The choice facing China as yuan becomes more global

Being a world financial hegemon comes with meaningful costs, not just benefits

The question is whether China is content to have a global reserve currency, or if it aspires for the yuan to be as important to trade and finance as the US dollar is now.
The question is whether China is content to have a global reserve currency, or if it aspires for the yuan to be as important to trade and finance as the US dollar is now.PHOTO: EUROPEAN PRESSPHOTO AGENCY

There is surely some clinking of champagne glasses, or perhaps a Chinese celebratory equivalent, taking place in the hallways of China's finance ministry and central bank. Those officials will now be the proud guardians of a "global reserve currency" after a long-sought decision on Monday by the International Monetary Fund (IMF).

But they will soon find that the step raises more questions than it answers about China's role among nations and that the hardest decisions lie ahead. Being a world financial hegemon comes with meaningful costs, in addition to benefits.

The direct implications of the IMF decision are narrow. The yuan (also known as the renminbi) will join the US dollar, euro, yen and pound in an elite group of currencies. But if you're not a reserve manager for some national treasury seeking to build emergency savings to buffer the vicissitudes of global finance, the direct impact of China's inclusion in "special drawing rights" is limited.

The big question for the future is whether this is akin to what happened about a century ago, when the US dollar was gradually supplanting the British pound as the predominant currency for global trade and finance. This development was a crucial piece of the nation's rise to superpower status. Conversely, China's leaders in the years ahead could decide that being a world financial hegemon carries too many costs, in which case the yuan will be more like the British pound or Japanese yen - important currencies, certainly, but not so important as to create continuing political and economic burdens on their nations.

The decision for China is whether it is content to have a global reserve currency, or if it aspires for the yuan to one day be as important to trade and finance as the US dollar is now.

These are both benefits and costs in being the leading global reserve currency: the default currency for world trade and financial transactions, the most widely used unit for savings, and so on. Understanding these pluses and minuses is essential to understanding the tensions China faces as it decides how far it wishes to go down the road of financial liberalisation and leadership in the world economy.


Remember when the global financial system nearly melted down in 2008 because of problems centred in the United States housing market and banking system? That's the kind of crisis that in most countries would prompt a currency crisis and sharp outflow of capital, making a dire situation worse.

In that miserable fall of 2008 though, the US dollar actually soared. Treasury bonds were in such hot demand that US interest rates plummeted. The United States' role as the bedrock of the global financial system was a crucial reason a terrible situation didn't become worse; when things went bad, the United States - and especially its government debt - was a beacon of safety.

Even in times of non-crisis, the country that is the leading global reserve currency will tend to have a stronger currency and lower interest rates than it would otherwise, thanks to continuing purchases of its assets by individuals, companies and other nations.

Then there's geopolitics. Ownership of the premier global reserve currency gives a country sway in global politics and security that are hard to obtain any other way. In the last few years, the United States has enforced economic sanctions on countries including Russia, Iran and North Korea, and waged outright financial war against what it considered to be terrorist groups.

In effect, any bank that facilitates the transfer of money in violation of those sanctions risks being cut off from global transfer of US dollars - which in turn means being cut off from much of the global economy.

Analysts at the Eurasia Group have called this the "weaponisation of finance", and it is one of the important ways that financial supremacy and geopolitical supremacy go hand in hand for the United States.

Surely China might like to have a similar scale of influence on global affairs, but to do so it would need the yuan to be as fundamental to finance as the dollar. Which raises the reasons not to do that.


It may be a cliche to observe that with great power comes great responsibility, but here it applies. The US enjoys what's been called an "exorbitant privilege" from the dollar's central role in global finance, but researchers have also taken to calling it an "exorbitant duty". Essentially, the price the United States pays for that role is having fewer tools to manage its domestic economy.

China has long restricted the ability of businesses and individuals to transfer funds in and out of the country, helping it prevent huge economic swings as investors' interest in investing in China waxes and wanes.

It has made exports central to its economic development strategy, using market interventions and those capital controls to keep its currency undervalued relative to fundamentals, at least until recently.

Contrast that with the United States. Pretty much anyone, anywhere can buy a US Treasury bond, for any reason. The US dollar rises or falls based on market forces, and on net is probably stronger than it otherwise would be because of the reserve currency role. That leaves American exporters at a perpetual disadvantage.

Chinese officials seemed caught by surprise this summer when decisions to liberalise trading in their currency and prop up their domestic stock market caused widespread ripples through global markets. This is one of the more subtle costs of becoming a major player on the global financial scene: Your actions don't affect just you.

Part of the reason the US dollar is so important is that the United States has legal, political and monetary institutions that make international investors and business people feel confident they can always get easy access to money traded in dollars.

The US government has control in some areas (economic sanctions for geopolitical foes, for example) because it gives up control in many others (exchange rate, capital flows, legal protections for foreign investors).

The question for China's political leaders is whether that trade-off is worth it.

"The yuan will not be seen as a safe-haven currency unless economic reforms are accompanied by broader legal, political and institutional reforms that are necessary to inspire the trust of foreign investors," said Professor Eswar Prasad, an economist at Cornell and author of The Dollar Trap, in an e-mail.

"China's government has made it abundantly clear that such reforms are not on the cards."

Still, financial history moves slowly, and Monday's action from the IMF is one more baby step towards China's financial pre-eminence.


A version of this article appeared in the print edition of The Straits Times on December 03, 2015, with the headline 'The choice facing China as yuan becomes more global'. Print Edition | Subscribe