The IMF announced on Nov. 30 that its executive board had approved the inclusion of the Chinese yuan into the basket of currencies making up the SDR, joining the U.S. dollars, Euro, Yen and British Pound, to be effective on Oct. 1, 2016.

This is a symbolic acceptance of the yuan as a major international currency and is not surprising. China is now the world’s largest trading nation in terms of value of exports plus imports, and China’s GDP in current market value will likely surpass that of the U.S. sometime in the next two decades. It would therefore be very odd if the yuan does not become a more and more important international currency. 

Actually, if China continues to rely on the U.S. dollar as its major currency denomination for trade and investment, it will continue to be exposed to U.S. policy and problems. We have already seen problems that acute U.S. dollar shortages after the closure of Lehman’s Brothers can cause, and also how spillovers from U.S. QEs create a lot of problems for emerging market economies.

The use of the yuan in international transactions has grown with the growth of China’s trade and investment transactions with the rest of the world and encouraged by the Chinese authorities. According to SWIFT, the yuan’s share as an international payment currency by value has increased from about 1 percent at the end of 2013 to about 2.5 percent currently, ranking around number 4 or 5 among all major currencies. This share will grow much more in the future as more and more trade and investment between China and the rest of the world are denominated in yuan. However, the true test of the yuan’s importance as an international currency is not whether most of China’s transactions with the rest of the world are denominated in yuan, but rather whether a substantial percentage of transactions among third parties (i.e. among other countries) are denominated in yuan. Along this dimension, the yuan still has a very, very long way to go to become a significant currency for transactions among third parties.

The U.S. dollar is certainly in such a position. In all cases, whether for exports from Thailand or imports to Thailand, and the extent of internationalization of the main currency of the trade partner, the U.S. dollar is the most used denomination. This shows the dominant role of the U.S. dollar and this is why the U.S. dollar is the dominant reserve currency, as central banks need to make sure that there is enough liquidity for the main currency used for trade and investment.

It is important to note that the dominance of the U.S. dollar, whether for trade and investment or as reserve currency, is not because the U.S. is forcing people to denominate their transactions in U.S. dollars or for central banks to keep most of their reserves in U.S. dollars. These are voluntary choices. The bottom line is that the U.S. dollar is the best currency to use for international transactions because it minimizes transaction costs and has extensive potential investment benefits.

Take the example of exchange rate transaction costs in Thailand. The sell-buy gap for the U.S. dollar is much lower than for any other currencies. So for exporters or importers who need to change back and forth between foreign currencies and the local currency, the U.S. dollar is by far the cheapest currency to use, and this is why people use the U.S. dollar. On the other hand, the yuan lags far behind.

The most important reason why the sell-buy gap for most currencies is large is because there are no direct exchange markets between that currency and the Thai baht. For example, trading yen for baht and vice versa has to go through the dollar, i.e. changing from baht to yen involves the bank implicitly changing from baht to U.S. dollars and then U.S. dollars to yen. The outcome is that the gap between the buying and selling rates between the baht and the yen is about 2.74 times that between the baht and the U.S. dollars. For the yuan, the gap is about 4.2 times.

Information from Japanese banks as to why they don’t operate a direct exchange market between the baht and the yen indicate that they want to be able to square their exchange risk position daily, but this is not possible because there are no forward markets between the yen and the baht. Clearly, as there is no spot market, there will not be a forward market. So this is a situation of market failure and government intervention will be needed to establish these markets. These forward markets also provide numerous hedging instruments to reduce the exchange rate risks for traders and investors.

If the yuan is to eventually rival the U.S. dollar as a major international (and reserve) currency, government action to set up direct exchange markets between the yuan and various currencies should be a priority. This will make using the yuan for international transactions more attractive and also pave the way for the development of many types of derivative markets involving the yuan to make available hedging instruments to reduce exchange rate risks when using the yuan. 

Although some direct currency markets between the yuan and other currencies are being established, there is still a long way to go. Also of extreme importance is the ability of yuan holders to have access to deep markets for yuan financial assets. This will increase the potential benefits to holding yuan. Again there is a long way to go to bring this about.

Apart from developing currency markets between yuan and other regional currencies, markets between various major regional currencies also need to be developed. This will facilitate the development of the region’s capital markets. Since the East Asian financial crisis, there have been a lot of discussions about the need to develop East Asian capital markets in order to keep the region’s saving surplus within the region, rather than recycle the surplus to finance the U.S. deficit and then have hot money flowing back to East Asia with all the problems that they can cause. The development of deep and well functioning currency markets in the region will reduce the transaction costs of investing and earning in the regions’ local currencies and help to promote the region’s local currency capital markets.

By Chalongphob Sussangkarn

Chalongphob Sussangkarn is a Thai economist. ―Ed.

(Asia News Network)