Are the Chinese finally getting serious about loosening their ties to the dollar—and even replacing the greenback with the yuan as the global economy's reserve currency? The evidence is mounting that they are.
For the last two months, China's leadership has been complaining about the country's dangerous dependence on the dollar. Beijing holds $2 trillion in dollar assets, accumulated through years of exports to America and massive purchases of Treasuries by the Chinese government. If Washington can't rein in its mounting budget deficit, both Treasuries and the greenback could weaken considerably—and the Chinese could be big losers as a result.
The Chinese began generating attention on the issue in March, when Chinese Premier Wen Jiabao said he was worried that the country's dollar assets could slide. Ten days later Chinese central bank chief Zhou Xiaochuan suggested replacing the dollar as the international reserve currency. One idea, Zhou said, was to replace the dollar with a basket of currencies supervised by the International Monetary Fund.
Skeptics said the Chinese were merely talking. The dollar is too entrenched as the international currency of choice, with the U.S. by far the world's largest economy, went the thinking. And in any case, the Chinese act so deliberately that, even if they did wish to elevate the yuan globally, they wouldn't do it in the short or medium term. Finally, if the Chinese were to bring the yuan into competition with the dollar as a medium of international trade, they would have to turn the yuan into a convertible currency whose value would be dictated by the market, with traders, investors, governments, and companies around the world freely buying and selling it. Such a loss of control, said many Western investors, would never be allowed by the authoritarian Chinese. It would mean lowering all kinds of financial trade barriers, allowing foreign access to Chinese securities markets and more. No way.
Now some observers are changing their tune. China's financial moves during the last two months have persuaded Western experts that the nation's leadership intends to make the yuan freely convertible into other currencies—the first big step toward open confrontation with the dollar—within a few years.
Why have perceptions started to change? Last month, Beijing completed the last of a series of so-called currency swaps—providing yuan to other central banks for use in trade with China—with Argentina, Hong Kong, Indonesia, Malaysia, South Korea, and others. These arrangements theoretically removed any need for these trading partners to use the dollar as an intermediary currency in dealing with China. Last week, Beijing denominated a bilateral trade deal with Brazil in the two countries' currencies, rather than in dollars; the value of the agreement was not specified. The value of the other agreements comes to $95 billion. By way of comparison, U.S.-Chinese trade amounted to $333 billion in 2008.
Big hurdles remain for the Chinese. Making the yuan freely convertible is one: Major central banks would be loath to hold any large sums of any currency—the purest definition of a reserve currency—if they could not sell or trade it without limitation. Another is the absence of a large market for yuan-denominated bonds. One key sign of acceptance as a reserve currency would be if Western countries such as the U.S. purchased bonds denominated in yuan and sold at market rates. Until now, yuan-denominated bonds have been sold only by Chinese banks, along with multilateral banks such as the Asian Development Bank and International Finance Corporation, and the bonds have been sold only in China.
Yet there was movement even on that aspect last week: HSBC Holdings (HSBC) and Bank of East Asia said they would become the first foreign banks to be authorized to sell yuan-denominated bonds in China.
Doubts remain that the Chinese can challenge the greenback. Former Brazilian Central Bank chief Gustavo Franco poured cold water on the notion that Brazil and China would fully abandon trading in dollars, calling it "pure idle talk." Others agree. "For now, the safe haven aspect of the dollar has overwhelmed other concerns. When people need liquidity, they go to the United States," says Morris Goldstein, an economist at the Peterson Institute for International Economics in Washington.
Still, what is more or less a consensus among Western experts on China seems to have formed that the Chinese are on an unmistakable path toward challenging the dollar. What remains lacking is a political decision to shift from acting on the margins to making a decisive move, many experts say.
That resolve may be forming. A Chinese official said on May 20 that the yuan could be a serious reserve currency by 2020. Zhang Guangping, vice-head of the Shanghai branch of the China Banking Regulatory Commission, told reporters that this date would coincide with the timetable of making Shanghai an international financial center like London and New York. Turning Shanghai into China's money capital would be meaningless if the yuan were not convertible.
That rough timeline — a 10- or 15-year transition — coincides with the projections of many Western experts.
But among those predicting that the Chinese may move more rapidly is Nicholas Lardy, a China expert at the Peterson Institute. Lardy says the idea of making the yuan convertible is not new: The Chinese first raised the issue in the 1990s but were derailed by the 1997 Asian economic crisis. "They could do it in two or three years," Lardy said. "We tend to underestimate how far they've come in reforming various aspects of their financial system."
Whatever the timing, such a move would be dramatic in terms of the Chinese economy. Until now, Beijing has maintained a tight grip on the value of the yuan—many experts believe it is undervalued—including limiting who can convert it to hard currency and how many dollars flow into the country. "China has maintained the currency at below the market clearing rate to help its exporters," said Brad Setser, a currency specialist at the Council on Foreign Relations, for whom he writes a blog, Follow the Money.
In addition, there is the matter of China's massive reserve of dollar assets. "If the Chinese stop buying dollars, the value of their assets will fall," said Rachel Ziemba, a China analyst at RGE Monitor, a financial think tank. "So the change is not going to be tomorrow or next year."
One way the Chinese can lessen their exposure to dollar assets over time is to shift their reserves from long-term Treasuries into shorter-term U.S. bonds. That shift would give the Chinese more flexibility in easing away from the dollar. The New York Times reported last week that the Chinese seem to be maintaining dollar-asset ownership levels, but shifting their holdings into maturities of a year or less—something they have not previously done.