THE RISE OF THE YUAN

Days before world leaders met in London to address the global economic crisis, China’s
central bank proposed replacing the US dollar as the world international currency with a new “super-
sovereign reserve currency” under the surveillance of the International Monetary Fund. Following
the 1971 “Nixon Shock” when President Nixon unilaterally ended the Bretton Woods fixed exchange
rate system, the US dollar has maintained its special status as the world reserve currency. Since the
US dollar is perceived to have the lowest default risk among all the currencies of the world,
governments and corporations demand US dollars as the standard store of cash and liquidity to use
in times of crisis.

However, what if the leading global currency is under threat? Currently, there is no national
currency that is an attractive alternative. China is in a precarious position as the largest holder of US
financial assets with over $2 trillion of foreign exchange reserves, about half in US Treasury bonds
and other government-backed debt. Therefore, the Chinese fear a weakened US dollar because it
will erode the value of Chinese investments.

If the status quo continues, the fiscal and monetary policies of the US government will
generate inflationary pressure that may weigh down the value of the US dollar. As a result, Chinese
investments will lose their value commensurate to the US dollar’s devaluation. The Obama
administration is currently overseeing multiple government bailouts, stimulus spending, two foreign
wars, and a potential overhaul of domestic programs. The only means of financing these
expenditures is through borrowing. Now that the Chinese are diverting their savings toward
domestic consumption and investment, the US will have greater difficulties servicing our deficit. In
fact, the gravest risk is the monetization of debt—the Federal Reserve has purchased US Treasury
bonds in an effort to further reduce the cost of credit.

If the Chinese decide to transfer their foreign exchange reserves from US dollars to a basket
of currencies, the outcome may be worse. The massive transfer would prompt other countries to
lose confidence and to pursue the same policy. This wide-scale shift would create volatility in the
global currency markets, negatively affect the US financial markets, and most importantly, will also
weaken the US dollar.
Given this context, Governor Zhou Xiaochuan of the People’s Bank of China, along with Premier Wen
Jiabo have cautiously articulated their distress about China’s substantial holdings of US debt and
their underlying fear of volatile global currency markets. Since there is no attractive alternative at
this time, Zhou has evoked the creation of an international reserve currency “that is disconnected
from individual nations and is able to remain stable in the long run.”

But nevertheless, China is currently globalizing the yuan and promoting its influence
overseas, which may reflect ambitions to eventually supplant the US dollar as the world reserve
currency in the long-term. China has brokered deals with six countries, including South Korea,
Malaysia, and Argentina for a currency swap arrangement to facilitate trade transactions. If these
deals are repeated with other countries, the Chinese can effectively create a trading network that
will use yuan and thereby bypass the US dollar. In addition, the Chinese are encouraging loans and
investments to be made in yuan in order to spread its influence abroad; and even Chinese tourists
contribute to this trend when they carry pocketbooks of yuan to their travel destinations.
Both Western and Chinese analysts are predicting that the yuan will become the dominant reserve
currency by 2020. Tim Condon, the chief Asian economist for ING, agrees with this forecast, “That’s
a reasonable time table…I see undesirable risk against the dollar and appreciation pressure on the
Chinese yuan.”

Today, hip hop rappers in music videos fan out Euros as a sign of success, but one day we
may all have to bow down to the “All Mighty Yuan.”