CRISIL YOUNG THOUGHT LEADER, 2010

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WILL CHINESE YUAN BECOME THE NEXT RESERVE CURRENCY?

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DISSERTATION POSTGRADUATE CATEGORY

BY

B.CHANDRASHEKAR
MBA (2009-2011) DEPARTMENT OF MANAGEMENT STUDIES, ANNA UNIVERSITY, CHENNAI

WORD COUNT: 2496 PAGES: 10 (Excluding Cover Page, Index, References and Bibliography)

INDEX
EXECUTIVE SUMMARY 1. INTRODUCTION 2. HOW DOLLAR BECAME A RESERVE CURRENCY? 3. RESERVE CURRENCY FACTORS 3.1 SIZE OF THE ECONOMY AND TRADE 3.2 FINANCIAL MARKETS 3.3 CONVERTIBILITY OF THE CURRENCY 3.4 RULE OF LAW 3.5 GEO-POLITICAL STRENGTH 3.6 NETWORK EXTERNALITIES 4. CURRENCY SWAP AGREEMENTS 5. SOME CONCERNS ON THE GROWTH OF CHINA 6. CURRENT STATUS OF RESERVES 7. CONCLUSION REFERENCES BIBLIOGRAPHY 3 4 4 4 4 7 8 8 9 9 9 10 11 12 13 13

EXECUTIVE SUMMARY:

Due to the recent financial crisis, the strength of the dollar and its status as the reserve currency are in question mark. China being the fastest growing economy and with increase in its share of trade, the focus is on yuan today. This paper starts with a brief historical look at how dollar became a reserve currency. Then the important factors that act as a prerequisite for a currency to attain reserve status are analysed individually. The size of the economy, trade, current account balance, government debt etc of China is compared with that of the US. Also the factors like openness of financial market, currency convertibility, rule of law, geo-political strength and network externalities are studied. The conclusion is drawn for each and every factor, indicating whether the yuan fits the bill or not. The steps being taken by China, importantly the currency swap agreements with its trade partners are highlighted and the current reserves holding pattern is graphed. Though China is growing rapidly, some concerns on whether it can sustain its growth in the future too are discussed. In the end, considering all factors, it is concluded that China has to take some drastic policy changes in the areas of capital account convertibility, opening financial markets, improving rule of law etc. to be treated as a worthwhile competitor to dollar. Even if it meets all prerequisites, factors like network externality and geo-political strength being tilted in favour of dollar, and possible pace of policy changes, it is concluded that yuan can become an important currency but cannot surpass dollar in the near future.

1. INTRODUCTION:
US dollar has been the reserve currency for many years due to its stable economy. Owing to the recent global financial meltdown, this has been challenged. Global leaders have started stressing the importance to find an alternative to dollar. After the advent of euro, it contributed to most of the international transactions, only next to the dollar. But due to the raising concerns in euro zone especially in countries like Greece, Portugal, Italy, Spain and Ireland which are in deep financial distress, the focus is now being shifted towards yuan. China is poised to grow rapidly as it has been doing for last three decades and it has emerged as an economic power that has a large contribution to the international trade. Will yuan become the next reserve currency challenging dollar? Is China ready?

2. HOW DOLLAR BECAME A RESERVE CURRENCY?

Post World War II, the Bretton Woods system gave rise to the pegging of dollar to the gold. All other currencies were pegged to the dollar. But this system collapsed after President Richard Nixon, in 1971 announced that the dollar would no longer be pegged to gold. This came as a shock, but still dollar continued to rule the world, because the world at that time had no other alternative and oil trade was basically carried out on dollar terms which kept the demand for dollar intact. Network externality also played a part in sustaining the hegemony of dollar.

3. RESERVE CURRENCY FACTORS:

A reserve currency should play the following roles: Store of value Medium of exchange Unit of accounting There are various factors that determine whether a currency can be a reserve currency or not. Some of them are quantitative while some are qualitative.

