Chinese Currency Hits A Milestone

by: Brad McMillan

I spent a week or so recently writing about the problem of money, concluding with a discussion of the dollar's reserve currency status. There, I noted that, in the next 10 years or so, the dollar would remain the dominant reserve but that other currencies, particularly the euro and the yuan, could also become major reserve currencies if they addressed certain shortcomings.

Per Bloomberg today, the yuan has passed the euro to become the second-most used trade finance currency. Use of the yuan was 8.66 percent in October, up from 1.89 percent in January 2012, while use of the euro dropped from 7.87 percent to 6.64 percent.

You can see a couple of things from these figures. First, while the combined euro/yuan share has increased from just under 10 percent to just over 15 percent, they remain a relatively small part of the total trade picture. That limited share is further constrained because much of the trade is with China itself, rather than between third parties.

Given those caveats, though, the reality is that China has made significant progress in only a year, and has taken a bigger piece of the pie in absolute terms, rather than just from the euro. Clearly, China is doing what needs to be done over time to make the yuan a credible reserve currency. It is stepping away from exchange rate management, has started currency trading markets, and is gradually opening and liberalizing its financial markets, all of which are mentioned in the Bloomberg article.

So far, this is consistent with what we would expect. The question, though, is whether this will be a problem for the dollar over time.

It might be, but I doubt it. First, the rise of a new reserve currency doesn't necessarily mean the erosion of the old one. The yen, for example, became a major part of the international financial scene without affecting the role of the dollar, even as Japan became a dominant trading and manufacturing nation in the 1980s. The rise of the euro in the 2000s, before the great financial crisis, also didn't dislodge the dollar. While both of those currencies took a larger role, the dollar remained the bedrock reserve, given the dominant size of the U.S. economy and its even more outsized role in the international trading system.

The other reason I don't think this will be a problem are the changing trade and currency flows associated with the energy markets. U.S. energy imports have been declining as domestic production increases, limiting the dollar flows out into world markets, and the prospect of U.S. energy exports would pull more dollars back into the country. The world may end up needing another source of trade finance - another reserve currency - because there simply will not be enough dollars out there.

This is a long way away, but it's worth noting since the change in flows will result in a stronger U.S. dollar, as its value is bid up, and a consequent headwind for U.S. manufacturers, which are getting back on their feet. The rise of a new reserve currency could actually be good for the economy if it helps keep U.S. exports affordable. It's quite possible that the world - and the U.S. - will actually need another reserve currency and may demand that the Chinese actually speed up the changes required to make the yuan useful that way.

The short-term takeaway is there's nothing to worry about. This is a signpost on a road that many people are worried about but probably shouldn't be. The problem of money remains, but the current signs are that we're evolving a system that will retain the dollar's predominant role while also accommodating China - to the benefit of all.