ASCENDANCY OF YUAN AS A GLOBAL CURRENCY

For more than 7 decades, the U.S. Dollar has been central to the global monetary system. It is predominantly the standard currency unit in which goods are quoted and traded, and with which payments are settled. Most of the trade transactions in the world pass through the U.S. financial institution.

Regardless, the U.S. Dollar’s ascendancy in the global financial market is steadily being challenged by China. China’s growing economic power and prominent ideological differences from the United States have positioned the country as the United States’ top competitor. It has steadily grown and overtook the United States to become the world’s largest trading partner.

On October 1, 2016, the International Monetary Fund (IMF) announced that it awarded the Yuan status as a reserve currency, i.e currency which is held in significant volumes by governments and institutions as a supplement to national currencies. The IMF also included the Yuan in its Special Drawing Right basket, which is a global reserve asset established in 1969 to complement the official reserves of its member nations. Currently, the Euro, British Pound, Japanese Yen, and US Dollar are included in this basket. The introduction of the Yuan as a reserve currency marked a significant turning point in China's economic integration with the world financial system. The IMF's determination that the Yuan is freely usable reflected China's growing influence in world commerce as well as the Yuan’s significant rise in international use and trading.

China surpassed the US to become the world's largest trading nation in 2013, which was described as "a landmark milestone" by the United Nations Conference on Trade and Development. However, despite being the world’s largest trading partner, its currency still makes up less than 3 per cent ( ranking fifth) of the world’s reserve currency. On the other hand, the US Dollar makes up 60% of the world's reserve currency.

The Chinese Economy, primarily from Covid-19 onwards, has been through various restrictive statutory and political regulations. Xi Jinping's zero Covid policy was one of the most pressing concerns, shutting factories, putting millions of people under rolling lockdown and ultimately sending investors piling into Dollars. China is also going through an unprecedented crisis in its real estate sector -- which makes up more than a quarter of the country's GDP when combined with construction.

A weaker Yuan can have some negative spillover impact on other Asian currencies. As the volatility of the Yuan increased recently, the Taiwan dollar also paused and the South Korean Won started trending downwards.

A weaker currency, though can allow China to build on its export strength since the U.S. is its largest export market but Chinese officials won't want the currency to tumble too quickly, as that could potentially spook investors and prompt efforts to get capital out of the country as long as the market expectations can be stabilized, and as the policies to support the domestic economic growth of China continues to take effect, it will be hard for the Dollar index to bring huge volatility to the Yuan.

Currently, China maintains a very tight grip on the foreign exchange (Forex) market. Forex trading is legal in China but the stringent capital controls do not allow traders in China to open an account with any foreign brokers. All these restrictions on forex trading might be tied to the country’s control over the valuation of the Yuan. China is advised to be liberal and allow the Yuan to be freely traded on foreign exchange markets. This allows central banks of other nations to hold it as a reserve currency.

The People’s Bank of China has taken several measures to slow the Yuan’s depreciation. It recently remarked that the currency will achieve equilibrium by itself as supply and demand play a decisive role which indicates its reluctance to intervene heavily. In July, The People’s Bank of China also announced a collaboration with five nations and the Bank for International Settlements to achieve this. China, along with Indonesia, Malaysia, Hong Kong, Singapore, and Chile would contribute 15 billion Yuan each, about $2.2 billion, to the Yuan's Liquidity Arrangement.

In the meantime, Russia has already adopted the Chinese Yuan as its de facto reserve currency. Following sanctions imposed by the West as a result of Russia's invasion of Ukraine earlier this year, the Russian leadership turned to China. Currently, 17% of Russia's foreign reserves are pegged to the Yuan for the year 2022. The Yuan is also the third most demanded currency on The Moscow Exchange. As these partnerships become stronger, the Yuan’s status as a reserve currency could be further entrenched.

The prerequisite for any currency to be regarded as a global currency is that it should be a dominant reserve currency. According to the observations from a recently released report by IMF, The ratio of Yuan could rise further in the future, as the US Federal Reserve's interest hike regulations since the beginning of 2022 have dampened investor confidence in the US Dollar-dominated financial system, which could further boost Yuan's globalization.

Further, the Yuan’s relative stability - amid a recent steep depreciation of other major currencies, as well as amid the Ukraine-Russia crisis and conflict, will also speed up the Yuan’s global use, making it a "haven" asset that draws more investors.

Despite China's economic and political power, the country doesn’t dominate the global flow of fiat currency. However, the tide is about to turn.

Evidence suggests that Yuan reserves are steadily increasing in countries that have tighter trade relations with China. In a "multipolar" world, the Yuan may replace the U.S. Dollar as a result of its expanding dominance.

Therefore, China’s Yuan might gradually reduce the influence of the Dollar, though replacing the Dollar isn't a facile task. Nevertheless, if the forex market forecasts stand corrected, long-term investors should consider some exposure to Yuan-denominated assets and Chinese stocks with significant Yuan earnings as it could be just a few decades before the Yuan gains parity to US Dollar.

By: Saras Tuli and Samiha Juneja

Under the guidance of the R&O Director, Sanaa Chawla