Will China's Yuan Rival the Dollar?

The Wall Street Journal/ Eswar Prasad

The Chinese currency invariably provokes overwrought reactions. One view is that it will soon knock the dollar off its pedestal as the dominant global reserve currency. The other is that China is creating enormous risks by letting capital account liberalization get ahead of domestic reforms.

The reality is far more nuanced than much of the overblown rhetoric suggests. As with many other reforms, China is breaking the mold with a pragmatic, selective and controlled approach that I call capital account liberalization with Chinese characteristics.

Irrespective of government policies, China's capital account is becoming more open over time as rising trade and financial integration create more channels for getting around capital controls. Rather than resisting the inevitable, the government has embraced gradual change, relaxing but not eliminating controls on both inflows and outflows. The objective is full convertibility, unrestricted capital flows but with some "soft" administrative controls and regulatory oversight, rather than free convertibility with minimal restrictions.

The government is also positioning its currency for a broader role in global trade and finance. Hong Kong provides the ideal testing ground for putting the yuan in play through trade settlement transactions as well as yuan-denominated deposits and bonds. Some central banks have signed currency swaps with China's central bank and begun adding yuan to their foreign exchange reserve portfolios. Thus, given its sheer economic heft, China is successfully promoting the yuan's international use without fully opening up the capital account or allowing the currency to float.

An international currency does not guarantee reserve currency status, however. For that, an open capital account and a flexible exchange rate are essential. But even that is not sufficient.  More >>