3.1 SIZE OF THE ECONOMY AND TRADE: China has surpassed Japan in second quarter, 2010 (Q II nominal GDP figures: China - $1.337 trillion, Japan - $1.288 trillion) to become the second largest economy. China

has been growing at an astounding rate, the fastest growing economy in the world and expected to surpass US around 2027 [1].
Chart 1 - GDP in current prices
16 14 Trillions of US $ 12 10 8 6 4 2 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 Year Source: IMF China US

When we look at the trade data, the chances for Chinese yuan look brighter. Table 1: Trade Data Merchandise Trade (2009) Rank in world trade (exports) Rank in world trade (imports) Share in world total exports Share in world total imports Trade per capita (US$, 2007-2009) Trade to GDP ratio (2007-2009) Source: WTO Table 2: Major Trade Partners of China Exports EU (27) US Hong Kong Source: WTO China is the second largest exporter to the US, next to EU. The pattern is clear that the China is catching up with the US and has a good chance that it will surpass the US in the coming years. % of overall exports 19.70% 18.40% 13.80% Imports Japan EU (27) Republic of Korea % of overall imports 13.00% 12.70% 10.20% China 1 2 9.62% 7.93% 1921 58.6 3 1 8.45% 12.66% 12728 27.3 US

Chart 2 - Total Merchandise Trade

4000 3500 US$ billions 3000 2500 2000 1500 1000 500 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 Year Source: WTO China US

Apart from GDP and trade, it is worthwhile to compare other economic indicators like general government gross debt, current account balance etc. Table 3: Gross Debt and Current Account Balance Indicator (2009) General government gross debt, US$ (billions) China 926.88 US 11896.59 84.259 -378.434 -2.68

As % of GDP 18.595 Current Account Balance, US$ (billions) 297.1

As % of GDP 5.96 Source: IMF

Chart 3 - General Government Debt
90 80 70 60 50 40 30 20 10 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 Year Source: IMF

Debt as % of GDP

China US

The US debt position is very high compared to China and the current account balance is negative for the US. China is a net exporter, while the US is a net importer. All these indicators point to a very weak US economy and add to the chances in favour of yuan.

Chart 4 - Current Account Balance

600 400 US $ billions 200 0 -200 -400 -600 -800 -1000 Year Source: IMF 2001 2002 2003 2004 2005 2006 2007 2008 2009 China US

3.2 FINANCIAL MARKETS: The index of capital account liberalization first generated by Chinn and Ito (2008) is used to measure the degree of openness to global financial markets [2]. The Chinn-Ito index (KAOPEN) is an index measuring a countrys degree of capital account openness. The index was initially introduced by Chinn and Ito, Journal of Development Economics, 2006. China is ranked 113 in the total of 182 countries for the period 1984 to 2008. Table 4: KAOPEN index for major economies Country China France Germany Japan UK US KAOPEN -1.14 1.45 2.50 2.50 2.50 2.23 Rank 113 67 1 1 1 57

Table 5: Summary of Chinn & Ito KAOPEN index Summary Statistics: Full Sample Industrialized Countries Developing Countries Emerging Markets Minimum -1.83 -1.83 -1.83 -1.83 Mean 0.00 1.23 -0.22 -0.22 Median -0.60 1.70 -1.14 -0.87 Maximum 2.50 2.50 2.50 2.50 Standard Deviation 1.52 1.40 1.43 1.43

China does very poorly when it comes to open financial markets. When we compare with US, Japan or other Euro countries, it lags far behind. It is well below the mean values for developing countries and emerging markets. From the illustrations below (Charts 5&6), it is clear that the daily foreign exchange turnover in China is midget compared to the UK or the US. To add to this, there is no deep domestic bond market in China. This is because of two factors: the government has leaned on banks to assist in lending and has used direct quantity and price controls in the conduct of monetary policy [3].
Chart 5 - Currency Distribution of Global Foreign Exchange Market Turnover - % of Shares of Average Daily Turnover in April 2010
84.9 Source: BIS Percentage 100 Percentage 80 60 40 19 20 0 US dollar Euro Yen Sterling Yuan Source: BIS
(As tw o currencies involved in each transaction, sum total of all currencies w ill be 200%)

