Will the global currency club of five comprising the US dollar, Japanese yen, euro, pound sterling and Swiss franc be expanding soon by including the Chinese yuan?

China?s astounding pace of economic growth and the rapid expansion in the size of its economy over the last three decades has made its currency a serious contender as a global currency. Among the three emerging markets in the world?s 10 largest economies?China, Brazil and India?the Chinese yuan is touted as the hottest favourite for becoming a new international currency.

While China?s rapid rise to the second spot in the world economy has helped in currying favour for the yuan, the precarious state of the dollar has also been equally responsible. Among all international currencies, the American dollar has been the most prominent since the Second World War. The reign of the dollar has been threatened since the global financial crisis took a heavy toll of the US banking and financial systems from late 2008. The high public debt in the US has been steadily eroding the confidence of the international financial community in the greenback. The result has been appreciation of national currencies of all major economies against the dollar (except Argentina?s) during the last one year. The prospects of the debt-strapped US economy do not offer much hope for revival in the fortunes of the dollar.

Escalating budget and current account deficits in the US economy during the last decade had given rise to doubts over the resilience of the dollar, even before the financial crisis set in. The euro was widely tipped to unseat the dollar. Since the middle of the last decade, several emerging markets, including India, began holding larger parts of their foreign exchange reserves in the euro. However, the euro, too, has run into difficulties largely because of the financial stress experienced by Europe and also because of the incomplete financial integration within the Eurozone. Japan?s economic sluggishness has prevented the yen from being talked about as a replacement for the dollar.

The problems faced by the world?s major international currencies, particularly the dollar, have intensified speculations over whether the yuan (renminbi) will expand the global currency pool, and occupy some of the space that the dollar has held for long. The experience of the dollar and other international currencies shows that there are three main factors that global currencies must satisfy. The first is they must be of large economies that play major roles in global trade and commerce. The second is assuring holders of the currencies steady returns from the holdings and minimum volatility. Finally, international currencies should be easy to liquidate and convertible into other currencies at low transaction costs. All these features not only encourage businesses to invoice cross-border transactions in particular currencies, but also motivate national governments to hold their foreign exchange reserves, and borrow from overseas markets, in the specific currencies.

How does the yuan fare in these three respects?

The first condition is firmly fulfilled. China is now the world?s second largest economy in both nominal (i.e., current market prices) as well as purchasing power parity (PPP) terms. It is also the world?s third and fourth largest trader of global merchandise and services. There is little doubt over China?s significant presence in global trade and financial transactions.

With respect to the second condition, however, China does not exactly come out with flying colours. For several years, it was a low inflation economy and was able to avoid much of the growth-inflation trade-off that emerging markets and developing economies suffer from. However, high consumer prices over the last 2-3 years have affected China?s inflation record. High inflation economies cannot assure stable returns on their currencies since the values of the latter erode in real terms. Inflation and its concomitant effect on the yuan will continue to worry investors and governments about the return on the wealth they park in yuan-denominated deposits.

The biggest problem appears to be with the third condition. The dollar has enjoyed enormous popularity as a reserve currency due to the ease of liquidating dollar-

denominated securities. Not only are these securities easily convertible to cash, they are also convertible into assets denominated in other currencies. This is possible due to the deep and broad domestic financial market in the US that offers a large array of financial instruments enabling such conversion. Countries have been comfortable parking their reserves in dollar-denominated assets armed with the knowledge that low inflation in the US will assure stable returns. Conversion to other assets at low costs is also simple, should prospects of the dollar change. Unfortunately, China does not offer similar comforts for the yuan to investors till now.

The Chinese currency is fully convertible in current account transactions. However, there are several restrictions on its use in capital account transactions, both for inflows and outflows. Except for Hong Kong, there are hardly any other locations for investors to put money in yuan-denominated deposits. Dominance of the Chinese financial system by banks and lack of adequate non-banking financial intermediation has prevented proliferation of diverse financial instruments. China?s predominantly state-owned banks hardly face any competition from a heavily underdeveloped corporate debt market and have not developed enough asset-backed savings products other than bank finance.

There are, however, a few policy moves that signal China?s intentions to internationalise the yuan, albeit in a calibrated fashion. The gradual relaxation of a tight pegging to the dollar apart, China is likely to allow foreign holders of Chinese currency to invest in mainland China in yuan-denominated assets for foreign direct investment purposes. It is also expected to allow qualified foreign institutional investors (FIIs) to buy yuan-denominated securities in mainland China?s equity market up to an initial quota of 20 billion yuan. These measures are expected to develop closer linkages between offshore and onshore markets of Chinese currency and facilitate moves towards full convertibility of the currency in capital account transactions.

Notwithstanding currency use reforms, acceptance of the yuan as an international currency by the global community is unlikely till China?s domestic financial market undergoes fundamental changes. Financial sophistication is clearly the biggest obstacle to the Chinese yuan?s global aspirations.

The author is a visiting senior research fellow in the Institute of South Asian Studies in the National University of Singapore. These are his personal views