While the Chinese yuan has been rising in prominence on the international stage, it is unlikely to become the world's predominant reserve currency anytime soon. This is because China's leaders are not actively seeking such a role for their currency.

The Chinese government has been deliberate in its approach towards advocating for the yuan as a reserve currency. While China's rising prominence in the international financial system has led to some increase in the yuan's use in cross-border transactions, it is unlikely to become the world's predominant reserve currency in the near future. This is partly due to China's awareness of the challenges and responsibilities that come with such a role, including the need to maintain a stable exchange rate and control inflation. As a developing country facing numerous economic challenges, China may not be ready to take on the added pressures of being a reserve currency country.

Moreover, China's leaders are cautious about the political implications of having a reserve currency. The US has historically used the dollar's status as a tool for national security purposes, and China does not want to be vulnerable to such tactics. Additionally, being a reserve currency country often requires running a trade deficit, which could be perceived as a sign of weakness by China's leadership and citizens. Hence, China's approach towards advocating for the yuan as a reserve currency is driven by both economic and political considerations.

The link between Reserve Currency Status and Current Account Deficits

It is useful to clarify these concepts first in order to comprehend the connection between reserve currency status and current account deficits.

A country experiences a current account deficit when it imports more goods and services than it exports, which causes a net outflow of money. This imbalance must be paid for by a mix of foreign borrowing, asset sales to foreign buyers, and restrictions on foreign investment. A current account deficit, then, indicates that a nation is a net borrower from the rest of the globe.

A reserve currency is a currency that is frequently used to settle international trade and that central banks and other financial institutions hold in substantial quantities as a store of value. In the international financial system, this grants the issuing nation important benefits including cheaper borrowing rates and more monetary policy flexibility.

Thus, why could a nation be forced to put up with ongoing current account deficits in order to issue enough debt held by non-residents?

One way to approach this is to think about how a country's capital account and trade balance (i.e., the difference between exports and imports) relate to one another (i.e., the flow of financial assets between the country and the rest of the world). A country's trade balance and capital account balance must always be equal under a basic model of international commerce and finance since any transaction that includes the inflow or outflow of products or services also involves the inflow or outflow of financial assets.

A nation must establish an equivalent obligation for foreign investors to hold in order to issue debt or other financial assets to such investors. This obligation may be represented by money or other financial assets. Nonetheless, the nation must make sure that there is enough demand from non-residents for its liabilities in order to maintain reserve currency status.

Maintaining a current account deficit, which results in a net outflow of money from the economy, is one strategy to generate this demand. The financial assets of the issuing nation, such as corporate debt or government bonds, may then be purchased with this outflow. The nation can sustain a steady demand for its liabilities and continue to issue enough of them to support reserve currency status by continuously producing financial assets that can be bought.

In other words, a reserve currency country effectively borrows from the rest of the world by accepting persistent current account deficits in order to generate a consistent flow of financial assets that may be retained as reserves. The country's status as a reserve currency makes it feasible for it to borrow at cheaper interest rates than other nations and to issue debt that is highly sought after by overseas investors.

It's important to note that there are some cons to this correlation between reserve currency status and current account deficits. Running a big and ongoing current account deficit in particular can render a nation vulnerable to rapid changes in investor sentiment or changes in the state of the global economy. Nonetheless, reserve currency status may provide important advantages in terms of access to money and influence in the international financial system for nations who are able to maintain a stable balance of payments.

Challenging the Myth of Complete Exchange Rate Flexibility for Reserve Currency Status

The idea that a country must have complete exchange rate flexibility in order to attain reserve currency status is a commonly held myth. In reality, there have been several instances where countries have achieved reserve currency status without possessing a completely flexible exchange rate system.

US dollar

During the era of the gold-exchange standard, which lasted from the end of World War II until the early 1970s, the US dollar was a notable example. The Bretton Woods Agreement and System created a collective international currency exchange regime based on the US dollar and gold[1]. The countries agreed to keep their currencies fixed (but adjustable in exceptional situations) to the dollar, and the dollar was fixed to gold[2].Under this system, the value of the US dollar was fixed to the price of gold, and other countries could exchange their dollars for gold at a fixed rate. This effectively restricted the flexibility of the US dollar's exchange rate.

Despite this lack of complete flexibility, the US dollar was still able to achieve reserve currency status during this period. This was due in part to the fact that the US was the largest economy in the world and a major player in international trade and finance. Additionally, the Bretton Woods system, which established the gold-exchange standard, was largely designed to maintain the primacy of the US dollar in the international financial system.

British pound

Another example of a country that achieved reserve currency status without possessing completely flexible exchange rate systems is Great Britain. In the late 19th and early 20th centuries, the British pound sterling was the dominant reserve currency in the world despite Britain maintaining a fixed exchange rate system known as the gold standard[1].Under the gold standard, the value of the pound was fixed to the price of gold, which limited the flexibility of its exchange rate. However, Britain's dominance in international trade and finance, as well as the stability and reliability of its financial institutions, made the pound a highly sought-after currency for international transactions and reserve holdings.

Furthermore, Britain's imperial expansion and the establishment of the sterling area, a network of countries that used the pound as their primary currency, also contributed to the pound's reserve currency status. By maintaining close economic ties with other countries through the sterling area, Britain was able to maintain demand for the pound and strengthen its position as a global reserve currency.

The examples of the US dollar under the gold-exchange standard and the British pound under the gold standard demonstrate that complete exchange rate flexibility is not a necessary condition for achieving reserve currency status. Rather, a combination of factors including the size and importance of a country's economy, its role in international trade and finance, and the stability and attractiveness of its financial markets can all contribute to the attainment of reserve currency status.

While the Chinese yuan is rising in prominence and has the potential to become a major reserve currency, it is unlikely to become the dominant global reserve currency for a long time to come. This is due to the fact that China would have to fundamentally shift its economic model and take on significant responsibilities, as well as the Chinese government's cautious approach to pushing for such a role. Ultimately, the global reserve currency status of a currency is determined by a complex set of economic, political, and historical factors that cannot be reduced to a single measure such as exchange rate flexibility.

Personal Notes

I've lived in Taiwan for a while, and I must say that this country has the most incredible weather. Taiwan has been suffering from a comparatively mild winter season while other regions of the world are dealing with brutal winters. It is usually pleasant to go outside without a heavy jacket on even the coldest days because the temperature seldom falls below 15 degrees Celsius. As February draws to a close, I can already feel the warmth of spring approaching, As the end of February approaches, I can already sense the arrival of spring and eagerly look forward to the arrival of summer.

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Why the Chinese Yuan doesn't want to be the World's Reserve Currency Anytime Soon