In the first such change since 1999, the International Monetary Fund announced on Monday that the Chinese yuan will be recognized among the elite group of worldwide reserve currencies. China’s currency—also known as the renminbi—joins the dollar, yen, euro, and pound as “safe-haven” currencies that governments typically hold in high quantities as foreign exchange reserves. These reserves are used to manage exchange rate risk and pay off international debt obligations.
Here, professor of economics Kamran Dadkhah explains the rationale behind reserve currencies, the process that led to the yuan’s inclusion, and what implications the IMF decision might have for the world economy going forward.
What is the impact of this decision on the world economy, and what does it say, specifically, about China’s standing in a global economy?
The decision by the International Monetary Fund, which will go into effect next October, has two symbolic messages for China and the Chinese economy. First, it acknowledges China’s standing as the second-largest economy in the world with its vast international trade. Second, it urges China to continue the liberalization of the renminbi (yuan), which has been going on for some time. For many years China deliberately kept the value of the yuan low to encourage and help its exports. But now it has made a commitment to keep the value of the yuan stable. Indeed, it is believed that presently the yuan is somewhat overvalued. Now China is managing the yuan’s free exchange rate; it is expected that in the near future the yuan will become “free.”
China is experiencing a slowdown in its economy at present and would like to further devalue its currency to stimulate its economy. Given the decision by the IMF we can expect such a devaluation to take place but at a gradual pace. The effect of the IMF decision on the world economy will not be drastic. The Special Drawing Rights is a basket of elite currencies consisting of the U.S. dollar (41.73 percent), euro (30.93 percent), Chinese renminbi (10.92 percent), Japanese yen (8.33 percent), and pound sterling (8.09 percent). To quote the IMF, “the SDR is neither a currency, nor a claim on IMF. Rather, it is a potential claim on the freely usable currencies of IMF members.” The total value of the Special Drawing Rights is equal to $285 billion, which is a help to smaller countries and at times of crisis, but it is very small in relation to the volume of international transactions.
What is a reserve currency, and why do countries typically hold large amounts of foreign currency in reserve?
International reserves are used by countries to obtain currencies of their trading partners. In transactions inside a country goods are exchanged for the currency, usually a piece of paper. The seller accepts a piece of paper because the government guarantees its value. In international trade there is no such guarantee. If Turkey wants to buy commodities from Brazil it has to offer Brazilians the dollar or a currency acceptable to them.
Until the 20th century the international currencies were gold and silver because of their intrinsic value. But difficulties with such a system led to the gathering of 44 countries in Bretton Woods, New Hampshire, in 1944. In the Bretton Woods Agreement the dollar, backed by gold, was designated as the international currency. Still there was not enough gold and dollars to satisfy the needs of international trade and finance. During the 1950s and the early 1960s Europeans complained of the dollar shortage. Hence, in 1969, the IMF introduced the Special Drawing Rights.
On Aug. 15, 1971, President Richard Nixon suspended the gold backing of the dollar and ended the Bretton Woods era. Still the dollar remained the international currency. But many countries were in need of international money for their transactions. In this regard the SDR helped other, especially smaller, countries to carry out their transactions.
In your opinion, will there come a time when the dollar is no longer among the group of reserve currencies?
No. In the foreseeable future and even beyond, the dollar will keep its place in international trade and finance. Needless to say, the source of the strength of the United States economy is the free market where entrepreneurship is valued and people can enjoy the rewards of their work and innovation. As long as the country adheres to the principles of free market, the U.S. will remain economically strong and the dollar the main international currency.
We can imagine a world with a globalized united economy where there are only one central bank and one international currency. But frankly, at present, such a thought is the stuff of science fiction novels.