Yuan Vs. Dollar: The Fight of the Century

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on May 4, 2015 1:21:37 PM

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yuan vs. dollarI know I’m a couple days late on the “fight of the century” theme. Apparently, there was a major boxing match the other night, which, characteristically, I missed.

Nonetheless, better late than never, especially since there’s another “fight” going on that will ultimately have a much bigger effect on our lives.

The matchup

I’m talking about the contest between the Chinese currency, the yuan/renminbi, and the U.S. dollar. Not that long ago, the bookies had the Chinese contender heavily favored. The dollar was said to be down and out, due for an inevitable and unstoppable decline at the hands of the yuan and other currencies.

It hasn’t worked out that way, of course. The dollar has recovered to multiyear highs; the U.S. economy is strengthening while the Chinese economy is weakening; and the Chinese government is gradually increasing its economic stimulus even as the Fed continues to pull back. Things look very different than they did even two years ago.

Recently, though, the situation seems to have changed again, with reports that the International Monetary Fund (IMF) was considering replacing the dollar as the world’s dominant reserve currency.

Is the dollar doomed after all?

Short answer: no. The dollar’s role as the leading reserve currency is safe.

What’s activating the doom-and-gloom complex is a possible decision, later this year, to add the yuan to the IMF’s mix of currencies known as the Special Drawing Rights (SDR). The SDR is not a currency but an accounting tool, a way for countries to hold their reserves easily on a diversified basis. It is a basket consisting of the dollar, euro, yen, and the UK pound, all of which are commonly held as reserve currencies.

Adding the yuan to the mix would indeed indicate that it has moved into reserve-currency status. But it wouldn’t mean that any of the other currencies, especially the dollar, have lost that status.

The yuan comes of age . . .

Given the size of the Chinese economy and China’s status in Asia, adding the yuan to the SDR is only common sense. The last time the yuan was considered for inclusion, the IMF decided it was not “freely usable.” I’ve written before about what it takes for a currency to acquire reserve status, and at that time, the yuan had not. Now, the issue is much less clear cut.

According to Bloomberg:

  • About 20 percent of Chinese trade is in yuan.
  • The market for yuan bonds has grown to more than $70 billion.
  • The yuan is now freely tradable in several markets.
  • Outsider access to China’s financial markets has improved, and the yuan has become the seventh most-used currency.

All good reasons to say the yuan has come of age and should be included in the SDR basket.

At the same time, that seventh-place finish accounted for only 1.7 percent of all transactions—hardly a commanding position, especially when compared with the dollar’s share of 60.7 percent and the euro’s 24.2-percent share. Even the British pound is used more than twice as much, at 3.9 percent. Although the yuan is clearly a rising currency—and one that will likely become more powerful in coming years—it’s still a relatively minor presence in the markets.

But the dollar is still a major contender

By adding the yuan to the SDR basket, the IMF would acknowledge China’s size and continuing growth, but that move shouldn’t be interpreted as an attempt to supplant any other currency. Whether this year or five years from now, the yuan will be included eventually.

Over time, as other economies grow, the U.S. dollar will become less dominant as well. This is actually a good thing, as the leading reserve currency role comes with costs as well as benefits.

In the bout of yuan vs. dollar, we're nowhere near getting knocked out of the ring.

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