The use of yuan as international currency

The dazzling steps China has taken recently to expedite wider and better use of the yuan in cross-border trade and investment mark the country’s latest efforts to make its currency truly international.

This accelerated pace to internationalize the yuan was long overdue. But given the complexity and problems with the global financial and currency systems, Chinese policymakers need not go too fast on narrowing the gap between China’s huge contribution as the world’s second largest economy and the inadequate role its currency plays in the world economy.

On Thursday (Jan. 13), China announced that qualified domestic businesses and banks could settle their overseas direct investment in yuan.

The move that could expand the yuan’s global reach came just one day after Bank of China began offering yuan-denominated accounts in the United States and two days after residents of Wenzhou, Zhejiang province, were allowed to invest abroad as individuals.

After moving at a glacial pace for years, the internationalization of the yuan has suddenly gained faster-than-expected momentum.

The surge of the yuan on Thursday to its highest level against the U.S. dollar since China scrapped the fixed exchange rate in July 2005 might have created the impression that the government is taking stopgap measures to preempt foreign criticism against its currency policy. But the truth is that China’s growing need to better manage its ballooning foreign exchange reserves and, more importantly, curb rising inflation demands significant changes in its foreign exchange regime.

On the one hand, with the foreign exchange reserves crossing $2.85 trillion at the end of 2010, concerns have understandably been heightened over their safety and returns, as well as their impact on inflation. Since China’s central bank has to issue an equal amount in yuan to offset the massive inflow of foreign currency, accumulation of larger foreign exchange reserves will only make it harder for the government to control inflation.

On the other hand, the increasing urge of Chinese individuals and companies to invest overseas has made the country’s strict capital controls increasingly obsolete. China badly needs a more globalized currency to enable its investors to better distribute their businesses across the globe.

The gradual rise of the yuan as a new global currency will facilitate China’s rise as a major trade, investment and financial power. It is important to keep the pace of the yuan’s internationalization in line with the country’s actual need for sustainable growth.

So, had the yuan been substantially undervalued as some of China’s trading partners insisted? The answer is obvious. But no one should expect the rise of a new global currency to be that easy and simple.

(China Daily, Jan. 16)