China’s big role in international trade has resulted in increasing acceptance of the yuan as a foreign exchange reserve. And though many see this as a sign that the yuan will replace the dollar as the global reserve currency, nothing could be farther from the truth.
Yuan and foreign exchange reserves
Bloomberg quotes Goldman analysts as saying that the International Monetary Fund estimates the yuan’s share of global reserves to “rise to around 3 to 4 percent by the end of 2022… If financial markets deepen faster than we expect, then these estimates could prove to be too conservative. However, there are also a number of downside risks, including the fact that reserve allocation decisions tend to be rather sticky.”
The move to position the yuan as a reliable foreign exchange reserve has the strong backing of the Chinese government due to military and strategic reasons. Beijing has been engaging with several countries to sign trade agreements where the exchange currency used will be the yuan.
China also has been opening itself up to global investors in a bid to stabilize the exchange rates. This would also allow domestic investors to bet their money on overseas ventures. Such developments will contribute greatly to raise the yuan’s position as a reliable foreign exchange currency.
And even though some believe that the yuan will become the global reserve currency soon, the fact of the matter is that the U.S. dollar is still going strong and will never be replaced by the yuan in the near term.
The potential of being a reserve currency
To understand why the yuan won’t beat the dollar and become the global reserve currency, you first need to understand the qualities that characterize a reserve currency.
In order for a currency to even be considered worthy of being a potential reserve, it needs to be backed by a stable, trustworthy government. If the country descends into chaos or the government running the country is not trustworthy, then the currency won’t be seen as a reserve currency.
The U.S. is a stable society with a government that is elected by the people. This guarantees that the government is trustworthy and won’t indulge in questionable practices since they can be punished in case they are brought to a court of law.
In contrast, China is run by an authoritarian government that can do anything it wants without being questioned by any authority. This increases the chance that the Chinese government might end up doing something illegal that would go against the interests of the people who might use the currency as a reserve.
As such, the dollar comes across as a more stable, trustworthy currency than the yuan. Another reason why the dollar will continue to remain the global reserve currency is its liquidity. It is the most liquid among all currencies in the world, which makes trade swift and easy.
“There is simply not enough liquidity in all the other currencies combined to switch away from the dollar,” Forbes quotes Jeff Christian, founder of CPM Group, a commodities consulting company.
And since businesses will not ditch the dollar for any other currency in order to keep their financial transactions smooth, the yuan currently has no chance to dethrone the dollar as the global reserve currency. In fact, only an economic event of catastrophic proportions can ever displace U.S. dollar from its reserve currency position. Until that happens, the dollar is where you need to bet your money.