It may not be mathematically possible according to the International Monetary Fund, IMF. There are about $11.5 trillion in foreign exchange reserves (forex) in the world.
A foreign exchange reserve is an asset held by a country’s central bank usually in the form of a sovereign bond (like a U.S. Treasury) or bank notes. Of those $11.5 trillion, $6.6 trillion are allocated reserves of which about $4.2 trillion are in U.S. dollars. That means the U.S. dollar accounts for over 60% of all allocated currency holdings! China is barely a grain of sand in the forex markets and, while that may change going forward with its status as a global IMF currency, it will be decades upon decades until it can surge to overtake the U.S. dollar.
But here is where the mathematical impossibility may come in. The U.S. towers over all other countries in terms of foreign reserves because the U.S. has the most available currency assets to trade. The U.S. has about $13 trillion tradeable U.S. Treasuries out there, which foreign central banks love to own because it’s the safest, most liquid debt in the marketplace.
For the Chinesse yuan to overtake the U.S. dollar, it would mean that enough yuan and “tradeable Chinese securities” have to be available in the marketplace for central banks to buy it. That is simply not the case today because there is only around $1.5 trillion in Chinese government debt. Even if central banks wanted to ditch all their dollars for yuan (which they absolutely don’t), it would not be possible because there are not enough yuan to go around.
As of right now, the yuan is only convertible into six currencies: the U.S. dollar, the yen, euros, British pounds, Russian rubles, and Australian dollars. If someone in Mexico wants to buy goods direct from China, they have to convert their pesos to dollars in order to make the purchase.
If the Chinese yuan is going to become the top currency in the world, it has a mountain of currency agreements to make first. This will not happen overnight because capital controls by the Chinese government make capital difficult to access in China. China has scores of regulations for how foreigners can invest, who can participate in the Chinese stock markets and how the Chinese yuan’s exchange rates are set.
Additionally, Chinese state debt is not necessarily available for purchase from any central bank because it is regulated. Capital controls of this scale are not conducive for being at the center of the global marketplace. China needs fairly radical change before achieving that designation, which could take decades if it even occurs at all.
Inclusion of the yuan into the International Monetary Fund’s ‘Special Drawing Rights’ basket is simply an acknowledgement of China as a legitimate player on the global economic scale. It reflects recognition that China has developed to the point where it deserves a seat at the ‘global capital markets’ table. For now, though, the U.S. dollar reigns supreme. The weights for the IMF’s drawing basket will be: 41.73% for the U.S. dollar; 30.93% for the euro; 10.92% for the Chinese yuan; 8.33% for the Japanese yen, and 8.09% for the British pound.
Investors need not fear China’s increased participation in global capital markets, nor should anyone read too much into what this means for the dollar. As long as the U.S. remains the largest, most diverse and most sophisticated economy in the world, the U.S. dollar will be the most important currency in the world.
SUPPLEMENTAL SOURCE: ZACKS INVESTMENT MANAGEMENT DECEMBER 13, 2015