concurrently a (nonresident) senior research associate at the East Asian Institute, National University of Singapore.

Business Exchange

Track and share business topics across the Web.