Can Yuan replace US Dollar?

Tue, 20 Mar Pre-Open

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US dollar has been the official world reserve currency since World War II. During the world war US supplied arms and ammunitions to various countries and accumulated huge gold reserves. Having a substantial amount of world gold reserves made US dollar a fungible currency. Countries did not fear accumulating US dollars as Federal Reserve (Fed) was ready to convert them into gold whenever required. This gave the US dollar a status of an anchor/reserve currency, backed by huge gold reserves. However, the subsequent money printing exercise by Federal Reserve (Fed) resulted into huge influx of US dollars into the system. With gold reserves not increasing at the same pace the reserve currency status of the US dollar came under threat.

However, by that time US had already emerged as a super power. It was in a position to dictate trade terms with its neighboring countries. And in order to maintain its reserve currency status it eyed oil, a crucial commodity of world trade. It may be noted that US supplies arms to Organization of Petroleum Exporting (OPEC) countries. Hence, the OPEC countries are dependent on US to meet their defence obligations. Taking the advantage of this dependency factor US convinced OPEC nations to trade oil in dollars and thus saved its currency from losing the reserve status. The only difference being now there was no official backing of gold reserves but unofficial oil demand that helped greenback maintain its reserve status.

So, can US dollar ever be dethroned of its reserve status? Well, it can if the International Monetary Fund (IMF) is to be believed. As per IMF, Chinese Yuan has the potential to become world reserve currency in future provided the dragon nation undertakes a set of reforms. Migration to a flexible exchange rate system is one of them. But that would sacrifice the competitiveness of Chinese exports. And right now, China's exports are artificially competitive due to the currency peg. Removing the peg can impact the export demand and thereby the currency demand as well. Thus, the reform road map is not as straightforward as anticipated.

Lastly, it must be noted that replacing US dollar as reserve currency can spell disaster for the US economy. The world demand for dollars would decline significantly and the money printing exercise of Fed can come to a halt. This could mean a pro-longed recessionary environment in the US. It could also impact the debt servicing capability of US as it would have to earn reserve currency (via exports) to make payments as against just printing the same which is the case now. So, US through political weightage will strongly oppose for a switch in the reserve currency, if any. And being the most powerful nation on the earth it has the will and fire power to do that. Remember, Saddam Hussain?