The Independent Market Observer

Yuan Becomes Reserve Currency

Posted by Brad McMillan, CFA®, CFP®

Find me on:

This entry was posted on Dec 1, 2015 2:11:49 PM

and tagged In the News

Leave a comment

yuanThis post is a follow-up of sorts to one I wrote a couple of weeks ago, “U.S. Dollar Still Failing to Collapse.” As expected, the International Monetary Fund (IMF) decided to add (as of next October) the Chinese currency to the list of reserve currencies. Also as expected, the world is not ending just yet.

I closed that last post with the thought that China may end up getting just what it wanted—and regretting it. Thinking it through a bit further, I wanted to expand on that, as well as what it means for us here in the U.S.

A recap

The Chinese currency, the yuan, will be added to the IMF’s list of reserve currencies, those that make up its internal unit of accounting called the special drawing rights. This will officially put the yuan in the same class as the dollar, the euro, the pound, and the yen—making it part of an elite club.

Although there has been a considerable amount of worry that this would dethrone the dollar as the primary world reserve currency, a moment of thought suggests otherwise. Since the euro, pound, and yen have not managed to do this, there is no reason the yuan would either—at least in the short term. Indeed, with the dollar continuing to gain in value with respect to other currencies, the opposite has happened.

What will China lose?

From a Chinese perspective, this is a good thing, as the last problem China needs is a stronger yuan hurting its trade competitiveness. China has carefully managed the yuan’s value to prevent just that. But, with the yuan as a reserve currency, it will be less able to do so going forward. In fact, China will actually lose a number of tools it currently employs:

Currency valuation. Reserve currencies are typically free floating; that is, the markets determine what the value will be. As mentioned above, a strong yuan—which might come from more general holdings of the currency—would hurt the country's economy. Up until now, China has managed to prevent this, but it will be much harder in the future.

Capital controls. China has limited the amount of money that investors and businesses have been able to move in and out of the country, which has also limited the consequent economic swings, forced outside investors to take a long-term view, and forced its own citizens to keep money in the country. With domestic capital flight already a concern, and with international investors increasingly interested, the potential for destabilizing capital flows is very real—and potentially much less manageable with the yuan as a reserve currency.

Independence. In past years, China has been able to make policy based solely on its domestic concerns. But a greater international role for the yuan will require China to consider the global impacts of its decisions, making them harder and more complex.

The cost of reserve currency status

You may note that all of these are problems the U.S. is facing right now. The strong dollar is hurting our manufacturing sector, capital flows are free and affect our interest rates both positively and negatively, and the Fed is struggling with how its policy decisions affect the rest of the world, with the “taper tantrum” giving a vivid example of the potential consequences. These are problems that China has not faced to the same degree in the past, but it will have to face in the future. By electing to move to a reserve currency status, China is incurring costs both direct and indirect that will make its primary objective—recasting its economy from investment to consumption driven—harder to achieve than it is right now.

What does it mean for the U.S.?

For the U.S., this might actually start to ease some of the burdens of these costs over time, as China takes some of the load while potentially leaving many of the benefits in place. Rather than dreading the yuan as a reserve currency, we might want to cautiously welcome it—that is, if the Chinese decide they want to continue bearing the costs.

  Subscribe to the Independent Market Observer

Subscribe via Email

Crash-Test Investing

Hot Topics



New Call-to-action

Conversations

Archives

see all

Subscribe


Disclosure

The information on this website is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets.

The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. All indices are unmanaged and investors cannot invest directly in an index.

The MSCI EAFE (Europe, Australia, Far East) Index is a free float‐adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of 21 developed market country indices.

One basis point (bp) is equal to 1/100th of 1 percent, or 0.01 percent.

The VIX (CBOE Volatility Index) measures the market’s expectation of 30-day volatility across a wide range of S&P 500 options.

The forward price-to-earnings (P/E) ratio divides the current share price of the index by its estimated future earnings.

Third-party links are provided to you as a courtesy. We make no representation as to the completeness or accuracy of information provided on these websites. Information on such sites, including third-party links contained within, should not be construed as an endorsement or adoption by Commonwealth of any kind. You should consult with a financial advisor regarding your specific situation.

Member FINRASIPC

Please review our Terms of Use

Commonwealth Financial Network®