China Yuan Becoming Reserve Currency

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Market Liberalization… with Chinese Characteristics:
Can the Chinese Yuan become a Global Reserve Currency?

Jessica Davis

Fort Hays State University

ECFI 644 International Economics

April 30, 2012

Dr. Dosse Toulaboe

Abstract

China’s economy is growing ever larger, but is that enough to get the Chinese Renminbi (more commonly known as Yuan) to be accepted as a global market currency? This paper will look into the liberalization, but with Chinese characteristics, of five determining factors in becoming a country whose currency is a global reserve currency. These factors are as follows: economic size, macroeconomic policies, flexible exchange rates, financial market development, and finally having an open capital account, and will ultimately prove the China is not quite the rising economic power some believe it to be (Prasad, 2012). Market Liberalization… with Chinese Characteristics

In China, it is currently the year of the dragon, a symbol of good fortune and sign of intense power. With this symbol of fortune and power many Chinese are hoping for a year of economic prosperity, especially for the growth of the Yuan. In recent years, China has maintained that it’s “special” economy is pursuing a “market economy, but with Chinese characteristics”. Some of these characteristics include encouraging more of an international use of the currency, while being famous for their inflexibility with exchange rates, and not fully opening up the economy to the free flow of capital. However, the Yuan’s acceptance as a reserve currency will be based on China’s economic size, macroeconomic policies, flexible exchange rates, financial market development, and finally having an open capital account. It seems that with time, it is inevitable that China’s Yuan will one day become a global reserve currency. Depending on the development of these five criteria, China’s currency may become a global reserve currency sooner than predicted.

China’s Economic Size
The Chinese economy is now the second largest economy in the world, and estimated to have 10 – 15 percent of the world GDP. Further, in 2011 China accounted for almost 25 percent of the world’s GDP growth (Briscoe, 2012). Despite this, GDP and economic size are not the main determinants of a country’s reserve currency status. If we remember US history, we will note that the United States surpassed the United Kingdom in terms of GDP in 1870, but still did not become a reserve currency until 1944 (Prasad, 2012). Thus, economic size in not the most important factor in becoming eligible for world currency status.

Macroeconomic Policies
The continued role of the government in the banking system is a limiting factor when trying to encourage a more open capital account. However, the government maintains that keeping a tight control over their currency prevents economic crisis. Many argue that this strict regulation helped China avoid the Asian financial crisis in the late 1990’s and the more recent global crisis in 2008 (Briscoe, 2012).

On the other hand, just over a month ago China announced that they would be allowing all firms in China to pay for exports and imports directly with Yuan. This is a push to further open the capital account, but still government regulation exists especially on debt financing, portfolio investment and overseas direct investment. Simply put, “Chinese officials view economic stability as crucial to maintaining political stability” (Carbaugh, 2011).

Flexible Exchange Rate
As our International Economics textbook notes, “Floating (or flexible) exchange rates means currency prices that are established daily in the foreign-exchange market, without restrictions imposed by government policy on the extent to which the prices can move.” Having a floating exchange rate is the norm for global reserve currency countries, as it offers flexibility, and tends to be “self-correcting” as...
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