Yuan: The Growing Reserve Currency

Short Term or Long Term?

Central banks around the world have been diversifying away from the U.S. dollar given the risk of recent volatility led by political, trade, and budgetary concerns. The Chinese Yuan and the Euro are the two primary recipients from the greenback’s recent decline. The U.S. dollar is still overwhelmingly the reserve currency held by central banks, but is this decline a temporary drop or part of a long term trend toward the ascension of the Chinese yuan?

Background on Currency Reserves

Central banks hold reserve currencies for a number of reasons. These reasons include holding the value of their local currencies at a fixed rate or a lower floating rate than the value of the dollar. Banks also keep foreign currencies to maintain liquidity in the case of a local crisis, meet external credit obligations, boost financial returns, and generally help provide confidence to capital markets, among other primary reasons.

The Chinese yuan officially became a world reserve currency on Novemebr 30th, 2015. This made the Chinese yuan the fifth reserve currency after the U.S. dollar, Japanese Yen, British pound sterling, and the Euro.

Latest Data

According to the International Monetary Fund (IMF)’s latest statistics on central bank reserve currency holdings, the U.S. Dollar holdings by central banks dropped to a four year low as of the end of 2017 to 6.282 trillion, or 62.72 percent of allocated reserves. This figure has since increased slightly to 6.499 trillion or 62.48 percent of reserves due to recent currency instability in parts of central Europe, trade war concerns, and news that the ECB will delay raising interest rates until mid to late 2019.

While this data shows that the U.S. dollar is still a safe haven of value, there is a growing trend toward holding more Yuan in central banks reserves around the world.

Trading Oil in the East

Earlier this year, the global oil industry faced a fundamental shift when the Shanghai International Energy Exchange announced their intention to create a yuan based payment system for imported oil. This petro-yuan means that they will offer oil imports on a yuan based system rather than the current West Texas Intermediate (WTI) or Brent crude priced in U.S. dollars. This petro-yuan Asian benchmark signals the end of the dollar’s hegemonic position in international commodity markets. A pilot program for yuan payments was launched in March has been surging with news of the U.S. leaving the Iran nuclear deal. 

Global financial institutions are now offering pricing for the imported oil in yuan which further validates the yuan’s importance in this market. The oil markets are heavily influenced by the insatiable consumption of oil in China and China is the largest importer of crude oil in the world, so it makes strategic sense for China, but it represents another step away from the U.S. dollar currency dominance in the world. This move will likely create demand for other yuan based commodity product pricing which will further increase the importance of the yuan currency in other arenas.  

The Long Term

The establishment of a yuan based Asian benchmark is an important strategic step for China. This move shows the international community that the yuan is a stable currency of growing importance to the global markets. It also provides a potential political counter to U.S. interests. When The U.S. government announced new Iranian oil sanctions, the new Chinese oil futures surged due to the belief that restrictions on Iranian oil sales in dollars would boost activity on the yuan based benchmark.

These trends all indicate that the yuan’s move into oil isn’t an isolated event. China will continue to find new uses of the yuan in international markets to assert the currency’s influence because of the importance of the Chinese economy on the global markets. Greater yuan holdings in central bank reserves will continue over time if the yuan can avoid significant volatility for foreign investors. Additionally, the Chinese government needs to continue to develop new opportunities to use the currency in global markets.

The United States will continue to be the reserve currency of the world, but a shift away from the greenback’s hegemonic position is slowly occurring in the east.

Written by: Nick C.