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While chinas merchandise trade has already exceeded

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Unformatted text preview: for most of the global exports and imports. While China’s merchandise trade has already exceeded US’s, it will take another 15 years for China to overtake US in GDP terms. As China’s economic size and share in international trade grow, its trading partners will start holding a part of their reserves in the Yuan-denominated assets. Source: IHS Global Insight • Source: WTO Low inflation and exchange rate stability – On the face of it, the Yuan seem to pass the test. However, given that China follows a quasi-pegged exchange rate and manages capital controls, it doesn’t seem to fulfil the condition in reality. But expectations are high, and it is widely believed that China will deliver on low inflation and exchange rate stability in case it adopts convertibility albeit in gradual manner, along with execution of necessary domestic institutional reforms. This will entail implementation of secondary reforms to ensure financial sector stability postconvertibility and reduction in direct control over the financial system. China has to move away from developmental approach to maintaining quasi-pegged currency and capital flows to a floating currency and open capital account. As China grows bigger, its dependence on export-led growth will reduce, enabling a shift to the policyfriendly flexible exchange rate regime. • Broad, deep and efficient financial markets – This is the biggest bottleneck for Yuan in becoming the global reserve currency. China’s domestic bond market is relatively shallow and illiquid, with limited access to foreigners. Further, in order to establish Yuan as a reserve currency, it also has to strengthen its foreign exchange and derivatives markets. Although China on various occasions has reaffirmed its commitment to develop bond, currency and derivatives markets, it has a long way to go before it makes a bid for the global reserve currency. • Political stability, rule of law and geo-political strength – While China scores good on political stability, it continues to lag on rule of law. According to the World Bank, China has stagnated on this score over the past decade. If doesn’t improve the conditions, the foreigners may continue to remain reluctant vis-a-vis investment in onshore Yuan assets. It is clear from the above discussions that China needs to introduce significant capital market and legal reforms necessary to enable Yuan emerge as a reserve currency. It may take China anywhere around 20 years to create the necessary conditions. Further, China’s politics will have a big say in the evolution of Yuan as a reserve currency. Countries such as India and Japan, which do not have close political relations with Beijng, are unlikely hold the bulk of their foreign reserves in Yuan. Precedent Analysis By comparing the current conditions with those during the pound-dollar transition in the 1920s,...
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