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“Will Chinese Yuan become the next Reserve Currency?”

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.

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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. more

(The writer Mr B Chandrashekar is a student undergoing MBA course in the Department of  Management Studies, Anna University, Chennai. This formed the basis for his presentation in a lecture programme organised under ‘Crisil Young Thought Leader – 2010’ at Chennai. The views expressed are his own. Email.: bchandru89@gmail.com)

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