Chart 6 - Global Foreign Exchange Market Turnover Daily Averages in April 2010
40 35 30 25 20 15 10 5 0 36.7

17.9 6.2

39.1 12.9 0.3

0.4 China

2.1

4.7

France Germany

Hong Kong

Japan

UK

US

There has to be some drastic improvement in these areas to make yuan a worthwhile contender for reserve currency.

3.3 CONVERTIBILITY OF CURRENCY: The yuan is not convertible and there are tight capital controls. Central banks would not be interested in holding a large amount of a currency if they would not be able to sell it or trade it without any limits. Thus, if at all China wants yuan to give competition to the dollar and aims to make it a reserve currency; it has to make yuan convertible. An Asian Development Bank study points out that in the future, the yuans share will be insignificant despite the significant share of China in world GDP if it fails to make yuan convertible [4].

3.4 RULE OF LAW: Though there are various indicators to measure the rule of law in a country, here we use the strength of legal rights index. This index measures the degree to which collateral and bankruptcy laws protect the rights of borrowers and lenders and thus facilitate lending. The index ranges from 0 to 10, with higher scores indicating that these laws are better designed to expand access to credit.

Table 6: Strength of legal rights index for major economies: Country China France Germany Japan UK US World 2005 4 4 8 7 9 8 5 2006 4 6 8 7 9 8 5 2007 4 7 8 7 9 8 5 2008 6 7 7 7 9 8 5 2009 6 7 7 7 9 8 5

Source: World Bank Though there is political stability in China, the rule of law index indicates that the foreigners may be unwilling to invest there as it scores poorly in comparison with the US or other Euro countries. In this area, China has a long way to go.

3.5 GEO-POLITICAL STRENGTH: Post world war, the US enjoyed the advantage of being a superpower when the world became populated with dollar. So was the case with pound sterling and the UK, when it colonized countries and promoted trade. We do not see a similar situation now, nor can we expect in the near future.

3.6 NETWORK EXTERNALITIES: The network externality effect is heavily tilted towards dollar. The incumbent reserve currency will have a natural tendency to remain dominant, and it will be very difficult for any new currency to replace the incumbent altogether. Each country is more likely to use whatever currency is used by others. Higher will be the value of a currency when more people use it. There is an inertia that stops countries from switching to a new reserve currency swiftly. So the switch will happen only gradually. This is a reason why it took many years for dollar to replace sterling as reserve currency though US economy surpassed Britain in 1872.

4. CURRENCY SWAP AGREEMENTS:

So far we have analysed each and every factor and concluded where China stands. Now let us see some measures being taken by China to popularize its currency. 9

Peoples Bank of China has entered into bilateral currency swap agreements with central banks of various countries so that they can trade using their own currencies. Table 7: Currency Swap Agreements Partner Bank of Korea Amount Date December 12, 2008 January 20, 2009 February 8, 2009 March 11, 2009 March 23, 2009 April 4, 2009 July 23, 2010

180 billion yuan / 38 trillion KRW Monetary Authority of Hong 200 billion yuan / 227 billion Kong HK dollars Bank Negara Malaysia 80 billion yuan / 40 billion MYR National Bank of the 20 billion yuan / 8000 billion Republic of Belarus BYR Bank Indonesia 100 billion yuan / 175 trillion IDR Central Bank of Argentina 70 billion yuan / 38 billion ARS Monetary Authority of 150 billion yuan / 30 billion Singapore Singapore dollars Source: Peoples Bank of China

Apart from this, Chinese Central Bank Governor Zhou Xiachuan has suggested replacing the dollar as international currency with a basket of currencies supervised by the IMF.

