The Chinese Yuan vs. the Dollar

By Daniel Wagner and Joseph Tam
0 CommentsPrint E-mail, January 18, 2011
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China and Russia's recent agreement to allow their currencies to trade on spot inter-bank markets should be welcomed as a sign that both countries have matured to a stage where they can compete in the global currency markets. Although the official purpose of the move is to promote bilateral trade and reduce conversion costs, it also reduces both countries' reliance on the US dollar as a trading currency and may ultimately supplant the dollar's status as the premier reserve currency for trade between the two countries.

Cash payment for bilateral trade between China and Russia, valued at approximately $40 billion annually, had been denominated exclusively in dollars until last month. In effect, both governments seek to phase out the dollar as a means of supporting bilateral trade. This is consistent with former President Putin and President Medvedev's long held desire to reduce the volatility of the ruble and establish a ruble denominated exchange for oil and gas sales. It is also consistent with China's ongoing ambition to eventually make the yuan a global currency and in the process strengthen its ties with its most important trading partners.

Although the dollar remains the premier currency for global trade and foreign exchange transactions, China's and Russia's action marks the beginning of an era in which the largest emerging markets are raising the profile of their currencies in an attempt to influence the decades-old, dollar dominated global trading system. The dollar is being gradually isolated among other important bilateral trading partners in emerging markets. For example, last month India's central bank proposed alternative methods of payment for crude oil from Iran, which had previously been processed through the Asia Currency Union.

The larger question is whether any other currencies can at this time supplant the dominance of the US dollar. The short answer is "no". In the absence of a major shock to the dollar, there simply is no viable alternative. In spite of the growth of Euro-denominated transactions since the currency began circulation in 2002, euro-dominated capital markets remain inconsistent in terms of liquidity availability, and many central banks remain hesitant to hold euro-denominated securities as a result of the ongoing economic convulsions in Europe. This is unlikely to change in the medium-term.

Also, given the European Central Bank's neutrality on the use of euros as an international currency, European governments would undoubtedly voice objection toward any overture by China to enhance the value of the euro as a global currency.

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