ITHACA, New York: A few years ago, Chinas currency seemed to be rising inexorably to global dominance.
The yuan had become the fifth most important currency for international payments, and in 2016, the International Monetary Fund (IMF) included it in the basket of major currencies that determines the value of Special Drawing Rights (SDR) – the IMFs global reserve asset.
Since then, however, the yuans progress has stalled.
Its share of international payments has fallen below 2 per cent, and the share of global foreign-exchange reserves held in yuan-denominated assets seems to have plateaued at about 2 per cent.
Earlier this year, China rolled out a central bank digital currency, making it one of the first major economies to do so.
Trials of the so-called Digital Currency/Electronic Payment (DCEP) have started in four cities, and the government recently announced plans to expand the tests to major metropolises such as Beijing and Tianjin, as well as Hong Kong and Macau.
But the DCEP on its own will not be a game changer that elevates the yuans role in international finance.
True, China has leapfrogged the United States (US) and other advanced economies in the technological sophistication of its retail payment systems. It seems plausible, therefore, that the digital yuan will give China an edge in the competition for global financial market dominance.
CAN IT REALLY BE A GAME CHANGER?
But the reality is more sobering.
The DCEP will initially be usable only for payments within China, although this could change over time. For all the hype about the new digital currency, Chinas Cross-Border Interbank Payment System, introduced in 2015, is a more important innovation that makes it easier to use the yuan for international transactions.
This payment system is also able to bypass the Western-dominated SWIFT system for international payments and thus circumvent US financial sanctions, a tempting prospect for many governments.
Russia – or, for that matter, Iran and Venezuela – will now find it easier to be paid in yuan for their oil exports to China.
As the yuan becomes more widely used, other smaller and developing countries that have strong trade and financial links with China might start to invoice and settle their transactions directly in that currency.
The DCEP could eventually be linked up to the cross-border payments system, further digitising international payments.
Still, the DCEP by itself will make little difference to whether foreign investors regard the yuan as a reserve currency.
After all, the Chinese government still restricts capital inflows and outflows, and the Peoples Bank of China (PBOC) still manages the yuans exchange rate. Neither policy is likely to change significantly anytime soon.
A SAFE HAVEN CURRENCY?
Yuan boosters will point out that the government has eased restrictions on capital flows and signalled its intention eventually to open the capital account fully, and that the PBOC has pledged to reduce its currency interventions and let market forces have their way.
But whenever shifts in capital flows put significant pressure on the yuan, the government invariably reverts to command-and-control mode and tightens capital controls and exchange-rate management.
Foreign investors, including central banks, will therefore remain sceptical about the prospect of unfettered capital flows at market driven exchange rates.
In any event, foreign and domestic investors are unlikely to view the yuan as a safe haven currency in times of global financial turmoil. That requires trust, which is fostered by adherence to the rule of law and well-established checks and balances in the political system.
Some argue that the rule of law does exist in China, and that the countrys one-party system of government contains enough self-correcting mechanisms to prevent policymakers from running amok.