Will the Chinese Renminbi Replace the U.S. Dollar as the World's Favored Reserve Currency?

As China's economic development has progressed by leaps and bounds many have, time and again over the years, wondered just how far it would go, how fast. Much of the talk has been pessimistic, ever predicting the stagnation or even collapse of China (George Friedman, for example, back in 2009's The Next 100 Years, picturing this happening in the '10s). However, others have been more bullish, anticipating China's ascent to a position of world economic leadership, and even speculating in detail about its achieving particular milestones along such a trajectory at particular points. Naturally they have raised the question of whether the Chinese currency (the renminbi, or yuan) will replace the American dollar as the world's favored reserve currency--and the chatter about this prospect appearing to be picking up yet again these days.

Considering this it seems worth looking to past precedent. The modern era has seen a succession of global reserve currencies, though the most recent and most relevant examples would seem to be the U.S. dollar post-1945, and before it the British pound sterling. In each case the country in question was, at the moment of its currency's rise to that status, the world's largest economy by a long way, with this reflecting a "full-spectrum" superiority by a significant margin. That included the country's being the world's leading manufacturing power, not just in terms of aggregate output but in pushing forward the "production frontier," and the leading financial power as well, because of what it meant for the strength of the economy whose currency they would be holding, and what its policies seemed likely to be.

As it happens China is the world's largest economy when measured in Purchasing Power Parity-adjusted terms--but not by very much (perhaps a fifth larger than the U.S.), while in nominal terms it remains well behind the U.S. (about three-quarters as big as the U.S.). If "number one" it is so only imperfectly, with this underlined by the gap between the PPP and nominal calculations. As these remind one, China is not the technological and commercial leader of the advanced industrialized world, or even an advanced industrialized country, but still a developing nation in which the super-city of Shanghai looks "First World," but much of the country remains in the "Third"--making progress that by the standards of the rest of the world is enviable, but not all the way there.

One sees all this confirmed not only in China's per capita income (still just a third or even just a quarter that of the high income states, depending, again, on whether one goes by PPP-adjusted or nominal), but China's manufacturing output when approached in the same manner. China is, beyond doubt, the world's largest manufacturer, with an output approaching twice that of the U.S.. However, in per capita terms it is again less impressive, with China's output just 70 percent or so of the least industrialized member of the Group of Seven nations, Britain, while being not much more than two-fifths of U.S. output, and a third that of Japan--with this partly a matter of its still playing "catch-up" in critical areas like machine tools and microchips.

Again, the result is that if China is "number one" in manufacturing it is only in a fairly qualified way, while it is far from being number one in the financial realm by any measure. Where Chinese holdings of financial assets were concerned in 2021 the country commanded about a fourth of the global proportion of the U.S. according to the latest Allianz Global Wealth Report, while the data from the Organization for Economic Cooperation and Development (OECD) indicates that it is the same with the country's "inward" and "outward" stocks of foreign investment (what others hold inside China, what Chinese investors hold outside their country)--China's profile, again, about one-fourth that of the U.S. here.*

Moreover, the difference between China's position in manufacturing, and its position in finance, themselves matter. They mean that relative to the country's output and income manufacturing is that much greater, finance that much smaller, a factor than in the case of the U.S. (where the ratio of financial assets-to-GDP is three times what it is in China's case). And it has its reflection in policymaking, monetary policy included. Manufacturing-minded nations favor an undervalued currency for the sake of making their exports more attractive (and imports less attractive), finance-minded nations a "strong" currency for the sake of attracting foreign savings and advantaging their own investors in relation to others abroad--and so has it gone with the U.S. and China. And that matter of a currency's strength counts greatly in the minds of others when they decide which currency they want to hold--to the advantage of the U.S., and the disadvantage of China.

The result is that, to go by the precedents of Britain and the U.S., China--a developing nation, whose financial rise, as is usually the case, is lagging an industrial ascent that is itself incomplete in key ways--remains a long way from being the kind of all-sided superpower, and especially the financial superpower, whose currency is a natural for the rest of the world's reserves when one looks at the hard economic facts--and the orientation of its policy that goes with them. Moreover, with China's economic slowdown these past many years, and the headwinds its continued progress faces in the coming years (from trade war with the U.S. to demographic slowdown to the pandemic's raging through the country now with uncertain outcome) it is far from being a foregone conclusion that it will become such a power within any meaningful time frame.

Moreover, China's attractiveness does not become much clearer when one looks to other, less quantifiable factors. These states were, again, attractive because of their economic might and weight. However, there was also what that comparative prosperity and strength gave them--the stability of their position in the world, and at home, and confidence on the part of others that their policies would be predictable. Certainly the U.S. looked like an island of such power and stability to investors the world over after 1945, with Eurasia in ruins and opposition to empires, and to capitalism, on the march everywhere; while amid the turmoil of post-Napoleonic Europe Britain similarly looked like an island of stability. (Even if less than perfectly quiescent, just compare its record of internal unrest with the succession of revolutions, uprisings, and other such episodes in the then-second economic power in the Western world, France, over 1830-1873.)

China's situation here is, again, more questionable. There is the uncertainty about China's ability to defend its interests amid global stresses--and, able or not, what it would mean to hold China's currency in a world where the trade war against it has been escalating and spreading for years (reaching a new height with the U.S. enlisting Japan and the Netherlands in its campaign to curb export of essential chip-making equipment to China). Even were one somehow to discount such realities there is also the combination of its half-developed state, with all its implications for stability (looming the larger with even the oldest, richest democracies themselves looking less stable), and leeriness on the part of investors about its statist economic model, under a government whose nominally Communist character may bother some more now than it did before to go by the ferocity of the denunciations of an ideology so many had recently treated as unquestionably relegated to the dustbin of history forever, and the more general unraveling of the blithe optimism about "globalization" that prevailed for so long.

Indeed, it is not for nothing that the last great change in the world's reserve currency occurred with the resolution of the conflict over the international order, not before such a conflict, such as so many fear we are headed for now (the Bretton Woods Agreement concluded in July 1944, not in the 1930s).

The result is that the world will likely go on favoring the dollar for a long time to come--albeit with a not insignificant qualification, namely that China's desire to see other states hold more of its currency seen in 2022's Renminbi Liquidity Arrangement, the amenability of those economies most closely linked to its own to doing so, and the way in which geopolitical tensions are further fracturing a damaged world-economic system (e.g. the sanctions the U.S. has applied to Russia), will encourage some to hold more renminbi. However, this will be in spite of, rather than because of, the factors discussed here, and seems unlikely to threaten the dollar's dominance any time soon, the more in as that dominance remains so great. The dollar as yet used for 87 percent of international transactions, as against the 3 percent in which the renminbi is used, underlining what a long way both currencies would have to shift in relation to each other for the Chinese currency to become the foundation of global reserves.

* As of the end of 2021 the stock of inward Foreign Direct Investment in the U.S. amounted to $13.6 trillion, versus $3.6 trillion for China according to the OECD. The stock of outward investment was $9.8 trillion in the U.S. case, and $2.6 trillion in the Chinese case.