Will the Yuan Replace the Dollar?

It seems lately that every time the U. S. dollar has a particularly bad day, China and Russia renew their calls for ending the dollar’s long run as the world’s reserve currency. Given the dollar’s recent track record, it is easy to understand why China and Russia feel compelled to issue such statements, but do they really want to see the dollar replaced? Is there a realistic alternative?

Certainly, there is no doubt that Russia’s dependency upon oil sales – which happen to be paid in dollars – makes it vulnerable to swings in the dollar; likewise, China needs a strong market for its exports. Yet, when the dollar falls, the cost to buy China’s products effectively increases, resulting in a drop in demand. Despite these concerns, Russia and especially China, continue to buy and hold massive quantities of US debt and this is the tricky bit – threatening to replace the dollar actually weakens the currency and translates immediately into further losses in the value of the foreign reserves held by the two countries.

Because of this, I saw the comments made prior to the G20 meeting last April as little more than a warning shot across the bow of the still-new Obama administration, reminding them to be prudent with respect to actions affecting the value of the dollar. But now, I’m not so sure – maybe China really does want to replace the dollar with some form of supranational currency? Or maybe they have just given up and are cutting their losses?

For many years, China’s monetary policy was to peg the yuan to the US dollar. This was a deliberate attempt to prevent the yuan from gaining in value, thereby making China’s exports more expensive for international contracts settled in dollars. History has proven this fear to be justified, as just four years later, the yuan has appreciated by more than twenty percent since this restriction was removed in 2005.

Adding further to the evidence that China is preparing to advance the yuan as an alternative to the US dollar, is the fact that this past April, China gave approval allowing companies in Shanghai and several other border cities to use the yuan to settle international trades. Prior to this, individual companies were required to settle accounts in US dollars. Then, just last week, China sent an impossible-to-ignore signal by adding Hong Kong to the list of jurisdictions that could settle directly in yuan, and it is expected that up to 50 percent of Hong Kong’s trade could be settled in yuan within the next three years. In 2008, trade between China and Hong Kong amounted to $204 billion so this is not an insignificant figure we are talking about here!

In the end, we may be witnessing economic evolution in action – a changing of the guard, if you will. Even just a few years ago, the idea that the greenback could someday be replaced by another currency, was inconceivable. I mean, when everything else was in doubt, you bought dollars as a safeguard! But now – dragged down by rising unemployment and unsustainable debt – the dollar is increasingly seen as a liability.

Perhaps Pushpanathan Sundram – Deputy Secretary-General with ASEAN (the Association of Southeast Asian Nations) summed up the inevitability of the yuan superseding the dollar when he said recently “the use of the yuan may eventually boil down to simple economics. Given China’s growing share in international trade, traders may find it makes economic sense to make settlements in yuan”.

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