5. SOME CONCERNS ON THE GROWTH OF CHINA

Though China is poised to overtake US as the largest economy around 2030, there are various concerns being raised against China. The question is whether China will get old before it gets rich due to increasing longevity and one child policy being followed for years. Per-capita GDP even with most optimistic scenario will be very less compared to that of the US, Japan or Germany in 2030 [5]. Many studies suggest China to overtake the US in coming decades, but a word of caution was raised by Paul Krugman [6]. Krugmans argument was that these kinds of predictions were bound to fail because they ignored the intangible forces: the multipliers of innovation, technology and competitive efficiency. When the World Bank estimated in early 90s, that by 2010, Chinese economy would be a third larger than that of the US, Krugman rightly concluded that this prediction would fail. Still Chinese economy continues to be less than 40% of the US.

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China had pegged its currency to the dollar till 2005, and again from October 2008. It is artificially keeping its currency value very low to gain competitive advantage in exports. This will pose a problem in long run not only for China, but for the global economy as a whole [7]. China has to adopt some drastic policy changes in this area. China is following the path of export led growth. Japan, followed a similar strategy but could not sustain its growth and the bubble burst in late 1980s. It went through a lost decade through the 90s. The asset price burst was the main reason behind that. China too may have to bear a similar brunt, if careful macroeconomic policies are not formulated immediately. If Chinese economic bubble bursts, then there is no question of yuan becoming a reserve currency at all.

6. CURRENT STATUS OF RESERVES:

Table 8: Currency Composition in %
Currency US dollars Sterling Yen Swiss Francs Euro Others 2001 71.51 2.70 5.05 0.28 19.18 1.28 2002 67.08 2.81 4.35 0.41 23.80 1.55 2003 65.93 2.77 3.94 0.23 25.16 1.97 2004 65.95 3.37 3.83 0.17 24.81 1.88 2005 66.91 3.60 3.58 0.15 24.05 1.72 2006 65.48 4.38 3.08 0.17 25.09 1.80 2007 64.13 4.68 2.92 0.16 26.28 1.84 2008 64.09 4.01 3.13 0.14 26.42 2.21 2009 62.17 4.28 2.94 0.12 27.40 3.10 2010 (Q II) 62.11 4.22 3.31 0.11 26.48 3.77

Source: IMF and authors calculations The dollar forms major chunk of the reserve, but well below its share in 2001. For the last ten years, we have been seeing a decline of around 10% in the dollar reserve. Euro has been consistently increasing its share, so is the pound sterling but yuan is not even in the picture.
Chart 7 - Currency Composition of Foreign Exchange Reserves
80.00 70.00 60.00 50.00 40.00 30.00 20.00 10.00 0.00
20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 2 20 0 0 10 9 Q II

Chart 8 - Total Allocated and Unallocated Reserves Share

120 100 80 60 40 20 0
20 01 20 02 20 03 20 04 20 05 20 06 20 07 20 08 2 20 0 0 10 9 Q II

% of Currency

Percentage

US dollars Euro Other currencies

Unallocated reserves Other Currencies Euros Swiss francs Japanese yen Pounds Sterling U.S. dollars

Year Source: IMF

Source: IMF

Year

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7. CONCLUSION:
There is no doubt that China is going to be an important country in world economy in the coming years. If all the concerns about the Chinese economy pointed out above are answered by careful macroeconomic policies, there is a good chance that China will surpass the US before 2030. Though some prerequisites like size of the economy, trade etc are tilted in favor of yuan, unless issues in relation to the openness of financial markets, domestic bond market and convertibility are addressed, it will be difficult for yuan to give competition to dollar. The pace with which China will carry out these reforms is a question mark. Apart from that, geo-political strength and network externalities are equally important factors working against the chances of yuan. Chinas major trading partners (Table 2) are EU, the US, Japan etc, which are unlikely to use yuan. Since diplomatic and military factors are also important, oil exporters will think twice to give up dollar because of their ties with the US. Yuan cannot completely replace or surpass dollar or even euro in terms of percentage holdings. If China moves to capital account convertibility, opens up the financial markets more, creates a deep domestic bond market, improves the rule of law and finally, maintains the high growth path in the coming decades, we can expect the future to be tripolar (dollar, euro and yuan) with yuan occupying an important position. Right now, yuan is far from ready.

