China | November 6, 2015 Written by Linda Lim. China’s currency, the yuan, recently (and briefly) became the world’s fourth-most-used form of payment, behind the US dollar, euro and pound sterling, having (marginally) pushed past the Japanese yen. Last week, China’s central bank discussed whether to make an explicit pledge to dismantle the capital controls that prevent the yuan from becoming fully convertible with other currencies at rates determined by the market. Does all this mean the yuan’s heyday has finally arrived? Hardly. As we will see, there is less significance to this phenomenon – and talk of the yuan becoming an “official IMF reserve currency” – than media headlines suggest. A drop in the bucket The yuan still accounts for a small fraction of world payments, 2.45%, to be precise in September after edging up to 2.79% – and fourth place – a month earlier. This is less than a third of the pound’s 9% share, a tenth of the euro’s 29% and a drop in the bucket of the dollar’s 43%. Another measure of a currency’s international prevalence is in foreign exchange reserves, which result from the accumulation of export surpluses. The yuan accounts for just 1% of other countries’ allocated reserves, compared with 64% for the dollar, even though China accounts for the same share of world trade (about 12%) as the US. In other words, the yuan is underrepresented in payments and reserves relative to its share of world trade, while the dollar is similarly overrepresented, due to the popularity among investors and governments of the US’ broad, liquid and secure capital markets. Market forces alone should lead one to expect the yuan’s share to rise and the dollar’s to fall over time. Matching the currency used in payments and receipts in trade and investment reduces transaction costs, currency risk and volatility exposure, so more people will want to use the yuan as their transactions with China increase. A shift away from trade China’s share of world GDP (13.3% in nominal terms as of 2014) will likely rise as its economy continues to outpace the average of other large economies. But use of the yuan for payments and reserves may increase at a slower pace as China shifts away from an economy fueled by trade. This is because China plans to reduce its reliance on export-led growth and increase domestic consumption as a share of GDP (which is currently very low). Though there are few signs of this happening so far, the plan, if successful, means that trade as a share of GDP will begin to shrink. And that will likely mean slower growth in use of the yuan than in the recent past. The difficult road to becoming a reserve currency To become an “official” IMF-endorsed “reserve currency,” China has to meet various criteria that would make the yuan “freely usable”: that is, readily bought and sold by anyone at any time. These criteria include a market-determined interest rate, exchange rate flexibility and convertibility, a more open capital account, and a significant share of official reserves, international banking liabilities and global debt securities. While many steps have been taken in these directions, including very recently, none of these criteria is close to being fully achieved. All this requires politically and technically difficult domestic financial market reforms and liberalization. Such reforms reduce the government’s ability to establish policies that reduce volatility and encourage growth. That’s because of what is known as the “trilemma” of international finance, in which only two of the three goals of monetary policy – control of interest rates, exchange rate flexibility and capital mobility – can be achieved at the same time. Market manipulations The Chinese government’s own reactions to this past summer’s financial market turmoilsuggest that it is not ready to undertake or complete many of the required reforms. Its interventions show that it is not yet willing to allow market forces to rule in its currency and financial markets. This includes its effort to halt the precipitous decline of an overvalued stock market – which it itself had previously boosted – and to devalue the yuan by the largest amount in two decades. Trust must be earned Even if the IMF designates the yuan as a reserve currency, this does not mean that its use as such will rise quickly or greatly. World central banks and individual investors will only increase their use and holdings of yuan if they have confidence in the currency. And that won’t happen until Chinese financial markets develop the depth, diversity, transparency and security that have kept the dollar reigning supreme as the world’s preferred reserve currency, even as the US share of global trade and investment has declined. Governments are understandably reluctant to hold reserves in a politically managed rather than market-determined currency. The trust of market actors has to be earned over time and cannot be merely conferred by an international body like the IMF. Benefits and disadvantages There are some benefits when a currency becomes more widely used in the global monetary system – its “internationalization” – regardless of whether it gets the IMF’s imprimatur. One benefit is “seignorage,” which is the revenue the issuer gets from the value of a currency over and above the cost of producing it. Others include a looser (more stimulative) monetary policy, enabling (marginally) faster growth, and the ability to borrow and invest internationally in one’s own currency, thus avoiding currency risk. But there are also disadvantages, including losing control over the effectiveness of monetary policy and exposing the domestic economy to destabilizing (and increasingly volatile) global capital flows. This is why small open economies like Singapore and Switzerland, whose currencies are popular with international investors, have long resisted internationalization. In contrast, China seems to regard reserve currency status as desirable for its own sake, as a “status good” conferring an assumed prestige that it craves. In the longer run, both China and the world economy stand to gain from increased international use of the yuan. China will benefit from the domestic financial market reforms that internationalization will require, and the rest of the world will get a more diverse basket of currencies to choose from to finance trade and investment and hold reserves, reducing the current overdependence on the US dollar. This should also help us avoid the chronic and excessive trade and financial imbalances among countries. But before we can get there, China needs to follow through on major reforms of its domestic financial system, which will not be quick, easy or certain. Linda Lim is a Professor of Strategy at the University of Michigan. This article was first published on The Conversation and can be found here. Image credit: CC by David Dennis/Flickr. Bao Zhuoxuan’s arrest and Mong La-China relations: Business as usual When Xi’s gone home: Where now for the UK-China relations?