U.S. Dollar Collapse: Will the Yuan Become the New Reserve Currency?

Chinese_renminbiLondon Becomes China’s Yuan Currency Trading Hub

A week ahead of President Xi Jinping’s visit to London, the city will become a major trading hub for Chinese currency. China’s Ministry of Finance is holding its first offshore debt sale, denominated in yuan. It’s just another sign of China’s plan to make the Chinese renminbi a reserve currency and the coming U.S. dollar collapse.

The Asian powerhouse made an official application to the International Monetary Fund (IMF), a long-term play to stabilize the Chinese currency. Each day that passes moves us closer to the November review of China’s bid for reserve currency status.

Issuing yuan-based debt in London is no small feat for China. Historically, the country has maintained a tight hand on its currency, but the IMF says that must change. A free-floating yuan is necessary for inclusion to the exalted club of reserve currencies. (Source: “China Gives London’s Yuan Hub Ambitions a Boost Before Xi Visit,” Bloomberg, October 14, 2015.)

This sale is incredibly important for China. Last week, a state-owned Chinese firm issued corporate bonds in London, possibly as a test balloon for the upcoming sale of government debt. Demand was weak.

With President Jinping arriving the week after the issuance, it would be embarrassing if yuan-denominated bonds underperformed. But the constancy of China’s push shows how serious it is about achieving reserve currency status.

Here’s why China will probably be successful.

The Rise of the Chinese Renminbi

History shows us there is a strong relationship between a country’s participation in global trade and the importance of its currency to world affairs. In fact, the relationship is quite intuitive. When importers buy Chinese goods, they must convert to the yuan.

Thus, the relevance of China’s renminbi has swelled with its dramatic growth in trade. China is officially the world’s leader in merchandise trade. You can hardly lift a cup, cloth, or gadget without seeing those three little words: “Made in China.”

The case study for a currency-to-trade relationship is the United States. Let’s not forget that Britain was the leading economic power in the world until two world wars sapped its strength. The British pound receded into the background of history.

After WWII, German marks were replaced by the U.S. dollar as a reserve currency. Global trade was dominated by the United States, forcing many international transactions to be conducted in U.S. dollars. It only made sense.

Now that China is the largest merchandise trader on the planet, doesn’t it make equal sense to grant the yuan reserve currency status? That’s part of the reason the IMF will likely approve China’s application.

Selling yuan-denominated bonds in London is the dutiful showing that China will embrace the internationalization of the yuan.

Why China Wants Reserve Currency Status

You can be forgiven for wondering why reserve currency status matters. It is an arcane subject, but an important one. Central banks around the world hold reserve currencies as a way of stabilizing their own currency.

Let’s use Australia as an example. Imagine there is a sudden shock to the Australian economy, an earthquake that devastated some key production facilities or a major bank collapse, perhaps. It would be tragic, but investors would get spooked.

The loss of faith in Australia’s economy would directly hurt its currency. Investors would start selling their Australian dollars, driving down its value. The purchasing power of ordinary Australians (how much they can buy with a given income) would collapse.

To counteract the fall, the Australian central bank can use its basket of reserve currencies. It can sell some U.S. dollars or euros to buy Australian dollars, thus bolstering some confidence in the currency. The reverse is also true.

Countries that have printed too much money can add reserve currencies to their holdings to show their currency is built on strong foundations. It’s all about managing perceptions.

For instance, part of China’s strategy to float the yuan was to amass huge reserves of U.S. dollars and gold bullion. Holding hard assets and the greenback was a key move towards winning investor confidence in the Chinese currency.

But hasn’t China wanted to keep its currency low? Doesn’t that help boost the country’s exports?

Yes, but China is in the middle of a grand transition. The country tripled its national income since 2000, but living standards have yet to match that growth. In order to see a rise in lifestyle, China has to help its consumers. It needs a strong and stable currency.

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