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Why China’s yuan is poised to be the next global super-currency

China’s yuan has a great opportunity to achieve super-currency status.

The major currencies have had a torrid time in recent years, raising huge question marks about their future reliability as reserve currencies in the global monetary system. The reputations of the US dollar, Japanese yen, euro and UK sterling have all taken a heavy pounding thanks to recession, deflation, currency debasing and political upheaval since the 2008 financial crash.

It is no wonder global investors, central banks and governments are feeling bruised and looking for better options. Other reserve currencies like the Canadian and Australian dollars and Swiss franc are too small to absorb the world’s great glut of monetary liquidity so there is a unique opportunity for the yuan, as a newly fledged reserve currency, to jump in and fill the gap.

It has only been a short while since the yuan was granted reserve currency status by the International Monetary Fund late last year, so it is still early days. The yuan’s inclusion in the IMF’s basket of reserve currencies, as recently as last month, means it will take some time before China emerges as one of the leading players in the global payments and reserves system.

To reach true reserve currency status, the yuan must meet three key criteria – cementing credibility, convertibility and confidence in the currency. It will be challenging but not impossible. Governments and multinational institutions must be certain China’s currency not only satisfies these conditions, but it is also backed by credible and transparent policies, in order to feel safe about diversifying their foreign exchange reserves in any significant size into yuan.

Currency reserve managers must have confidence that China remains fully committed to let the yuan function in a fully market-driven way, free from official meddling to gain a more competitive advantage in world trade. It is also imperative for China to develop deeper and more liquid capital markets to reinforce the yuan’s growing appeal to global investors.

Some pundits believe the yuan’s emergence as a fully-fledged major reserve currency could take decades. But the odds seem to be swinging in China’s favour. The competition is not much to write home about, especially for the world’s two most popular reserve currencies – the US dollar and the euro. The dollar’s dominance as a reserve currency is in long term decline, while the euro has been engulfed in a survival struggle in recent years.

The dollar’s share of world foreign exchange reserves has fallen steadily to around 63 per cent right now, while the euro has sunk to 20 per cent. Both look set to fall even further. Sharp devaluations since the 2008 crash have not helped confidence in either currency.

Since the global financial crisis first broke in 2008, demand for the US currency has been compromised by the shock of zero interest rates and the debilitating effect from quantitative easing’s mass dollarization. Even now, with the US economy on a strong footing and the US Federal Reserve poised to raise rates again, global investors are having significant doubts about US political risk. This week’s US elections could hit long term dollar demand very hard.

The euro is far from being a safe haven for global investors after years of incessant economic and political uncertainties in the euro zone. The euro is not out of the woods yet and its future survival is still in jeopardy. Britain’s vote to quit the European Union raises a copycat risk of weaker euro zone nations throwing in the towel on euro-austerity and dumping the single currency at some stage.

Greece came very close to destroying the euro during the European debt crisis and the risks are not over yet. Meanwhile, the European Central Bank’s extremely loose monetary policies and negative interest rates pose a very heavy drain on the currency’s global appeal.

In the present climate, decisions by central bank reserve managers to diversify foreign exchange reserve holdings almost boils down to what’s the ‘best of a bad bunch’. If China sets its sights high on the yuan becoming a top-quality, high-performing currency, this could all change.

If China plays its cards correctly and the yuan’s stock rises with governments, institutions and investors, the currency could leap up the reserve management league tables. Over the next decade yuan denominated holdings could account for as much as 10 per cent of global official foreign exchange reserves – if not more. The sky’s the limit.

China has nothing to lose and everything to gain in its quest for yuan super-currency status.

David Brown is chief executive of New View Economics