EXPERT Q&A

Linda Lim, strategy professor at the University of Michigan’s Ross School of Business, shares her insight on the yuan’s prospects in the New Year. Contact: 734-763-0290, lylim@umich.edu.

Q: With International Monetary Fund endorsement of the yuan as a reserve currency, what impact will this status likely have on the value of Chinese currency in the year ahead?

A: In the short term, there will be little impact. First, the change in status will take place only in October 2016. Second, the yuan will continue to be under downward pressure from market forces due to slow economic growth, government policy and financial market uncertainties, domestic capital flight, etc. This will outweigh any increase in demand for yuan to be held in other countries’ foreign exchange reserves (which in any event will not be substantial).

In the longer term, beyond 2016, the conditions required for reserve currency status—market interest rates, exchange rate flexibility and convertibility, a more open capital account—will encourage China to follow through with more domestic financial market reforms. It is these reforms—not yet completely enacted—that will make the yuan an attractive currency to hold and eventually boost its value.

Q: Give us some perspective on where the yuan ranks now and where you think it will be this year?

A: The yuan recently became the world’s fourth-most-used payment currency, behind the U.S. dollar, euro and pound sterling, having marginally pushed past the Japanese yen. There is less significance to this phenomenon than media headlines suggest. The yuan accounts for a small fraction of world payments, 2.79 percent, or less than half the share of the pound sterling, a tenth of the share of the euro, and way below China’s nearly 12 percent share of global trade.

In contrast, the U.S. dollar accounts for 45 percent of world payments and 63 percent of world foreign exchange reserves, of which the yuan accounts for just 1 percent, though the U.S. share of world trade is about the same as China’s. Thus, the yuan is underrepresented in world payments and reserves relative to its share of world trade, while the dollar is overrepresented, due to the popularity among global investors and governments of the United States’ broad, deep, diverse, liquid, transparent and secure capital markets.

Market forces alone should lead one to expect the yuan’s share to rise and the dollar’s to fall over time, since matching the currency used in payments and receipts in trade and investment reduces transaction costs, currency risk and volatility exposure. But any shift in these percentage shares in the next year are likely to be small, and at the expense of the euro rather than the dollar.

Q: Do you expect investors to embrace the yuan in 2016?

A: World central banks and individual investors will only increase their use and holdings of yuan if they have confidence in the currency. Chinese financial markets also must develop the depth, diversity, transparency and security that have kept the U.S. dollar reigning supreme as the world’s preferred reserve currency even as the U.S. share of global trade and investment has declined.

Governments are understandably reluctant to hold reserves in a politically managed rather than market-determined currency, while the trust of market actors has to be earned over time and cannot be merely conferred by an international body like the IMF.

The most likely scenario for 2016 would be a gradual increase in yuan holdings by non-Chinese entities, but probably not enough to change the market dynamics which favor a weaker yuan.

In the longer run, both China and the world economy stand to gain from increased international use of the yuan—China from the domestic financial market reforms that internationalization will require, and the rest of the world from having a more diverse basket of currencies to choose from to finance trade and investment and hold reserves, reducing the current overdependence on the U.S. dollar. Global macroeconomic rebalancing—away from chronic excess balance-of-payments deficits and surpluses—would also be more achievable.