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The Chinese Yuan vs. the Power of the Dollar

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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 U.S. 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 U.S. 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.

The only other currency that could conceivably be considered an alternative to the dollar is the Japanese yen. However, more than a quarter of Japan's $8+ trillion government debt is short-term, and Japan has the highest ratio of debt to GDP of any wealthy country. This limits the long-term desirability of the yen as a trading currency.

The Chinese yuan is not yet convertible on the capital account, its capital markets are not yet well developed, and foreigners have no access to Chinese government securities. However, if as anticipated the Chinese government does eventually make the yuan fully convertible and is successful in developing its capital markets to become competitive internationally, the yuan is perhaps best suited to become an alternative to the dollar over the next two decades.

China could in theory seek to influence the U.S. financial system in the interim in a variety of ways, but given its own vast holdings of dollars, any significant decline in the value of the dollar would not be in its own interest. There is no 'cost free' way for China to disengage itself from its own reliance on dollars.

In an effort to reduce its reliance on the dollar, the Chinese government began to allow Chinese companies to use the yuan to settle international trade transactions in 2009. The government has also promoted the practice of state-owned companies using the yuan to make acquisitions, and has just taken an important step in further internationalizing the role of the yuan by permitting domestic companies to shift yuan offshore for investment purposes. This attempt to internationalize the yuan is being done while the government is maintaining extensive capital controls -- in essence, having its cake and eating it too -- an unsustainable approach over the long-term.

In the absence of any realistic alternative to replace the supremacy of the dollar, it is likely to remain the dominant global currency for many years to come. No other currency is more widely accepted or used. Unless some coordinated action is taken by the world's leading governments to supplant the dollar, China's savvy push to enhance the perceived future value of the yuan is likely to result in stronger bilateral trading relationships and greater flexibility for Chinese companies, but little else for the foreseeable future.

Daniel Wagner is Managing Director of Country Risk Solutions, a political and economic risk consulting firm based in Connecticut, USA. Joseph Tam is a graduate of the London School of Economics in Comparative Chinese Politics, and is based in London.