The International Monetary Fund, presumably under pressure from the United States, recently declined to add the Chinese yuan to its basket of reserve currencies.
But the move was far from permanent. The IMF normally reviews and adjusts the basket, which currently includes the US dollar, the euro, the British pound and the Japanese yen, every five years. To give the financial markets time to anticipate possible changes, the review date was postponed by nine months this time, so that adding the Chinese currency will again be a possibility in October 2016 at the earliest.
Admission to the currency basket is important for China. Its government is familiar with the benefits of a domestic currency being a global one. Countries that issue a reserve currency can use their money to buy commodities, consumer goods and capital goods almost anywhere.
They can provide the world with liquidity or withdraw it, and they are able to influence exchange rates by intervening in foreign currency markets. A reserve currency can also serve as a safe-haven currency for investors.
Seigniorage revenues, which are earned when a central bank produces money that is worth more than it cost to create, are especially important. These profits increase with a currency’s growing acceptance.
Only when the euro zone succeeds at becoming a political union will it be able to permanently benefit from the advantages of the euro as a global currency.
In addition to stable political conditions and a solid monetary policy, the most important feature of a reserve currency is its full convertibility. This is where the yuan still comes up short.
Until the beginning of the 1970s, the currency of the respective dominant economy was the globally accepted currency, and the most powerful economy controlled its usage. Spain was the dominant economy in the Western world until the end of the 16th century. Starting in the 17th century, after a short interlude involving the Netherlands, the United Kingdom became the dominant power until the late 19th century. Then the United States replaced it as the world’s most important economy.
Economic development in the United States set the pace of the global economy, and the world economy gradually became “dollarized” as of the mid-1920s. Even after a collapse of the Bretton Woods fixed-rate system in 1973, the dollar remained and still is the key global currency.
U.S. dollars accounted for 63 percent of international foreign currency reserves in 2014, with the euro making up 22 percent and the British pound and Japanese yen representing 4 percent each.
Next to the dollar, the euro is effectively the only significant global currency today, even though the economic importance of both economic zones is declining. Based on purchasing power parity, China’s gross domestic product is bigger than that of the United States today.
In this situation, it is only a matter of time before Beijing allows the yuan to float freely, especially as China has always seen itself as the dominant global economy. If it is allowed to float, the yuan will rapidly establish itself as the third most important reserve currency.
Until then, Beijing will attempt to convince the international community of its reliable legal system and economic and monetary policy, because the political leadership wants to enjoy the advantages of having a global currency as quickly as possible.
At the same time, Europe is squandering confidence in its currency. Key members of the euro community are unwilling to transfer central political functions to Brussels that would transform the increasingly heterogeneous monetary union into an economically stable association of states with the ability to take action.
Only when the euro zone succeeds at becoming a political union with a coordinated economic policy, solid fiscal policy, full banking union and collective unemployment insurance will it be able to permanently benefit from the advantages of the euro as a global currency.
As recently as 2011, the World Bank assumed that the dollar’s dominance could come to an end around 2025 and be replaced by a system “in which the dollar, the euro and the yuan are considered equal currencies.” It is questionable whether the World Bank would use the same language today.
A breakup of the euro zone as a result of its members drifting apart economically would allow the aging continent to fall into sectionalism and global irrelevance.
When the world is bipolar once again, who will still be asking Brussels, Frankfurt, Berlin and Paris about economic and currency issues? Certainly not an economic and currency alliance between Washington and Beijing, forged together by free trade agreements and foreign currency reserves, which will soon represent 40 percent of global economic output.
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