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Topic10-Nishant - Nishant IIM,Bangalore Executive Summary...

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W INNER CRISIL Y OUNG T HOUGHT L EADER 2010 Nishant IIM, Bangalore Will Chinese Yuan become the next reserve currency?
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Executive Summary To summarize the whole thing in one sentence – the Yuan has the potential, but it may take another 15-20 years before China can start to strongly promote the currency. While the macro-conditions are in favour of China, it needs to improve the rule of law, make the Yuan convertible and create deep domestic bond market. However, in spite of these efforts, political obstacles, network externalities and competitors may preclude the Yuan from becoming the dominant reserve currency. China’ relationship with major economies such as US, Japan, India and Russia will also determine the success of the Yuan. If China is unable to garner the support of these economies, which are expected to together constitute around 60% of the world GDP in 2030, the crowning of the Yuan as the global reserve currency would be next to impossible. From the two approaches that were adopted to analyse the strength in the Yuan’s bid for the next reserve currency, it was found that some conditions favour China to promote the Yuan while others require significant improvement. In the first approach, where Papaiouannou and Portes’ critical factors for reserve currency were tested, China and the Yuan could only partially satisfy the requisite conditions. China has made significant strides on economic front – it is at par with the US in merchandise trade and only second to the US in terms of GDP. However, it lacks strong financial institutions, rule of law and currency convertibility. In the second approach, where the current situation was benchmarked against the pound- dollar transition in 1920s, it was found that although it has the same motivation as the US had in the 1920s – to promote its currency as the reserve currency – its GDP, investment position, and the state financial institutions are not up to mark. When compared to the US of 1920s, it has large reserves; however, not in gold but denominated in dollar. China is trying to support the dollar as the US did for the pound in the 1920s. But this doesn’t seem sustainable because accumulation of dollar-denominated US securities exposes China to the exchange rate risk. It may not seem imminent, but with China taking steps to push the Yuan’s internationalization, and to diversify its reserves, the Yuan can claim the status of the reserve currency in next two decades.
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