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Beijing can consider expanding the role of the yuan globally to challenge the dominance of the U.S. dollar, he told CNBC's Tanvir Gill in an interview which aired Thursday.
While the greenback — the reserve currency of the world — is dominant today, the "only way that can ever change" is if there's a genuine, "long-term alternative" to the U.S. currency, O'Neill said.
China has already made some strides in internationalizing the use of its currency.
Chinese A-shares — those traded in mainland China — were included in index provider MSCI's global and regional indexes. The A-shares, as well as Chinese bonds in the Bloomberg Barclays index, are traded in yuan.
As Chinese assets are increasingly traded in global markets, more foreigners will need to trade in the yuan, which is the intent of the internationalization drive.
"Some people would say, of course, the ultimate weapon would be for China to start selling very large numbers of U.S. bonds ... but it would probably hurt, of course, the value of Chinese investments, " O'Neill said.
China is currently the largest holder of U.S. government debt, owning roughly $1.12 trillion in U.S. Treasury bonds. Analysts have debated on whether Beijing will consider the so-called "nuclear option" in its trade fight with the U.S. — defined as selling off its holdings of U.S. Treasurys and triggering a rise in interest rates, which could hurt the American economy.
A weaker yuan has been a key source of contention between U.S. and the China, with U.S. President Donald Trump accusing Beijing of intentionally letting its currency slide lower in order to make its exports cheaper.
But a weak yuan will also reduce investor confidence.
"I don't think a renminbi ... devaluation makes a lot of sense at all," he said, referring to another name for the yuan — the renminbi.
The other way China could strengthen its global position is to tap on the growing power of its consumers, O'Neill said. Currently, domestic consumption makes up only 40% of the country's GDP, versus 70% in the U.S., he pointed out.
"Over the next decade to 20 years, there's no way the U.S. consumer can continue to be the dominant share … of the U.S. economy ... Whereas for China to reach the BRIC-type dream ... the Chinese consumers got to continue to rise," said O'Neill.
O'Neill famously coined the term BRIC — an acronym referring to the economies of Brazil, Russia, India and China. He had predicted those four emerging countries were on their way to reshaping the world economy.
— CNBC's Yen Nee Lee contributed to this report.