Published in Financial Express, Sunday, Dec 20, 2009.

It has been doing its share of rounds in the global financial arena from some time, but it only took the global financial crisis to heighten the debate of anchoring the world’s monetary system on the greenback. As Dominique Strauss-Kahn, Managing Director, International Monetary Fund, in his recent visit to China announced that ‘the yuan may be added in future to the basket currencies that set the value of special drawing rights (SDRs) and supported efforts to create a new global currency based on SDRs’, currency contours assumed a new shade.

Observers opine that the announcement by Strauss-Kahn not just spells a widening role of yuan in the global financial system, but also hints at how over the past 11 months, the world’s de facto reserve currency has started losing its sheen. The world has been over-relying on the dollar as a reserve currency, but the US in order to solve its own economic problems, has to print more money, which is devaluing its currency, explains Ajit Dayal, President, Quantum Asset Management Company. “It is clear, that the economy of the reserve currency of the world is facing structural problems, which are serious and unsustainable, leading to worldwide concern, particularly at the policy level. The issues of low savings rate, the large current account deficit and the large budget deficit, are coupled with the question of how willing are those economies with surplus savings to continue financing these deficits,” Dayal shares.

“Renminbi or the Chinese yuan will have a wider role in global financial markets in years to come,” avers Jamal Mecklai, CEO, Mecklai Financial, “Given that China will soon enough be the largest economy, there will have to be huge changes in the domestic Chinese forex market which will have significant implications for the Chinese economy at large. While this would normally be a very long term process, considering how undeveloped the domestic Chinese market currently is, everyone has learned that the Chinese are always able to surprise expectations!” He adds that the Chinese central bank is getting ready to let the yuan appreciate shortly; however, it is a long road from simply allowing the peg to move under supervision to being largely market determined.

A sentiment also echoed by Niru Yadav, Senior Research Associate, Centre for International Trade, Economics & Environment, Jaipur, “Yuan is already cited as the third most important currency in the world by Robert Mundell and its use as trade settlement currency is likely to increase. Considering that China accounts for a substantial share of output and trade in the global economy, a currency that adequacy reflects its domestic conditions would certainly aid the global economy.”

Independent analyst Sitharam Gurumurthi corroborates that the world’s third largest economy that recently surpassed Germany as the largest exporting nation, is on its way to overtake Japan’s GNP by 2010 and that of the US by 2020. Gurumurthi adds, “China has started encouraging the settlement of trade in yuan. It recently allowed companies in Shanghai and four other cities to take part in this pilot programme. This trade agreement is however limited to Hong Kong, Macau, and the Asean. These developments undeniably underline the expanding role for the yuan, at a time when Russia and emerging economies like India are seeking an alternate to the dollar.”

However, convertibility remains an issue for yuan, as Dr. D. R. Agarwal, Director, Institute of International Trade, Kolkata, points that even as China is allowing its select trade partners to use yuan as a medium of exchange by way of currency swaps, it can only be a solution for bilateral trade between China and the other trading partners. “In order to become a currency of international reserve where a third country may keep a surplus in Chinese yuan, the first and foremost condition is convertibility, which is missing. Also, it can work only as long as the trade surplus is in favour of China. However, the moment the trade surplus goes in favour of the other country which has its obligation to pay for its import from the third countries in USD or in Euro, the same will not be acceptable. The other important issue is about the ultimate balance of payment. As long as China’s balance of payment remains positive and it continues to remain a surplus economy, it will have to keep its foreign exchange surplus in the currency of other countries, say either euro or sterling or dollar or yen or to some extent in SDR.”

Kalpesh Shah, CEO, investmentguruindia.com opines that the recent statements from various quarters on the issue by US President Barack Obama, Strauss-Kahn, Chinese authorities, is more due to political reasons, with each having different purpose. He adds, “Managing yuan in a particular band vis-a-vis the USD is the core strategy of the Chinese government and it is very unlikely for it to change in near future for various macro economic reasons. As a growth strategy of Chinese economy, the idea is simple, to make sure that Chinese goods remain cheap and that Chinese factory workers remain employed, China needed to keep the dollar strong. To achieve this, China had two key strategies, prevent the yuan from becoming a freely-traded currency, in order to maintain government—and not free market—control over its exchange rate; and spend a large part of the proceeds from its export industries to purchase US Treasury Bills. In a nut- shell, China cannot get rid of its USDs, if China starts selling them, or even just stops buying them, their value will decrease, China now wants the world to come together and share its burden.”

The refusal of China to allow its currency to appreciate does not only affect the US, but several Asian economies like India whose currencies have been appreciating significantly since March 2009, affirms Gurumurthi. He adds, “The value of the yuan which had been fixed at 8.28 yuan to US$1 since 1996 was changed to the current level of 6.83 yuan to US$1 from July 2008. This fixed exchange rate is protecting exporters from slumping demand. During the last one year, as a result of the weakening dollar, the trade-weighted value of the yuan has been pulled down, whereas currencies of several other countries have witnessed unprecedented appreciation. For example the Korean won and the Brazilian real have gained 36% and 42% against the yuan, making dents into the export prospects of these countries’ .”

Nevertheless, if China were to have a more flexible currency regime, “It would impact not only global trade competitiveness but also, more importantly, the efficiency of resource allocation in China itself, this will lead to substantially enhanced productivity in China, which will give world growth a definite boost,” confirms Mecklai.

Source: Financial Express