The $1 Trillion Dollar Reserve-currency Decision

The RMB’s road to a major reserve currency comes with economic and geopolitical challenges. In the past, the value of the currency has caused major debates. These came to an end in May, when the IMF reported that the RMB was fairly valued, while urging Beijing to develop a floating exchange rate within three years.

Nevertheless, US Congress and the Treasury continue to argue that the RMB should be trading at higher levels against the dollar, due to China’s trade surplus, the plunge of oil prices, and rising Chinese productivity. These arguments are no longer persuasive, however.

The fall of the oil prices was triggered by the US shale revolution and the Middle East’s overcapacity. The US has had regional trade deficits for decades with East Asia (first with Japan, then with the Asian tiger economies, and more recently with China). And in the decade prior to recent turmoil, the RMB appreciated 30% against the dollar.

According to China’s central bank, foreign central banks held over $110 billion in RMB-denominated assets in April. Despite rapid RMB expansion, the starting-point is low. In 2014 total foreign exchange reserves amounted to more than $6 trillion.

Today, the RMB fulfills most basic preconditions of a reserve currency. China has become the second-largest economy in the world. Second, the RMB has evolved in an environment of low inflation, small budget deficits and stable growth. Third, the rise of the RMB as major reserve currency relies on strong institutional support. The fourth condition requires deep, open and well-regulated capital markets, which is why China is accelerating financial reforms. In April, Beijing pledged that the capital account liberalisation will occur by the end of the year.

China had hoped the RMB could be added in the IMF’s basket by January 1, 2016. However, in early August, the IMF was asked to delay its RMB inclusion until September 2016. The timing matters. Before the summer, Standard Chartered and AXA Investment Managers estimated that at least $1 trillion of global reserves will switch into Chinese assets when the IMF endorses the RMB as a reserve currency.

Toward Multiple-currency Reserves

In nominal terms, the size of the Chinese economy is likely to exceed that of the US in the 2020s. But size is not everything. While the US economy surpassed that of Britain in the late 19th century, sterling remained the preferred currency in international commerce and the dominant instrument for investments and sovereign reserves well into the early 20th century.

Things began to change after World War I, when the dollar surged in trade finance. As investors began to move from sterling to dollar and central banks started to expand their dollar reserves, the stage was set for a transition.

In the past half a decade, the RMB has achieved dramatic progress in commodities, trade, investment and sovereign reserves. It is increasingly central to commodity trading. The RMB’s catch-up with the Japanese yen and the British pound will take longer – and even longer to gain parity with the dollar and the euro, which still represent 45% and 28% of international payments, respectively.

Nevertheless, the RMB’s role as a major reserve currency is now a matter of time. In the short-term, the transition means increasing market volatility. In the medium-term, it has potential to support China’s rebalancing and thus growth prospects globally.

The RMB will be the first emerging-economy currency that will join the sovereign reserves. In that role, it will pave way to other major emerging-economy currencies in the future.

The author is a columnist with China.org.cn. For more information please visit: http://www.ccgp-fushun.com/opinion/DanSteinbock.htm

The original version of the commentary was released by The World Financial Review on Sept. 4, 2015.

Opinion articles reflect the views of their authors, not necessarily those of China.org.cn.