Asia FX

How the Yuan Could Take the Dollar's Crown

Matt Clinch, News Assistant

China could eclipse the United States sooner than many think as the yuan (renminbi) becomes a major player on the world stage that could put the dollar in the shade, analysts told CNBC.

Grant Faith | The Image Bank | Getty Images

China's meteoric rise has propelled it into second place among the world's biggest economies, leaving all but the United States in its wake.

Consumption as a share of gross domestic product is still relatively low in China (35 percent compared to around 70 percent in the U.S. according to the World Bank). But a booming middle class could see the country move away from its export driven economy to a more import and domestically focused market. A market that would need a dominant yuan to allow it to have a trade deficit but remain competitive.

"China is clearly seeking to internationalize the renminbi. It has a sequenced strategy: use in trade settlements first, use for specified investment purposes second, use as reserves third," Barry Eichengreen, professor of economics at the University of California told CNBC.

And it's been a big year for the currency, with swap deals agreed with Australia, Russia, Japan and Brazil. The China Development Bank has made steps to offer loans to BRIC nations using the yuan, the China Construction Bank launched a yuan bond in London on Friday and the Japanese yen has recently become directly exchangeable with the currency.

In 2009 China allowed its currency to be partially convertible outside the country, setting up the offshore deliverable-CNY market for Hong Kong (the CNH) which will likely spread to other jurisdictions. RBS reports that from a basis of nearly zero four years ago CNH-denominated deposits now total some 500 billion.

"Economic prowess has clearly shifted from Japan to China,"analysts at Citi said in a research note.

"Hence policymakers in Asia are more wary of relative strength of their currencies versus China than Japan."

Simon Derrick, chief currency strategist for BNY Mellon, has been tracking the foreign currency reserves China holds and has kept a keen eye on policy announcements by the country's politburo.

He highlights a marked decrease in growth of foreign currency reserves the country holds. September's third quarter figure showed foreign exchange growth of 2.76 percent year-on-year. Last year the same figure showed 20.9 percent growth.

Taken alongside announcements by the People's Bank of China he concludes that the Chinese authorities could be ready to pull away from the market and concentrate on promoting the 's convertibility that's fast approaching its equilibrium rate.

"Rumors have surfaced since the start of the month about a possible further widening of the trading band," Derrick told CNBC, indicating that the upper and lower limits of the currency price could increase from its current 1 percentage point.

"All this suggests that the first quarter of next year could prove an interesting one. Although further clues (one way or another) will likely surface through January and February, the most likely point for an announcement will come on or around March 14," he said, adding that the date was significant as it coincides with the National People's Congress in Beijing.

(Read More: Why China's New Conservative Leaders Will Be Reformists)

US Power Weakened?

These measures taken by China would decrease the transaction costs for the country's importers and exporters says Dr Zha Xiaogang, a research fellow at the Shanghai Institute for International Studies. Speaking at a seminar in Bahrain in October, he said it would lessen China's reliance on the dollar and the big fluctuations that seriously affect its foreign trade and investment, including oil.

"The US monetary authorities are only responsible for its domestic concerns and ignore the possible spillover effects to the rest of the world," he said.

(Read More:)

Jeremy Cook, chief economist at FX company World First, told CNBC that everyone in the currency markets believes that the importance of the RMB will increase alongside China's expanding global influence. However, not everyone agrees on when it will be officially classified as a "reserve currency".

"Opening its capital account would be China's first step towards achieving this status, but long-run developments such as a maturity of bond markets and a continuation of further involvement in the global financial markets cannot be simply created overnight," he said.

Researchers at RBS suggest it will become "prominent on the international stage" within the next 10 to 20 years. UC's Eichengreen suggests it will be a "ten year plus process". Larry Edelson, financial analyst at Weiss Research, told CNBC that dollar could lose its crown, but it won't necessarily be to the yuan.

"The world is headed toward a new reserve currency,either backed by the IMF SDRs (special drawing rights) , or some other neutral basket," he said.

Dr Zha Xiaogang argues that the real reforms needed are for China's financial sector to be modernized in line with developments in its manufacturing sector. He worries for the U.S.'s status when these adjustments unfold.

"The basis of U.S. power could be weakened," he said, explaining that the dollar as the world's reserve currency gives the U.S. great potential and helps it to finance its overseas actions (military, aid, investment etc.) at very low cost.

"There are many uncertainties about how the U.S. will respond to the dollar's possible loss of dominant status. We are therefore not sure whether the transformation of international monetary system will take place smoothly and peacefully."