A yuan that's more widely used in international trade and investment could eventually challenge the dollar's supremacy, correct some of the imbalances that plague the Chinese and global economy, and force a profligate
It won't be an easy transition. There are powerful vested interests in
For more than a decade,
As important, denying foreign-exchange markets a role in setting the exchange rate has allowed the government to maintain the value of the yuan at an artificially low level—supporting a 30-year export boom. Since Chinese savers can't take their money overseas, banks have also gotten away with offering them low interest rates, keeping the cost of capital for industry at bargain-basement prices and underpinning an investment binge.
Take the example of Shenzhen—a fishing village in
But manipulation of the exchange rate and repression of the interest rate comes at a cost. Cheap capital has resulted in overcapacity in the industrial sector and bubbles in the mainland's property market. Managing the exchange rate in the face of trade surpluses has resulted in the buildup of gargantuan foreign-exchange reserves—$3.04 trillion that China has little choice but to recycle as cut-price loans to the U.S.
One of the first cracks in
By the first quarter of 2011, $55 billion of
Restrictions on outbound flows are also being lifted. In the past month, the
But more substantial opening of the capital account will require progress in two areas: an exchange rate that is close to fair value and market-set interest rates. The yuan is still undervalued, but two factors suggest it's much closer to market value than it used to be: It has appreciated 20% in real terms against a trade-weighted basket of currencies since 2005, and
If the yuan is approaching fair value, the Chinese government will be able to loosen controls on the capital account with less chance of triggering destabilizing speculative inflows.
At the beginning of the reform era,
According to the Royal Bank of
The increase in trade settlement and the development of
What Comes Next
Now pressure is building on
A more expensive yuan will limit demand for exports that have catalyzed the explosive growth of
The same dynamic that will make investment less affordable and exporting less profitable means more spending power for China's households—kick-starting efforts to bring domestic demand to the fore as a driver of growth. In the
Not all of the changes will be so positive for the U.S. Reduced intervention by
Displacing the Dollar?
The next step in the development of the yuan as an international currency—a role as a reserve currency held by central banks—will require more substantial progress. A capital account that still remains tightly controlled means the Chinese currency can't fulfill the main function of reserves: a liquid asset that central banks can use to stabilize the value of their domestic currency.
The transition to an open capital account won't be easy. Powerful groups in the export sector, state-owned enterprises, banks and local government benefit from a low interest rate and undervalued yuan. The door to reform is not wide open, but neither is it locked.
Reform has its own logic and its own momentum. Companies that raise yuan financing offshore today will demand increased opportunities to bring those yuan onto the mainland tomorrow. If interest rates are higher offshore, investors on the mainland will find opportunities to move their yuan in the other direction. If legitimate channels don't exist, companies with an onshore and offshore presence will find ways of circumventing
We aren't there yet. Yuan deposits in
When the tide of offshore yuan starts to wash over the wall