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REFERENCES:
[1] BRICs and Beyond, Goldman Sachs Global Economics Group, 2007. [2] Ito, Hiro and Chinn, Menzie. Notes on the Chinn-Ito Financial Openness Index, 2008 Update, August 5, 2010. [3] Bonding the BRICs: The Ascent of Chinas Debt Capital Market, Chapter Fifteen, BRICs and Beyond, Goldman Sachs Global Economics Group, 2007. [4] Lee, Jong-Wha, Asian Development Bank. Will the Renminbi Emerge as an International Reserve Currency? June 2010. [5] Will China Grow Old Before Getting Rich? Chapter Three, BRICs and Beyond, Goldman Sachs Global Economics Group, 2007. [6] Krugman, Paul. The Myth of Asias Miracle, Foreign Affairs; November/December 1994. [7] Rajan, G.Raghuram. Fault Lines, How Hidden Fractures Still Threaten the World Economy, pages 217-221, Collins Business, 2010.

BIBLIOGRAPHY:
JOURNALS, PAPERS AND REPORTS: 1) Chinn, Menzie and Frenkel, Jeffrey. Why the Euro Will Rival the Dollar. International Finance 11:1, 2008. 2) Deutsche Bank Research, Yuan as a reserve currency, Likely prospects & possible implications, July 16, 2010. 3) Papaioannou, Elias and Portes, Richard. Costs and benefits of running an international currency. European Economy, Economic Papers 348, November 2008. BOOKS: 1) Bahl, Raghav. Superpower? The Amazing Race between Chinas Hare and Indias Tortoise. Penguin Allen Lane, 2010. 2) Ferguson, Niall. The Ascent of Money, A Financial History of the World. Penguin Books, 2009. WEBSITES: http://www.imf.org/external/data.htm http://www.wto.org/ http://data.worldbank.org/ http://www.bis.org/publ/rpfx10.pdf http://www2.goldmansachs.com/ideas/brics/index.html http://www.pbc.gov.cn/publish/english/963/index.html http://web.pdx.edu/~ito/Chinn-Ito_website.htm NEWSPAPERS, MAGAZINES AND OTHER ARTICLES: 1) China takes a small step away from the dollar TIME. Retrieved from: http://www.time.com/time/business/article/0,8599,1889587,00.html 2) China's Yuan: The Next Reserve Currency? BusinessWeek. Retrieved from: http://www.businessweek.com/globalbiz/content/may2009/gb20090522_665312.htm 3) Chandy, Jacob. The Hindu Business Line: End of dollars hegemony? March 31, 2009. Retrieved from: http://www.blonnet.com/2009/03/31/stories/2009033150070800.htm 13

4) Dhuddu, Adhvith. The Hindu Business Line: Perilous state of the dollar. May 19, 2009. Retrieved from: http://www.blonnet.com/2009/05/19/stories/2009051950050900.htm 5) Foroohar, Rana. Everything You Know About China Is Wrong. Newsweek, October 17, 2009. 6) Gurumurthy S. The Hindu Business Line: What is the alternative to the dollar? April 22, 2010. Retrieved from: http://www.thehindubusinessline.com/2010/04/22/stories/2010042250220800.htm 7) Venkitaraman S. The Hindu Business Line: China proposes to dethrone the dollar. April 6, 2009. Retrieved from: http://www.blonnet.com/2009/04/06/stories/2009040650170800.htm 8) Yuan starts on long slog to reserve currency status | Reuters. Retrieved from: http://www.reuters.com/article/idUSTRE5650W720090706

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