The rise of China as an economic powerhouse and the relative nervousness in the US economy often leads discussion in the domain to questions such as can the Chinese yuan become the next reserve currency? Will the yuan challenge the status of US dollar?
The biggest economic advantage, it is often argued, that the US has today is its currency -- the US dollar. Put differently, the US, like any other country such as India, for all practical purposes, does not necessarily has to export goods and services to earn foreign currency to be able to buy goods and services in the world market. It can simply print more dollars and buy anything it wants anywhere in the world. This is because dollar is accepted all over the world and a bulk of trade happens in dollar terms.
Therefore, central banks also prefer to hold the surplus of a country in dollar-denominated assets such as bonds issued by the US government, which makes dollar a reserve currency. Since a bulk of the trade happens in dollar terms, it is also termed as vehicle currency.
How does it benefit the country it belongs to?
Having a reserve currency brings in a number of benefits to the country it belongs to. For example, if an Indian company imports, say, cotton from Pakistan, it will have to convert rupees into dollars, while the exporter from Pakistan will have to convert dollars into Pakistani rupee to pay for the cost. So there is transaction cost involved on both the sides. But if US businesses trade with other countries, they can always pay in their own domestic currency and save on costs. Other significant benefit of having a reserve currency is the lower cost of borrowing. Since surpluses from all over the world chase US government bonds, it is able to sell them at lower interest rates. Lower interest rate on government bonds also translates into lower cost of money for businesses and households.
Can yuan be a reserve currency?
A status of reserve currency is a reflection of confidence in that currency and the economy it represents. It also depends on the scale and availability and assets backed by that currency. Even though China has shown interest to present its currency as a vehicle currency, those efforts are limited and may not be sufficient to achieve the scale required. Also, China will have to open up its capital account so that international capital can freely move in and out of its territory, meaning that it loses the power to influence the value of its currency. This is something that China may not accept at this stage as it has long resisted the demand of revaluing its currency, which could affect its exports and growth. Therefore, there is a long way to go before Chinese yuan can come anywhere close to being a reserve currency.
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